Middle Market Transaction Update Winter 2025
Middle market M&A activity rebounded in the third quarter of 2025, although year-to-date activity remains depressed compared to prior-year levels.
Services
The valuation advisory & opinions and financial advisory service lines are interrelated. The technical discipline of providing well-grounded valuation opinions is buttressed by real world experience gained in providing advisory services. Likewise, the market-centered orientation of financial advisory services has as its foundation a keen understanding of valuation drivers.
Services
Independent Valuation and Advisory Expertise.
Corporate Valuation
Mercer Capital’s ability to understand and determine the value of a company has been the cornerstone of the firm’s services and its core expertise since its founding.
Financial Reporting Valuation
In an environment of complex fair value reporting standards and burgeoning regulatory scrutiny, Mercer Capital helps clients resolve financial reporting valuation issues successfully.
Transaction Advisory
Mercer Capital provides investment banking, transaction advisory, and restructuring services to a broad range of public and private companies and financial institutions.
Litigation & Dispute Resolution
Complex commercial litigation requires the insight of experienced professionals who understand the practical application of traditional and emerging financial theories.
Family Business Advisory Services
Mercer Capital helps family business leaders navigate complex financial, governance, and shareholder issues with clarity and confidence.
Senior Professionals
Insights
Thought leadership that informs better decisions — articles, whitepapers, research, webinars, and more from the Mercer Capital team.
Being Ready for an Unsolicited Offer
Preparedness is often mistaken for “getting ready to sell.” In reality, it is a governance discipline, one that gives families clarity about what the business means to them, how decisions will be made under pressure, and whether opportunities will be evaluated thoughtfully rather than reactively.
The Third Appraiser Isn’t There to Split the Difference
For many family businesses, valuation is treated as a one-time event rather than an ongoing tool. When viewed only at moments of necessity, valuation can create surprises, tension, and misalignment. Directors who treat valuation as a continuous process, however, use it to support better governance, promoting clear communication and more informed decision-making over time.
Valuation Is a Process, Not an Event
For many family businesses, valuation is treated as a one-time event rather than an ongoing tool. When viewed only at moments of necessity, valuation can create surprises, tension, and misalignment. Directors who treat valuation as a continuous process, however, use it to support better governance, promoting clear communication and more informed decision-making over time.
What Are You Prioritizing in 2026?
As the new year begins, family business boards have an opportunity to reflect on the often-unspoken priorities that shape their strategic finance decisions. This post explores four key “matched pairs” of priorities—optionality vs. conviction, growth vs. resilience, reinvestment vs. liquidity, and concentration vs. diversification—where misalignment can create tension and confusion. Entering 2026 with clarity and open dialogue about these tradeoffs can be one of a family business’s most valuable strategic assets.
Top 12 Family Business Director Blog Posts of 2025
Over the past year, we shared posts exploring the issues that matter most to family enterprises, from capital allocation and liquidity to governance, leadership, and long-term stewardship. Together, they reflect both the complexity and the joy of guiding a family business across generations. In this post we look back at some of the most impactful Family Business Director blog posts from 2025, with brief summaries and links to revisit (or discover) each one.
Compensation Questions: Staying True to Your “True North” in an Era of Volatility
Macro-economic volatility has put pressure on compensation programs that depend on accurate goal-setting and stable growth, affecting executive morale and jeopardizing talent retention. Ultimately, the family-owned companies that best weather this uncertainty consider pay adjustments within the broader context of family shareholder and business needs.
Making it Through December
As each year draws to a close, family business directors naturally assess how the business performed and the firm’s profitability over the course of the year. For some, profitability was assured months ago. For others, it remains uncertain whether they will make it through December without incurring a loss for the year.
Fair Value of Contingent Consideration (Earn-Outs) in M&A
Financial Reporting Flash: Issue 3, 2025
Contingent consideration, often structured as earn-outs, helps buyers and sellers in M&A transactions navigate differing views on price. Under accounting rules, these arrangements must be measured at fair value on the acquisition date, with potential remeasurements in future periods. Analytical approaches vary depending on the payout structure, underlying metrics, and risk characteristics. Careful attention to structure, modeling approach, and documentation of key assumptions is essential for financial reporting.
100 Pounds of Popcorn and the Lessons of Family Enterprise
To be frank, we find most “business books” to be boring, earnest attempts to render the blindingly obvious as unique insight and the banal as profound. So, when asked about our favorite business books, we don’t hesitate to recommend Hazel Krantz’s 100 Pounds of Popcorn, a children’s book published in 1961 and now, sadly, out of print. Three siblings stumble upon a mysterious 100-pound bag of popcorn in the road. What starts as a curiosity quickly becomes an adventure in decision-making, cooperation, and the sometimes-messy economics of running a tiny enterprise.
The Long Run: Gratitude, Trust, and Legacy in Family Business
As we head into Thanksgiving, I encourage family business leaders to take a moment and reflect on who makes your success possible; recognize those contributions in tangible ways; reinvest in the community that supports you; and reaffirm the shared values that unite your family and your enterprise.
Dividends as Dialogue
Using Policy to Communicate & Align Across Generations
Dividends communicate more than cash flow. In family businesses, dividend policy is not merely a financial decision.
Capital Budgeting in 5 Minutes
In this video, Travis Harms provides a concise overview of the key elements of the capital budgeting cycle, highlighting some common missteps along the way.
Insights from Brown Brothers Harriman’s 2025 Private Business Owner Survey
Succession Planning Is a Persistent Challenge: While a majority of family business owners recognize the importance of succession, only 23% have a fully implemented plan.
Capital Budgeting in 30 Minutes
A Guide for Family Business Directors and Shareholders
This latest guide continues our mission to help family business directors navigate complex financial concepts with clarity and confidence. Capital budgeting decisions—those that determine which projects a company should invest in—are among the most consequential choices a board can make. “Do-overs” are expensive, and understanding how to evaluate potential investments is critical to preserving and enhancing shareholder value.
When Family Mission Meets Family Business
Aligning Purpose and Prosperity
Mission statements articulate why the family exists. Understanding the economic meaning of the business clarifies how the enterprise sustains that mission.
5 Things to Know About Selling Your Business to Private Equity
We recently read a fantastic post on the Altair Advisers' blog, "Words on Wealth," by Jason M. Laurie, Managing Director and Chief Investment Officer. The post addresses five things that founders wish someone had told them before selling their businesses to private equity firms. We thank Jason for allowing us to share the post with our readers.
Navigating the Sale of Your Family Business
Lessons from the Auction Block
Selling a family business is a deeply personal and strategic endeavor, much like auctioning a rare and storied object.
Beyond the Balance Sheet: Four Strategic Questions for Family Business Directors
Understanding your family business’s asset base is more than a financial exercise; it is a strategic responsibility. By asking the right questions about cash, working capital, capital investments, and what truly drives value, directors can shift the conversation from what the business owns to why it owns it.
The Family Business Director To-Do List: Shareholder Liquidity
For this week’s post, we put together a to-do list that includes important tasks for family business directors to complete whether planning for a one-time share redemption or establishing a family shareholder liquidity program.
A Valuable New Resource: The UHNW Institute’s “Wealthesaurus”
Without common definitions, conversations can quickly veer off track. That’s why we were intrigued to discover a new resource from the UHNW Institute: the Wealthesaurus.
Navigating Buy-Sell Agreements Part II
Three Examples Where Independent Appraisers Make the Difference
In this post, we examine three compelling reasons why engaging an independent appraiser is essential in these scenarios, with practical examples tailored to the dynamics of private family businesses.
Navigating Private Company Valuations
When and Why to Use an Independent Appraiser
An independent appraisal, also known as a business valuation, provides an unbiased assessment of a private company’s fair market value, conducted by a skilled and impartial expert or firm. This process generates an objective valuation by drawing on financial information, market trends, and other relevant factors in order to effectively eliminate the distortions that can arise from in-house valuations. For private business owners and directors, this independence can provide peace of mind when making key financial and strategic decisions.
Rollover Equity in Private Equity Transactions
Rollover equity has become a defining feature of U.S. middle-market private equity transactions, offering sellers a blend of immediate liquidity and future upside while helping buyers bridge financing gaps and align incentives. As its use continues to rise, careful attention to valuation, capital structure, and exit dynamics is critical to understanding the true economic impact of a “second bite of the apple.”
Middle Market Transaction Update Fall 2025
Middle market M&A activity rebounded in the second quarter of 2025, although year-to-date activity remains depressed compared to prior-year levels.
Navigating Buy-Sell Agreements: Part 1
Buy-sell agreements aren’t set-it-and-forget-it documents; they evolve with your business and family.
Video: Dividend Policy in 5 Minutes
Travis Harms explains how to go about the decision-making process regarding distribution and why considering various shareholder characteristics and business attributes matters.
Stock Buybacks at Record Highs
What’s the Lesson for Family Businesses?
Family businesses face unique challenges in executing share redemptions.
Dividend Policy in 30 Minutes
A Guide for Family Business Directors and Shareholders
The purpose of this booklet is to help family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction. We hope this provides a helpful resource for you and your fellow directors and shareholders.
Value Matters® August 2025
Navigating Business Valuations During Active M&A Processes
Critical Considerations for Estate PlannersExecutive SummaryThis article summarizes Mercer Capital’s newest whitepaper, Valuing a Business for Estate Planning Purposes During a Transaction, which addresses the complex intersection of business valuations and estate planning when M&A processes are underway.Estate planning for business owners becomes much more complicated when a merger or acquisition process is underway. IRS guidance suggests requirements that business valuations for transfer tax purposes must consider all knowable facts as of the valuation date—including pending transaction processes. This creates both opportunities and risks for estate planners working with clients who own businesses actively engaged in sale discussions.The challenge lies in determining how much weight to assign to potential deal proceeds versus traditional standalone valuations at different stages of the M&A process. While early-stage processes may warrant minimal consideration of transaction value, later stages with formal offers require greater weighting of expected proceeds. Understanding the nuances of an engagement of this type is essential for avoiding costly mistakes and ensuring credible valuations that optimize estate planning outcomes.The intersection of business transactions and estate planning presents one of the most complex challenges in wealth transfer strategies. When business owners—whose enterprises often represent the majority of their wealth—simultaneously pursue exit opportunities and engage in estate planning, the valuation considerations become particularly intricate and consequential.IRS Chief Counsel Advice 202152018In Chief Counsel Advice 202152018 (“CCA 202152018”), the IRS addressed two issues in the context of a business owner who funded a GRAT during an active sale process. First, it considered whether hypothetical willing buyers and sellers would take into account a pending merger when valuing stock for gift tax purposes. The Service answered affirmatively: under the fair market value standard, known or knowable facts—including an ongoing sale process and offers already received—must be incorporated into valuation. Second, the IRS considered whether the donor retained a “qualified annuity interest” under §2702 when the GRAT was funded using a stale §409A appraisal that ignored the pending merger. The Service held that the retained interest failed to qualify, treating the entire transfer to the GRAT as a taxable gift.The facts of the case reveal a pattern of valuation inconsistencies. The taxpayer used a seven-month-old §409A appraisal—prepared for deferred compensation purposes, not transfer tax purposes—to support the GRAT funding, even though multiple offers had already been received at higher prices. Shortly thereafter, however, the same taxpayer funded a charitable remainder trust using a contemporaneous qualified appraisal that reflected the higher offer price. This inconsistency, coupled with reliance on an outdated and contextually inappropriate appraisal, invited IRS scrutiny and resulted in the Service’s determination that the GRAT was fatally flawed.While CCAs do not carry precedential weight, they are instructive of how the IRS is likely to approach similar fact patterns. CCA 202152018 signals heightened IRS vigilance where GRATs or other transfer tax strategies are executed amidst an ongoing or foreseeable liquidity event. It highlights the necessity of contemporaneous, purpose-appropriate appraisals that consider all relevant facts at the valuation date. Failure to do so risks not only valuation adjustments but also possible disqualification of retained interests under §2702, leading to the result of treating the entire transfer as a taxable gift.Understanding the M&A Process FrameworkTo properly value businesses during transaction processes, estate planners must understand the typical stages of mergers and acquisitions. The process generally unfolds through six distinct phases, each presenting different levels of transaction certainty and information availability.During the planning phase, when owners hire M&A advisors and organize information, there may be little quantifiable expectation of proceeds. However, once confidential information memorandums are distributed to potential buyers, expectations around selling prices become clearer. As the process progresses through qualification phases with indications of interest, buyer selection with letters of intent, due diligence, and final negotiations, the probability of completion and the certainty of proceed size generally increase.The critical insight for estate planners is that valuation weight should shift toward transaction proceeds as deal certainty increases. A business in early marketing phases might warrant only modest consideration of potential proceeds, while a company with binding letters of intent is more likely to merit substantial weighting of expected transaction value.Market Reality of Deal Success and FailureUnderstanding transaction success rates provides crucial context for valuation decisions. In a McKinsey & Company analysis of over 2,500 large deals valued above €1 billion, approximately 10.5% of deals were canceled, with larger transactions facing higher failure risks. Deals exceeding €10 billion experienced cancellation rates above 20%, while those under €5 billion maintained consistent 10% annual cancellation rates.In this analysis, industry factors significantly impacted success probability. Energy and financial sector deals showed the lowest cancellation rates at around 7%, while consumer discretionary and communications services faced higher failure rates of 13% and 19% respectively. Nearly 75% of canceled deals failed due to price expectations, regulatory concerns, or political issues.However, these statistics apply primarily to publicly announced transactions, making them most relevant for closely held companies in later deal stages. Earlier-phase failures often remain private, suggesting estate planners should shift weight toward no-sale scenarios when businesses are in preliminary transaction stages.Critical Success FactorsSeveral factors influence deal completion probability and should inform valuation weightings. Expected deal timelines matter significantly—longer processes face higher failure rates. Deal structure complexity creates additional risk, as mixed cash-and-stock transactions prove less successful than simpler all-cash or all-stock arrangements.The number and quality of bidders affect completion likelihood. Multiple interested parties provide fallback options, though this dynamic can shift if secondary bidders lose interest. More sophisticated bidders, such as private equity firms or strategic acquirers with dedicated M&A teams, typically conduct more thorough early evaluation but also identify issues that might derail transactions.External factors including economic conditions, political stability, and regulatory environment all influence completion probability. Companies with clean financial records, predictable cash flows, and minimal discretionary items in recent results face higher completion probabilities due to reduced due diligence risks.The Levels of ValueBusiness owners and their professional advisors are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in the figure below, there are three basic “levels” of value for a business.Estate planning transfers typically involve minority interests valued at the nonmarketable minority level, which may incorporate discounts for lack of control and marketability. In contrast, M&A transactions occur at control levels and may include strategic premiums for synergies.This creates significant value gaps. A business with $100 per share marketable minority value might be valued at $65 per share for estate planning purposes after appropriate discounts. However, strategic buyers might pay $130 per share, creating a substantial differential between transfer values and transaction proceeds.Understanding Deal ProceedsExpected transaction proceeds require careful analysis beyond headline multiples. Deal terms may include earnouts, contingent payments, or non-cash consideration that should be risk-adjusted and converted to cash equivalency. The proposed transaction could trigger corporate-level taxes that would need to be considered in valuing an equity interest. A transaction appearing to price at 12x EBITDA might only deliver 9x value on a cash-equivalent basis after considering payment timing, corporate taxes, and performance risks.Practical Application FrameworkEstate planners working with businesses in transaction processes should expect valuation frameworks that appropriately weight no-sale scenarios against expected proceeds based on process stage and specific circumstances.As transaction processes progress through marketing phases with distributed information memorandums, modest weighting of expected proceeds becomes appropriate, though determining precise allocations requires careful analysis of company-specific factors and buyer interest levels.Once formal indications of interest are received, increasing weight is likely to shift toward transaction proceeds, with the specific allocation depending on offer quality, buyer sophistication, and deal structure. By the time binding letters of intent are executed, substantial weighting of expected proceeds is typically warranted, though some consideration of failure scenarios remains appropriate until closing occurs.Compliance and Documentation RequirementsThe IRS guidance emphasizes that valuations should ideally use valuation dates matching transfer dates and consider all knowable facts. Using outdated appraisals prepared for other purposes creates significant compliance risks, particularly when those appraisals ignore ongoing transaction processes. Business appraisers should document their consideration of transaction processes and provide clear rationale for their weighting decisions.Strategic Implications for Estate PlanningUnderstanding these dynamics enables more effective estate planning strategies. Business owners contemplating both exit strategies and wealth transfer can time their planning to optimize valuations while maintaining compliance. Earlier transfers in transaction processes may capture lower valuations, though this must be balanced against deal completion risks and the potential for significant value increases.The complexity of these valuations underscores the importance of engaging qualified professionals who understand both IRS transfer tax requirements and M&A market dynamics. Estate planners need valuation specialists who can navigate the technical requirements while providing credible opinions that optimize client outcomes.ConclusionThe intersection of business transactions and estate planning presents both opportunities and pitfalls for wealth transfer strategies.Success in this complex environment requires understanding M&A process stages, deal success factors, valuation methodologies, and compliance requirements. Estate planners who understand these concepts can help business owners navigate simultaneous exit and wealth transfer strategies while avoiding the costly mistakes that have drawn IRS scrutiny.The stakes are significant—business interests often represent the majority of owner wealth, making proper valuation essential for effective estate planning. With careful planning, appropriate professional guidance, and an understanding of regulatory guidance, these complex situations can be managed successfully to achieve both transaction and estate planning objectives.With 40+ years of transfer tax valuation and M&A experience, Mercer Capital understands the complexities that arise when business transactions intersect with estate planning objectives. Our team of credentialed professionals has worked with numerous clients through these challenging scenarios, providing the expertise necessary for these engagements.For estate planners seeking experienced partners who can navigate the intricate requirements of valuing businesses during active transaction processes, Mercer Capital offers the depth of experience and technical proficiency that these engagements demand.
The 2025 Family Business Benchmarking Study
Family business directors are best served by assessing financial performance on both an absolute and a relative basis.
The Family Business Benchmarking Study
Family business directors are best served by assessing financial performance on both an absolute and a relative basis. Absolute financial performance can simply be read off the face of the financial statements, but making appropriate relative comparisons requires reliable data on similarly situated firms.Benchmarking data typically focuses on financial performance but provides little perspective on the strategic financial decisions that can have a major influence on the sustainability of the family business.Family business directors generally have little perspective on how other companies handle certain items like capital allocation, capital structure, and dividend policy. With the release of our Family Business Benchmarking Study, we aim to fill that gap.Each section includes both data analysis and insights to help family business directors interpret the findings and apply them to strategic decisions.
3 Strategic Financial Questions for Family Businesses
Our family business advisory practice is focused on three strategic financial questions that weigh on family business directors.
Kellogg Shareholders Complete the Cash-In
The Kellogg story offers family business directors and managers plenty of food for thought.
Private Equity and Family Business
A Complicated Relationship
If private equity and family business had a relationship status on social media, it would undoubtedly be “It’s Complicated.”
Financial vs. Strategic Buyers
Understanding the differences between financial and strategic buyers is critical when selling a business. While financial buyers focus on cash flow, leverage, and exit returns, strategic buyers evaluate how an acquisition fits into their long-term plans and may pay premiums for synergies. The right buyer ultimately depends on the seller’s goals—whether maximizing price, preserving employees, or remaining involved post-transaction.
2025’s Halftime Performance
When it comes to investor sentiment, 2025 has been a tale of two very different quarters.
Middle Market Transaction Update Summer 2025
Middle market M&A activity remained muted in the first quarter of 2025, with political and economic uncertainty weighing heavily on the market.
March 2000 vs. June 2024: How Different Is It?
We at Mercer Capital do not know which way markets will go in the coming quarters and years, but we can speculate. Mercer Capital does know bank valuation and transaction advisory.
How to Sell Your Family Business
Selling a business is a three-step process. In reality, each of the phases overlaps to some degree, making the process more of a continuum than a finite set of procedures. A turnkey, orderly process typically requires four to six months. Ultimately, the collective team goal as a family business is to win the race, whether it be at the pace of the hare or the tortoise. In this week’s post, we take a deeper dive into those three phases and what that may look like for you and your family business when the time comes.
Review of Key Economic Indicators for Family Businesses
As we approach mid-year 2025, uncertainty in the U.S. economy remains elevated, making this a good time for family businesses to return to the fundamentals and review key macroeconomic indicators from the first quarter of 2025 and into the second quarter.
The Quest for Shareholder Alignment
At their best, multi-generation family businesses foster superior outcomes for shareholders, employees, customers, suppliers, and the communities in which they operate. Those are powerful incentives for maintaining family control of businesses across generations and through decades. Yet this remains the exception rather than the rule. Why? Enterprising families that are not aligned around key issues cannot expect to last.
Value Amidst Uncertainty
How Will Your Family Business Fare If a Recession Sets In?
The month is June 2025, the windows in the car are rolled down, and “School’s Out” by Alice Cooper is playing. Summer of 2025 is here, and it should be a hot one. Outside, of course, but what about the U.S. economy? In 2025, the S&P 500 is up roughly 1% to date, recovering from what was a 15% year-to-date decrease in early April.
Corporate Finance in 30 Minutes
A Guide for Family Business Directors and Shareholders
We put this piece together to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions. An informed and engaged shareholder base is the most important factor in preserving stability within the family business.
Video: Corporate Finance in 30 Minutes
A Guide for Family Business Directors and Shareholders
In this short video Travis Harms discusses three fundamental corporate finance questions that will help family business shareholders understand the basics of corporate finance and will ultimately result in more engaged and valuable shareholders.
Understanding Family Ownership Roles
In a Harvard Business Review article entitled “5 Kinds of Ownership Roles in a Family Business,” author Nick Di Loreto describes five types of family business owners based on what they are willing to commit to the business: capital, intellect, heart, time, and career.
Does Your Family Business Have More Than One Value?
It is understandably frustrating for family business directors when the simple question — what is our family business worth? — elicits a complicated answer. While we would certainly prefer to give a simple answer, the reality that a business valuation attempts to describe is not simple. The main reason is that this answer depends on why the question is being asked. We know that sounds suspect, but in this post, we demonstrate why it is not.
Market Volatility & Shareholder Liquidity
We make no predictions as to how long the elevated market volatility will persist. Some of the world’s wealthiest families are seeing opportunity in the chaos. What about yours?
Next Gen Up
The transition to the next generation has been one of the main impediments to family businesses trying to establish a multigenerational enterprise. For many family businesses, this transition can be rocky (and often unsuccessful) due to the next generation’s lack of exposure to the business and last-minute succession planning.
Middle Market Transaction Update Spring 2025
Middle market M&A activity rebounded in the fourth quarter of 2024, albeit, marginally, over the “summer slowdown” experienced in the third quarter of 2024.
Capital Budgeting and the Meaning of Your Family Business
When it comes to capital budgeting, deciding the “what” is often just as (or even more) difficult than the “how.” In other words, what types of capital projects should be going into your capital budgeting funnel?
Negotiating Net Working Capital Targets in a Transaction
Net working capital targets are among the most consequential—and often misunderstood—components of middle-market M&A negotiations. Because these targets directly affect purchase price adjustments at closing, buyers and sellers must carefully define, analyze, and negotiate working capital levels to ensure the transaction economics hold up beyond day one.
The Patience to Prevail, Revisited
We formerly wrote a post comparing the challenges presented in golf’s Open Championship to those of operating a family business in times of economic uncertainty. We highlight those challenges again in this week’s post for two reasons. With global financial markets in turmoil stemming from proposed retaliatory tariffs by the United States on effectively the rest of the world, it is more important than ever for family businesses to circle the wagons and turn their focus inward in an effort to respond to potential challenges from outside forces.
Dividend Policy & the Meaning of Your Family Business
Our multi-generation family business clients ask us about dividend policy more often than any other topic. This isn't surprising, since returns to family business shareholders come in only two forms: current income from dividends and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.
Basics of Financial Statement Analysis
A Guide for Private Company Directors and Shareholders
We are excited to offer our readers a physical version of our piece, “Basics of Financial Statements: A Guide for Private Company Directors and Shareholders.”
Crown Castle's Lessons for Family Businesses
Crown Castle’s divestiture of its Fiber segment offers plenty for family business directors to chew on. The story highlights the need for an integrated framework for directors to evaluate and monitor the key strategic finance decisions that influence family shareholder returns for the years and decades to come.
Why the Value of Your Family Business Matters
In this week’s post, we have compiled a selective list of reasons why it is essential for both family shareholders and family business directors to know what the family business is worth (even if the family has no intention of selling).
Succession Planning Options for RIAs
Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The industry’s demographics suggest that increased attention to succession planning is well warranted: a majority of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. While there is growing recognition of the importance of succession planning, it often lags far behind other strategic initiatives with more immediate benefits like new client and staff growth1. In the long run, however, firms with a well-developed succession plan have a distinct competitive advantage over those without. Fortunately, many viable options exist for RIA principals looking to solve succession planning issues. In this post, we review several of the more common options.Internal transition to the next generation of firm leadership. Internal transitions of ownership are the most common type of transaction for investment management firms and for good reason. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. A gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.Debt financing. Debt financing has become a readily available option for RIAs in recent years as the number of specialty lenders focusing on the sector has increased. External debt financing is often used to finance internal transactions as an alternative to seller financing. Such arrangements avoid introducing a new outside equity partner and can work well when the scope of succession issues to solve is limited to financing the transaction.There are potential drawbacks, however. For example, debt financing for RIAs typically requires a personal guarantee, which many borrowers oppose. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Sale to a consolidator or roll-up firm. RIA consolidators have emerged, promising a means for ownership transition, back-office efficiencies, and best practices coaching. The consolidator model has been gaining traction in the industry in recent years. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.For RIA principals looking for an exit plan, a sale to a consolidator typically provides the selling partners with substantial liquidity at closing, an ongoing interest in the firm’s economics, and a mechanism to transfer the sellers’ continued interest to the next generation of management. There’s a wide spectrum of consolidator models, and they can vary significantly in terms of their effect on the day-to-day operations of the acquired RIA. RIA owners considering selling to a consolidator should think carefully about which aspects of their business they feel strongly about and how those aspects of the business will change after the deal closes.Sale to a private equity firm. Drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model, private equity managers have sharpened their focus on investment management firms in recent years. Private equity can be used to buy out a retiring partner, but it is not typically a permanent solution. While PE firms provide upfront cash, remaining principals must sacrifice most of their control and potentially some of their ownership at closing.Minority financial investment. Minority financial investments can provide existing ownership with liquidity while allowing remaining shareholders to maintain control and an ongoing interest in the firm’s Minority investors typically do not intrude on the firm’s operations as much as other equity options, but they will seek deal terms that adequately protect their interest in future cash flows.Sale to a strategic buyer. A strategic buyer is likely another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. On paper, this scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees, clients, or the company’s identity.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.1 See https://content.schwab.com/web/retail/public/about-schwab/2024-Charles-Schwab-RIA-Benchmarking-Study.pdf
Back to Valuation Basics
Early in his career, our founder, Chris Mercer, considered six underlying financial, economic, logical, and psychological principles that provide a solid basis for considering valuation questions and issues. Each principle provides a way of looking at the world from a valuation perspective, and integrating the perspectives provides a logical framework to examine elements within business valuation.
The Most Efficient Way to Increase the Value of Your Family Business
Is it really true that a higher EBITDA margin will also bring a higher multiple, or were we just getting carried away with our own thesis?
Nissan’s Search for a Merger Partner
If you own or manage a Nissan dealership, you likely have questions about what the company’s next steps mean for your business. Many of these questions are prudent, as Nissan’s ongoing search for strategic partnerships could still have significant implications for dealers down the line. Below are the key factors that could shape the future for Nissan dealers.
RIA Valuations and How to Maximize Yours
This episode of the The Buyer’s Boardroom podcast discusses RIA valuation methods, misconceptions surrounding rule-of thumb measures, key value drivers, and the pros and cons associated with internal versus external sales of your business.
Is All EBITDA Created Equal?
In the world of family-owned and other private businesses, most everyone looks to EBITDA (earnings before interest, taxes, depreciation, and amortization) as an indicator of financial performance. Legendary investor Warren Buffett, however, holds a long-standing grudge against EBITDA. We believe there is a time and a place for EBITDA in financial analysis, but Mr. Buffett does have a point — some EBITDA is better than others. But why?
What Family Business Director Has Been Reading
Fresh off Super Bowl 2025 with no more football in sight, it’s time to pick up that book collecting dust on the shelf. To help ease you back into the routine of things as we head into the dog days of winter, here’s a quick roundup of what we have been reading.
Tariff Talk and Adaptive Forecasting
How Family Business Directors Can Stay Ahead of Unpredictable Times
For family business directors, it is critical to keep a pulse on current developments and understand the different implications that may impact or change their industry moving forward. Maintaining an adaptive forecast is one of the best practices for being able to pivot during unpredictable times.
Relative Total Shareholder Return Compensation
Financial Reporting Flash: Issue 2, 2025
Relative total shareholder return (TSR) has become a central metric in long-term incentive plans, particularly for aligning executive compensation with shareholder outcomes. As companies navigate market volatility and evolving governance standards, a clear understanding of relative TSR-based awards is essential for effective plan design and regulatory compliance.
What Does the RIA Valuation Process Entail?
For this week’s post, "What Does the RIA Valuation Process Entail?," we’ll channel our inner Nick Saban and focus on the process.
A New Approach for Business Succession Planning
While not “new” under the law, the use of purpose trusts for business succession planning became more prominent when Yvon Chouinard, founder of clothing company Patagonia, transferred ownership of the company to a purpose trust in September 2022.
Personal Goodwill: Implications for RIAs
Goodwill and the distinction between personal and enterprise goodwill can have important economic consequences in RIA transactions and disputes.
Winter M&A Update for Family Businesses
Middle market M&A activity in the third quarter of 2024 showed signs of the “summer slowdown,” as fewer PE deals were reported compared to the first two quarters of the year. However, as deal activity begins to revert to pre-2023 levels, the outlook for 2025 points to signs of optimism, while some hurdles remain on the horizon. In this week’s post, we look back at middle market (defined as total enterprise value of $100 - $500 million) transaction activity in 2024 and look ahead to what may be on the horizon for middle market M&A in 2025.
Three Considerations for Capital Projects
Capital budgeting tools are ideal for answering the question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting — no matter how sophisticated or quantitatively precise — cannot answer the second. To answer the second question, family business directors need to consider three qualitative questions identified in this post.
The Elements of a Quality Business Valuation: A Guide for Estate Planners
In the course of a business valuation practice, a business appraiser may either be involved in an examination of an opinion that they have issued or serve as a consulting expert to assist legal counsel in an opinion issued by an unaffiliated business appraiser.While an accepted-as-filed resolution of an independent and objective opinion of value for a federal tax matter is the desired outcome, an IRS examination also provides an opportunity for appraisers to critically evaluate their work, and, in so doing, strengthen future work product.As Mercer Capital is frequently requested to provide expert consulting services related to federal tax valuation matters under examination, this issue of Value Added® explores the elements of a quality valuation that increase the prospects of a favorable resolution of an examined matter, or the desired accepted-as-filed outcome at an initial reporting stage.Elements of a Quality ValuationQuality business valuations possess four common elements:Identification of the rights and benefits of the business interest being valued;Relevant and sufficient capital market evidence;Sound financial analysis; and,Effective reporting to the intended audience.Identification of the Rights & Benefits of the Business InterestFundamental to any sound valuation is a thorough understanding of the rights and benefits of the business interest being valued.Most often this involves a close review of the basic governance documents of the business such as corporate articles of incorporation and bylaws, partnership or limited liability operating agreements, buy/sell agreements, and additional legal documents that address the rights and benefits related of the subject business interest. Absent formal governance documents, relevant statutory provisions in the entity’s state of domicile provide this guidance. This guidance directs the appraiser as to the appropriate level of value for the assignment, i.e., controlling interest, minority interest or veto block interest.While it is not the role of the business appraiser to be the ultimate arbiter of the legal rights and benefits related to the interest, it is the responsibility of the appraiser to have as complete an understanding as they can of these defining attributes. In cases of ambiguous governance documents or situations of default to statutory provisions, assistance from legal counsel is warranted to provide legal direction as to the attributes of an interest.Once a complete understanding of the legal rights and benefits of the interest is gained, it is critical for the business appraiser to keep this understanding at hand throughout the appraisal process and report on this understanding in a concise and clear manner.Relevant and Sufficient Capital Market EvidenceA cornerstone of every sound opinion of value resides in the capital market evidence that is relied upon for its support. Relevancy and sufficiency are two essential concepts for consideration in evaluating capital market evidence.RelevanceThe relevance of capital market evidence is a key component of the valuation of interests in privately held businesses, as often there is a dearth of pertinent capital market evidence related to the interest being valued. This reality illustrates the inherent challenge associated with the valuation of privately held business interests; by definition financial and transactional information related to private businesses is most often not in the public domain. As a consequence, business appraisers frequently look to capital market evidence related to publicly traded businesses to find the capital market evidence necessary to support their opinion. Material differences between the subject business interest and the capital market evidence relied upon must be reconciled and explained.SufficiencySufficiency is the second core concept related to capital market evidence. The time-tested adage that “one sale does not make a market” certainly applies.Often, the business appraiser is faced with a scenario of capital market evidence of limited quantity. In such instances the appraiser should expand search parameters in order to obtain capital market evidence with similar investment risk attributes as the subject interest.A default to the opinion based on the personal experience of the appraiser without sufficient market evidence will be subject to intensive scrutiny, and quite likely, may be considered a failure of the opinion for its intended use.Sound Financial AnalysisThorough and sound financial analysis is crucial to any supportable valuation. The fundamental valuation principle is that the value of a business is a function of three components: (1) expected cash flows, (2) risk profile, and (3) growth prospects.Expected Cash FlowsIdentifying and estimating the expected cash flows of a business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business (a more exhaustive list of data and factors that should be considered is included in IRS Revenue Ruling 59-60).RiskAn evaluation of the risk profile of a business cannot be done without understanding the key drivers of the business. A business is subject to and impacted by a litany of factors including market risks, operational risks, and financial risks that must be evaluated.GrowthAn appraiser's assessment of growth prospects should consider growth due to market share, growth of the market, growth from profitability, and the sustainability of each.Business appraisers should conduct robust financial analyses and due diligence to evaluate these three components, and quality appraisals will provide sound and reasonable support for the concluded estimates of each.Effective Reporting to the Intended AudienceThe most important aspect of the valuation may well be how effectively the appraiser communicates to the intended audience of the valuation report.For federal transfer tax valuation matters, the intended audience consists of estate planning and tax attorneys as well as Internal Revenue Service trust & estate examining attorneys.For federal income tax matters the intended audience consists of tax attorneys, certified public accountants, enrolled agents and Internal Revenue Service agents, typically individuals with an accounting and tax background.As the readers of a valuation report may be more verbally rather than numerically oriented, a valuation report prepared for a transfer tax matter should be written in a communication style and structure that matches this orientation. In contrast, it may be more appropriate for reports prepared for income tax matters to have a quantitative tilt.ConclusionWhile the examination of a federal tax valuation matter can be a challenging exercise laden with complexity, past examination experience also provides opportunities to focus on the fundamentals of the valuation process that underlie a quality valuation.Adherence to the concepts presented in this article will improve the likelihood of accepted-as-filed outcomes as well as place the valuation work product in a position of strength in the event of an examination.At Mercer Capital, we diligently incorporate each of the four elements of quality valuations into our reports. To discuss your valuation need on a confidential basis, please contact one of our professionals.
Middle Market Transaction Update Winter 2024
Middle market M&A activity in the third quarter of 2024 showed signs of the “summer slowdown,” as fewer PE deals were reported compared to the first two quarters of the year.
For the Love of the Game?
What Can the San Diego Padres Teach Us About Succession Planning?
Every business has a succession plan, whether formulated or not. Careful planning today can stave off heartache in the future. Successful family businesses need to prioritize flexible succession planning to be prepared for potential adverse or unforeseen changes.
Goodwill Impairment Troubles Cost UPS $45 Million
Financial Reporting Flash: Issue 1, 2025
A recent $45 million settlement between UPS and the SEC over allegedly flawed goodwill impairment tests and earnings overstatements puts a spotlight on the goodwill impairment testing process.
6 Ways to Evaluate Business Value
Along the road to building the value of a business it is necessary, and indeed, appropriate, to examine the business in a variety of ways.
Bank M&A 2024 — Off the Bottom
In our year ago M&A epistle, we speculated that activity would improve and that a related theme could be equity recap transactions. The prediction was hardly heroic because M&A activity in 2023 represented a multi-decade low, while low public market multiples for a small subset of banks with high CRE exposure signaled investor expectations that an equity infusion was possible.
The Rise of Staying Private
Shareholder Liquidity Strategies for Family Businesses
Cash-strapped early-stage companies have long relied on equity-based compensation to attract, motivate, and retain employees. Employees endure long nights of software coding or other work, comforted by visions of riches when the company reaches the goal line (the initial public offering). For a variety of reasons, the IPO is no longer the goal line for founders, many of whom are now content to remain private far longer than previously expected. While founders may be content with their illiquid billions, most employee-shareholders want to convert at least some of their illiquid thousands to spendable cash.
Evolving Need for Estate Planning Amid Legislative Shifts
For estate planning, the stakes are high. The elevated lifetime exclusion amount is one of the most significant opportunities for reducing future estate tax liabilities, allowing individuals to transfer substantial wealth that falls under the threshold tax-free. However, the political and fiscal landscape introduces critical timing considerations.
Nvidia’s Jensen Huang Has an Estate Plan — Do You?
It’s Never Too Early for Family Business Directors to Establish an Estate Plan
Jensen Huang, the chief executive officer of Nvidia, and his family are on track to save north of $8 billion in estate and capital gains taxes. So, how has the tenth-wealthiest person in America managed to protect his wealth from the 40% estate tax? He has a plan.Beginning in 2012, the Huangs set off on their estate tax planning journey by setting up an irrevocable trust. Without getting too far into the weeds, the Huangs and their team of advisors formulated an estate tax plan that involved the use of tax planning maneuvers involving intentionally defective grantor trusts and several grantor-retained annuity trusts (“GRATs”). These tax planning vehicles enabled the Huang family to effectively (and legally) circumvent hefty gift and estate taxes that would apply to a direct transfer of the assets to Huang’s heirs.Just like the Huangs, most family business owners aim to provide financial stability and support for future generations of their families. Putting in the work on the front end and establishing a plan, like the example above, can potentially result in significant estate tax savings for you and your family in the future.Estate TaxThe Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the “decedent’s gross estate,” less the taxpayer’s remaining gift and estate tax deduction, which in 2025 will be $13.9 million per individual, as well as other specific deductions. Family business owners face a unique hurdle as a substantial portion of their estate typically consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Ignoring estate taxes altogether is not an affordable option either. While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay those estate taxes without some action on the part of the company. The required actions may range from a shareholder loan to a special dividend to the sale of the business. A bit of forethought can relieve the burden on heirs, but when is the right time to get started?The Sooner, the BetterAs a family business owner, it is never too early to review your estate plan. While there are things that will certainly change over time, taking the pulse on your estate plans can have a major impact on the volume of wealth you pass to your heirs.Preparing to transfer ownership to the next generation in the most tax-efficient way is daunting, but here are some ways you can start thinking about your estate plan:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that — were the unexpected to happen — would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority).
The most difficult time to make decisions regarding your estate plan is the short term. Should we accelerate plans to sell so we can avoid a larger tax bill? Should we realize some gains in the family securities portfolio to avoid the possibility of an increase in long-term capital gains rates? We believe these questions can be avoided when a well-thought-out estate plan is established. Diligent planning on the part of family shareholders allows directors to focus on the long-term success and sustainability of the business without the distraction of potential estate tax exposures. Give one of our family business professionals a call today to talk about balancing tax concerns with the long view on your family business.
Quality of Earnings Report for Would-Be PE Sellers
After a prolonged slowdown, M&A activity is expected to rebound as economic conditions stabilize and pent-up demand returns. As deal flow recovers, sellers who invest in a Quality of Earnings (QofE) report will be better positioned to articulate sustainable profitability, withstand buyer diligence, and defend value throughout negotiations.
Thanksgiving Resources for Family Business Directors
Over the years, we have used Thanksgiving as a time to remind family business directors that family is indeed the most important part of the family business. See below for some helpful resources before you sit down to eat some turkey with the family this Thursday.
Richard Fuld, Spirit Airlines, and Fairness
Given the price and terms of the JetBlue deal, rendering fairness opinions by Spirit’s financial advisors (Morgan Stanley and Barclays) in July 2022 should have been a straightforward exercise; however, one deal point a board must always consider is the ability of a buyer to close.
Where Do Dividends Come From?
For the unprepared, it is a question that can paralyze any parent: “Mommy, where do dividends come from?” Among our family business clients, the issue of shareholder liquidity is always top of mind, and is occasionally a source of confusion among shareholders, managers, and directors. In this week’s post, we attempt to bring some clarity to the question of where dividends come from. Large or small, regular or “special” dividends paid to family shareholders can really only come from five places.
What to Look for in a Purchase Price Allocation
Purchase price allocation is a critical step in the transaction reporting process under ASC 805. This article provides an overview of the PPA process, discuss common intangible assets, and review some best practices and potential pitfalls.
A Framework for Ownership Strategy – Part II
In our last post, we introduced a simple yet effective framework for developing and managing an ownership strategy. We follow up with some further thoughts on the framework as we look at the implications of the various combinations of the three points of the framework below. Thinking about the combinations of growth, liquidity, and control can allow family business owners to further fine-tune an ownership strategy in that it forces ownership groups to consider the benefits and tradeoffs that come with developing a strategy. We examine these tradeoffs and benefits in this week’s post.Control + GrowthThe combination of control and growth implies that a business has not taken on equity or debt capital to the extent that it has given up control over key operations and financial decisions and that ownership has decided to reinvest residual profits back into the business. The reinvestment rate, which measures the percentage of profits being reinvested into the business as opposed to being distributed, can be a useful metric for observing the extent to which ownership is funding the business’ growth with residual profits. This is an easily understandable measure that can direct owner strategy in the tradeoff between growth and liquidity. The decision to reinvest heavily often comes at the expense of shareholder liquidity, and an impatient shareholder base may start clamoring for returns while the company is still actively reinvesting. At any rate, ownership has retained control over the reinvestment vs. distribution decision by not bringing in large amounts of outside capital.For a further look into the reinvestment rate and its applications, we’d point our readers to this recent article in the Harvard Business Review by Hans Latta, Andy Bahnfleth, and Rob Lachenauer: Is Your Family Business on the Path to Growth?Liquidity + ControlThis situation is the other side of the coin from the control and growth scenario. In this strategic position, ownership controls the business and pays a steady stream of dividends or distributions to its shareholder base. This is a positive in that shareholders will generally be satisfied by this financial return, which can promote long-term sustainability and unity within the business. Owner groups operating with this strategy in mind may also provide liquidity to owner-operators via above-market compensation packages or to owner-board members through board fees. Conversely, giving up growth and reinvestment can be a detriment to the business and its ability to compete with businesses that are actively reinvesting profits into newer facilities, technologies, and processes. Control remains with ownership in this scenario, giving ownership “the ability to act economically irrationally,” as Rob Lachenauer, the co-author of the Harvard Business Review Family Business Handbook, put it last week as we discussed the benefits of control in a family business.Growth + LiquidityThe final combination is that of growth and liquidity. In this scenario, ownership has given up control of the business, whether that be to lenders who have provided debt capital or equity investors. Outside investment can be used to fund a myriad of growth opportunities — both organic and inorganic. Residual profits under this scenario are also sufficient to distribute money back to shareholders, which is likely to be a demand of private equity investors. While the family’s ownership in the business may have been diluted, financial returns and favorable exit prospects have likely increased due to the growth promoted by an infusion of outside capital.The triangle framework provides a simple yet effective starting point for family businesses to develop an ownership strategy. We’d encourage family business owners and board members to consider their current position on the triangle and whether or not they are satisfied with it. If you are considering a decision that would strategically realign your business to another side of the triangle, give one of our family business professionals a call.We’d also like to thank Rob Lachenauer of BanyanGlobal for providing a few minutes of his time to discuss the triangle framework with us. Rob co-authored the Harvard Business Review Family Business Handbook with Josh Baron, which introduces the triangle framework for ownership.
A Framework for Ownership Strategy – Part I
We recently attended a family business symposium where owners, board members, and consultants gathered to share strategies and insights.
ROIC for Family Businesses in 5 Minutes
Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware if Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital (ROIC), because it tells you the Rest of the Story.?Don’t forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies.The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.
Fairness Opinions: Evaluating a Buyer's Shares from the Seller's Perspective
Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.
The Boar’s Head Family: Why Worry About Succession Planning?
It is hard to imagine the founders of Boar’s Head envisioned this sort of conflict-ridden path for their family business. While avoiding shareholder conflict is never guaranteed, family business directors can add an additional layer of protection to their family legacy and long-term wealth through focused succession planning. Here are a few things to consider when developing your family business succession plan.
Dispatch from the Fed
The ability to be attuned to economic trends that will affect your family business without being distracted by short-term economic “noise” (indeed, the ability to even distinguish reliably between the two) is typically hard-won and learned only through the trial-and-error of being in business for decades. Respect those lessons and strive to collect wisdom from your fellow directors. Markets may overreact to Fed decisions, but you and your fellow directors don’t have to.
RIA Market Update: Q3 2024
RIAs outperformed the S&P in the third quarter of 2024, with alternative asset managers experiencing the strongest returns amid multiple expansion. All groups examined experienced growth in AUM and revenue year-over-year. We explore further in our Q3 2024 Market Update.Download Update
Communication Matters for Family Businesses
How can family business leaders develop effective and sustainable communication programs? For family businesses, the goal is to communicate, not inundate. At some point, too much information can simply turn into noise. Family business leaders should focus on the dimensions in this post.
Is Your Buy-Sell Agreement a Ticking Time Bomb?
With the release of Chris Mercer's new book, we've got buy-sell agreements top of mind, and you should, too. Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.
Five Ideas to Turn Your RIA’s Success Into Momentum
Understanding why you’ve been successful is important to sustaining your success.
Three Considerations BeforeYou Sell Your Business
As middle-market M&A activity begins to rebound, business owners considering a sale must prepare thoughtfully. Setting realistic value expectations, understanding the tax implications of a transaction, and clearly defining the strategic reasons for exiting are critical steps toward achieving a successful and well-executed sale process.
"Buy-Sell Agreements: Valuation Handbook for Attorneys" Now Available
We are excited to share the release of our latest book Buy-Sell Agreements: Valuation Handbook for Attorneys authored by Z. Christopher Mercer, FASA, CFA, ASA and published by the American Bar Association. This week, we share an excerpt from the book that discusses what you can expect to find in the full copy. Whether you are an attorney who advises clients on their buy-sell agreements or are a party to a buy-sell agreement, you will find important information in this book. You can purchase your copy of the book here.
Wishful Thinking and the Time Value of Money
What lessons can family business directors glean from the Nordstrom saga? We will consider three in this post.
Mind the Margin
Why Margins Are an Important Metric for Your Family Business
Margin analysis can be a beneficial tool for evaluating performance. Becoming familiar with the typical margins of your family business will provide a touchpoint for identifying where opportunities to preserve and grow profits exist for your family business. Since ‘typical’ margins vary from industry to industry, being able to benchmark to similar companies can give family businesses a better idea of where they stack up.
Middle Market Transaction Update Fall 2024
The tale of the tape in middle market M&A activity in the second quarter proved similar to that of the first quarter, though reported multiples for PE deals generally improved in the second quarter.
Equity Capital Raises
The banking zeitgeist is evolving: 2023 was about a liquidity crisis that claimed three banks who were members of the S&P 500; 2024 is shaping up as the year of capital raises by a handful of regionals to deal with the aftermath of the Fed’s ultra-low-rate environment.
A Private Equity Tactic to Consider for Your Family Business
A few weeks ago, we observed private equity investors learning a lesson about liquidity risk, which family shareholders have always known. This week, we turn the tables and explore a PE strategy that might be worth considering for some family businesses – dividend recapitalizations.
Review of Q2 2024 Key Economic Indicators for Family Businesses
Coming off a run of economic data releases in the last few weeks, we take a look at the numbers and some of their implications for the broader economy in this week’s post. GDP growth in the U.S. economy measured 2.8% in the second quarter of 2024, outpacing growth of 1.4% in the first quarter. Following persistently elevated measures in the first quarter, recent inflation readings have cooled. The following sections provide a brief look at these trends and their implications.
Kellogg Company Case Study
Attempting to Unlock Shareholder Wealth in a Mature Business
Today is was announced that Mars has reached a deal to acquire Kellanova, which was spun off from Kellogg’s last year. Our Family Business Advisory team put together this powerpoint deck, “Case Study: Kellogg Company – Attempting to Unlock Shareholder Wealth in a Mature Business” which tracks key events in Kellogg’s history and comments on the transaction. There are lessons family business owners can learn from the transaction and from Kellogg’s recent moves.
Heat Waves, Hurricanes, Selloffs, Oh My
As the heat waves, hurricanes, and potential for a recession loom, we wanted to take a step back and highlight three strategies family business directors can adhere to in these volatile and uncertain times.
Personal Goodwill and Valuation Issues in Marital Dissolution Cases
What is personal goodwill and why is personal vs. enterprise goodwill such an important topic? Find out more in this powerpoint deck.
Real Estate and the Family Business
As the pandemic recedes further into the rearview mirror (4+ years!), long-term business consequences continue to reverberate through the economy. In addition to recalibrating expectations among domestic manufacturers, foreclosures on distressed commercial real estate are accelerating. Since enterprising families often accumulate significant real estate holdings, the lingering pandemic-induced weakness in real estate values may encourage families to evaluate their real estate strategies. There are three broad strategies for families owning and operating businesses.
The Patience to Prevail
What Can Family Businesses Learn from the Open Championship?
It’s no secret that the writers of the Family Business Director blog share a collective affinity for the game of golf. Over the weekend, we enjoyed watching the final major tournament of the professional golf season, the Open Championship. The last of golf’s four “majors” presents a unique and esoteric challenge relative to the other three majors and the rest of the PGA and LIV tour tournaments on which professional golfers compete week in and week out. The Open, as it is often called, is played every year on one of ten courses in the United Kingdom that comprise the venerable “Open Rota.” These courses are among the oldest and most revered in the world and include the Old Course at St. Andrews in Scotland, widely considered the oldest golf course in the world. Aside from the Open being contested on some of the most hallowed grounds in the sport, perhaps its most distinctive characteristics compared to other majors and regular tour events are the conditions and style of play it requires its participants to navigate. Courses within the Open Rota are situated upon the windswept coastal dunes of Scotland, England, and Northern Ireland, where players are often at the mercy of whatever Mother Nature decides to conjure up on a given day, whether that be a persistent grey mist, gale-force winds, or a nasty combination of both. The courses themselves are also a jarring departure from the tree-lined parkland-style courses that dominate the American professional golf landscape. Links golf, as exhibited in the Open, is void of trees and replete with rolling mounds, deep bunkers, and penal natural grasses that punish and often stymie inaccurate shots. In summary, the Open presents a radically different test and set of questions than the other three majors and the typical courses on which tour events are played. Technological advancements in golf equipment and stat tracking devices have created a data revolution within the game. Pros know the yardages that they can hit their clubs to a single yard and can often adjust these yardages for certain variables (wind, turf conditions, etc.) in the relatively benign conditions they face on a week-to-week basis on the tour. Bryson DeChambeau, in particular, exemplifies this data-driven approach that has yielded him two U.S. Open Championships. However, the unpredictable conditions at the Open Championship often render this approach useless, as most obviously displayed in DeChambeau’s score of nine-over-par (+9) for the championship, resulting in a missed cut. On the other hand, there are golfers who not only embrace the volatile conditions presented in the Open but thrive in them. Winners of the Open typically fall into this category because they can conquer unpredictable conditions by understanding that “golf is not a game of perfect” and overcoming the inevitable bad breaks that come with playing links-style golf.With the Open in mind, we considered how family businesses can mirror this approach in today’s ultra-data-rich operating environment, particularly against the backdrop of evolving economic conditions. We believe this thought exercise is prudent given the specter of multiple unknowns looming large in the U.S. economy. Our post from last week highlights several of these unknowns, including the prospect of rate cuts by the Federal Reserve later this year. When times are good and visibility is clear, well-positioned businesses can often go on autopilot, generating robust cash flows and returns on the rising tide of a strong economy. When businesses are presented with operating conditions similar to those in the Open Championship, the uncertainty can make the prospects of generating robust cash flows and returns more precarious. In the following sections, we submit a few practical suggestions for family businesses to successfully navigate the grey mist and pea soup fog of economic uncertainty.Embrace and Amplify Core ValuesDuring times of economic uncertainty, family businesses would be well-served to lean into their core values. Whether these come by way of a mission statement or a set of non-negotiable guiding principles, core values are crafted not only to act as a north star in high times but also as an anchor and ballast in uneven times. Anecdotally, our firm adopted a new mission statement as part of a strategic planning process several years ago. This new mission statement has become so engrained into our firm’s collective mind that it is often the opening slide in any of our internal training presentations. Boards and management teams define an enterprise’s core values for a reason. During operating volatility and economic uncertainty, where results often seem arbitrary regardless of internal processes, these values should be embraced and amplified to ensure that all stakeholders are pulling in the same direction without losing sight of the mission.Exhibit PatienceAs seen again and again throughout history, bad times do not last forever. Golfers who conquer the Open Championship and lift the Claret Jug are acutely in tune with this maxim. The patience to brush off a double bogey resulting from a nasty lie or a bad bounce is one of the most important attributes required to win the Open. Similarly, family business owners should not depart from their core values and management practices in the face of seemingly random results that can manifest themselves in a downturn. More often than not, the ability to patiently grind and stack up “pars” without radically diverging from the plan pays dividends in the end, whether those dividends be in the form of the oldest golf trophy or a robust return to shareholders.Communication and AlignmentIn the face of volatility and uncertainty, the importance of constant communication within a family business is magnified. This communication should flow in all directions—between managers, employees, suppliers, shareholders, and even competitors. Keeping these lines of communication open will ensure that a family business has all the information required to make informed decisions in a changing and dynamic environment.This is not dissimilar to the golfer-caddy relationship, which becomes even more important when playing in volatile conditions like those on display in the Open. Communication between parties not only facilitates the transfer of information between parties but also creates alignment. Alignment regarding a set of values (strategic), course of action (tactical), or internal process (operational) naturally morphs into commitment over time. Commitment to a plan is perhaps the most important lynchpin in hitting a proper golf shot, and this type of commitment often only arises from strong communication and alignment. This chain works through family businesses as well, and keeping the lines of communication open in times of economic uncertainty and volatility is crucial to ensuring that all stakeholders in a family business remain aligned and committed.Current economic uncertainties may have family businesses feeling more like they’re playing in an Open Championship than a routine PGA/LIV tour event. While there are many ways to steer your family business through uneven times, we believe the lessons we’ve prescribed are a good starting point. Feel free to reach out to one of our professionals to discuss further.
Supreme Court Upholds Connelly
The primary takeaway from Connelly is that life insurance received at the death of a shareholder is a corporate asset that adds to the value of the company for federal gift and estate tax purposes.
Mild, Medium, or Hot
Will the Fed Cut Interest Rates This Year?
With inflation falling to its lowest level in a year, officials are trying to balance the risk of cutting rates too soon and allowing inflation to persist with the risk of waiting too long and causing unnecessary damage to the job market.
Private Equity Investors Learn What Family Shareholders Have Always Known
Family shareholders bear the risk of illiquidity. So what can family businesses and family shareholders do to manage the burden of illiquidity? Five things come to mind:
The Supreme Court Weighs in on Shareholder Redemptions
The Supreme Court’s Connelly decision is a timely reminder that family businesses and their shareholders need to work together to prepare for possible redemptions. An independent opinion regarding the fair market value of your family business is an essential component in advancing that conversation productively.
Middle Market Transaction Update Summer 2024
Middle market M&A activity remained depressed in the first quarter of 2024, although pricing multiples did show signs of improvement relative to 2023 pricing data.
How Does a Quality of Earnings Report Differ From an Audit?
A quality of earnings (“QoE”) report and an audit are both essential tools in the business world, but they serve distinct purposes and offer varying insights.Audits are broader and regulatory in nature, whereas QoE analyses are more focused and strategic, catering to the needs of investors and decision-makers who require a deeper understanding of a company’s true financial health and future potential.
5 Reasons Your Financial Projections Are Wrong
Today, we highlight a post written by Travis Harms back in 2019 that focuses on financial projections and the biases that contribute to overly optimistic forecasts. The inspiration for this blog came from Daniel Kahneman, author of Thinking, Fast and Slow and a man whose research in behavioral science changed our understanding of how people think and make decisions. Unfortunately, Mr. Kahneman passed away earlier this year, but the lessons from his legendary work are timeless and still vital for family business directors to consider.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of June 3, 2024
Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.
FASB Provides Clarity on Accounting for Profits Interest Awards Under ASC 718
FASB's issuance of ASU 2024-01 represents a significant step towards enhancing consistency and understanding in accounting for profits interest awards. Clearer guidance and the illustrative example will help entities can make more informed decisions regarding the treatment of these awards, ultimately benefiting stakeholders and investors alike.
Mastering the Dividend Dance
With the competing claims on operating cash flow from the perspectives of the family business and family shareholders, managing dividend expectations can be a delicate dance. Finding and forging consensus on what the family business means to the family can help make sure that everyone is at least dancing to the same tune.
A To-Do List for Evaluating Acquisition Offers
This week, we share a to-do list to help prepare for such offers if and when they come.
How Should Family Businesses Respond to an Acquisition Offer?
Successful businesses don’t have to go looking for potential acquirers—potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but serious inquiries from legitimate buyers of capacity occasionally appear that require a response.
Review of Key Economic Indicators for Family Businesses
In this week’s post, we look at recent economic data and the implications of this data regarding the Fed’s monetary policy actions in the coming months.
The Case for Research and Development
A Case Study of Innovation and Taxes
No family business can be successful over generations without innovation. Consistent investment in research and development is at the heart of many family business breakthroughs. Like any investment, R&D spending consumes family capital today in the expectation of generating more cash flow in the future.
The Noncompete Agreement Is Dead, Long Live the Noncompete Agreement
The FTC Wants to Ban Noncompete Agreements but They Will Likely Endure in Certain Circumstances
Your Family Business Is on the Clock – Are You Ready?
Having a plan for when succession becomes a reality is imperative for continuing on-the-field success. If an unforeseen event occurs, you will have a strategy in place to determine how the business will operate moving forward. While you cannot plan for a devastating injury to your starting quarterback, you can have the framework for how to respond to such an event.
What to Look for in a Purchase Price Allocation
Financial Reporting Flash: Issue 5, 2024
What to Look for in a Purchase Price Allocation
What to Look for in a Quality of Earnings Provider
In this article, we discuss four things buyers and sellers should look for when evaluating potential QofE providers.
What to Look for in a Quality of Earnings Provider
The cost of corporate M&A failures is high for both buyers and sellers. In this article, we discuss four things buyers and sellers should look for when evaluating potential QofE providers.
Navigating Change in the Family Business
2024 Transitions Conference Recap
Mercer Capital had the opportunity to sponsor and attend Family Business Magazine’s 2024 Transitions Spring Conference in sunny Tampa, Florida. As always, the team at Family Business Magazine did a great job organizing and hosting the gathering of a few hundred representatives from nearly 90 successful enterprising families.
Market Resilience: Asset Managers Thrive Amidst Economic Volatility in 2023
Despite persistent inflation, elevated interest rates, and heightened geopolitical tensions, the asset management industry and the stock market as a whole saw a resurgence during 2023. Our index of publicly traded asset management firms generally tracked the movement in the broader market, with stock prices for smaller asset managers (AUM under $250 billion) up 30.3% and large asset managers (AUM over $250 billion) up 22.0% over the year ended March 31, 2024, while the broader market (S&P 500) was up 29.9%.Fund FlowsWhile market movement is often the dominant contributor to AUM changes over a particular period, it’s a variable that’s largely outside a manager’s control. On the other hand, organic growth can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer periods.Many asset managers have struggled with organic growth in recent years, partly due to rising fee sensitivity and the influence of passively managed investment products. This year proved no different, with our index of publicly traded asset/wealth management companies seeing $103 billion in aggregate net outflows, compared to aggregate net outflows of $62 billion in 2022.As expected, considering the performance of the stock and bond markets over the past year, market movement was the primary driver of the change in AUM, accounting for $551 billion additional AUM for the index during 2023. During the challenging market conditions of 2022, the index saw an aggregate $922 billion decrease in AUM due to market movement.Click here to expand the image aboveOutflows from Active Funds AccelerateWhile asset managers saw net outflows over the past twelve months, there were significant variances between active and passively managed funds. Fund flow data from Morningstar (table below) shows that total outflows across active funds for the year ended March 31, 2024, were approximately $377 billion. The aggregate outflows over the past year were most severe for U.S. equity, allocation, and international equity, with these asset classes shedding a combined $427 billion in assets. All categories of actively managed funds except alternative investments, taxable bonds, alternatives, and nontraditional equities saw net outflows over the past year.On the other hand, passively managed funds continued to outpace active funds in terms of net new assets over the past twelve months. The Morningstar data shows that total inflows across passively managed funds for the year ended March 31, 2024, were approximately $621 billion, with all asset classes except commodities and miscellaneous assets reporting positive net inflows.Click here to expand the image aboveAs you can see from the following chart, there has been a trend over the past ten years of investors moving from active to passive funds, and this trend accelerated with the market downturn in 2022. The relative underperformance of active managers, when compared to their benchmarks over the past ten years, has driven investors to low-fee passive funds. This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Click here to expand the image aboveOutlookThe outlook for asset managers depends on several factors. Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.With inflation starting the year higher than expected, it remains to be seen if the Fed will be able to implement the rate cuts that many investors expect to come during 2024. With the prospect of interest rates remaining higher for longer, persistent inflation, and geopolitical tensions, there is much uncertainty in the market heading into 2024. Despite these challenges, the industry enters 2024 with higher starting AUM levels, offering a potential boost to revenues and earnings. Navigating these uncertain times requires a proactive approach to capitalize on emerging opportunities and mitigate risks effectively.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.
Spring M&A Update for Family Businesses
Following up on our post from a couple of weeks ago regarding the acquisition of SRS Distribution by Home Depot, we provide a brief update on private M&A markets in this week’s post.
The Green Jacket Guide to Family Business Surveys
What Can We Learn from the Masters?
Bringing together a group of any size is undoubtedly challenging, but nothing a little time and planning cannot fix! The Masters has maintained a focus on the long game by building traditions and interest in the game itself. Family businesses are in the unique position to do the same by cultivating a deeper sense of engagement and legacy among the shareholder base.
5 Reasons Upstream Sellers Need a Quality of Earnings Report
Apart from a number of headline deals, M&A activity was sidelined for much of 2022 and 2023. But needing to replenish a depleting asset base with quality mineral acreage, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business model.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses or assets to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their assets. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, assumption of asset retirement obligations, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.
Home Depot Announces SRS Distribution Acquisition
An M&A Case Study
Home Depot’s recent announcement that it was acquiring roofing and construction material distributor SRS Distribution may signal the return of more robust deal activity. Even if your family business has nothing to do with construction materials, there is plenty to note in this deal.
FASB Provides Clarity on Accounting for Profits Interest Awards Under ASC 718
Financial Reporting Flash: Issue 4, 2024
In March 2024, the Financial Accounting Standards Board (FASB) issued ASU 2024-01, which clarifies the accounting treatment of profits interest awards.
Middle Market Transaction Update Spring 2024
Although middle market transaction activity remained depressed in the fourth quarter of 2023 compared to 2022, M&A activity and multiples improved a bit compared to recent quarters. Possible Fed rate cuts, an economy that has remained resilient in spite of 525bps of rate hikes by the Fed, and ample dry powder held by PE firms to deploy may be the catalysts for a stronger rebound in 2024.
NYCB Incurs Heavy Dilution in Its $1.0 Billion Capital Raise
The other significant industry news from the first quarter was the $1.05 billion equity investment in New York Community Bank (NYSE: NYCB) by an investor group led by former Secretary of the Treasury Steve Mnuchin. The investment was necessary to boost loss absorbing capital and to shore up confidence to stem a possible deposit run after its share price collapsed during February following a surprise fourth quarter loss that was later revised higher for a $2.4 billion goodwill write-off.The initially reported 4Q23 loss of $252 million was not catastrophic, especially considering the company reported net income of $2.4 billion excluding the goodwill write-off as a result of the bargain gain from the purchase of the failed Signature Bank; however, the fourth quarter loss that arose from a $538 million provision for loan losses highlighted investor concerns about NYCB’s sizable exposure to NYC rent-controlled apartments and offices.The figure on the right presents our proforma analysis of the transaction and its impact on the consolidated company (NYCB), the parent company in which the group invested, and wholly owned Flagstar Bank, N.A. The adage that capital is exorbitantly expensive if available at all when it must be raised comes to mind here with NYCB.Source: Mercer Capital, NYCB SEC filings, and S&P Global Market IntelligenceWe note the following:The investor group paid $1.05 billion for 525 million common share equivalents consisting of 59.8 million common shares for $2.00 per share and $930 million of Series B and C preferred stock with a 13% dividend that is convertible into 465 million common shares at $2.00 per share.Tangible book value per share (“TBVPS”) declined by about one-third from $10.03 per share as of year-end 2023 to $6.65 per share on a proforma basis.Inclusive of 315 million seven-year warrants with a $2.50 per share strike price, diluted proforma TBVPS is ~$5.80 per share.The 525 million common shares represent ~40% of the 1.25 billion proforma shares while dilution to existing shareholders exceeds 50% inclusive of the warrants.The capital injection boosted the Company’s consolidated leverage ratio by ~80bps to 8.6% and total risk-based capital ratio by ~120bps to 13.0%.NYCB will generate ~$1.4 billion of pretax, pre-provision operating income in 2024 and 2025 based upon consensus analyst estimates that will supplement the new capital to absorb loan losses.Given NYCB’s shares are trading around 50% to 60% of proforma TBVPS, investors are questioning the magnitude of loan losses to be recognized; whether more capital will be required; and long-term earning power.Our additional thoughts on the transaction can be found HERE, and a link to NYCB’s investor deck announcing the transaction can be found HERE.If we can assist your board with a capital raise or other significant transaction, please call us.Originally appeared in the March 2024 issue of Bank Watch.
Capital One Financial Corporation to Acquire Discover Financial Services
The four major credit card networks are American Express, Discover, Mastercard, and Visa.In 2023, Discover had only 2.1% of the total market share in the U.S. based on the value of transactions, compared to Visa’s 61.1% market share and Mastercard’s 25.4% market share.1 Prior to its acquisition of Discover, Capital One partnered with both Visa and Mastercard for issuing their credit cards.So, why would Capital One pay $35.3 billion to acquire Discover’s 2.1% market share?Discover Financial Services operates as both a credit card issuer and credit card network.By owning its own credit card network, Discover is not partnered with any payment processors (Visa, Mastercard, etc.) and avoids “swipe fees” that payment processors collect. Therefore, one of Capital One’s primary objectives in acquiring Discover is to move its credit and debit cards onto Discover’s network over time and reduce its purchase volume on the Visa and Mastercard networks.The two companies entered into a definitive agreement on February 19, 2024, in which Capital One Financial Corporation agreed to acquire Discover Financial Services in an all-stock transaction valued at $35.3 billion.The deal represents a 26.6% premium to Discover’s closing price of $110.49 (2/26/24) as Discover shareholders will receive 1.0192 Capital One shares for each Discover share.More details on the transaction as well as the companies’ financials as of fiscal 2023 are displayed on the right.Summary of Transaction AnalysisFinancial ComparisonPreparing for the FutureAs technology continues to advance, both traditional, tech-heavy banks and Fintech companies have increased competition in the global payments industry.If the acquisition is approved, Capital One will surpass JPMorgan as the largest credit card company based on loan volume and become the third largest company based on purchase volume. With increased volume and market share, Capital One would be better prepared to compete against these other banks and Fintech companies. Richard Fairbank, the CEO of Capital One, strives to deal directly with merchants by owning his own payments network. This rare asset allows Capital One to create a closed loop between consumers and merchants, which better positions the company to deal with increasing threats from buy-now, pay-later companies (Affirm, Afterpay, Klarna, etc.).Both Capital One and Discover customers may have a lot to look forward to in the future should the deal be approved.Capital One intends to move 25 million cardholders onto the Discover network by 2027 and offer more attractive rewards for both debit and credit cardholders. The proposed merger would expand both issuers’ physical presence, and Discover customers would gain access to physical bank locations.Capital One will also leverage its international presence to increase accessibility and convenience for Discover cardholders on an international scale.In terms of credit and debit rewards, the increased competition in the industry is expected to drive companies to bolster their rewards program to seem more attractive to consumers.Regulatory HurdlesThe proposed deal between Capital One and Discover is expected to close by the end of 2024 or the beginning of 2025. However, the completion of the deal could depend on the results of the presidential election. Senators Elizabeth Warren and Josh Hawley have both expressed interest in blocking the deal as they believe the deal will create a “juggernaut” in the industry and lead to the extortion of American consumers. The Biden administration is more likely to block the deal or implement limitations and requirements in order for it to be executed.On the other hand, the proposed deal could stop legislation that threatens credit card rewards. Congress is considering new legislation known as the Credit Card Competition Act (CCCA).The purpose of this legislation is to reduce the swipe fees paid by merchants by enabling access to a wider range of payment networks. If the legislation is approved, credit card networks and issuers would face reduced transaction fees causing issuers to potentially reduce the wide range of rewards offered. However, the primary objective of the CCCA could be accomplished through the proposed merger, as routing Capital One’s purchase volume through Discover’s payment network would create a more viable competitor to the Visa/Mastercard duopoly.ConclusionMercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and providing valuations of financial institutions. If you are considering acquisition opportunities or have questions regarding the valuation of your financial institution, please contact us. 1 Statista.com; Market share of Visa, Mastercard, American Express, Discover as general purpose card brands in the United States from 2007 to 2023, based on value of transactionsOriginally appeared in the March 2024 issue of Bank Watch.
Your Family Business Will Transact: Are You Ready?
Approximately 75% of business owners regret selling their business within the first year following the sale, according to a new report. Why? The emotions of running and owning a family business are complex, and disentangling your identity from the business can be challenging. However, we suspect some of the heartache comes down to poor planning, the feeling of leaving money on the table, and a harried transition process. So, have you checked in on your succession plan?
Now Could Be a Great Time to Transfer Stock to Heirs
Issues on the tax and policy front also should be top of mind in current estate planning discussions. The Tax Cuts and Jobs Act enacted in December 2017 doubled the basic exclusion amounts individuals could give away without paying estate taxes. The sunsetting of this provision on December 31, 2025, makes considering transfers all the more important.
5 Reasons Sellers Need a Quality of Earnings Report
M&A deal flow was sidelined for much of 2022 and 2023, but the economy’s soft landing, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their businesses. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, frameworks for roll-over ownership, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.WHITEPAPERQuality of Earnings AnalysisDownload Whitepaper For buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.
5 Reasons Sellers Need a Quality of Earnings Report
The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business. In this post, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.
Worldwide Impacts on Marine Shipping – Q4 2023
We discussed reshoring and nearshoring trends a bit in the last Value Focus Transportation and Logistics newsletter.There’s been some developments on that front, especially as it relates to the ongoing battle between East Coast and West Coast ports.As we mentioned last time, a variety of pandemic-related and regulatory issues resulted in long delays at California ports, the traditional import location for the majority of goods from East Asia.Many carriers shifted their import handling to East Coast ports – with the port of Savannah being one of the biggest winners.Georgia has posted three straight record–setting years for exports. A study by Cushman Wakefield that ran through October 2023 shows that volumes at East Gulf Ports exceeded West Coast volumes for the majority of 2022 and 2023.However, early results indicate the West Coast ports grew faster than East Coast ports in November and December 2023, and there are a couple of reasons behind that.(click here to expand the image above)The El Niño weather event has hit the Panama Canal hard.Under normal conditions, between 36 and 38 ships per day will make the transit.Due to the worst droughtPanama has experienced in over 70 years, the Canal Authority began reducing the number of ships passing through on a daily basis in July 2023.In February 2024, the Canal Authority reduced the total number of ships to 18 per day.Meanwhile, approaching from the other direction has been made harder by attacks on vessels in the Red Sea.About one-fifth of freight reaching East Cost ports travels through the Red Sea and the Suez Canal.Shippers continuing to use the Suez canal route will face higher insurance charges, while shippers opting to go around the Cape of Good Hope can expect to add at least a week to transit times.More recently, the first fully sunk ship from the conflict also disrupted underwater data cables.So far, analysts have had mixed opinions on the overall impact that will arise from the Houthi attacks.Between Red Sea disruptions and climate issues in Latin America the impact of worldwide current events on marine logistics cannot be ignored.
The Times They Are A-Changin’
The Tax Cuts and Jobs Act as the largest tax code overhaul in the last three decades. Built into the TCJA was the sunset of certain provisions on December 31, 2025. Meaning that on January 1, 2026, certain portions of the tax law revert to pre-TCJA unless Congress acts to prevent it. With time change on the horizon, we discuss two of the more significant sunsetting provisions that will affect you and your family business.
The Noncompete Agreement Is Dead, Long Live the Noncompete Agreement
Financial Reporting Flash: Issue 3, 2024
The FTC Wants to Ban Noncompete Agreements but They Will Likely Endure in Certain Circumstances
Capital Planning and IRS Section 6166
For family businesses with significant ownership concentrations, the estate taxes eventually payable upon the death of a primary shareholder can represent a significant contingent “non-operating” liability. Unlike the uses of capital typically evaluated in capital budgeting, the obligation to pay estate taxes is not discretionary. But if the deceased shareholder’s estate does not include sufficient liquidity, the economic burden of the tax effectively falls upon the family business, which must allocate capital toward either a redemption of the estate’s shares or a pro rata distribution. From the perspective of the business, this obligation may “crowd out” other, more attractive uses of capital that would help build value for subsequent generations. In specific circumstances, Section 6166 of the Internal Revenue Code provides a capital planning alternative for family businesses facing large contingent liabilities for shareholder estate tax obligations.
Ownership Succession and the NFL
Per a recent article from Bloomberg, the NFL will consider another change to its ownership rules at its league meetings next month — allowing private equity groups to take ownership stakes in teams. Given this, we take a brief look at some of the pros and cons of allowing private equity to enter NFL ownership structures and their broader applications to family businesses.
Pay Versus Performance: What’s New in Year 2?
The complexity of implementing the Pay Versus Performance rules in Year 2 will vary by firm.
Viva Diversification: The Vegas Transformation and Your Family Business
As markets move and tastes evolve, what worked for your family’s business in the first generation may not work for the second or third. Diversification and how you approach where to invest limited family capital should not take a backseat to the tyranny of the now. Perpetuating your family business takes thinking about generations rather than quarters and strategizing for the next phase in your family’s journey today.
A Matter of Life (Insurance) and Death
Life Insurance as a Funding Mechanism for Shareholder Buyouts
A buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. For companies using life insurance as a funding mechanism for shareholder buyouts, the treatment of life insurance proceeds in determining the buyout price is always a thorny issue. A recent estate tax case (Connelly v. United States) addresses this issue. For our full analysis, read the article here.
Pay Versus Performance: What’s New in Year 2?
Financial Reporting Flash: Issue 2, 2024
The 2024 proxy season marks Year 2 under the SEC’s new Pay Versus Performance disclosure framework for public companies.
The Tangled Path to Banking’s Garden of Earthly Delights
Hieronymus Bosch, The Garden of Earthly Delights, 1490-1510, Museo del Prado, Madrid.One of BankWatch’s favorite artists is the Dutch painter Hieronymus Bosch (1450-1516). His work is both enigmatic and fantastical, with bizarre human/animal hybrid forms and other monstrous creations of Bosch’s fecund imagination. Indicating its lasting relevance and, in a sense, modernity, centuries later Bosch’s work served as inspiration when the Surrealist movement sought to depict dreamlike scenes formed from the depths of their unconscious mind. One triptych, The Garden of Earthly Delights, depicts a utopian scene in the middle panel adjacent to a hellscape in the right panel.It serves as an apt metaphor for the banking industry’s stomach churning volatility in 2023.As in the hellscape panel on the right side of the triptych, the banking industry sunk to the depths of despair beginning in March 2023, tormented by bank failures and deposit runs.From year-end 2022 to the nadir in May 2023, the Nasdaq Bank Index sunk 34%. Bank stocks rebounded during the summer but remained under pressure through the fall as the ten year Treasury rate briefly exceeded 5%.Finally, more dovish comments from Chairman Powell lifted sentiments, causing the Nasdaq Bank index to appreciate by 12% in November 2023 and 15% in December 2023.While we have not returned to a banking utopia, the greener pastures in which Bosch’s hybrid forms graze in the triptych’s middle panel seem more representative of industry conditions at year-end 2023.2023 PerformanceFor 2023, the Nasdaq Bank Index and the KBWNasdaq Regional Bank Index depreciated by 7% and 4%, respectively (see Figure 1 ). This marks the second year of negative performance for bank stock indices. Between year-end 2021 and 2023—covering the entire period of rising rates—the Nasdaq Bank and Regional Bank indices decreased by 24% and 13%, respectively (see Figure 2).After losing 19% in 2022, the S&P recovered in 2023 with 24% appreciation, meaning that the S&P 500 at year-end 2023 returned to a level virtually identical to year-end 2021. Struggling with earnings pressure, banks lost favor with growth minded investors, thereby underperforming the broader market.Figure 1 :: Index Performance (12/31/22 - 12/31/23)Figure 2 :: Index Performance (12/31/21 - 12/31/23)Figure 3 stratifies the 328 banks and thrifts traded on the NYSE and Nasdaq by asset size. Banks in the three strata between $1 billion and $100 billion performed similarly, with the median bank’s stock price falling by about 5% in 2023. Between 30% to 40% of banks reported share price appreciation over year-end 2022. The largest banks outperformed in 2023, as several banks like J.P. Morgan Chase (NYSE: JPM) “over-earned” their long-term return on equity target. JPM and other money center banks were boosted by low-cost deposits flowing from smaller banks in the wake of the failures of SVB, Signature Bank, and First Republic Bank.JPM also recorded a bargain purchase gain from the acquisition of First Republic Bank as did First Citizens BancShares (NYSE: FCNCA) and New York Community (NYSE: NYCB), the winning bidders for SVB and Signature Bank.Figure 3Figure 4 replicates the analysis for the period between year-end 2021 and year-end 2023. Not all banks have struggled through this rising rate environment, as 28% of banks reported share price appreciation over the two-year period. Nevertheless, the largest number of banks have experienced a 10% to 20% decline in their share prices.Figure 4Catalysts for (Under)PerformanceChanges in the net interest margin have the greatest effect on profitability and share price performance in the current environment, given limited credit issues. Figure 5 includes publicly traded banks with assets between $1 billion and $10 billion, sorted into quartiles based on their NIM change between the fourth quarter of 2022 and the third quarter of 2023.Figure 5The first quartile, including banks with the most severe NIM pressure, experienced a median stock price change of negative 14% in 2023. Meanwhile, banks in the fourth quartile—with the least NIM pressure or even NIM expansion—eked out a positive 2% change in stock price.This relationship holds true if we consider the entire rising rate period between the first quarter of 2022 and the third quarter of 2023 (see Figure 6). Over this period, approximately one-half of the banks reported a higher NIM; however, the market provided a meager reward with share prices for banks in the fourth quartile appreciating by a median of 4%. This reflects the market’s focus on the more recent trend in the margin—generally downward for most banks—rather than a historical anchor in a low rate environment. Meanwhile, the banks in the first quartile that were most exposed to rising rates suffered a median -24% change in their stock prices.Figure 6Valuation ImplicationsFigure 7 illustrates the earnings pressure resulting from tighter NIMs.For 2023, analysts’ EPS estimates indicate a median EPS decline of 15% for publicly traded banks with assets between $1 and $15 billion, with 73% of the banks in the analysis expected to face lower year-over-year earnings in 2023. These estimates are based upon recent data. Measured from January 2023, the reduction in earnings estimates is much more severe, meaning analysts cut estimates as the year progressed.Figure 7The outlook is only marginally better in 2024, as the median decline in EPS is 8%. Analysts generally expect NIMs to stabilize, or at least decline at a more modest rate, in the first half of 2024, followed by some expansion in the second half of 2024. The NIM stabilization in the latter half of 2024 leads to earnings growth in 2025 for most banks, with a median EPS growth rate of 10%. However, only 28% of banks in our analysis are projected to have higher EPS in 2025 than in 2022.With the share price recovery in late 2023, publicly traded banks with assets between $1 and $15 billion reported a median price/one year forward earnings multiple of 11.5x and a price/tangible book value multiple of 1.26x. As indicated in Figure 8, these multiples are in-line with the range over the last five years. Therefore, the catalyst for further share price appreciation likely will be earnings improvement rather than P/E multiple expansion.Figure 8ConclusionThe worst has passed for banks, with slowing deposit attrition and stabilizing NIMs, unless credit performs materially worse than expected.However, conditions likely are not ripe for rapid earnings growth. First, NIMs likely will recover more slowly than they contracted due to volume of assets repricing years into the future. Second, many banks are reporting slowing loan growth, as higher rates have gradually eroded loan demand. Third, if loan demand exists, marginal funding remains difficult to obtain at a favorable cost of funds.For many publicly traded banks, returning to the garden of earthly delights remains a ways off.Orginally appeared in the January 2024 issue of Bank Watch.
5 Reasons Buyers Need a Quality of Earnings Report
After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure buyers back onto the field in 2024.And when deal activity heats back up, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep. In this week’s post, we review five reasons family business directors need a QofE report before approving an acquisition.1. Avoid overpaying for earnings that aren’t sustainable.Audited financial statements provide assurance that the past performance of the target company is faithfully represented. However, successful acquirers are focused on the future, not the past. A thorough QofE report helps buyers extract what truly sustainable performance is from the welter of the target’s historical earnings. Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital. QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile.2. Identify opportunities for cost savings in the target’s expense base.The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target through cost-saving initiatives. By observing trends in headcount by function, occupancy, and other components of operating expense, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target.3. Find revenue synergies with your existing business.A thorough QofE report is not just about expenses. Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the existing business of the buyer, which can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis. Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table more confident of the upside to be unlocked through the transaction.4. Clarify working capital needs of the target.Incremental working capital investment is the silent killer of transaction return on investment. A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital. Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings. Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.5. Assess capital expenditure needs at the target.Not every dollar of EBITDA is equal. EBITDA multiples are a function of risk, growth, and capital intensity. Buyers cannot afford to overlook capital intensity when evaluating targets. A thorough QofE report examines historical trends in capital expenditures and fixed asset turnover to help buyers better discern the prospective capital expenditure needs of the target and how those needs influence the transaction price and prospective returns. For family businesses contemplating an acquisition, the stakes are high. You can’t eliminate risk from an M&A transaction but obtaining a thorough QofE report on the target can help directors avoid mistakes and increase the odds of a successful deal. If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team.WHITEPAPERQuality of Earnings AnalysisDownload WhitepaperFor buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.
5 Reasons Buyers Need a Quality of Earnings Report
For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep.
Goodwill Impairments Are on the Rise. Surprised?
Executive SummaryPreliminary results for 2023 show that the number of goodwill impairments is increasing for both large and middle-market public companies. Based on data through November, the number of impairments recorded by firms on the S&P 500 and Russell 2000 indices had already eclipsed 2021 and 2022 full-year figures. Interestingly, these trends materialized even as the indices themselves posted favorable total returns for the year of 25% and 14%, respectively. Public and private companies currently in the process of performing their annual/interim impairment tests should be on the alert if their peer group turns out to be the one recording impairment charges.Back in 2020, the stock market downturn stemming from pandemic shutdowns resulted in triggering events and impairment charges for many companies.This was especially evident among smaller publicly-traded companies (as tracked by the Russell 2000 versus the S&P 500).The number of charges dropped drastically in 2021 (even compared to 2019 results), suggesting that some of the 2020 impairment charges may have reflected a pull-forward of later charges.Since that time, the number and percentage of companies recording charges has steadily increased, with preliminary figures for 2023 already exceeding the numbers recorded in 2022.Total Goodwill Impairment Charges and % of companies with GW that recorded chargesThis trend held across sectors as well.In the Russell 2000, eight of eleven sectors reported an increase in number of charges to goodwill between 2019 and 2020.Charges in the consumer staples sector declined among S&P 500 companies, while increasing for Russell 2000 companies.Charges in the utilities sector declined for S&P 500 companies but remained stable for Russell 2000 companies.For both groups of companies, charges taken by the materials sector declined.Following 2020, impairment charges dropped below 2019 levels – sharply, in the case of many sectors over 2021 through 2022.More recently, the number of charges and the magnitude of total goodwill charges for the first eleven months of 2023 had already exceeded the full year of 2022.Additional impairments may be on the way as companies complete and file their year-end financials. Based on the preliminary figures for the Russell 2000, the sectors recording the most charges appear to be healthcare and industrials.Despite the increase in impairment charges taken in 2020, the number of small-cap companies reporting year-end goodwill balances increased in 2020 and continued to increase through 2022 and 2023.Approximately 60% of Russell 2000 companies carried goodwill in 2019, while over 63% did so in 2023.The percentage of S&P 500 companies reporting goodwill declined from 89% in 2019 to 86% in 2023.Percent of Companies Reporting GoodwillIt is impossible to attribute the rise in impairment charges to a single specific factor. However, it is likely that rising interest rates and higher inflation played a significant role in 2023 results. Impairment charges also tend to have a larger impact on smaller companies.Generally speaking, smaller companies tend to be less diversified in terms of product or service offerings, and their client bases may be more sensitive to external economic factors.Ultimately, the preliminary data for 2023 shows that impairments do not necessarily taper off when overall equity markets are rising. Company-specific factors, including financial performance relative to history, expectations, and peer performance, are critical when evaluating goodwill for potential impairment. Will the impairment trends seen in the large and middle-market public markets extend to private companies? Perhaps.The valuation specialists at Mercer Capital have experience in implementing both the qualitative and quantitative aspects of goodwill impairment testing under ASC 350. If you have questions, please contact a member of Mercer Capital’s Financial Statement Reporting Group.
WHITEPAPER | Quality of Earnings Analysis
What Buyers and Sellers Need to Know About Quality of Earnings ReportsFor buyers and sellers, the stakes in a transaction are high. You only get one chance to do it right.Commissioning a quality of earnings report is an essential step in getting the transaction right.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.Leverage the experience of our QofE team to generate Insights That Matter in support of your next transaction.
Ownership & Succession Planning in 2024
Who knew the Green Bay Packers could be a source of inspiration for your family business’s succession planning?
Forward Air Corporation to Acquire Omni Logistics, LLC?
Another tough call for the merger arb community – acquirer and target sue each other in Delaware Court of Chancery to respectively terminate the merger agreement or force consummation of the merger
How Does Your Family Business Think About Philanthropy?
While we’ll be the first to say there are others better suited to help you think about the existential questions (why should we give, to what causes), we think there are some considerations and strategies that you and your family board can keep in mind when determining how your family business thinks about philanthropy.
A 2024 M&A Update
Middle-Market Deal Activity in 2023 and Thoughts on 2024 Activity
In last week’s post, Travis Harms opened the year by offering a few key questions that family business owners and directors should ask themselves in 2024. One of these questions suggests a thorough review of your family business’s M&A strategy. In this week’s post, we take a closer look at middle-market deal activity in 2023, which sank to its lowest level in a decade, and offer a few thoughts regarding the state of the middle market as we see it in 2024.
5 Questions for Family Business Directors in 2024
For some family businesses, 2023 was a year to remember, while others hope it won’t be repeated. Regardless of how your family business fared last year, 2024 is here. What should you and your fellow directors be thinking about as the new year starts?
Middle Market Transaction Update Winter 2023
Although middle market transaction activity remained depressed in the third quarter of 2023 compared to 2022 levels, M&A activity and possibly deal multiples could improve in 2024 given the potential for Fed rate cuts, an economy that has remained resilient in spite of 525bps of rate hikes by the Fed, and ample dry powder held by PE firms to deploy.
Capital Structure in 5 Minutes
New Video Released on Family Business On Demand Resource Center
Family businesses are built on long-term capital investments. Capital structure refers to the mix of debt and equity financing used to make those investments. In this video, we explore what capital structure means for family businesses, the effect of capital structure on the weighted average cost of capital, and some qualitative considerations to consider when establishing a target capital structure.
Talking Money with the Next Gen
Communicating financial results to family shareholders is not optional, and one-size-fits-all solutions may not work for your family. Being intentional and taking the duty to communicate well with your next-gen family members today can save everyone a lot of grief tomorrow.
Memorable Mungerisms
Our colleague Brooks Hamner wrote a great post for sister blog RIA Valuation Insights last week, marking the passing of investing legend Charlie Munger. Brooks’ post unearthed some Mungerisms we had not heard before, and we think Mr. Munger’s wisdom is just as relevant inside the family boardroom as it is for professional investment managers. Enjoy!This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients):“I think the reason why we got into such idiocy in [personal] investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don’t sell to fish.’”
– 1994 speech at the University of Southern California Business School
We’ve all taken the bait on a flashy investment opportunity that didn’t pan out. We knew better but couldn’t resist the prospect of doubling our money in a short amount of time. Rational investing leads to rational returns, and irrational investing leads to irrational returns (typically below 0%). Maximizing the ratio of rational investing to irrational investing for clients is easier said than done, but one of the primary responsibilities of a prudent financial advisor. Feel free to share Charlie Munger’s thoughts on crypto the next time a client asks about Bitcoin:“A cryptocurrency is not a currency, not a commodity, and not a security. Instead, it’s a gambling contract with a nearly 100% edge for the house, entered into in a country where gambling contracts are traditionally regulated only by states that compete in laxity.”
– 2023 Wall Street Journal op-ed piece
Charlie Munger often distinguished between investing and gambling, which, in his mind, was the same thing as “investing” in a cryptocurrency. That probably seems obvious to you (and your clients), but unfortunately, that’s not the case for much of the investing public. Interestingly, he had a similar disdain for diversification, which probably isn’t so practical for most individual investors:“A lot of people think that if they have a hundred stocks they’re investing more professionally than they are if they have four or five. I regard this as insanity.”
–2021 shareholder meeting for the Daily Journal Corporation
Mr. Munger called this ‘diworsification,’ and this philosophy allowed him to achieve above-market returns for several decades and become one of the most successful investors of all time. This mentality probably only applies to active managers (like he was himself) who devote much of their professional careers to investment research and analysis. His colleagues Warren Buffet and Jack Bogle would certainly not recommend this approach to most individual investors.“Usually, I don’t use formal projections. I don’t let people do them for me because I don’t like throwing up on the desk, but I see them made in a very foolish way all the time, and many people believe in them, no matter how foolish they are. It’s an effective sales technique in America to put a foolish projection on a desk.”
– 2003 Herb Kay Undergraduate Lecture at the University of California, Santa Barbara Economics Department
Since we often rely heavily on projections in our DCF valuation models, it’s probably best that Mr. Munger was never a client of ours (actually, I’m sure he would've been great to work with). We understand the fallacies of projections and contend that all models are wrong, but some are useful (to quote the British statistician George Box) when grounded in reason and reality.“I think you would understand any presentation using the word EBITDA, if every time you saw that you just substituted the phrase, bull**** earnings.”
– 2003 Annual Berkshire Hathaway Shareholder Meeting
We often utilize EBITDA metrics in our valuation models, so Mr. Munger probably wouldn’t have appreciated that aspect of our analysis either. Mr. Munger clarified this later in the meeting by stating, “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Fortunately, your business is the former, and you get to keep most of its EBITDA every year.“I am personally skeptical of some of the hype that has gone into artificial intelligence. I think old-fashioned intelligence works pretty well.”
– 2023 Berkshire Hathaway Annual Meeting
Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.
Elon Musk on Fairness and Solvency Opinions
While portfolio valuations are driven by governance and reporting requirements, major transactions often demand fairness and solvency opinions that extend beyond financial analysis to include process, legal standards, and conflicts of interest. High-profile transactions involving Elon Musk — including Tesla–SolarCity and the acquisition of Twitter — offer timely lessons for private equity and private credit investors navigating complex deals.
Stock-Based Compensation in Volatile Markets: Employee, Management, and Investor Perspectives
Financial Reporting Flash: Issue 3, 2023
Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.
Navigating the Buffet of Investment Options
A Guide for Family Businesses
There is no “right” answer for where or how your family should invest. Ultimately, your family’s risk tolerance and return objectives will determine the right option for your family business. However, your family needs to have a process for objectively estimating expected returns and analyzing the riskiness of its options. Please give one of our professionals a call for an independent perspective on your family businesses’ investment options.
Review of Key 3Q 2023 Economic Indicators for Family Businesses
Before we dig into our turkey and dressing later this week, we look at Q3 2023 economic data in this week’s post.
UPDATE: Analysis of the Spirit Fairness Opinions re the JetBlue Acquisition
Spirit-JetBlue’s stalled merger highlights regulatory risk and time erosion, as Spirit shares trade far below the $33.50 offer.
Who Eats First, the Family or the Family Business?
It’s that time of year again. The grocery list has been made, the headcount has been verified, and the dusted box with pilgrim decorations has been taken down from the top shelf of the storage closet. The table might not be set yet, but for the most part, we know who we will be eating turkey with next week on Thanksgiving Day. Aunt Cathy may or may not bring Cousin Lenny, but Cousin Lenny prefers ham and doesn’t even eat any cornbread stuffing or pumpkin pie, so we don’t need to worry about him!Traditionally, we have offered some suggestions on what not to talk about at the Thanksgiving dinner table. But this year, we decided to focus on something new. Who eats first, the family or the family business?There is no cookie-cutter recipe or fine-tuned formula one might use to answer this question. On the surface, it does not seem like a tough one. However, every family business operates differently, with different shareholder preferences, family dynamics, and investment decisions. So, before answering the most important question of who eats first on Thanksgiving Day, ponder these three topics to help guide you.The Meaning of the Family BusinessThe meaning of a family business is a function of both family and business characteristics. As shown above, the meaning of the family business, in turn, influences the company’s dividend policy, investing, and financing decisions.Family business directors must decide how to dispose of every dollar the business generates through its operations. At the most basic level, a dollar of operating cash flow can be returned to owners in the form of dividends and share redemptions or reinvested in the business.When the family business can access many investments offering high returns, reinvestment will be more attractive. However, if there aren’t many attractive investment options out there, retaining capital in a business that can’t use it well drives down returns and risks the future of the family enterprise.When discerning what the family needs, there is no substitute for asking.What are the liquidity needs of family shareholders?How much risk are family shareholders willing to bear in pursuit of capital appreciation?How important is the family’s legacy? Shareholder circumstances and attitudes are constantly evolving, so even if you had a good feel for what the family needed five years ago, you may not know what they need today. In our experience, the most successful family businesses balance the business needs with the family shareholders' needs.Dividend PolicyOnce the “meaning” has been embraced by the family, the distribution policy will more naturally follow. Answering the dividend policy question for your family business requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce?Some family businesses have shareholders who are highly dependent on distributions from the company to fund their lifestyle and are focused on the dividend-paying capacity of the family business. Other shareholders may fund their lifestyle needs from other sources and are more focused on the rate at which the value of their investment in the family business grows.Ultimately, family business directors need to remember their shareholders are just that: shareholders. While their equity may have been earned hereditarily, the family business directors owe a duty to the family shareholders — a focus on maximizing shareholder value through a mix of good reinvestment opportunities and distributions.Capital AllocationDividend policy decisions are not made in a vacuum. When operating cash flows are used to pay dividends, those cash flows cannot be reinvested to grow the business. Conversely, cash allocated for the future growth of the business is not available to provide for the liquidity needs of family shareholders.Click here to expand the image aboveSuccessful family business directors must balance the company’s needs with those of the family when making capital allocation decisions. Analyzing investment choices and understanding your family shareholder objectives is not easy, but going back to the meaning of your family business will help provide a backdrop for making these decisions.ConclusionA clear understanding of what the business means to the family is essential if decisions about dividend policy and capital allocation are to be made in a coordinated manner. Matching your family shareholders’ growth objectives with their relative risk tolerance is a key challenge for family business directors and one that is tied directly to what your family business means to you.Our professionals are eager to help your family discern what your family business currently means so that everyone has a seat at the Thanksgiving dinner table.
Capital Budgeting in 5 Minutes
New Video Released on Family Business On Demand Resource Center
Capital budgeting can’t be avoided — the only question is whether your family business has a consistent and disciplined process for evaluating potential investments or instead makes significant capital commitments in a more haphazard way. In this video, we describe the key elements of the capital budgeting cycle and identify some common potholes along the way.
Letters From the SEC: Business Combinations Edition
Financial Reporting Flash: Issue 2, 2023
We discuss and comment upon four examples covering customer relationships, tradenames, contingent consideration, and bargain purchases.
The Scariest Thing That Faces Family Business Directors
Happy Halloween! This week, we have four frightening guests who share their most terror-inducing family business challenges. It’s definitely not for the faint of heart, but if you are brave enough to face your fears, check it out!Get your preferred copy of the book, The 12 Questions That Keep Family Business Directors Awake at Night,here.The Scariest Thing That Faces Family Business Directors - Halloween 2023 from Mercer Capital on Vimeo.
Opportunities for Ownership Succession in the Beer Wholesaler Industry
For those wholesalers contemplating succession, now is the time to act.
Decisions, Decisions: 3 Questions to Start Thinking About Capital Structure
Capital structure decisions are crucial to the longevity of a family business. By addressing questions about available borrowing capacity, current capital structure, and peer comparisons, family businesses can be better equipped to make optimal capital structure decisions.
An $80 Billion Estate & Gift Tax Valuation Update
3 Things to Do When Selecting a Business Appraiser
How would you spend $80 billion in new funding? Much politicking and articles have been written about the Inflation Reduction Act. One piece of that legislation that will impact every taxpayer is an increased IRS of roughly $80 billion over the next ten years. The Tax Foundation analyzed how the IRS plans to deploy additional funding, as shown in Figure 1.Figure 1 :: IRS Funding Increases per Inflation Reduction Act Noticing “money sent back to my bank account” didn’t make the list, one quickly notices “Enforcement” getting the largest dollar increase over the next ten years at nearly $46 billion. The IRS lists five objectives in its 2023 strategic operations plan. One of the objectives includes: “Focus expanded enforcement on taxpayers with complex tax filings and high-dollar noncompliance to address the tax gap.” Again, from the Tax Foundation: “Digging more into the specifics of enforcement, individual initiatives acknowledge some of the trade-offs in expanded enforcement operations. Within the third objective, dedicated to expanded enforcement, five of the seven initiatives involve expanded enforcement on certain types of taxpayers: large corporations, large partnerships, high-income and high-wealth individuals, other areas where IRS audit coverage has declined (including employment, excise, and estate and gift taxpayers), and developing areas such as digital assets.” A recent presentation by Stephanie Loomis-Price and Marissa Pepe Turrell at the ASA’s International Conference summarized 709 (gift) and 706 (estate) filings and audit rates, excerpted in Figure 2 below.Figure 2 :: Gift and Estate Tax Filings and Audit Rates Total gift tax audits have been just under 1% for the last decade, and estate tax audits have been around 10% on average, per Figure 2. And while audit rates have remained stable overall for gift and estate tax filings, one doesn’t have to connect too many dots to see that may be changing. Much has been written on declining audit rates, and policymakers have explicitly said they plan to audit wealthier Americans. So, with plenty of dry powder to beef up enforcement and looming changes to the estate tax horizon (including a reduction in the estate and gift tax exemption), family businesses and estate planners need to be cognizant of the changing tax landscape and increased audit scrutiny.3 Things Family Businesses Should Do When Selecting a Business AppraiserHow do business appraisers fit into this shifting gift and estate tax paradigm? If your gift tax return involves a business valuation, having a trusted and reputable valuation firm as part of your estate planning roster is more important than ever. Below are three criteria that can help you think about who you want in your corner.Insist on an appraiser with experience and credentials. Each business appraisal is unique, and experience counts. Most business valuation firms are generalists rather than industry specialists, but the experience gained in discussing operating results and industry constraints with a broad client base gives the appraisal firm substantial ability to understand the client’s specific situation. Credentials do not guarantee performance, but they do indicate a level of professionalism for having achieved and maintained them. Family businesses and their estate planning counsel should insist upon them.Involve the appraiser early on. One of the most common concerns such owners cite around long-term planning is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way. Even in seemingly straightforward gift and estate tax planning, it is helpful to seek the advice of a business appraiser as part of the planning process. Understanding the finer points around fair market value, the levels of value, discounts for lack of marketability, and ultimately estimated tax liabilities are all questions a business appraiser should be able to provide feedback and guidance upon.Expect the best. In most cases, the fee for appraisal services is nominal compared to the dollars at risk. The marginal cost of getting the best is negligible. Family businesses can help their appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above but recognize the delicate balance between the inherent art and science when valuing private companies. Mercer Capital has been performing business appraisals for over 40 years and has a long track record of delivering reasonable and supportable business valuations. Our team of professionals is ready to help you and your clients navigate your valuation challenges.
Twitter (X Holdings I, Inc.) Solvency
Exploring the issuance of a solvency opinion for the October 2022 acquisition of Twitter, Inc. by Elon Musk’s X Holdings I, Inc.
Should I Stay, or Should I IPO?
What kind of family business are we? Dividend policy & capital allocation decisions help define what kind of company your family business is. Matching your family shareholders' growth objectives with their relative risk tolerance is a key challenge for family business directors and one that is tied directly to what your family business means to you. Successful family businesses need to evaluate how they invest for future growth and their distribution policies in light of their family's risk tolerance, growth objectives, and business meaning.
Why ROIC Matters for Family Business Directors
New Video Released on Family Business On Demand Resource Center
Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware if Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital (ROIC), because it tells you the Rest of the Story.
Impending Guidance on Business Combinations
Financial Reporting Flash: Issue 1, 2023
Working Draft of The AICPA Accounting and Valuation Guide: Business Combinations
Fall 2023 Private Company M&A Update
In this week’s post, we take a look at recent trends in private company transaction activity up to this point in 2023.
You Can't Spend the Same Dollar Twice
A key element of shareholder education for such families is the concept of capital allocation. In other words, family capital is a scarce resource that can either be put to work inside the business or distributed to provide liquidity to shareholders, but not both. Or, in other simpler words: You can't spend the same dollar twice.
Middle Market Transaction Update Fall 2023
Middle market transaction activity fell in the second quarter of 2023, continuing an ongoing decline in transaction activity in the middle market.
Five Reasons to Conduct a Shareholder Survey
New Video Released on Family Business On Demand Resource Center
In this video, Atticus Frank breaks down the top five reasons why your family business should consider conducting a shareholder survey. He emphasizes how these surveys can provide critical insights into shareholder perspectives, facilitate informed business decisions, and enhance communication among family members involved in the business. From uncovering deeply held views to promoting educated and engaged shareholders, the video offers valuable guidance for multi-generational family businesses looking to align interests and build trust.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.
Review of Key 2Q 2023 Economic Indicators for Family Businesses
Now that economic data for the second quarter of 2023 has been released and made available over the last several weeks, we take a look at the tale of the tape in this week’s post.
Navigating the Estate Tax Horizon
The Time Is Now
Looking for a golden opportunity? A recent series of articles from the Wall Street Journal suggests that one exists, but time is of the essence. There is an urgency to consider a range of estate tax strategy options in order to maximize gifting family wealth rather than family drama.
Private Equity (Still) Wants to Buy Your Family Business
Private equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.
How to Communicate Financial Results to Family Shareholders
Whitepaper Release
Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this week's blog we introduce a whitepaper that offers practical suggestions for presenting key financial data in ways that family shareholders find useful.
How to Communicate Financial Results to Family Shareholders
Whitepaper Release
Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this week's blog we introduce a whitepaper that offers practical suggestions for presenting key financial data in ways that family shareholders find useful.About Mercer Capital Mercer Capital provides valuation, financial education, and other strategic financial consulting services to family businesses.We help family ownership groups, directors, and management teams align their perspectives on the financial realities, needs, and opportunities of the business.WHITEPAPERHow to Communicate Financial Results to Family ShareholdersDownload Whitepaper
WHITEPAPER | How to Communicate Financial Results to Family Shareholders
Suppose that your exposure to the French language consists of two years of high school classes twenty-five years ago. Imagine how frustrating it would be if suddenly the only news outlet available to you was Le Monde. With no small effort on your part, there’s a good chance you would be able to discern the broad outlines of the day’s events, but the odds of misunderstanding a key part of the story would be high, and any subtleties or nuance in the writing would be totally lost on you.That is likely how many of your family shareholders feel when it comes to comprehending the financial results of your family business. Perhaps they took an accounting course at some point in their lives. Or simply by virtue of having grown up around the family business, they have developed a vague sense of the differences between revenue and equity, or assets and expenses. As a result, when they read a financial report, they are generally able to discern the broad outlines of performance for the year or quarter, but the odds of misunderstanding a key part of the story are high, and any subtleties or nuance beyond the most rudimentary data are likely to pass them by.Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this whitepaper, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful.
Dividend Policy for Family Businesses
New Video Released on Family Business On Demand Resource Center
Travis Harms provides an insightful examination into the important topic of dividend policy in family businesses. He explains how to go about the decision-making process regarding distribution and why considering various shareholder characteristics and business attributes matters.
A Tale of Two Shoes
Is there merit to emphasizing scarcity as a product attribute for your family business? Why or why not? If so, what does scarcity look like for your brand/product? Does your family business have a “core” customer? If so, who is that core customer, and how do you pursue innovation and growth strategies without alienating that customer? We discuss in this week's post.
Managing Your Complete Family Business Balance Sheet
Having a mindset that considers not just your family business balance sheet, but your complete balance sheet, will help you and your fellow family shareholders make better decisions that align with your shareholders. A holistic view will also help foster business longevity, health, and family harmony.
Earnings Season
As a private family business, earnings season may not look the same as it does for Elon Musk or Mark Zuckerberg, as there are fundamental differences between large public companies and family businesses. But this does not mean successful family businesses should ignore the Street’s earnings season dance. Family business leaders should use some characteristics from earnings season as an opportunity to ask their family board these questions.
Fairness Opinions and Down Markets
Fairness opinions do not offer opinions about where a security will trade in the future. Instead the opinion addresses fairness from a financial point of view to all or a subset of shareholders as of a specific date. The evaluation process is trickier when markets fall sharply, but it is not unmanageable.
What We’ve Been Reading
We hope that you and your family enjoyed a relaxing Fourth of July holiday this week. To help ease you back into the routine of things, we’ve compiled a brief reading list of items we’ve found to be interesting and informative in the past couple of weeks. Think of it as your Family Business Director summer reading list. Don’t worry – next week’s post won’t include a test.Family OfficeIn this piece, Deloitte takes a look at a few ways that families can protect, preserve, and grow their wealth, even in the complex tax rate environment we currently find ourselves in.Family Business Magazine provides a set of considerations for families looking to start up a family office in this recent article. As with any worthwhile endeavor, the article stresses the importance of defining the end goals of a family office as the starting point of the process.Estate PlanningThe National Law Review gives a concise look at a few of the estate planning tools at the disposal of couples subject to the federal estate tax in this recent overview.Firm ManagementThis case study from The Family Business Consulting Group highlights the importance of alignment in family businesses with multiple generations of shareholders and the difficult, but necessary, work needed to ensure that shareholder incentives are aligned within a family business.Finally, we turn to Mercer Capital’s RIA Advisory group for a look at some considerations regarding your buy-sell agreement that should help align expectations in a triggering event. While this blog piece was written with RIA owners in mind, we think that the considerations laid out are applicable to businesses across a wide swath of industries.
Valuation of a Business for Divorce
In this article, we introduce the three valuation approaches and discuss the importance of normalizing adjustments to the subject company’s income statement.
Economic Indicators for Family Businesses
New Video Released on Family Business On Demand Resource Center
In this video, Tripp Crews discusses a few key economic indicators that family business owners and directors would be well-served to keep an eye on as we continue to navigate through a turbulent macroeconomic environment. Having a working knowledge of these indicators can help inform decision-making processes for owners and directors both in the office and in the board room.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.
The Hardest Thing to Do in Business
What is the hardest thing to do in business? Stand still. Businesses are either growing or shrinking.
Just Released: 2023 Benchmarking Guide for Family Business Directors
Growing up playing football, the team would gather after every game to run back the tape and review film. Rewatching games where you made a big play and the team won was always a good feeling. A loss? As my college coach from East Tennessee used to say, “Katy, bar the door.”If 2021 was a comeback win for a lot of companies after the COVID-19 downturn, 2022 was like running into a stonewall defense. Rising interest rates, breakneck inflation, and the Russia-Ukraine conflict stifled offenses like the ’85 Bears. But despite some bumps and bruises, the tape was more favorable than one might have expected. While shareholder returns were down with a broad decline in equity markets, EBITDA margins held up, albeit unevenly across industries, and total distributions (distributions and share repurchases) rose considerably over 2021. Or for a coaching cliché: “The game was really a lot closer than the scoreboard would indicate.”We are happy to share the release of our 2023 Benchmarking Guide for Family Business Directors. Benchmarking helps provide valuable context to directors when making their most critical decisions: what should our dividend policy be, what investments should we make, and how should we finance our business? For our benchmarking report, we have used the Russell 3000 Index Companies, excluding financial institutions, real estate companies, and utilities. We also excluded companies with less than $10 million in revenue in 2022. We have also sorted the data into five quintiles based on company sizes and the following industries. This blog post summarizes some of our financing, operating, investing, and distribution findings. For a comprehensive and detailed report on all the above questions, download the full guide.How Much Money Do Companies Like Ours Make?Inflation may have originally been billed as transitory and only here for a short visit, but 2022 showed us CPI is not taking the hint. The 12-month percentage change in Consumer Price Index, or CPI, has run north of 2% every month since March of 2021, with 2022 exceeding 6% the entire year. Red-hot inflation does appear to have been finally shown the door, with growth peaking in June 2022, but CPI is still well above recent historical norms and Federal Reserve targets.The chart below shows the number of industry constituents who saw gross margin increases and decreases in 2022 relative to 2021. Strong results in the energy sector masked gross margin challenges across other industries as companies struggled to adapt to an inflationary environment not seen since the early 1980s. The majority of energy companies saw gross margin expansion, while the majority of companies in all other industry sectors saw gross margin decline.Gross Margin Year-Over-Year How did costs affect the bottom line? While Wall Street often looks at earnings, EBITDA is the key earnings measure for family businesses. EBITDA serves as a proxy for discretionary cash flow available to service debt, pay taxes, fund reinvestment, and provide for shareholder distributions. The table below highlights EBITDA margins by industry in 2022 and 2021.EBITDA Margin Year-Over-Year Following gross margins, EBITDA margins compressed in certain industries as pricing pressure affected industries less able to pass along price increases or reduce operating expenses. Communication services, consumer staples, and healthcare all saw year-over-year EBITDA margin declines. The energy sector saw the largest change in margin, with improving oil prices serving as a tailwind to the sector.What Is The Hurdle Rate for Companies Like Ours?The Fed aggressively took on the challenge of inflation. It increased rates precipitously in the middle and back half of 2022, with four 75 basis point increases between June and November of 2022. The Fed Funds Target range went from 0% to 0.25% in early 2022 to 4.25% to 4.50% by year-end.The weighted average cost of capital is the blended return expectation of lenders and shareholders. We calculate the cost of each capital source and the weighted average regarding the market value of total capital. WACCs are generally higher for smaller and perceived riskier companies.Companies use hurdle rates to help screen out potential investments. All family businesses face capital constraints, meaning they could invest in more investments than they should invest in. Along with a robust strategic review, using a hurdle rate (often the WACC) can help directors limit review of potential projects to those that are financially feasible.Weighted Average Cost of Capital As shown above, calculated WACCs in 2022 were over 2.0% higher than in 2021 on average. Increase in interest rates, with 20-Year Treasury rising from 1.94% to 4.14% from year-end 2021 to year-end, the main driver. Borrowing costs (as reflected in BBB Corporate Bond Yields) were also up in line with treasuries. What’s the impact? Higher WACCs mean higher hurdle rates for companies and family businesses. This changes the calculus in reviewing potential projects and determining what is financially feasible for the business, affecting capital allocation and investment decisions. The chart below tracks aggregate spending on maintenance and growth capital expenditure, as well as acquisitions for the companies in the sample. Spending on acquisitions decreased in 2022 amid higher capital spending totals. Higher hurdle rates likely influenced this spending shift, as project-specific hurdle rates tied to acquisitions became perhaps less palatable to boards of directors. With more rate hikes occurring in 2023 and potentially more in the offing, 2023 could see further shifts in capital allocation decisions as we off-ramp the low/no interest rate environment.Aggregate Investment Trends Download your complimentary copy of the 2023 Benchmarking Guide for Family Business Directors, which gives you an in-depth analysis of the topics discussed here as well as discusses additional questions, including:How much money do companies like ours distribute?How much money do companies like ours borrow?How fast should companies like ours grow?What kind of return do companies like us generate for their shareholders?For more targeted insights and observations, call one of our professionals to talk about a customized benchmarking analysis for your family business.
The Benchmarking Guide for Family Business Directors
Family business directors need the best information available when making strategic financial decisions that will help set the course of their business for years to come.
Tax Court Sides with Family Business in Cecil
In a recent decision (Cecil v. Commissioner, T.C. Memo. 2023-24), the Tax Court tackled the thorny issue of how to value a minority interest in an operating business with valuable underlying assets. Although the decision does not directly address the appropriate “premise of value” in its decision, that is ultimately what the case was about. The Court’s ruling was a resounding victory for the taxpayers and will likely provide critical support for future family businesses facing similar fact patterns.
Middle Market Transaction Update Summer 2023
Middle market transaction activity, as measured by both deal value and deal volume, fell again in the first quarter of 2023.
Steps in a Business Valuation
New Video Released on Family Business On Demand Resource Center
Join Zac Lange from Mercer Capital as he guides you through the comprehensive process of business valuation. His walkthrough reveals the important steps of a valuation, from defining the engagement, gathering and analyzing relevant data, to selecting appropriate valuation approaches, and finally issuing the report. He emphasizes the importance of understanding the company's specific context, industry, and economic environment, and how different levels of control and marketability can impact a company's value.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.
The Oracle of Omaha: Lessons to Be Learned
Can you guess who said the following?“[M]y long-time partner, and I have the job of managing the savings of a great number of individuals. We are grateful for their enduring trust, a relationship that often spans much of their adult lifetime. It is those dedicated savers that are forefront in my mind as I write this letter.”No, that quote isn’t from some dear family member or close friend but from the opening paragraph of Mr. Warren Buffett’s 2022 Shareholder Letter for Berkshire Hathaway. Mr. Buffett’s understated demeanor and self-deprecating midwestern mannerisms have a way of making you forget he is, in fact, the fifth richest man in the world. Buffett and his business partner Charlie Munger recently held court in Omaha for Berkshire Hathaway’s annual shareholder meeting, fielding questions for over five hours. Not a bad showing for Buffett and Munger, 92 and 99, respectively.In what amounts to a near cliché for financial writing, we share a handful of lessons based on this year’s musings from the Oracle of Omaha in his 2022 Shareholder Letter.$38,000,000 vs. $250,000In the understatement of the century, Mr. Buffett offered the following assessment of his capital allocation performance:“At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so.”Let’s review Berkshire’s performance: if you invested $1,000 in the S&P 500 in 1965, at the end of 2022, you would have (including dividends) $250,000, nearly a 10% return every year. Not bad. If you had invested that same amount into Berkshire Hathaway, you would now have almost $38 million, just under a 20% return annually. What does Mr. Buffett chalk that” so-so performance” to?“Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”When your family business is thinking about its next big growth endeavor or capital allocation decision, it may be helpful to remember Mr. Buffett: long-term outperformance comes from good decisions played out for a long time.It’s important to make good capital allocation decisions with a solid framework, considering both your family business’s hurdle rate and your long-term strategy.The power of good, solid decisions over months will move the needle. Done over decades, these decisions will impact your family for generations.A Family Gathering in OmahaHere is how Buffett describes what his over $700 billion market cap conglomerate does:“Charlie and I allocate your savings at Berkshire between two related forms of ownership. First, we invest in businesses that we control, usually buying 100% of each. Berkshire directs capital allocation at these subsidiaries and selects the CEOs who make day-by-day operating decisions….”“In our second category of ownership, we buy publicly-traded stocks through which we passively own pieces of businesses. Holding these investments, we have no say in management.”“Our goal in both forms of ownership is to make meaningful investments in businesses with both long-lasting favorable economic characteristics and trustworthy managers.”Simple? Yes. Insightful? Definitely. As Mr. Buffett points out, “Almost endless details of Berkshire’s 2022 operations are laid out” in the financial disclosures. This year’s letter was shorter than past years at 11 pages, and Berkshire still abstains from quarterly conference calls. However, there is no dearth of information that would be important to a Berkshire shareholder and may give you and your family business ideas on how to present financial and business results to your family shareholders.We have discussed how to effectively communicate with your family shareholders, but ultimately the frequency and detail will depend on your shareholder base. Remember that while shareholder communication is an investment of time and energy, it has an attractive return for both your company and your shareholder base.There Is No FinishYou may be a fifth-generation family business that has been around for over 100 years, or you may be in the early innings. Regardless, family business owners need to be thinking not in terms of quarters but in decades. This is how Buffett described Berkshire’s genesis.“In 1965, Berkshire was a one-trick pony, the owner of a venerable – but doomed – New England textile operation. With that business on a death march, Berkshire needed an immediate fresh start. Looking back, I was slow to recognize the severity of its problems. And then came a stroke of good luck: National Indemnity became available in 1967, and we shifted our resources toward insurance and other non-textile operations.”As we’ve noted in previous posts, family businesses need to be both long-term-minded and nimble enough to adapt to market demand.You should be asking yourself if you are meeting market demand or hoping the market will accept what you want to produce. How is market demand different today than it was five years ago? What will customer preferences look like five years from now? Ultimately you are aiming to make decisions that will impact your family business longevity many years from now.Analyze the tough decisions with a mindset to ensure your family business continuity through the next generation, even if it may be painful today. From Buffett:“At Berkshire, there will be no finish line.”Final Thoughts and “Munger-isms”Over nearly 60 years, one may describe Berkshire’s performance as better than “satisfactory.” Check out Berkshire’s 2022 Shareholder Letter, and I hope you enjoy it as I did. Below are a couple of my favorite quotes from the “artfully blunt” Munger in this year’s letter.“Don’t bail away in a sinking boat if you can swim to one that is seaworthy.”“A great company keeps working after you are not; a mediocre company won’t do that.”“All I want to know is where I’m going to die, so I’ll never go there. And a related thought: Early on, write your desired obituary – and then behave accordingly.”
Book Review: The Psychology of Money
Successful family business directors recognize the role of luck and risk in success and failures, are adaptable, and make alternate operational decisions based on changing goals. Housel’s book does a nice job of expanding on these themes and can be an excellent addition to your family business library.
Is TXO's Strategy Paying Off?
The TXO Energy Partners IPO
As our colleague Bryce Erickson said in a recent post, uncertainty rules the day in the upstream world despite strong demand for oil and elevated commodity prices. The war in Ukraine has contributed to this, but there is no way of knowing when or if it will wind down. Interest rates continue to rise, and recession fears loom. We believe the recent initial public offering (IPO) of TXO Energy Partners LP offers an interesting case study of how investors are responding to these mixed signals.
In the early 2010s, upstream IPOs were at a peak. In 2011, there were no fewer than 20 IPO announcements, and the average targeted capital raises for IPOs climbed to well over $550 million by 2013. Things went sour from there. Since 2015, there have only been 22 IPOs announced. Due in part to the pandemic, average IPO targets for upstream firms have sunk to $15 million. Despite the vital role of oil and gas in the US economy, the market for public equity in upstream firms can certainly be described as underweight due to few publicly available investments in the sector and, thus, fewer opportunities for investment. Despite this, 2022 featured more IPO announcements than any year since 2016. Soaring commodity prices are bringing back interest in upstream investments. Upstream managers are confronting investor uncertainty by strengthening their balance sheets, using their historically high revenue to continue ramping production, and making generous distributions to shareholders.
Click here to expand the image aboveValuation ConsiderationsTXO Energy Partners LP, formerly MorningStar Partners LP, is an E&P firm that IPO’d on the New York Stock Exchange on January 26, 2023, under the ticker TXO. The Partnership is focused on plays in the Permian and San Juan Basins within Texas, New Mexico, and Colorado. TXO offered five million common shares with a target price of approximately $20 per share (which would raise about $100 million). The IPO also allowed underwriters to purchase another 750,000 common shares at the IPO price net of discounts and commissions.One of the most important factors when considering TXO’s fundamentals is its recent acquisitions. In late 2021, they purchased 24,052 leasehold acres, a CO2 plant in the Permian Basin, and additional CO2 assets in Colorado (these assets are referred to as the “Vacuum Properties”). Within just a month, they also acquired an additional 21,112 gross leasehold acres in the Permian (the “Andrew Parker Acquisition”). Finally, they increased their interest in the Vacuum Properties in August 2022. Every transaction involved proven producing wells.Further, these wells have an average decline rate of just 7% (compared to a 9% projected decline rate across all TXO’s assets). By making such acquisitions, TXO noticed a short-term impact on its income statement but has ultimately set itself up for reliable, comparatively non-risky cash flows. The table below summarizes TXO’s developed and undeveloped acreage as of December 31, 2022. One observation immediately jumps off the page: despite the recent Permian Basin acquisitions discussed above, TXO’s acreage is heavily weighted towards developed acreage in the San Juan Basin. Questions arise from this observation: Is TXO indicating a shift in priorities from the San Juan Basin to the Permian Basin? Will the company sell some of its San Juan Basin assets and use the proceeds to purchase more developed acreage in the Permian Basin after 2023? At the very least, the company’s focus is clearly on developed acreage rather than undeveloped acreage (see below for management’s immediate investment plans).In its S-1 statement, TXO reported PV-10 as of year-end 2021 of $986.6 million, compared to established firms like Diamondback Energy ($21.8 billion) and Black Stone Minerals ($972.1 million). A summary of TXO’s reserves per its most recent 10-K is shown below.Despite its comparatively small war chest of reserves (per the table above this paragraph showing the company’s reserve portfolio as of December 31, 2022), management has indicated that they anticipate most of their 2023 expenditures will go towards optimizing existing wells rather than continuing to make acquisitions to grow the wells in their portfolio.In the nine-month period ended September 30, 2022, revenues for TXO were $204.0 million, as opposed to $138.9 million for the same period in the prior year. TXO’s Vacuum and Andrews Parker acquisitions helped boost production volumes by almost 1,200 Mboe. Higher commodity prices also provided a significant boost, with realized prices for both oil and gas over 50% higher than in 2021. TXO reported net income of $14.6 million for the nine-month period ended September 30, 2022, compared to $25.2 million for the nine months ended September 30, 2021 ($0.58 per unit and $1.01 per unit for each respective year). The year-over-year decrease in net income was primarily attributable to higher production expenses in 2022 as well as transportation and tax expenses. On a year-over-year basis, production expenses climbed 105% as of September 30, 2022, while taxes and transportation expenses climbed 92%. Management stated that both items increased due to the two Vacuum and Andrews Parker property acquisitions. The higher production cost is a function of the acquired properties’ strong focus on oil production, which is typically more expensive on a Boe basis than natural gas production. The increase in taxes and transportation expenses was caused by rising commodity prices and changes in the Partnership’s production mix.In its S1, TXO portrays itself as holding a conservative balance sheet. Per Capital IQ, at the end of 4Q 2022, their largest liability was a credit facility with a balance of $113 million. Paying this debt down was the primary reason for their IPO. TXO has one of the smallest debt-to-capital ratios among its peers, as shown below. With less leverage, TXO is a comparatively less risky investment, all else being equal. This makes it particularly attractive to investors preparing for a potential downturn in the larger economy or upstream space.What is interesting about these financials is that despite tailwinds from commodity prices and growth from new acquisitions, YTD EPS shrank by 50%, yet TXO filed for an IPO anyway. Why? First, the EPS shrinkage is related to their acquisitions. Second, TXO’s stated strategy plays to the current desires of the market. As mentioned earlier, TXO is spending most of its money optimizing existing wells. Despite this, they still have plans to identify new opportunities. When describing how they are going to go about spending the portion of their capital dedicated to development, TXO stated that “over the next 24 months we anticipate that approximately half of our development activity will be focused on drilling new wells, virtually all of which we expect to be conventional, vertical wells.”Additionally, 97% of TXO’s current wells are conventional plays rather than more risky shale operations. By focusing on conventional plays, TXO can take advantage of slower production volume decline rates and earn steady cash flows to pay out dividends. The Partnership clearly had a distribution-focused plan in mind setting up their firm, as their Partnership Agreement specifies that every quarter it must pay out virtually all cash available for distributions. At one point, the S1 directly states that “our primary goal is to maximize investor returns through cash distributions and flat to low production and reserves growth over time.” At the time of this blog post, TXO has yet to make its first distribution since its IPO. How it sets its policy relative to other smaller upstream companies will be an interesting phenomenon to watch.The market does not currently seem to be valuing aggressive growth programs. Instead, investors are looking for companies like TXO with conservative balance sheets, large amounts of distributable cash, comparatively non-risky reserves, and steady, stable growth.All of this naturally begs the question of whether TXO’s strategy is paying off. Between TXO’s IPO date and May 4, the market price of the Standard and Poor’s Exploration & Production Select Industry Index has decreased by about 19%. On the other hand, TXO’s share price has only decreased by just under 2%.With such a high degree of uncertainty in the market, investors are bracing themselves for Murphy’s Law to take effect. They are seeking shelter in stable growth, safe balance sheets, and frequent dividend payments. TXO offered that, so investors have rewarded it.Mercer Capital has its finger on the pulse of the energy industry. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For a more targeted energy sector analysis that meets your valuation needs, please contact a member of the Mercer Capital Oil & Gas Team.
Fair Market Value and the Nonexistent Marketability Discount for Controlling Interests
This article discusses the concept of fair market value and its various effects. First, we explain what fair market value means. Then, we explore the hypothetical negotiations between potential buyers and sellers when determining fair market value and the implications of these discussions.
A Lifelong Succession Plan
Lessons from the Arnault Family
Bernard Arnault and his children present a unique, large-scale case of clearly defined and equitable succession planning to ensure their family business’s future for generations to come. If you’d like to explore what this could look like in your own family business, please feel free to reach out to one of our seasoned family business professionals.
Corporate Finance in 5 Minutes
New Video Released on Family Business On Demand Resource Center
Family shareholders are entitled to know what long-term strategic decisions are being made on their behalf by the managers and directors of the family business and why those decisions are being made. In this video, Travis Harms discusses three fundamental corporate finance questions that will help family business shareholders understand the basics of corporate finance and will ultimately result in more engaged and valuable shareholders.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) If you want to dive even deeper into the world of corporate finance, read our whitepaper "Corporate Finance in 30 Minutes." In the whitepaper, we provide more insight into the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make. Our goal with this whitepaper is to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.
Middle Men: Family-Owned Auto Dealerships
In this 5-minute video, originally recorded in May 2022 for Mercer Capital’s Family Business On-Demand Resource Center, Scott Womack addresses the topic of auto dealership valuation. He explains the economic and financial challenges that have affected the auto dealer industry and what drives the ultimate value of your dealership.
The New 3 Circles of Family Business and How to Be a Good Owner
Recap of the Transitions 2023 Conference
We were pleased to be a sponsor of last week’s Transitions Conference organized and hosted by the publishers of Family Business Magazine. The organizing framework for this year’s conference was “The New 3 Circles.”
Toronto-Dominion Bank and First Horizon National Merger
FHN is a tough call for the merger arbitrage community: $25 per share of cash if the current deal closes; regulators reject the deal, causing FHN's shares to trade freely in a tough market for bank stocks; or the parties extend the merger agreement again, but does the price get renegotiated?
200-Year History: Family Business Lessons from an American Icon
A recent Barron’s article on the link between Elon Musk, corn, and John Deere piqued our interest. What can family businesses take away from this situation? We see two lessons: be open to seeking non-family members to run your business, and don’t be afraid to be a fast follower.
Three Reminders on Gift and Estate Taxes
New Video Released on Family Business On Demand Resource Center
Estate planning may appear to be less pressing than other issues on your family business’ radar. However, the positive impact of effective planning on the long-term health of both the family and the family business is hard to overstate. In this video, Atticus Frank covers some reminders and quick to-dos to help you and your family implement your estate planning goals.
(More) Lessons for Family Business Directors
From the Failure of Silicon Valley Bank
This week, we are pleased to feature a guest post from our firm’s founder, Chris Mercer. Before establishing Mercer Capital in 1982, Chris worked in the banking industry, and in its early days (during the height of the Savings & Loan crisis), many of the firm’s clients were troubled financial institutions. In this post, Chris brings his decades of experience to bear in analyzing the failure of Silicon Valley Bank and identifies four critical lessons for family business directors, regardless of industry. We hope you enjoy it!
Down, But Not Necessarily Out
In this week’s post, we attempt to divert your attention from interest rates and banking crises by looking at recent private company transaction multiples and some implications of these measures.
Unpacking the Corporate Transparency Act
In this week’s post, we answer the main questions stemming from the Final Reporting Rule of the Corporate Transparency Act that will most likely affect you and your family business.
Middle Market Transaction Update Spring 2023
Transaction activity in the middle market, measured both in terms of deal value and deal volume, fell in the fourth quarter of 2022, continuing a year-long skid in deal activity realized in 2022 against the backdrop of rising interest rates and looming economic threats.
SVB and Three Family Business Lessons
California (Bank) Dreamin’
In case you have been on an exotic vacation in a remote location, Silicon Valley Bank (SVB) imploded last week in a "gradually, then suddenly" fashion. You’ve likely read more about this California bank than you cared to over the last few days, so this post from Family Business Director aims to highlight three relevant family business lessons we can take from this: diversification, succession planning, and keeping a long-term focus.
Preparing for the Unknown Unknowns
The Importance of Sell-Side Due Diligence
I do not think it’s fair to say Focus’s foray into the public space was a failure. Over the years, I’ve blogged that the IPO was richly priced (it was). I thought some of their disclosures on things like organic growth were less than helpful (they were not). I wondered if they were overleveraged (and I wasn’t the only one). I noted that they had lots of competition in the acquisition space (as time went on, they did). It’s absolutely true that most of the total return on Focus was earned on the initial day of trading and the speculation over going private.
February 2023 SAAR
The February SAAR was 14.9 million units, down 6.3% from last month but up 8.6% from February 2022. Year-over-year increases in the SAAR have been a theme throughout the last several months. In fact, February 2023 marks the seventh month in a row that the SAAR improved from the year prior. Looking ahead, we believe that it is likely that year-over-year improvements will continue for several more months as nationwide inventory balances continue to recover.
A Little Planning—A Lot of Tax Savings
Charitable Giving Prior to a Business Sale
Over the last few weeks, I’ve had both professional and personal conversations with family business owners who utilized a business transaction to maximize their charitable giving and minimize their tax burden. While taxes are not generally the primary driver in making large gifts to charity, a little foresight and planning can create flexibility in your giving, yield more bang for your buck, and result in fewer taxes owed to Uncle Sam. In this week’s post, we discuss the tax strategy that charitable family business owners should keep in mind when selling their business.Charitable Gifts and Business TransactionFor many family businesses, the original cost basis of their business ownership interest is extremely low, if not zero. If you have received stock via gifting, your stock’s basis is "carried over" from the original donor (or was the stock's fair market value at the time of the gift). In short, for many family businesses, any sale likely has quite a large built-in capital gains tax, especially if your family business has generated solid returns over generations.So, where’s the beef? A donation of some portion of your family’s business ownership in its business prior to a sale provides two benefits:A charitable tax deduction for the fair market value of the interest at the time the gift is made.Minimized capital gains exposure for the portion donated and sold by the charity rather than the family. Below we provide an example and some thoughts on this strategy.Utilizing a Donor Advised FundA donor-advised fund, or "DAF," is a flexible and tax-efficient way to give to charities. A DAF operates like a charitable investment account for the sole purpose of supporting charitable organizations. When taxpayers contribute assets, such as cash, stock, or other (read: private business stock) assets to a DAF, they can take an immediate tax deduction, avoid capital gains recognition, and grow the donation tax-free.A primary benefit of using a DAF to implement this gifting strategy is a practical one. Many charities are not structured to take stock of privately held companies, whereas organizations that support DAFs are able to handle the complexities around private family-owned stock gifts.Gift TimingAs the saying goes, "Pigs get fat, hogs get slaughtered." If you already have a legally-binding transaction agreement in place, this strategy is less useful, and the IRS is not likely to allow recognition of the gift. However, a non-binding letter of intent ("LOI"), where each side can leave the table, meets the bill. For the gift, a qualified appraisal would likely give significant weight to the pro rata offer on the table in measuring fair market value. The likelihood of a near-term transaction would also limit the typical discounts for lack of marketability or control. This would maximize the value of the ownership interest for gifting purposes.This works for donating stock to charity broadly, not just in a business transaction context. However, if a path to liquidity is not on the horizon, discounts for lack of control and marketability are likely to be more significant. This lowers the total fair market value of your gift, reducing tax savings at the time of the gift. On the flip side, if the gift is made to a DAF, as discussed, the ownership interest may be held and grow as the business value grows. At a business exit, your DAF reaps the benefits of the sale and avoids the capital gains tax on that portion of ownership, maximizing future charitable gifts from the DAF.Qualified AppraisalIf you’re reading this blog, you may have guessed this already; Gifts of private family ownership interests require qualified appraisals per the IRS. We talk about what amounts to a "qualified appraisal" and how to pick a qualified business appraiser here.Tax Benefits of PlanningTo illustrate the benefits of this strategy, consider two alternative scenarios: (1) the business owner contributes to charity using funds after a sale of the business (“post-sale”), or (2) the business owner contributes stock to charity prior to the deal closing ("prior-to-sale"). We’ll briefly summarize Figure 1 below.In both scenarios, the value of the gift is assumed at $3.5 million. This represents the pro rata cash proceeds in the post-sale scenario and the value of the privately held stock based on a qualified appraisal (which referenced the non-binding LOI purchase price in developing the conclusion of fair market value) in the prior-to-sale scenario.In the post-sale scenario, the business owner pays a capital gains tax on the appreciation in the stock, or $700,000 (20% of $3.5 million, assuming a $0 basis). In the prior-to-sale scenario, the business owner avoids the capital gains tax because the stock was gifted to a DAF.Under both scenarios, the business owner is entitled to a charitable deduction of $1.295 million for income tax purposes.The total tax benefit in the post-sale scenario is $595,000 ($1.295 million less the capital gains tax paid of $700,000). The prior-to-sale scenario’s total tax benefit is $1.295 million, or $700,000 higher.Final ThoughtsAs we said in the beginning, tax considerations are generally on the back burner when considering major gifts. While gifts of family business stock can be complex, the benefits of the strategy and the impact it can have are too significant to ignore. We’ve worked with business owners to provide qualified appraisals for gifting purposes in both a charitable and estate planning context. Give us a call if you want to discuss a gifting strategy you are contemplating in confidence.Note: The example here and tax ramifications are for illustration only. This article does not consider state, AMT, or other complex tax situations. The value of stock in your situation may not equal post-sale pro rata proceeds. Please consult your independent appraiser and tax advisor regarding your situation and potential tax consequences.
Mercer Capital’s Value Matters® 2023-03
Navigating the Estate Tax Horizon
Out to the Public and Back Again
The Weber Grill Case Study
A recent Wall Street Journal article highlighted the trend of newly-public companies reverting back to private ownership after a very short time in public hands. Among the boomerang IPOs mentioned in the article was that of backyard grill maker Weber. With the advent of grilling season, we were curious about Weber’s experience in the public markets and any lessons that family business directors might be able to draw from the tale.
Analysis of the Spirit Fairness Opinions re the JetBlue Acquisition
As participants and observers in transactions, the pending acquisition of Spirit Airlines, Inc. (NYSE: SAVE) by JetBlue Airways Corporation (NASDAQGS: JBLU) offers a lot of fodder for us to comment on.
Review of Key 4Q 2023 Economic Indicators for Family Businesses
In this week’s Family Business Director post, we look at a few key macroeconomic trends that developed in the fourth quarter of 2022 and early 2023 and their impact on family businesses.
From Unfriended to Best Friends Again?
Attaining Efficiency Through Restructuring
This post discusses Meta's long-term planning.
6 Valuation Principles You Should Know
New Video Released on Family Business On Demand Resource Center
Family business directors and shareholders do not need to be valuation experts. However, there are six basic valuation principles that can help directors and shareholders make better long-term financial decisions for their family businesses. In this video, we identify and explain these six principles, which are great additions to your family business toolbox.
Whitepaper Release: Compensation Structures for Investment Management Firms
For this week’s post we’re introducing our whitepaper on compensation structures for investment management firms. Since roughly 75% of an investment management firm’s expenses are compensation costs, figuring out the right balance of salary, performance pay, and equity incentives is always front of mind for RIA principals. This whitepaper is designed to help you navigate the various compensation models to optimize firm growth and employee retention.
Should You Conduct a Shareholder Survey?
Five Reasons Why It's a Good Idea
This week’s post outlines a few reasons why boards and management teams should consider a shareholder survey as part of their strategy to keep the incentives of all a company’s stakeholders aligned.
Mercer Capital’s Value Matters® 2023-02
Estate Tax Exemption Uncertainty
WHITEPAPER | Buy-Side Considerations for Middle-Market Companies Looking to Enter the Acquisition Market
Many observers predict that the market is rife for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity. Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.In this whitepaper, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market.
The 84 Lumber King
Succession Planning and How to Find Your Next Leader
“Money won’t make you happy… but everybody wants to find out for themselves.” – Zig Ziglar
Estate Tax Exemption Uncertainty
And Other Takeaways from the Heckerling Estate Planning Conference
This year’s week-long conference was the first to be held in person in a few years, and the exhibit hall and education sessions were full of good information and details on the estate, gift, and tax planning fronts. Below we share just a few topics of conversation and tidbits we picked up from the sessions and conference last week.
Dividends, Shareholder Signals & Present Value
As market and financial data for 2022 continue to roll in, we are beginning to prepare for our annual benchmarking study. One early finding is that investors clearly distinguished between companies that pay dividends and those that don’t. Across the size spectrum, investors favored dividend-paying stocks in 2022, as illustrated in Table 1.Table 1 :: Average Returns by Dividend Status While it was a down year across the board, the average return for companies that paid dividends was less negative than those that did not. In this post, we explore two potential reasons for this outcome and the lessons for family business directors.Lesson #1 – Dividends are a powerful signal to shareholdersActions speak louder than words, and dividends speak louder than slide decks. Dividends tell shareholders what time it is and what the future looks like.Paying a dividend—or not—tells shareholders whether it is planting time or harvesting time. The implicit signal from non-dividend payers is that the company has more attractive investment alternatives than available capital (i.e., it’s planting time). However, dividend payers are communicating to shareholders that they are generating more cash flow than can be responsibly reinvested (i.e., it’s harvesting time).We can confirm this in general terms by looking at the prevalence of dividend payers among the small-cap (S&P 600), mid-cap (S&P 400), and large-cap (S&P 500) indices. As shown in Table 2, nearly 80% of the large-cap companies in the S&P 500 paid dividends in 2022, compared to just over half of the small-cap companies in the S&P 600.Table 2 :: Prevalence of Dividend Payers by IndexAs companies grow and mature, they often use dividend payments to signal to shareholders what time it is.Second, companies can use dividends to signal to shareholders what they believe the future holds. Stock prices are all about expectations for the future, not what has happened in the past. Companies tend to only change dividends when they believe the new level will be sustainable, so investors interpret dividend changes as powerful signals regarding management’s confidence in the company’s performance going forward.Table 3 :: 2022 Return by Dividend ChangeAs shown in Table 3, those dividend payers that increased dividends during the year outperformed those that maintained or reduced their dividends during 2022.So what is your family business’s dividend policy telling your family shareholders about what time it is and what the future holds for your family business? As we have often remarked, shareholder letters may or may not get read, but dividend checks always get cashed. Are your dividend actions aligning with your words about the family business’s circumstances and future prospects? If not, there is a good chance you are eroding credibility and trust with your family shareholders, and credibility and trust are the lifeblood of successful and sustainable family businesses.Lesson #2 – Dividends reduce shareholder riskMarkets are complicated, and returns are influenced by many factors. However, at the risk of oversimplifying, stock prices fell in 2022 because higher interest rates increased the cost of capital for businesses. As the Wall Street adage says: “Don’t fight the Fed.”Rising interest rates do not affect all investments equally, however. The longer investors have to wait to receive cash, the more sensitive an investment is to interest rates. A steady dividend stream shortens the “duration” of investments in dividend-paying shares relative to non-dividend-paying shares. So, in a rising rate environment like 2022, basic present value math suggests that dividend-paying stocks will outperform.But one shouldn’t expect that what worked in 2022 will not always work going forward. Table 4 summarizes average annualized returns for the same group of companies for four years ending December 31, 2021. Over this period, during which the federal fund’s effective rate fell from 1.42% to 0.08%, returns for dividend payers lagged those of their non-dividend paying peers.Table 4 :: Annualized 2017-2021 Returns by Dividend Status Dividends reduce risk (and upside potential) for public company investors. What about your family shareholders? What role do dividends play in managing the investment risk of your family shareholders? We’ve written previously about how your family business has more than one value. Of the three “values” of your family business at any given time, the lowest is the value of a minority (non-controlling) position in shares that is not readily liquid, as depicted in Table 5.Table 5 :: The Levels of Value The “marketability discount” in Table 5 measures the economic burden of illiquidity commonly borne by family shareholders. The magnitude of that discount is not the same for all family businesses. Rather, it is a function of several factors, prominent among which is the amount of expected future dividends. As markets demonstrated in 2022, dividend payments mean that investors don’t have to wait as long to receive a return on their investment. For family shareholders facing an uncertain but potentially lengthy holding period, regular dividend payments ease the burden of illiquidity.ConclusionYour family business’s dividend policy is sending a signal to and is affecting your family shareholders' risk (and potential return). Are you and your fellow directors being intentional about the signals sent by your dividend? Are you incorporating the risk-return tradeoff for your family shareholders in your dividend policy deliberations? Intentionally crafted or not, all family businesses have a dividend policy: is yours sending the right signals?Mercer Capital has worked with family businesses in crafting their dividend policy. Let us know if you have questions about your dividend policy and the message it is sending your family shareholders.
December 2022 SAAR
The December SAAR was 13.3 million units, down 5.3% from last month but up 4.7% from this time last year. This month’s SAAR data is a bit concerning for the auto industry, as supply chain improvements do not seem to be translating to improvements in vehicle sales pace as quickly as the last couple months have indicated. Over the past month, it has seemed more and more likely that plummeting trade-in equity, persistently-high interest rates, and growing fears of an economic recession are keeping the sale of automobiles low, which could spell trouble for auto dealers that have thrived in a high-price environment over the past eighteen months.
Middle Market Transaction Update Winter 2022
Overall deal activity at $45 billion in the third quarter of 2022 was roughly unchanged from the second quarter but down sharply from $63 billion in the third quarter of 2021.
Southwest Airlines Meltdown and Your Investment Decision
Come Fly With Me (Soon?)
So how do you make rational investment and capital expenditure decisions? Do you acquire a new business or modernize? What is a good investment? In this post, we discuss two key areas to address these questions: identify investments available to your business and evaluate your available investment opportunities.
Mercer Capital’s Value Matters® 2023-01
Estate Tax Exemption Uncertainty
Bank M&A 2022 — Turbulence
At this time last year, we thought bank M&A would be described as a second year of “gaining altitude” after 2020 was spent on the tarmac following the short, but deep recession in the spring of 2020. Our one caveat was that bank stocks would have to avoid a bear market following a strong performance in 2021 because bear markets are not conducive to bank M&A.The caveat was correct. Bear markets developed in both bank stocks and fixed income that included the most deeply inverted U.S. Treasury curve since the early 1980s. Among the data points:The NASDAQ Bank Index declined 19% through December 28;The Fed raised the Fed Funds target rate 425bps to 4.25% to 4.50%;The yield on the 10-year US Treasury rose 236bps to 3.88%; andCredit spreads widened, including 150bps of option adjusted spread (OAS) on the ICE BofA High Yield Index to 4.55% from 3.05%.The outlook for deal making in 2023 is challenged by significant interest rate marks (i.e., unrealized losses in fixed-rate assets), credit marks given a potential recession, soft real estate values, and the bear market for bank stocks that has depressed public market multiples. For larger deals, an additional headwind is the significant amount of time required to obtain regulatory approval.However, core deposits are more attractive for acquirers than in a typical year given rising loan-to-deposit ratios, the high cost of wholesale borrowings and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2023 provided any recession is shallow.A Recap of 2022As of December 28, 2022, there have been 167 announced bank and thrift deals compared to 216 in 2021 and 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percentage of charters, acquisition activity in 2022 accounted for 3.5% of the number of banks and thrifts as of January 1. Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,746 bank and thrift charters compared to 4,839 as of year-end 2021 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Also notable was the lack of many large deals. Toronto-Dominion’s (NYSE: TD)pending $13.7 billion cash acquisition of First Horizon (NYSE: FHN) represents 61% of the $23 billion of announced acquisitions this year compared to $78 billion in 2021 when divestitures of U.S. operations by MUFG and BNP and several larger transactions inflated the aggregate value.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—was unchanged compared to 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The median P/TBV multiple was 154% in 2022. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 134% in 2020 due to the impact of the short but deep recession on economic activity and markets.The median P/E in 2022 eased slightly to 14.6x from 15.3x in 2021; however, buyers focus on pro forma earnings with fully phased-in expense saves that often are on the order of 7x to 8x unless there are unusual circumstances. Accretion in EPS is required by buyers to offset day one dilution to TBVPS and to recoup the increase in TBVPS that would be realized on a stand-alone basis as investors expect TBVPS payback periods not to exceed three years.Figure 1 :: 1990-2022 National Bank M&A MultiplesClick here to expand the image abovePublic Market Multiples vs Acquisition MultiplesFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 2000 with the average daily public market multiple each year for the SNL Small Cap Bank Index.1Among the takeaways are the following:Acquisition pricing prior to the GFC as measured by P/TBV multiples approximated 300% except for the recession years of 2001 and 2002 when the average multiples were 248% and 267%.Since 2014, average P/TBV multiples have been in the approximate range of 160% to 180% except for 2020.The reduction in both the public and acquisition P/TBV multiples since the GFC reflects a reduction in ROEs for the industry since the Fed adopted a zero-interest rate policy (ZIRP) other than 2017-2019 and 2022.Since pooling of interest accounting ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition multiple relative to the average index multiple has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.P/E multiples based upon unadjusted LTM earnings have approximated or exceeded 20x prior to 2019 compared to 14-18x since then.Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but the pay-to-trade multiples are comfortably below 1.0x to the extent the pro forma earnings multiple is 7-8x, the result being EPS accretion for the buyer.Figure 2 :: 2000-2022 Acquisition Multiples vs Public Market MultiplesClick here to expand the image aboveFigure 3 :: 2000-2022 M&A TBV Multiples vs. Index TBV MultiplesClick here to expand the image abovePremium Trends SubduedInvestors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to public market prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns.As shown in Figure 4, the average five-day premium for transactions announced in 2022 that exceeded $100 million in which the buyer and usually the seller were publicly traded was about 20%, a level that is comparable to recent years other than 2020. For buyers, the average reduction in price compared to five days prior to announcement was 2.5%. There are exceptions, of course, when investors question the pricing (actually, the exchange ratio), day one dilution to TBVPS and earn-back period. For instance, Provident Financial (NASDAQ: PFS) saw its shares drop 12.5% after it announced it would acquire Lakeland Bancorp (NASDAQ: LBAI) for $1.3 billion on September 27, 2022.Figure 4About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has 40 years of experience in assessing mergers, the investment merits of the buyer’s shares and the like. Please call if we can help your board in 2023 assess a potential strategic transaction.
MedTech & Device - Industry Scan 2022
For this quarterly update, we bring together a couple of strands of our medtech and device industry practice.First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term.Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives.The implications for some of the larger companies in the space are probably clear-cut.The downstream reverberations to private, development stage companies may be less straightforward.Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.2022: A Brief ReviewA tumultuous year in the public markets is coming to a close.By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year.The broader medtech and devices industry largely followed suit.On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market.As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well.A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies.At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry.It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.The shift towards more caution also manifested in other measures of market sentiment and activity.Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples.The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022.By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021.The number of IPOs also slowed to a trickle.Looking Ahead to 2023 and Beyond: A Few Notes for Development Stage CompaniesNo industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones.In this context, some observations for development stage companies:An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.The sentiment shift towards more caution is shared by all investors, although the degrees will differ.Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.Wrap-upBeyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse.We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them.The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix.Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view.Even among these investors, financial terms and preferred deal structures vary considerably.For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality.In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector.Please contact us to discuss how we may be of help.For a more in-depth review of the industry, take a look at our most recent newsletter.
What Is on Your Family Business Box Score?
Back in the day when not all sporting events were shown on TV, reading the box score in the newspaper the next day was sometimes the only way to know the story of the game.A box score is a structured summary of results from a competition. The box score lists the game score as well as individual and team achievements. Here’s an example of a baseball box score—a savvy baseball fan might remember this game as it was especially memorable.As you see, the box score can tell the story of the game through key statistics—innings represent the primary measurement period, and runs, hits, and errors summarize the main takeaways from the game. Here's another example of a box score—personally, one of my favorites as I was born and raised in New Orleans.A question for you and your board, what is on your family business box score?When the lights are still on and things are stable, it can be easy to continue with business as usual and not look too closely at key return metrics. Creating a box score, and maybe more importantly, updating it consistently, can help prevent complacency. Establishing fundamental metrics important to your business and benchmarking your performance to peers or "opponents" can help quickly convey to you and your shareholders how the family business is doing.Consider these three metrics for your family business box score.Return on Invested CapitalReturn on Invested Capital—ROIC—is one of the best comprehensive measures of financial performance for family businesses. In its simplest form, ROIC is the ratio of NOPAT (net operating profit after tax) to invested capital (the sum of equity and debt capital invested in the business). It describes how much NOPAT the business generates per dollar of invested capital. ROIC depends on both the income generated by the business and the amount of capital invested. It is a great metric for the family business box score as it facilitates comparison to the performance of alternative investments that may be available to the family. As we have discussed previously, companies with higher ROIC display positive attributes for businesses: faster growth, more cash distributions, reduced risk, increased shareholder returns, and increased worth of the company as a whole. Paying attention to ROIC today is a reliable way to improve shareholder returns tomorrow. It is a powerful metric for evaluating how your family business has performed in the past and creating a strategy for future improvement.Shareholder ReturnsInvestment returns have two components: dividend yield and capital appreciation. The yield measures the current income a business generates, while capital appreciation measures the increase in value during the period. As depicted below, total return is the sum of yield and capital appreciation. These two components have an inherent tradeoff—greater current income limits future upside, and increased growth usually comes at the expense of current income. Investors choose from a menu of different investment alternatives, including short-term treasury notes, small-cap public stocks, private equity, and/or venture capital. Uniformly, investors desire higher returns; however, the greater the expected return correlates with the increased potential risk. Think of it like a football team: are we a run-first, ball-control offense, or do we sling the ball up and down the field? The two represent a tradeoff—but ultimately aim to achieve the same goal: a win. Or, in your family’s case: a return. Just like a team’s "identity" aims to play to its strengths, your total shareholder return profile likely reflects what your business means to you. Analyzing where the total return comes from (in the form of appreciation or yield) can help you see how you are doing relative to shareholder objectives and desired business meaning.Capital Structure & Financial LeverageUtilizing capital structure & financial leverage on your family business box score can lead to a plethora of important strategy discussions. Conversations with family shareholders that include: What is the appropriate mix of debt and equity? What is the current capital structure? How does the capital structure compare to our peers? What effect would different financing decisions have on the overall cost of capital? What is the target capital structure?Capital structure decisions are inevitably linked to family business meaning and shareholder objectives. Are you seeking to leverage current assets to achieve growth into the future (growth engine), heightening risk, or do you avoid debt to reduce volatility and shore up dividends? Financial leverage can be measured by comparing total debt to invested capital (book values of debt and equity), market values, or relative to cash flow. Ratios like debt-to-equity, debt-to-EBITDA, and debt-to-assets can be useful for your family business box score, especially when used to benchmark to peers in direct competition within your industry.ConclusionThe sports and business worlds are increasingly data-driven, and access to relevant data is essential to making the right decisions. The best performance metrics address not just “what” performance has been in the past, but reveal the “why” behind it and give direction for “how” to improve operations in the future. We believe that the individual statistics discussed above qualify as the best performance measures to help depict the “why” and guide the “how” in the future.Creating a process for your family business and understanding which key metrics to utilize for a box score can be challenging. But rather than stress about the exact measures, aim for consistent measurement and understand the drivers and outputs of your selected metrics. Our family business advisory professionals help family management teams develop their box score and align their perspectives on the financial realities, needs, and opportunities of the business.We’ll be taking next week off from the Family Business Director Blog. Enjoy the holiday, and we will see you in the new year!
Appalachian Production Holds True Despite Market Disruptions
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Marcellus and Utica shales.Production and Activity LevelsEstimated Appalachian production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 1% year-over-year through late December. Production in the Eagle Ford, Permian, and Bakken increased 16%, 11%, and 5% year-over-year. Despite a much-improved year-over-year commodity price environment, Appalachian production was fairly stable, largely due to high price volatility over the year, which left the markets uncertain as to where prices would be going forward.
Rig counts continued to climb in all four basins over the last year. Growth rates in the Appalachian and Permian basins were more modest, while rates for the Bakken and Eagle Ford basins were notably higher. The Appalachian rig count rose 30% from 40 to 52 rigs. Among the oil-focused basins, the Eagle Ford led with a 71% increase from 42 to 72 rigs. The Bakken followed with a 56% increase (27 to 42 rigs), while the Permian had the lowest increase with a 24% increase (283 to 350 rigs).
As is typical, Appalachian production has been relatively flat despite its rig count growth. That’s due to the basin’s higher production declines which necessitate a higher rig count to maintain production levels.
Commodity Price VolatilityHenry Hub natural gas front-month futures prices have experienced significant volatility over the latest year. Prices began 2022 on a general upswing before rising sharply as the market reacted to Russia’s invasion of Ukraine in late February. As Russia subsequently began leveraging its natural gas supplies against Europe in retaliation of Europe’s response to the war in Ukraine, natural gas prices became notably more volatile. They rose from an early March low of $4.56 to an early June high of $9.29 — only to drop back to $5.39 in late June and then hit a 2022 high of $9.42 in late August. By mid-December, Henry Hub had declined, albeit with only lightly reduced volatility, to $5.79.Oil prices, as benchmarked by West Texas Intermediate (WTI) and Brent Crude (Brent), also began 2022 on a steady upward trend that took the WTI from $76/bbl to $88/bbl and the Brent from $79/bbl to $91/bbl, prior to the Russian invasion. As the reality of the Russian-Ukraine war took hold, the oil benchmarks showed a marked uptick in volatility that lasted into mid-May, with prices hitting highs of $120/bbl and $128/bbl, and lows of $93/bbl and $96/bbl. Since then, WTI and Brent prices have trended downward, exhibiting more typical volatility other than modest rallies in August and October. As of mid-December, WTI sat at $73/bbl and Brent at $78/bbl.Financial PerformanceThe Appalachian public comp group saw markedly strong stock price performance over the past year (through December 12th), led by Antero and EQT with price increases of 90% and 77% as of December 12th. The remaining members of the comp group showed more modest 1-year price increases of 12% to 38%. Prices peaked in early June for all members, except EQT, with year-to-date increases of 71% to 171%. EQT’s stock price peaked in mid-September at a year-to-date increase of 143%. Stock prices fell sharply beginning in mid-September but reversed direction immediately following the sabotage of the Nord Stream pipelines in the Baltic Sea that transport Russian natural gas to northern Europe.Antero and EQT led the way among this group for several reasons. For Antero, one reason appears to have been its lack of hedging for 2023, which has allowed it greater exposure to the uptick in gas prices and has allowed Antero to be aggressive in paying down debt. EQT, on the other hand, does have more near-term hedging ceilings to deal with. However, its strength is in its operational efficiencies, whereby their recent literature demonstrates breakeven operating expenses at $1.37 per mcf. This is among the lowest in the industry and allows them to accumulate cash flow.ConclusionAppalachian production held steady in 2022 despite historically high commodity price volatility driven by the Russian-Ukraine war, the sabotage of the Nord Stream pipelines, and rising LNG exports to Europe to stave-off potential winter heating shortages. The Q4 Appalachian rig count is at a level beyond that needed for production volume maintenance, so there would seem to be at least some potential for Henry Hub price reductions going into 2023. However, the demand for new natural gas supplies to Europe provides a countervailing wind to any potential downward movement in natural gas prices. In the end, the natural gas markets seem to be in the midst of a series of events that promise continued supply and demand shifts with no certainty as to where the market will go in 2023.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Is Your Family Business Ready for the Next Recession?
A Look Ahead to 2023
Allow us to interrupt the usual glad tidings enjoyed in December with a dousing of cold water. No, we aren’t about to embark on a full-on airing of grievances a la the great 20th-century philosopher Frank Constanza. Rather, the intent of our post this week is to wave a cautionary flag one last time this year before we enter the Christmas season over the next several weeks. As we begin to put a bow on 2022 and turn our attention to 2023, we suspect that the dreaded “R word” is on the mind of many of our readers as they contemplate the myriad challenges and obstacles their businesses will face in 2023.While we are not professional economists and have no illusions of being so, those that have chosen to make their living by predicting the timing of fluctuations in the business cycle are in near unanimous agreement that the U.S. economy will enter a recession in 2023 if it has not done so already. Recent readings of The Conference Board Leading Economic Index® (LEI) for the United States suggest as much: “Indeed, given the LEI’s recent performance, The Conference Board projects that economic weakness will intensify and spread more broadly throughout the U.S. economy over the coming months with a recession to begin around the end of 2022 or early 2023.”As a family business owner or director, now is the time to think critically about how your family business is positioned for a potential economic slowdown. This post offers a few practical steps family business owners and directors can take to ensure their business continues to thrive even if Santa brings us a recession this year.Operating EfficiencyOne of our family business clients told us a long time ago that making good decisions is a lot easier when you don’t need the money. There’s a lot of wisdom in that maxim, given that sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business. When business is going well, it’s often easy to put off hard decisions regarding expense management. When you don’t feel like you “need” the money is typically the best time to make decisions in support of the long-term sustainability of the family business. If you wait until you feel the pressure in the heat of a downturn, making appropriate expense management decisions will be much more painful.Balance Sheet StrengthManaging the balance sheet is a constant trade-off between efficiency and flexibility. We often write about the perils of “lazy” capital in family businesses, yet some financial flexibility can help sustain family businesses during economic slowdowns. Balance sheets can be fortified in advance of a recession by shedding underperforming or non-operating assets and using all or some of the proceeds to reduce outstanding indebtedness and build up a war chest of cash to sustain operations in the event of a downturn. Bankers prefer to lend money to those who don’t need it, so now could still be an optimal time to expand borrowing limits on lines of credit or re-negotiate loan covenants.Competitive DynamicsOne oft-touted benefit of family businesses is the ability to maintain a long-term focus and avoid the short-termism that can afflict non-family public companies. Taking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity. You don’t have to outrun the bear as long as you can outrun the other hunters. Now is the time for management teams and boards to carefully assess competitive and industry dynamics to identify what opportunities might arise for the family business to solidify its long-run competitive position during a recession.Revenue CyclicalityThe cyclicality of revenue refers to the sensitivity of a family business’s revenue stream to overall economic growth. Companies that sell non-discretionary goods or services exhibit less revenue sensitivity since customers need such products and services regardless of the economic environment. Demand for food, personal care products, healthcare, and similarly situated industries can soften during a recession as consumers trim budgets, but the sensitivity is muted relative to that for discretionary goods and services (automobiles, home renovations, leisure goods, etc.) that consumers can more readily forego or defer when belts need to be tightened. Examining the cyclicality of your family business’ revenue and employing strategies to manage this cyclicality is one practical step owners and directors can take to limit the company’s revenue exposure in the event of an economic slowdown.ConclusionWe sincerely hope the next recession doesn’t start for a long time. You need to be prepared whenever it does start, whether in 2023 or later. As a family business director, you will probably never be able to make your business “recession-proof,” but now is the time to evaluate the prudent steps to prepare for the next downturn. Our family business advisory professionals have lived and worked through several recessions (and have the scars to prove it). Give us a call to discuss positioning your family business for the next one today.
M&A in Marcellus & Utica Basins
Shareholder Value Creation Abounds; ESG Interest Waning
Through November 2021, there were three M&A deals in the Marcellus and Utica shales. Compared to the 16 deals in the same period in 2020, companies looking to get into or out of the Appalachian basins effectively did so in 2020. The following table summarizes transaction activity in the Marcellus and Utica shales in 2021:Click here to expand the image aboveAs shown in the following table, M&A activity picked up in 2022 year-to-date, with twice as many transactions announced.Click here to expand the image aboveWhat has caused the slight rebound in M&A activity in the Marcellus and Utica shales? Companies are focusing on asset quality, strong balance sheets, prudent capital structures, and free cash flow growth. Below we examine the two largest transactions that occurred in but were not limited to the Marcellus and Utica shales in 2022.Sitio Royalties and Brigham Minerals, Inc. Merge to Create the Largest Public Minerals OwnerOn September 6, Sitio Royalties Corp. (NYSE: STR) (“Sitio”) and Brigham Minerals, Inc. (NYSE: MNRL) (“Brigham”) announced a definitive agreement to combine in an all-stock merger, with an aggregate enterprise value of approximately $4.8 billion based on the closing share prices of Sitio and Brigham on September 2, 2022. The combination brings together two of the largest public companies in the oil and gas mineral and royalty sector. Upon completion of the merger, the combined entity will retain the name Sitio Royalties Corp.Under the merger agreement's terms, Brigham shareholders will receive a fixed exchange ratio of 1.133 shares of common stock in the combined company for each share of Brigham common stock owned. Sitio’s shareholders will receive one share of common stock in the combined company for each share of Sitio common stock, based on ownership on the closing date. Brigham’s and Sitio’s Class A shareholders will receive shares of Class A common stock in the combined company, and Brigham’s Class B and Sitio’s Class C shareholders will receive shares of Class C common stock in the combined company. Upon completion of the transaction, the former Sitio shareholders will own approximately 54%, and the former Brigham shareholders will own about 46% of the combined entity on a fully diluted basis.Robert Rosa, CEO of Brigham, commented,“Our merger with Sitio creates the industry-leading powerhouse in the minerals space … with approximately 100 rigs running across all of our operating basins and greater than 50 activity wells to continue to drive production and cash flow growth.”The Sitio-Brigham deal press release discusses operational cash cost synergies, a balanced capital allocation framework that aligns with shareholder interests to drive long-term returns, enhanced margins, and increased access to capital. But, as a recent Forbes article points out, despite Kimmeridge Energy, which owns approximately 43.5% of Sitio, being a heavy promoter of ESG in the shale business, the press release has only a slight mention of ESG. The only direct mention of ESG is in the last bullet point of the strategic rationale behind the deal.EQT Corporation Continues to Add to Core Marcellus Asset BaseOn September 8, EQT Corporation (NYSE: EQT) (“EQT”) announced that it entered into a purchase agreement with THQ Appalachia I, LLC (“Tug Hill”) and THQ-XcL Holdings I, LLC (“XcL Midstream”) whereby EQT agreed to acquire Tug Hill’s upstream assets and XcL Midstream’s gathering and processing assets for total consideration of $5.2 billion. The purchase price consists of cash of $2.6 billion and 55 million shares of EQT common stock worth $2.6 billion. The transaction is expected to close in the fourth quarter of 2022, with an effective date of July 1, 2022. Transaction highlights include:~90,000 core net mineral acres offsetting EQT’s existing core leasehold in West Virginia95 miles of owned and operated midstream gathering systems connected to every major long-haul interstate pipeline in southwest AppalachiaCombined upstream and midstream assets at 2.7x next-twelve-month (“NTM”) EBITDAUpstream-only valuation of 2.3x NTM EBITDA300 untapped drilling locations in the Marcellus and Utica shales
The deal is the largest U.S. upstream deal since Conoco Phillips purchased Shell’s Permian Basin assets for $9.5 billion in September 2021.
EQT President and CEO Toby Rice commented,
“The acquisition of Tug Hill and XcL Midstream checks all the boxes of our guiding principles around M&A, including accretion on free cash flow per share, NAV per share, lowering our cost structure and reducing business risk, while maintaining an investment grade balance sheet.”
The Tug Hill/XcL Midstream transaction piggybacks EQT’s May 2021 $2.93 billion acquisition of all of the membership interests in Alta Resources Development, LLC’s (“Alta’) upstream and midstream subsidiaries. Consistent with his comments on the Tug Hill/Xcl Midstream deal, Mr. Rice commented that the Alta deal would provide attractive free cash flow per share accretion to EQT shareholders.
As with the Sitio-Brigham deal, Forbes points out that the EQT-Tug Hill-XcL Midstream press release provides only a token reference to ESG in a quote by the CEO of Quantum Energy Partners, the private equity backers of Tug Hill and XcL Midstream.ConclusionM&A transaction activity in the Marcellus & Utica shales increased in 2022 relative to 2021, with large industry players motivated by free cash flow growth and creating shareholder value and less motivated by championing the ESG cause.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction in the oil and gas industry, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
All in the Family Limited Partnership
Many enterprising families have January 1, 2026, circled on their calendars. Why? Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million. As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values. The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved. Instead, valuation discounts reflect economic reality.Fair Market Value Is an Arm’s-Length StandardEstate planning transfers must be accounted for using the “fair market value” of the subject interest. Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”Fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant factsThere’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange. Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.The Market Value Balance SheetThe first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities. FLPs hold all kinds of assets, some of which have more readily ascertainable values than others. So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process. Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.It's Nice to Be in ChargeIf the subject interest possessed sole discretion over the operations of the FLP, net asset value would be an appropriate proxy for fair market value. After all, rather than sell the interest at a discount, the holder of such an interest would instead liquidate the underlying assets and settle the liabilities of the FLP, thereby realizing the net asset value.However, the FLP interests used in estate planning transfers rarely have such authority (as would be possessed by a sole general partner). Small, limited partner interests lack the ability to direct the operations of the FLP or force the liquidation or distribution of the underlying assets. Willing buyers operating under the fair market value standard are wary of such investments. All else equal, they prefer to be the ones making the key investment and operational decisions. When submitting to someone else’s decisions, they demand a higher return on their investment by applying a discount to the pro rata share of net asset value.This reflects a simple economic reality: minority interests in asset portfolios are worth less than the corresponding share of net asset value. There is ample real-world evidence supporting this conclusion in the market for shares in closed-end funds, which regularly trade at discounts to NAV.It’s Even Better to Be LiquidThat is where the similarities between FLP interests and shares in closed-end funds end, however. Unlike investors in closed-end funds who can quickly convert their shares to cash, there is little to no liquidity for most interests in FLPs. All else equal, investors tend to prefer liquid assets to illiquid ones. As a result, our “willing buyer” from the fair market value definition requires an additional discount to be convinced to buy a minority interest in an FLP.The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristicsOnce more, this discount is no mere valuation parlor trick but instead reflects economic reality. The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics:Duration of the expected holding period. Since investors prefer liquidity, the longer a willing buyer would expect to be stuck holding the FLP interest, the larger the discount.Magnitude of expected distributions. Even when not readily marketable, some FLP interests receive regular distributions (beyond those needed to pay pass-through tax liabilities), while others receive none. The greater the magnitude of the expected interim distributions, the lower the discount.Expected capital appreciation of underlying assets. For the willing buyer, returns can only come from two sources: distributions (accounted for above) and capital appreciation. All else equal, the faster the underlying FLP assets are expected to grow in value, the smaller the discount.Holding period risks. Return follows risk, and owning the subject FLP interest is riskier than owning the underlying assets outright. The more incremental risk associated with the subject FLP interest, the greater the return required by the willing buyer, resulting in a larger discount.Be Sure the FLP Structure Is Right for Your FamilyValuation discounts for FLPs are not convoluted mirror tricks on the part of appraisers but rather reflect the straightforward economic reality of FLP interests. However, for these discounts to withstand IRS scrutiny, the economic reality we’ve described in this post must match, well, reality. As noted in the WSJ article, families forming FLPs should be prepared to live with the economic reality of having an FLP, including identifying and adhering to a clear business purpose, formal meetings, and pass-through taxes.We have valued minority interests in well over 1,000 FLPs over the past forty years. We don’t know if an FLP is right for your family, but if you and your tax and legal advisors conclude that it is, give one of our valuation professionals a call to see how we can help you.
Themes from Q3 2022 Earnings Calls
Part 2: Oilfield Service Companies
In a previous post, we highlighted common themes from OFS companies’ Q2 earnings calls, which included the role of OFS in energy security, OFS operators’ focus on margins rather than market share, and industry optimism. In last week’s post, we noted common themes from E&P companies, including a continued focus on share buybacks, moderate production growth, and the effects of inflation. This week we focus on the key takeaways from the OFS operators’ Q3 2022 earnings calls.Expanding Role of International Business SegmentsA common theme among OFS operators included the prevalence of quarterly growth in international segments and expectations of continued optimism among international segments. Executives noted that this growth is primarily driven by the need for updated oilfield equipment and technology outside the U.S. Their optimism is further enhanced by the surging U.S. dollar’s effect on overseas freight costs and labor. As broad-based activity increases tighten equipment availability, this will further drive price increases within global business segments.“Over the last few months, we booked orders for equipment into the Middle East and Africa. We’ll continue to selectively target international markets as we progress plans for more meaningful growth abroad. On the supply chain front, transit times and overseas freight costs are improving…while a strengthening dollar further supports improving margins.”
– Scott Bender, CEO, Cactus Inc.“Our third quarter performance demonstrates the strength of our strategy to deliver profitable international growth through improved pricing… International revenue in the third quarter for the C&P [Completion and Production] and D&E [Drilling and Evaluation] divisions grew year-over-year from a percentage standpoint in the high teens and mid-20s, respectively, which outpaced international rig count growth and reflects our competitiveness in all markets. Our year-over-year growth and the margin expansion demonstrated by both divisions give me confidence in the earnings power of our international business.”
– Jeff Miller, Chairman & CEO, Halliburton Company“I think international markets, in particular, have a long way to go in stepping up their technology that they apply in… in their drilling operations.”
– Clay Williams, Chairman, President & CEO, NOV Inc. The Suspected Result of Near-Term Market Tightness — Long-term Sustainable Growth for Oilfield Service CompaniesOFS operators attributed expectations of steady and sustainable growth in their business to near-term tightness in the hydrocarbon commodity market. Without an immediate fix to the current supply and demand imbalances, equilibrium in the global oil and gas commodity marketplace will require years of investment to level. The imbalance may be further prolonged by E&P companies focusing on returning cash to shareholders.“While broader market volatility is clear, what we see in our business is strong and growing demand for equipment and services. There is no immediate solution to balance the world’s demand for secure and reliable oil and gas against its limited supply. I believe that only multiple years of increased investment in existing and new sources of production will solve the short supply… [E&P operators’] commitments to investor returns require a measured approach to growth and investment. Service companies follow the same discipline, delivering on their commitments to investor returns and taking a measured approach to growth and investment. What I think is underappreciated is how this results in more sustainable growth and returns over a longer period of time.”
– Jeff Miller, Chairman & CEO, Halliburton Company“There’s very little used equipment that really can be refurbished economically, and what we’ve seen over the past year is more and more pressure pumpers in North America are pivoting towards buying new and the longevity and sort of the overall value offered by going to new versus used, I think, is a lot stronger.”
– Clay Williams, Chairman, President & CEO, NOV Inc.“And there’s some drill out rigs that, again, what a couple of our customers have said is that they wanted to --they were out of budget, they were out of wells to complete. They wanted to stop that in kind of mid-Q4 and then pick them back up in Q1. Now we’ve had demand that’s kind of been building up behind, and so most of those rigs have already been redeployed… We’re now in a situation where even though there was some budget exhaustion, those rigs are now being put to work. And we know we have demand coming on the backside and 2023.”
– Melissa Cougle, CFO, Ranger Energy Services Inc.E&P Production Growth Plans Concentrated Amid Strict BudgetsAs highlighted in a theme from last week’s post, domestic E&P production is expected to rise, albeit modestly. This growth is concentrated among certain large contracts; though the top lines may indicate relatively gradual and steady growth across the board, production growth is more concentrated among certain E&P operator plans. More generally, a limitation on broader growth for oilfield services companies in the near term is attributable to the E&P’s limited budgets. Considering the fragmentation in domestic production plans, some OFS companies have sought growth through acquisitions.“In terms of concentration, I’m going to guess that two-thirds — maybe a half to two-thirds — have to do with additions from our existing customers, which would be the publics and the other would be new logos. So, I guess the short answer is, [plans for production growth are] certainly concentrated with the large publicly traded E&Ps, at least ours.”
– Scott Bender, CEO, Cactus Inc.“For the fourth quarter, we expect growing opportunities associated with our Completion & Production Solutions segment’s backlog to be mostly offset by certain projects that were pulled forward into the third quarter and supply chains that remain elongated, resulting in revenues that should be relatively flat.”
– Jose Bayardo, SVP & CFO, NOV Inc.“It is clear that our acquisitions executed last year are now delivering strong returns, demonstrating the value of our consolidation strategy for Ranger and for the sector more broadly. The Ranger management team and board believe that consolidation remains an essential and ongoing process for the company within both existing and adjacent product lines. And we continue to be actively engaged on this front.”
– Stuart Bodden, CEO, Ranger Energy Services Inc.
Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
5 Things to Know About the SEC’s New Pay Versus Performance Rules
In August 2022, the SEC adopted final rules implementing the Pay Versus Performance Disclosure required by Section 953(a) of the Dodd-Frank Act. These rules go into effect for the 2023 proxy season and introduce significant new valuation requirements related to equity-based compensation paid to company executives. What does this mean, and how does it apply to you? What are the requirements, and why might there be significant valuation challenges involved? We discuss all that and more below.Executive SummaryThe new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Advance planning and processes will be needed to establish the scope and complexity of complying with the new rules, including identifying how many equity-based awards will require updated valuations to measure the period-to-period changes.1. Overview and BackgroundThe new disclosures were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and were originally proposed by the SEC in 2015. These rules will add a new item 402(v) to Regulation S-K and are intended to provide investors with more transparent, readily comparable, and understandable disclosure of a registrant’s executive compensation. The new provisions apply to all reporting companies other than (i) foreign private issuers, (ii) registered investment companies, and (iii) emerging growth companies.The rules apply to any proxy and information statement where shareholders are voting on directors or executive compensation that is filed in respect of a fiscal year ending on or after December 16, 2022. As such, the vast majority of registrants will be required to include related disclosure for their 2023 proxy statements, though there are relaxed requirements for smaller reporting companies.The new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.2. The Pay Versus Performance TableThe new rules require registrants to describe the relationship between the Executive Compensation Actually Paid (“CAP”) and the financial performance of the registrant over the time horizon of the disclosure. Additional items include disclosure of the cumulative Total Shareholder Return (“TSR”) of the registrant, the TSR of the registrant’s peer group, the registrant’s net income, and a company-selected measure chosen by the registrant as a measure of financial performance. These items are to be disclosed in tabular form (based on an example included in the final rule), which is replicated below.Click here to expand the table aboveThe table includes the following components:Year. The form applies to the five most recent fiscal years (or three years for smaller reporting companies)Summary Compensation Table Total for Primary Executive Officer (PEO). These are the same total compensation figures as reported under existing SEC proxy disclosure requirements. However, additional columns may need to be added if there was PEO turnover in the relevant periods.Compensation Actually Paid to PEO. For each fiscal year, registrants are required to make adjustments to the total PEO compensation reported in Item (b) for pension and equity awards that are calculated in accordance with US GAAP. This item is potentially complex and is discussed in detail below.Average Summary Compensation Table Total for Non-PEO Named Executive Officers (NEOs). These average figures would be calculated using the same compensation figures as reported under existing SEC proxy disclosure requirements for NEOs. Different individuals may be included in the average throughout the five (or three) year period. Footnote disclosure is required to list the individual NEOs.Average Compensation Actually Paid to Non-PEO NEOs. These amounts would be calculated using the same methodology as in Item (c), but then averaging the amounts in each year.Total Shareholder Return. The registrant’s TSR is to be determined in the same manner as is required by existing Regulation S-K guidance. TSR is calculated as the sum of (1) cumulative dividends (assuming dividend reinvestment) and (2) the increase or decrease in the company’s stock price for the year, divided by the share price at the beginning of the year.Peer Group Total Shareholder Return. This is calculated consistently with the methodology used for Item (f). Registrants are required to use the same peer group they use for existing performance graph disclosures or compensation discussion and analysis.Net Income. This is simply GAAP net income for the relevant period.Company Selected Measure. This item is intended to represent the most important financial performance measure the registrant uses to link compensation paid to its PEOs and other NEOs to company performance. The registrant can select a GAAP or non-GAAP financial measure.The remainder of this article focuses on the two shaded columns (c) and (e) which address Compensation Actually Paid and the valuation inputs that support these disclosures.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.3. What Is Compensation Actually Paid?For each fiscal year, registrants are required to adjust the total compensation reported in Columns (b) and (d) for pension and equity awards that are calculated in accordance with US GAAP. The following table describes these adjustments in detail. The pension-related adjustments should be calculated using the principles in ASC 715, Compensation – Retirement Benefits. The equity-based compensation adjustments will require registrants to disclose the fair value of equity awards in the year granted and report changes in the fair value of the awards until they vest. This means that it will be necessary to measure the year-end fair value of all outstanding and unvested equity awards for the PEO and other NEOs under a methodology consistent with what the registrant uses in its financial statements. For most registrants, this will be ASC 718, Compensation – Stock Compensation. Appropriate footnote disclosure may also be required to identify the amount of each adjustment and any valuation assumptions that materially differ from those disclosed at the time of the equity grant.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.4. What Are the Different Types of Equity Awards?The procedures used to calculate fair value will vary depending on the type of equity award.For restricted stock and restricted stock units (RSUs), fair value can be calculated using observed share prices at the grant date, fiscal year-end, and the vesting date. The change in fair value would simply be the difference between these dates.For stock options and stock appreciation rights (SARs), fair value at the grant date is often calculated using a Black-Scholes or lattice model. Therefore, updated fair values at year-end and at the vesting date should be based on updated assumptions in those models, including current stock price, volatility, expected term, risk-free rate, dividend yield, and consideration of a sub-optimal exercise factor (in a lattice model). Care should be taken to ensure that expected term appropriately considers moneyness of the options at the new date. The use of historical and/or option-implied volatility should be evaluated for consistency and continued applicability.For performance shares and performance share units (PSUs), the fair value calculations may be more complex due to the presence of a performance condition (e.g., the award vests if revenues increase by 15% and EBITDA margin is at least 20%) or a market condition (e.g., the award vests if the registrant’s total shareholder return over a three-year period exceeds its peer group by at least 5%). The performance condition will require updated probability estimates at year-end and at the vesting date. Awards with market conditions are typically valued at their grant date using Monte Carlo simulation and so a reassessment at subsequent dates using a consistent simulation model with updated assumptions will be necessary.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.5. Special Considerations for Market Condition Awards Using Monte Carlo SimulationMarket condition awards come in many different flavors. Three of the most common types of plans include:Market condition based upon performance in the registrant’s own stock. In this plan, vesting might be achieved if the registrant’s share price exceeds a certain level for a defined number of trading days or reaches an agreed-upon measure of total shareholder return.Market condition based upon relative total shareholder return. In this plan, the award vests based upon the registrant’s TSR in comparison to a similarly calculated TSR for a broad market benchmark index, an industry index, a peer company, or group of peer companies. Some plans employ a modification factor that adjusts the size of the award based upon varying levels of relative TSR performance.Market condition based upon ranked total shareholder return. In these plans, award vesting is based upon a numerical ranking of the registrant’s TSR against the TSRs of a group of peer companies or all of the companies on a particular broad market or industry index. The numerical or percentile ranking then determines the modification factor that adjusts the size of the award.Each of the above plans has inputs and assumptions that drive the Monte Carlo simulation. When performing a subsequent year-end or vesting date fair value analysis, each of the grant-date assumptions will need to be reevaluated. For example, for a relative TSR plan with a three-year term, the subsequent year-end valuations will necessarily have shorter terms (2-year and 1-year), which will require new inputs for volatility and correlation factors. Shorter terms may make the use of option-implied volatility more relevant if sufficient market data is available. For relative TSR plans that reference a group of companies or an index, some of the peers may have been acquired or merged in the subsequent periods. The plan documentation will often describe the steps to be taken when the composition of the peer group changes or there is a change in the benchmark index. A different group (or number) of companies will affect the correlation assumption as well as the percentile calculations in a ranked plan. Regardless of the type of plan, it is important for registrants to understand how even a relatively simple award, if granted consistently for a period of years, can lead to a large number of Monte Carlo simulations for this initial proxy season and a significant amount of disclosure complexity. As shown in Figure 3 below, if a company has made annual PSU grants (with a market condition) for each of the last five years, then up to eight Monte Carlo valuations could be required to calculate the CAP in each period.Click here to expand the example aboveIn the example above, the blue boxes indicate when a valuation of prior grants would be necessary to calculate the change in fair value for each period of the CAP disclosure. For the final period of a relative TSR market condition plan, the company could use the actual market performance of its stock (and the comparative index) to calculate the expected value of the award.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Summary and Next StepsWhile the new SEC Pay Versus Performance disclosure rules can seem daunting, they can be managed with proper planning and a systematic approach. For the CAP disclosures, registrants need to understand the details of all equity awards that have been awarded to named executive officers (how many and what type of award). The award characteristics will determine which valuation method is most appropriate and how many valuations need to be performed.If you have questions about the valuation techniques used for the various types of equity compensation awards or would like to discuss the process, please contact a Mercer Capital professional.
Bond Portfolio Update
The U.S. bond market is undergoing its worst bear market in decades. Barclays U.S. Aggregate Bond Market Index produced a total return of negative 14.5% through September 30, 2022 and negative 16.0% through November 8, 2022. Excluding coupon income, the year-to-date loss was 17.2% which speaks to how low coupon income is given the nominal difference between price change and total return.Click here to expand the image aboveAs shown in the figure below, U.S. commercial banks have suffered unrealized losses in their bond portfolios equal to roughly 10% of the cost basis of both AFS and HTM classified portfolios as of September 30, which compares to a price reduction of 15.6% in the Barclay’s index as of quarter end.The less-worse performance by U.S. banks likely reflects less duration than the index, which has an effective duration of 6.25 years and weighted average maturity of 8.25 years. Our observation is that for the most part outsized losses among U.S. banks reflect an outsized position in municipals and/or MBS. The index composition is heavily skewed to U.S. Treasuries and U.S. Agency obligations given the heavy issuance of government backed debt the past 15 years or so.While management and directors at most banks are unhappy with their bond portfolios, institutional investors have taken a more nuanced view of the impact of rising rates based upon the tenor of third quarter earnings calls and the reaction of most stocks upon the release of earnings. Rising rates have supported bank earnings even though fixed-rate loan and bond portfolios are slow to reprice as floating-rate loans have repriced and banks have lagged deposit rates.Investor concern is more focused on liquidity risks. Some (or many) banks eventually may have to raise deposit rates sharply to stem outflows and/or fund loan growth because selling bonds is not a viable option given the magnitude of unrealized losses that if realized will reduce regulatory capital.Our prior commentary on bank bond portfolios following the release of the first and second quarter Call Reports can be found here and here.
Community Bank Loan Portfolios Have Unrealized Losses Too
Fixed income is undergoing one of the deepest bear markets in decades this year.There has been a lot of discussion surrounding the impact of rising rates on bank bond portfolios and bank stocks as rising rates have resulted in large unrealized losses in bank bond portfolios. My colleague, Jeff Davis, provides an update to his previous commentary on the topic based on third quarter Call Report data here.If subjected to mark-to-market accounting like the AFS securities portfolio, most bank loan portfolios would have sizable losses too given higher interest rates and wider credit spreads; however, unrealized “losses” in loan portfolios do not receive much attention because there is not an active market for most loans unlike most bonds that populate bank portfolios. Further, accounting standards do not mandate mark-to-market for loans other than those held-for-sale.While the trend in loan portfolio fair values is harder to examine given the lack of data, the following charts provide some perspective based on a survey of periodic loan portfolio valuations by Mercer Capital. To properly evaluate a subject loan portfolio, the portfolio should be evaluated on its own merits, but markets do provide perspective on where the cycle is and how this compares to historical levels.Fair value is guided by ASC 820 and defines value as the price received/paid by market participants in orderly transactions. It is a process that involves a number of assumptions about market conditions, loan portfolio segment cash flows inclusive of assumptions related to expected prepayments and expected credit losses, appropriate discount rates, and the like.The fair value mark on a subject loan portfolio includes two components – an interest rate mark and a credit mark. The interest rate mark is driven by the difference in the weighted average discount rate and weighted average interest rate of the subject portfolio. The discount rate that is applied to a subject loan should reflect a rate consistent with the expectations of market participants for cash flows with similar risk characteristics. The credit mark captures the risk that the borrower will default on payments and not all contractual cash flows will be collected.Since the end of 2021, rising market interest rates have been the predominant factor driving the change (i.e., reduction) in loan portfolio fair values. As shown in Figure 1, the median interest rate mark for our data sample has fallen from a modest 0.55% premium at December 31, 2021 to a 5.65% discount as of September 30, 2022. While bank earnings benefit from a higher rate environment and net interest margin expansion, it takes time for the increase in market rates to be passed on to customers via higher loan rates and for lower, fixed-rate loans to roll out of the portfolio. In talking with Mercer Capital clients and in our loan portfolio valuation practice, so far it seems that banks have been unable to fully pass on the increase in rates to loan customers.Figure 1: Trends in Interest Rate MarksClick here to expand the image aboveThe shift in the valuation adjustment attributable to interest rates reflects an increase in market interest rates.Figure 2 depicts the LIBOR forward curve at December 31, 2021, March 31, 2022, June 30, 2022, and September 30, 2022.Relative to December 31, 2021, forward LIBOR rates have increased 66 bps to 394 bps on average with the largest increases occurring for periods ranging from 1 to 12 months following the valuation date.Figure 2: LIBOR Forward CurveFigure 3 depicts the trend in the credit mark for our data sample relative to credit spreads. Credit spreads provide perspective on a number of factors, including where the credit cycle has been and where we may be headed.Figure 3: Trends in Credit MarksClick here to expand the image aboveOver the period shown in Figure 3, credit marks peaked at the start of the pandemic given the uncertainty and expectation of higher losses on loan portfolios. Credit marks trended down from the March 31, 2020 peak through the first quarter of 2022, as did banks’ loan loss provisions, as credit quality remained stable. While credit quality continues to remain strong, both credit spreads and credit marks have ticked up in 2022 with the weakening economic outlook and concerns that the Federal Reserve’s tightening interest rate policy may trigger a sharper downturn in economic activity.Mercer Capital has extensive experience in valuing loan portfolios and other financial assets and liabilities including depositor intangible assets, time deposits, and trust preferred securities. Please contact us if we can be of assistance.
Double Down or Cash Out: The Reinvestment or Distribution Decision
I recently got back from the AICPA’s Forensic and Valuation Services conference in Las Vegas. While I came back richer in experience and CPE credit, the green felt of the blackjack table was less kind to my wallet.I had the opportunity to present at the conference on implied market multiples. To save you 75 minutes, multiples in public or private markets represent composite expectations regarding two variables affecting business cash flow: expectations of growth in cash flow and the risk associated with achieving those cash flows. Pricing power, industry position, proprietary processes, and management depth funnel down to risk and growth and, ultimately, your business value.Matching your family shareholders’ growth objectives with their relative risk tolerance is a key directive for family business directors and one that is tied directly to what your family business means to you. We highlight two corollary questions relating to growth, risk, and business meaning: investing decisions and distribution policy.Before We Hit the TablesBefore we look at investment and distributions, we have observed that families tend to assign one of four basic meanings to their family business: Readers of Family Business Director will be familiar with these concepts, but in short, the idea is that your family business’ appetite for growth and risk depends on what meaning your family assigns to the business. As shown below, the meaning of the family business, in turn, influences the company’s dividend policy and investing (as well as financing) decisions. All on Red?How your family business thinks about investment is tied to how you and the family think about risk and growth. In principle, families make investment decisions from a large menu of potential alternatives (both inside their business and through diversification). The image below illustrates some of the more common risk-return combinations available to investors. To achieve a higher expected return, investors must be willing to accept greater risk. This concept of accepting higher risk to achieve greater investment returns affects both the family business operator and gambler alike: no risk, no blue chips! For more on risk and return, see our “Corporate Finance in 30 Minutes” whitepaper. But how do family business directors approach the risk-return question? Going back to the meaning of your family business provides a backdrop for making that decision. For example, if your family business serves as a “Source of Lifestyle,” you are less likely to invest in higher return (higher risk) projects or diversification efforts that could jeopardize current dividends and harm business predictability. Alternatively, suppose your family views the business as the “Economic Growth Engine” meant to grow with your family. In that case, you will likely aim to make investment decisions that maximize the expected return (thus increasing risk) to drive the economic growth of your business for future generations. Ultimately, your goal as a family business operator is to match your family’s risk-return objectives and elucidate your business’s growth and risk profile with family shareholders.Taking Some Chips Off the TableThe flip side of reinvestment in your family business is distributions. Net operating cash flows can either be reinvested into your business or paid out to shareholders. Companies that understand what the business means to them can make distribution decisions that reflect shareholder objectives and needs. Suppose shareholders see the company as a growth engine; they will accept lower distributions to generate higher growth, just as shareholders seeking consistent distribution checks will (or should) accept muted long-term growth. As we have observed in a previous post, some family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources, “father knows best,” as well as empire building. Ultimately, family business directors need to remember their shareholders are just that: shareholders. While their equity may have been earned through their bloodline, family business owners deserve the same considerations paid to public company shareholders, i.e., a focus on maximizing shareholder value through a mix of good reinvestment opportunities and distributions.Know When to Hold ’Em and When to Fold ’EmBoth a process of analyzing investment choices (we discuss in detail here) and understanding your family shareholder objectives will help ease the burden of deciding when it’s time to pull some chips off the table and hit the buffet. All family businesses need to evaluate how they invest for future growth and their distribution policies in light of their family’s risk tolerance, growth objectives, and business meaning. If you need help analyzing some of these decisions for your business, give one of our professionals a call.
Themes from Q3 2022 Earnings Calls
Part 1: Upstream
In Part 1: Themes from Q2 2022 Earnings Calls, the common themes among E&P operators and mineral aggregators calls included the strengthening of balance sheets to offset price volatility, the increasing role of share buybacks, and the persistence of supply and demand imbalances. This week we focus on the key takeaways from the Upstream Q3 2022 earnings calls.Continued Focus on Share BuybacksAs we noted in our analysis of last quarter’s earnings calls, E&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in late 2021; companies accentuated paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“Look, we've seen the volatility in the market that every quarter, we've had the opportunity to buy shares back, and when that opportunity presents itself, we'll do so aggressively. I think the key to any of those questions is the ability to generate free cash flow. And that's certainly what our focus is… [as well as] maintaining the flexibility on how the return of that free cash flow gets prosecuted. I will say that in conversations with our long-only shareholders, a lot of those guys prefer to get the cash back. But again, we believe that we'll have opportunities to repurchase shares back.”
– Travis Stice, CEO & Chairman, Diamondback Energy Inc.“While we had guided third quarter return of capital to at least 50% of our CFO due to strong operating and financial performance, our financial strength, including our replenished cash balance and favorable market conditions, [and] including clear value in our stock price, we saw an opportunity to materially step-up the pace of repurchases. We bought back $1.1 billion of stock during the third quarter.”
– Dane Whitehead, Executive Vice President and CFO, Marathon Oil Corp.“On the capital allocation side… we continue to take advantage of current equity market conditions by repurchasing 8.4 million shares in the quarter and another 3.2 million shares after the close of the quarter through October 21. Said differently, we bought back another 4% of our total shares outstanding. And over the last eight quarters, we have repurchased approximately 20% of the outstanding shares of the company. We continue to see this as a remarkable low-risk capital allocation opportunity moving forward. And although we have not given an explicit capital allocation framework, if you extrapolate these levels of buybacks moving forward, you can see that we will continue to dramatically reduce our denominator and thereby meaningfully grow our free cash flow per share.”
– Alan Shepard, CFO, CNX Resources Corp.Moderate Production GrowthAs a consequence of a favorable pricing environment and continued tightness on the supply side, industry operators are increasing production in order to capitalize on strong market conditions. Ultimately, firms may not be able to fully capitalize on high prices due to increased labor and equipment costs as well as other miscellaneous supply-side challenges.“We generated total production volumes for the quarter of 40,000 Boe per day, an increase of 19% over our second quarter volumes. All that increase was from royalty volumes, which were up 23% to 37,300 Boe per day. Our base production is trending up as development activity remains robust across our acreage and as our target development programs with operators in the Shelby Trough, Haynesville and East Texas, Austin Chalk continue taking shape, while growing and moving forward. Production from the quarter exceeded expectations due to certain operators, particularly in Louisiana Haynesville, bringing new wells on line at more aggressive initial flow rates to take advantage of higher natural gas prices.”
– Tom Carter, Chairman and CEO, Black Stone Minerals, L.P.“We posted strong results this quarter that were underpinned by sequential production growth of 7% on a BOE basis and 8% on an oil-only basis, exceeding both our guidance and consensus estimates. These gains were driven by well performance that was above expectations and consistent execution in the field, particularly on the completions front with reduced cycle times in the Permian and Eagle Ford. At a bigger picture level, our commitment to a life of field development philosophy of our multi-zone resource base, paired with continuous improvements in drilling and completion designs, has resulted in year-over-year improvements in Callon's well performance at a time when concerns around inventory degradation are increasingly becoming a focal point of the industry.”
– Joe Gatto, President & CEO, Callon Petroleum“I think there is asset maturation. I think certainly, supply chain constraints are also limiting growth... I think all of those factors weigh into more of a muted production growth from US shale going forward. That said, out here in the Permian, I think we're still continuing to hit production records every month, somewhere close to 5.3 million to 5.5 million barrels a day. But that's going to be challenged to continue to grow that into the future. Do we have the assets out here? Yes, we do. But some of those other topical constraints that I mentioned are going to be impediments to efficient growth.”
– Travis Stice, CEO & Chairman, Diamondback Energy Inc.“I think, just generally we see some large pads coming on [in] Q2 and beyond… The Diamondback piece, which we have 100% visibility on, will grow 10%. It's just going to start growing in Q2 and Q3… the way we see it right now is basically flat oil from Q3, which was an all-time high into Q4 and Q1 and then the ramp starts to begin again in… Q2 of next year.”
– Kaes Van’t Hof, President, Viper Energy Partners, L.P.Inflation Continues To Limit GrowthThe current high-price environment incentivizes operators to grow rapidly. While most industry participants certainly would like to increase the scale of their output, multiple executives discussed how high inflation has constrained their efforts. The impact from inflation is evident in multiple areas, but especially in the cost of raw materials and labor.“One of the major topics of the year continues to be the inflation story. The price pressure we are seeing on steel, fuel and labor continues to be persistent. Our employees are maintaining their focus on finding ways to mitigate inflation through innovation and efficiencies in our operations. Through their efforts, we now expect our average well cost to increase a modest 7% as compared to last year.”
– Billy Helms, President, and COO, EOG Resources Inc.“The biggest concern we've got is not so much labor inflation or service inflation outside the company as much as it is… the quality of the available labor set or the quality of the available service skill set. And that's where we spent most of our time. So it's not just the easy question of will the individuals and the service provider be available. It's more a question of can we get the best of the individuals and the best of the service providers available.”
– Nicholas Deluliis, President, CEO & Director, CNX Resources Corp.“Casing has been a massive headwind for us and for the industry. Midland Basin casing is now $110 a foot, that is a huge number of… fixed cost that we can't really control here.”
– Kaes Van’t Hof, President & CFO, Diamondback Energy Inc.“I think on the labor inflation side, that's subject to kind of more of the macro environment. I mean you could potentially paint a scenario where if the company slips -- or the country slips into recession, some of those pressures ease. And conversely, if we avoid that, you can continue to see pressure on those fronts. So again, this just goes back to kind of the wider guidance we provided on this call, and then we'll have some more color as we move forward. I think we'll know a lot more a quarter from now about where things are headed.”
– Alan Shepard, CFO, CNX Resources Corp.
Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
Something to Chew on This Thanksgiving
We have traditionally advised you about what not to talk about at the Thanksgiving dinner table, but this year, we thought we would highlight a more positive family business conversation that you might want to have with your family shareholders—if not this weekend, then sometime soon.The question is: What is the economic meaning of the family business for our family? Is it an economic growth engine for the benefit of future generations or a source of lifestyle for shareholders today? Is it a “safe haven” store of value or a source of wealth accumulation allowing shareholders to diversify away from their economic dependence on the business? Gaining consensus on this question can help make the many other questions family businesses ask about dividend policy, capital structure, and capital budgeting easier to answer.Check out this brief five-minute video about the meaning of your family business from our recently launched Family Business On Demand Resource Center.The Four Meanings of Family Business from Mercer Capital on Vimeo.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of November 14, 2022
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of November 14, 2022Download Study
Review of Key Economic Indicators for Family Businesses in Q3 2022
With economic data for 3Q22 beginning to trickle in, we look at a few key trends that developed during the quarter. The tale of the tape in the third quarter was the same as it has been for virtually all of 2022—volatile equity markets, ongoing inflationary concerns, and rising interest rates.The sections below provide a concise and unbiased look at some of the manifested trends. We sourced data and commentary from Mercer Capital’s National Economic Review (subscription required), which is published quarterly and summarizes macroeconomic trends in the U.S. economy.GDPAccording to advance estimates released by the Bureau of Economic Analysis, GDP increased at an annualized rate of 2.6% during the third quarter of 2022. The increase in annualized GDP growth during the third quarter follows declines of 1.6% in the first quarter of 2022 and 0.6% in the second quarter. The increase was driven by gains in exports, personal consumption expenditures, nonresidential fixed investment, and government spending. Decreasing imports also boosted GDP (imports are deducted in the calculation of GDP). Mitigating factors to the increase in GDP were declines in residential fixed and private inventory investments.Economists expect GDP growth to stagnate in the next two quarters. A survey of economists conducted by TheWall Street Journal reflects an average GDP forecast of 0.4% annualized growth in the fourth quarter of 2022, followed by an annualized decline of 0.2% in the first quarter of 2023.Click here to expand the image above.InflationEstimates from the Bureau of Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.4% in October 2022 on a seasonally adjusted basis after rising 0.4% in September as well. On a year-over-year basis, the CPI increased 7.7% from October 2021 to October 2022, a slower pace than in recent months, which generally appreciated. The Wall Street Journal survey reveals that respondents expect inflation to remain persistent throughout 2022, as they predicted, on average, an annual rate of 7.2% in December 2022 before falling back to 4.1% by June 2023. The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI increased 0.4% month-over-month in September 2022 and increased 8.5% in the twelve months ended September 2022.Monetary Policy and Interest RatesDuring the third quarter of 2022, the FOMC met in late July and September, raising rates by 0.75% at both meetings. At the July meeting, FOMC members voted unanimously to raise the benchmark federal-funds rates to a range between 2.25% and 2.50%. Equity markets rallied in the week of the meeting because Chairman Powell offered few specifics regarding the magnitude of future rate increases and signaled an eventual slowdown in the pace and magnitude of future rate increases. Still, the FOMC raised the benchmark rate again by another 0.75% at its September meeting, leaving the benchmark rate between 3.0% and 3.25%. Projections released after the September meeting revealed that FOMC officials nearly unanimously expected to raise rates to a range of 4.0% and 4.5% by year-end 2022, which would require sizeable increases again at the November and December meetings of the FOMC.The Fed continued its rate-raising march at its recent November meeting, increasing the benchmark rate by another 75 basis points to a range between 3.75% and 4.0%. After the November meeting, Chairman Powell indicated that FOMC members could contemplate a smaller hike at the FOMC’s final meeting of 2022 in December but cautioned observers that borrowing costs could be higher in 2023 than previously projected. Chairman Powell also indicated that potentially reducing the size of rate increases would not necessarily equate to the FOMC pivoting away from its current monetary tightening policies.The FOMC’s decision to raise rates again in November came against the backdrop of conflicting economic signals. The job market remains strong amid elevated inflationary pressures and despite domestic demand and housing market downturns. Widespread price increases in retail goods and services have not stifled consumer demand, likely due to generous savings cushions boosted by pandemic relief and elevated gains in asset prices over the past few years. With these conflicting signals in mind, keen Fed observers have posited that Chairman Powell is forced to choose between promoting growth and taming inflation.Powell and the FOMC have decided to fight inflation head-on with historically significant rate increases, even at the expense of potentially curbing economic growth. Perhaps the tide will turn in 2023, but it has become increasingly evident that this won’t happen until inflation cools off. With pandemic dollars still percolating throughout the economy and contributing to inflation, the Fed will continue to make difficult decisions regarding interest rates. Some observers see the fed-funds rate topping out at 5.25% to 5.50%, which could trigger a U.S. recession. Adept and adroit family business owners and directors would be wise to begin planning now for this near inevitability in 2023. We’re reminded of the adage attributed to Benjamin Franklin: “By failing to prepare, you are preparing to fail.”
45Q Tax Credit Boosts Values Of Carbon Sequestration Projects, Yet Most Still In Development
Approximately half of the Inflation Reduction Act’s budget ($369 billion) has been authorized for spending on energy and climate change. One of the components buried in that act was the supercharging of an existing tax credit—45Q. This tax credit expanded from $50 per ton of sequestered CO2 to $85 per ton. What does this mean for potential carbon capture sequestration projects around the country? Perhaps a lot. However, it is too early to tell. According to Robert Birdsey of Greenfront Energy Partners, it would be like asking the pilgrims what they thought of America as they stepped off the boat.That has hardly kept interest and activity from moving forward. A few weeks ago, Exxon and EnLink announced a largest-of-its-kind commercial deal in Louisiana to capture emissions from CF Industries’ Ascension Parish and transport it on EnLink’s transportation network to store it underground on Exxon property. Start-up is expected in 2025 and will sequester up to two million metric tons of CO2 annually. At $85 per ton, that’s a commercially significant tax credit—$170 million. It won’t be the last one. There are dozens of projects at various points in the development pipeline for this space. In addition, capital has been flowing freely into the broader “sustainability” space. According to Morningstar, in the first half of 2022 alone, there was approximately $33 billion of net cash inflow into that sector, along with 245 new funds launched.Last week, I attended the Hart Energy Capital Conference, whereby Mr. Birdsey gave a presentation. I also spent some time with Mike Cain of U.S. Carbon Capture Solutionsto find out more. Some interesting facts and issues arose.IncentivesThis effect helps remove financing bottlenecks for a number of these green projectsThe White House has placed a value on the social cost of carbon at $51 per ton, which is partly why the tax credit was included in the Inflation Reduction Act (“IRA”). This effect helps remove financing bottlenecks for a number of these green projects. It can be, in effect, like the government financing approximately 30% of one’s equity in a project. In a space where being the low-cost producer is the name of the game, this puts a lot more players in the game. In fact, Carbon Capture Sequestration (“CCS”) volume could reach 200 million tons by the year 2030, a 13-fold increase relative to pre-IRA estimates, according to Net Zero Labs. Ironically, the upstream industry is the most qualified to capitalize on this incentive, giving traditional E&P players more opportunities to execute projects.IssuesEven so, most of the potential projects in the CCS pipeline remain in development, where memorandums of understanding and letters of intent abound. However, binding contracts are fewer and far between, and there are reasons for this. First, from the standpoint of the 45Q credit itself, there is a potential time-matching issue here. Projects like this are multi-year—even over a decade if permits get held up. If a small government congress comes along and abolishes the incentive, it would almost certainly submarine the economics of the project. At this point, the 45Q credit is at the heart of the project’s economic viability, so if it goes, the project goes. There could be a lot of elections between now and 2030, which makes some investors nervous.However, that’s less of an issue compared to others. There are three main elements to a successful CCS project: (i) an emitter, (ii) transportation, and (iii) a sequestration site. There are issues with all three. Emitters have been cagey about these projects because they are reticent about third parties adding infrastructure to an expensive asset such as a power plant. In addition, the long take-or-pay contracts that have been proposed for a lot of these projects are risky themselves. From the transportation aspect comes most of the same issues as other pipelines. Just ask the Keystone or Atlantic Coast Pipeline proponents. In addition, CO2 has to be transported at high pressures (say 1,100 PSI) in semi-liquid, low-temperature form. That makes the infrastructure potentially different than a conventional natural gas pipeline. Then, there are sequestration site issues. The injection sites for CO2 are known as Class VI wells. To date, there are only two active Class VI wells in the U.S., so permitting is a big unknown and presents a binary risk profile. Get your well approved, then move forward. If it gets rejected, your project could be finished. Oh, and did I forget to mention that these projects can be in the hundreds of millions of dollars of capital? That’s a lot of money that could wait a long time for a return.Many investors look for emitter and sequestration sites that are proximate to each otherBecause of this, many investors look for emitter and sequestration sites that are proximate to each other, which is not always easy to find. Emission concentration economics, issues with monetization of 45Q credits (there is not currently a robust trading market for these), and other issues can sideline a project.The Future?Nobody really knows, yet optimism remains. It’s an emerging market. U.S. Carbon Capture Solutions is pushing forward with its Wyoming project, even though it may be 2030 before it comes online. The 45Q appears to have given this space a shot in the arm; we’ll see in five or more years from now what that turns into.Originally appeared on Forbes.com.
What Do the Midterm Elections Mean for You & Your Family Business?
The 2022 midterm elections are here, and, as usual, one of the most significant differences between Democrats and Republicans is tax policy. While voters are contemplating significant issues ranging from inflation, immigration, abortion, and gun control, the election outcome will also influence which tax priorities Democratic and Republican lawmakers will pursue over the next few years.These tax issues could involve tax deductions and other incentives that directly impact your finances. The party controlling the House and Senate will dictate which tax policies are proposed and potentially passed into law. In this post, we focus on three main tax dilemmas that will be most important to your family business this midterm election season.Individual Tax RatesThere are a number of tax provisions set to expire in 2025 that were passed as part of the Republican’s Tax Cuts and Jobs Act (TCJA). This 2017 legislation significantly reduced the corporate tax rate and temporarily cut individual rates. If Republicans take control of Congress, protecting previously passed policies will be among the party’s top priorities, despite the potential impact on inflation. One of the tax breaks set to revert to the pre-2017 levels if the TCJA is not extended is the individual income tax rate, which would return the top marginal rate to 39.6% from the current 37%.Below are the current single-filer and married filing jointly tax brackets, as well as the changes if the TCJA does expire in 2025. In an interview on C-Span, Nebraska Rep. Adrian Smith said that if the GOP regains Congress, advancing legislation for permanent individual tax rate cuts would be his first priority. However, many economists have debated that the GOP tax plan goes against the promise to combat inflation and reduce the federal deficit. Howard Gleckman, a senior fellow at the Tax Policy Center, states that extending these tax cuts promulgated from the TCJA may further fuel inflation by stimulating consumer spending. What if Congress remains Democrat-controlled? While Democrats campaigned on rolling back provisions from the TCJA, actually doing so has proven politically more difficult. Earlier this year, Democrats tried to increase the corporate tax rate and raise taxes on the wealthy to pay for the Inflation Reduction Act but failed. Meanwhile, President Biden’s 2023 Budget Proposal calls for reducing the federal deficit by $1 trillion over the next year in part by raising the corporate tax rate from 21% to 28%. The proposal also contains a new 20% minimum tax on households worth more than $100 million, which accounts for the top 0.01% of earners.Estate TaxesOn October 28, 2021, President Biden announced a framework for the Build Back Better Act. This Act invests in family care, health care, and combatting the climate crisis. It will also implement key reforms to make the tax system more equitable by ensuring that the wealthiest Americans and most profitable corporations shoulder a more significant portion of the overall tax burden. Specifically, these proposals included a reduction of the federal estate tax exemption (amount of assets that can transfer to an heir free of estate tax) to $3.5 million per person, as well as eliminating the tax basis step-up at death. These proposals were dropped from the legislation as the Build Back Better Act stalled in the Senate.Regardless of the fate of these specific proposals, effective January 1, 2026, under current law, the estate tax exemption will be reduced to $5 million per person or $10 million for a married couple – subject to inflation increases. Currently, each U.S. citizen has a $10 million exemption from estate taxes, and for a married couple, that amount is doubled. As the exemption is indexed for inflation, in 2022, the exemption is $12.06 million per person. Persons whose estates may be subject to estate tax under the projected 2026 exemption levels should consult with legal counsel and advisors to review their current estate plans and evaluate possible strategies for preserving their wealth and planning for future generations.Qualified Business Income (QBI) DeductionThe IRS defines Qualified Business Income (QBI) as the net amount of qualified income, gains, deductions, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. The Tax Cuts and Jobs Act introduced a new deduction taking effect in 2018 for noncorporate taxpayers in respect of their qualified business income. This deduction is up to 20% of their QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. Income earned by a C corporation or from providing services as an employee is not eligible for the deduction.Prior to the TCJA, the corporate income tax rate was 35%, and dividends were taxed at a top rate of 23.8%, resulting in an aggregate tax rate of about 50% on distributed corporate business income. Contrast this to a pass-through entity, for which earnings are passed through and taxed in the hands of the owners. Before 2018 the top ordinary income tax rate was 39.6%, and thus, there was an approximate 10% tax rate advantage operating a pass-through entity rather than a corporation. The TCJA included a permanent reduction to the corporate tax rate from 35% to 21% and reduced the top individual rate to 37%. Without any further changes, the tax rate advantage in operating a business as a pass-through entity would have decreased from roughly 10% to less than 3%. The 20% QBI deduction was the TCJA’s answer, as only 80% of certain pass-through entity income is subject to tax for qualifying taxpayers.With the control of Congress up in the air and general gridlock in Washington, it is uncertain if the 20% QBI deduction will be a tax advantage for much longer, as the deduction would ultimately expire if the TCJA is not extended past 2025.ConclusionVoters are weighing many different policy questions at the ballot box this November, and the election results will set the stage for determining which major concerns are addressed first, as well as determine which tax priorities Democratic and Republican lawmakers will pursue over the subsequent few congressional sessions. The topics mentioned above highlight some of the most important individual, estate, and business owner tax implications that family business owners need to be aware of and evaluate as the election returns roll in.
Market Insights on Auto Dealer M&A Activity
A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss the current state of the M&A market and other timely trends in the auto dealer industry. Specifically, I wanted to discuss some of the movements in Blue Sky multiples for various franchises and interpret the range of multiples that Haig Partners recently published with the release of their Second Quarter 2022 Haig Report (subscription required).What is the current state of the M&A market for auto dealerships? Any signs of transactions slowing down? Are you seeing earnings or multiples start to plateau or revert?Kevin: The market continues to be quite active, with a nice balance of buyers focused on strategic growth opportunities and sellers who see valuations still at or near peak levels. The pandemic accelerated the need for scale to effectively compete in a changing retail environment—consumers are ever more focused on a seamless buying experience and are embracing a digital world for researching, negotiating, and transacting the retail purchase. Couple that with the benefits of marketing a broad and large selection of inventory and dealers recognize they need more franchises and locations to effectively compete.Our analysis indicates there may be over 8 million units of pent-up demand in the marketplaceNADA has suspended the publication of data on the performance of the total dealer body, but public company financial results do indicate we may have seen a plateau in earnings. Based on our analysis, the average public dealership earned $7.0M through the Last Twelve Months (LTM) ended 2Q 2022, down just slightly from $7.1M for the quarter ended 1Q 2022. However, that’s still up approximately $5M from 2019’s average of $2.1M!! From the data and research we are seeing, inventory constraints should continue for the next several years and ensure the dealer enjoys strong gross margins for some time. Our analysis indicates there may be over 8 million units of pent-up demand in the marketplace. Additionally, the high gross F&I and service departments continue to see an upward trajectory in results.As for multiples, our firm tracks this very closely by monitoring transactions we represent alongside ongoing discussions with industry leaders in finance, accounting, and the legal communities. In summary, multiples overall have changed little since the pandemic: it’s the underlying earnings that have contributed to the elevated valuations. That said, some franchises are gaining traction and are more appealing to buyers. These include Toyota, Hyundai/Kia, and Stellantis.Scott: With NADA’s suspension of dealership performance data, Mercer Capital has also pivoted to supplying information and trends from public companies in our recently published Mid-Year 2022 newsletter. Despite positive revenue growth in the last twelve and six months, revenue growth in the more recent period is less in all six public companies showing signs of slowing down. Additionally, public companies have continued to enjoy heightened gross profit from new and used vehicle departments compared to historical averages.Any new trends in buy/sell negotiations in the last few months? Any sticking points?Kevin: There really haven’t been any “new” issues that have arisen in buy/sell negotiations, but one trend we are seeing both in the industry and our practice is a willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise.The willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise is a recent trendSellers are seeing these alternatives as additional strategic options for their families and organizations. In some cases, a seller may choose to take some proverbial chips off the table by exiting a market or selling a couple of stores. Further, as outside capital investors continue to target auto retail due to strong and consistent returns, some dealers are selling a percentage of the business, which allows them to stay on and operate the business. Our recent publications have gone into greater detail on this subject if readers want to know more about this trend.Scott: The trend for dealers to sell a small minority stake in their entire group (or perhaps only divest of a rooftop or two) seems to be a new and interesting phenomenon. This trend appears to be a shift from dealers selling the entire enterprise or a majority stake in the dealership holdings. Auto dealers clearly value maintaining control and not having to answer to a family office group, private equity holders, or a third-party controlling stakeholder.Operating an auto dealership is very much a day-to-day and month-to-month business. Auto dealers are usually heavily invested in their communities and care deeply about their legacies.Selling a minority interest gives the auto dealer some liquidity. While dealerships have become very valuable and have generated record profits, often those profits are reinvested in the business or are leveraged against other assets, while the heightened value of the dealership only represents value on paper until a transaction or liquidation event occurs.Mercer Capital provides estate planning valuation services that may benefit owners who take some chips off the table once a firm like Haig Partners has helped them negotiate a minority investment.The latest Haig Report mentions Toyota is the most desirable brand. Is there any reason it would not obtain the same multiple as luxury brands?Kevin: It’s no surprise to anyone active in the auto retail space that Toyota dealerships are in high demand. Manufacturer relations are best in class, and the underlying product continues to resonate with consumers. Our firm has sold 33 Toyota dealerships, including the 2nd highest-valued dealership ever in August 2022 (John Elway’s Crown Toyota). Buyer interest is always substantial. In most cases, Toyota stores will bring better multiples than some of the smaller luxury makes like Jaguar, Land Rover, and Audi. But in general, the high-profile luxury nameplates still command a higher multiple. There are a number of reasons, but the most impactful cause is there are far fewer Lexus, Mercedes-Benz, or BMW dealerships in the market and even fewer for sale. So “Economics 101” is in play—limited supply and high demand bring higher multiples. Scott: Kevin’s comparison of a Toyota dealership investment to a luxury brand is equivalent to the allure of owning a professional sports franchise. Interested investors in luxury brands covet the exclusivity and market appeal of owning one of these franchises. There may only be a few luxury brands in each market, and if one becomes available, it may be a long time until another luxury franchise becomes available. To Kevin’s point, the approximate number of Toyota and various luxury brand franchises in the United States are as follows: Will the shift for Cadillac, Infiniti, and Lincoln blue sky from a dollar amount to a multiple materially shift the value of these franchises?Kevin: Over the past several years, several weaker franchises traded for a hard dollar amount rather than a multiple of earnings, given the lack of repeatable earnings. Buyers placed a value on the “shingle” and looked at used cars and fixed operations as their way to make money from these stores. However, as some of these brands have seen a resurgence in performance, partially from the post-pandemic bump but also from developing more appealing products, we have seen buyers take a more bullish approach. So, yes, these franchises have definitely seen an improvement in value. Nissan is another brand we have seen improve in the eyes of buyers. The franchise still has a way to go, but many believe the worst is behind Nissan — their products are solid, and the OEM has learned from its “volume at all costs” approach.Are there any new threats to the auto industry?Kevin: Open any automotive periodical, and you will see discussions about the potential impact of EVs. One consequence of the forecasted shift away from ICE to EV is the desire of some OEMs to modify their retail strategies. Tesla and other EV startups have gone the direct selling route, foregoing the traditional franchise model, and some major manufacturers are eyeing this strategy with jealousy. All despite historically failed attempts to replicate the proven ability of the franchise retailer to best serve the consumer’s needs. Ford, Hyundai, Mercedes-Benz, Volvo, and Polestar are examples of manufacturers who are overtly or quietly trying to change the retail model more toward the agency model seen in Europe. Haig Partners encourages dealers to be active participants with their state dealer associations to ensure franchise laws remain robust and protective of retailers. Scott: Despite the news and headlines dominated by EVs, the implications of EVs can vary drastically by brand. In other words, some OEMs are further along in producing EV models, while others do not anticipate producing EVs before 2024 and 2025. Additionally, the requirements of the various OEMs to auto dealers are also quite different. Some brands do not require any additional dealer commitments, while others, such as Ford, are forcing auto dealers to declare at what level they want to opt-in for selling EVs. Ford’s financial requirements can range from $0 for dealers that do not opt-in to selling EVs (only selling ICE vehicles) to $1,200,000 for dealers that opt-in to selling EVs at the premium level.What are the typical adjustments seen in negotiations for buy/sells?Kevin: One of the most important aspects of representing a seller is ensuring the buyer has a solid understanding of the historic and expected cash flows generated by the dealership. Just looking at the dealership’s financial statement doesn’t accurately depict the earnings opportunity of the store.Just looking at the dealership financial statement doesn’t accurately depict the earnings opportunity of the storeWe extensively analyze the dealership to understand what add-backs and deducts should be applied to reflect recurring cash flow. Some are non-cash entries; others are one-time expenses or income that should be adjusted.Some common add-backs are LIFO expenses, owner’s compensation (if excessive and/or not to be recurring for a future owner), owner’s perks that run through the statement (travel, airplane, etc.), and F&I over-remits/mailbox money that is generated outside the dealer statement.Deductions to earnings include PPP funds and one-time settlement funds or gains from asset sales.Scott: Similarly, Mercer Capital reviews the balance sheets of auto dealers for potential adjustments to inventories, fixed assets, working capital, goodwill, non-operating assets, and owner accounts receivable. Some typical areas for potential adjustments on the income statement include inventories, owner compensation, rent, other income, owner perquisites, and remittance, to which Kevin refers.Remittance is related to the service contract and other warranty-related products the dealership offers in connection with the purchase of a vehicle. A dealer can act as an agent in this process by offering products from multiple third-party vendors or acting as the principal, whereby they own a reinsurance company that offers those products to their customers. In either case, the dealership retains a portion of the service contract or warranty product and remits the other portion to the obligor or administrator of the contract. In an example where a vehicle service contract is $800, the dealership might retain $400, report that as income, and remit $400 to the obligor/administrator.In some cases, the dealer may have an “overpayment” arrangement in place with the third-party administrator or their reinsurance company, whereby the dealer might retain $250 in the previous example and then remit $550 to the obligor/administrator. The “overpayment” arrangement allows the dealership to determine the amount of the overpayment and designate a beneficiary outside the dealership to receive the overpayment amount. These arrangements effectively reduce or shift income out of the dealership. The presence and amounts of overpayments or over remittances should be considered as potential normalization adjustments to earnings when determining the value of a dealership.We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.
Unfriended? Long-Term Planning and Facebook's Stock Collapse
Meta Platforms (NASDAQ: META), formerly known as "Facebook," recently released its third-quarter earnings and guidance for 2023. Let's just say the market was less than pleased. Meta's stock fell over 20% in after-hours trading, which is down over 65% year-to-date. Per Figures 1 and 2, the stock is currently sitting at its lowest level since 2016, with a corresponding decline in implied valuation multiples.Figure 1 :: Meta (Facebook) Stock PerformanceFigure 2 :: Meta (Facebook) Variation Multiples A quote from Yahoo Finance piqued our interest: "Investors in Meta stock wanted to hear one thing on the embattled company's earnings call late Wednesday: an acknowledgment by founder Mark Zuckerberg that leaner spending times were ahead as margins have been squeezed by an ill-timed metaverse build out and a slowing ad market…They heard the opposite." Reading between the lines, it appears the market responded negatively to Facebook's continued commitment to high spending and capital expenditure into the metaverse, artificial intelligence ("AI"), and virtual reality ("VR") offerings, despite a contraction in margin and a potential slowdown in the U.S. economy. But so what? We think the current sell-off presents two lessons to family businesses: Maintain a long-term perspective even in rough weather, and understand the season your business is in.Next Quarter or Next Generation?Mr. Zuckerberg appears to be rebuffing the Street's next-quarter-ism and focusing on the long term. A snapshot of Meta's performance highlights this "horizon" difference in Figure 3.Click here to expand the image aboveAs shown in Figure 3, despite slowing revenues, Meta's capital expenditure increased nearly 50% from year-end 2021, and R&D expenses increased by over 32%. While the markets looked for belt-tightening, Mr. Zuckerberg went back for seconds.Readers of the Family Business Director will know that one of the strengths of family businesses is their ability to make tough decisions for the long-term health of their businesses despite possible negative, near-term impacts. Publicly traded companies often lack this advantage (or grace), as Facebook is acutely highlighting. While we don't know how Meta's strategy will turn out, Meta's current strategy appears forward-looking for better or for worse.Plant or Harvest?Mr. Zuckerberg on Meta's near-term challenges:"I think we're going to resolve each of these things over different periods of time," Zuckerberg said. "And I appreciate patience and I think that those who are patient and invest with us will end up being rewarded."Patience. When was the last time you or your family board asked for patience? Knowing what time, or season, it is for your family business will help you gauge how patient (or impatient) you need to be. Is it "planting" season or "harvesting" time? Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. In contrast, harvesters generate more cash flow from current operations than they invest for future growth.The goal of planting is to promise a future harvest. But as any farmer knows, it is a promise, not a known fact. You have to plant before you harvest. As a result, the principal peril of planting time is the risk that the harvest will turn out less attractive than expected. In contrast, harvest time promises you will finally reap the benefits of the risks and investments but potentially starve the business of needed investment.It would appear Mr. Zuckerberg will continue planting despite the market's scream to harvest before more storms arrive. As highlighted in Figure 3, Meta's adjusted EBITDA fell nearly 21% from the end of 2021, but capital expenditure continues to climb, and guidance expects operating expenses (including research and development) to climb further in 2023. With the most recent quarter's performance and macroeconomic woes, one could argue that Meta should ease off the gas and focus on core operations. However, failing to plant could let complacency set in and starve the company of future growth opportunities. Family businesses should take a step back and check what time it is for their family business and if a change of posture is in order.Next Frontier or Next Flop?Palmer Luckey, who sold Oculus VR to Facebook for $3 billion, had this to say on the metaverse in a recent interview: "It's hard for me to really wholeheartedly say, 'Oh, Horizon Worlds, what an absolute disaster,' because I look at it and I see something that's being developed in the open, developed in public. It is terrible today, but it could be amazing in the future. I think Mark will put in the money to do that." Will the metaverse be a winner? Digital real estate? AI technology? Meta's fourth-quarter earnings? We won't pretend to know what the future holds or how much patience investors ought to have. But we continue to think a competitive advantage of family businesses is the ability to be patient. Meta is refusing to stop investing in a number of new markets and opportunities despite near-term compressions on cash flow. Does your family business have to make some tough decisions to ensure you are around for another 100 years? There generally are no shortcuts to achieving long-term wealth, and there will be tough plant-or-harvest decisions along the way. Is your family business at a turning point and needs some direction? Give one of our professionals a call today to help you think about your next move.
How Are Tech-Forward Banks Performing?
In the year-to-date period, the KBW Nasdaq Bank Index has declined 22%, compared to a decline of 20% in the S&P 500 through October 27.Tech-forward banks have underperformed the broader banking sector, down 60% in the year-to-date period.1This is a reversal of the trend in 2021 when tech-forward banks outperformed the broader banking sector, logging a 70% increase compared to an increase of 35% in the KBW Nasdaq Bank Index.Figure 1 :: Year-To-Date Performance (Through October 27, 2022)Source: S&P Capital IQ Pro. Figure 2 :: 2021 PerformanceSource: S&P Capital IQ Pro. The tech-forward bank landscape encompasses a variety of business models but generally refers to banks utilizing technology or partnering with fintechs to deliver financial products or services.Banks that partner with fintechs are often referred to as providing “banking as a service (BaaS)”.This model involves an FDIC member bank offering bank products to fintech customers, for example, credit and debit cards or personal loans.The bank holds the deposits associated with the accounts and earns a fee based on a percentage of interchange income specified in an agreement negotiated with the fintech partner.Other models are focused on facilitating payments or providing financial services to a specific niche, such as cryptocurrency.While the largest banks have the resources to be at the forefront of technology adoption, many smaller banks have partnered with fintechs in recent years. This is due in part to the Durbin Amendment which places limits on interchange income for banks above $10 billion in assets.In many cases, the partnerships have accelerated growth and created new income streams for the bank partners.However, bank partners also face unique risks.As displayed in the market performance, tech-forward banks have been more volatile than traditional banks.Tech-forward bank performance has been moored, to some degree, to more volatile technology stocks, which explains the stock market outperformance in 2021 followed by a larger retrenchment in 2022.For a community bank pursuing a fintech partnership strategy, there are multiple considerations, including the following.Deposit GrowthMany fintech partner banks have continued growing deposits this year even though most banks have seen deposit growth stagnate or turn negative in the rising rate environment.An analysis performed by S&P Global Market Intelligence showed that fintech partner banks with assets between $1 billion and $3 billion experienced deposit growth of 15% (annualized) in the first half of 2022.This compares to deposit growth of 3% for commercial banks in the same asset size range.The deposits generated from fintech partnerships are often noninterest bearing accounts, which are especially valuable in the currentrising rate environment. Bank partners earn spread income from the deposits, often holding them at the Federal Reserve due to their volatility and uncertain duration. Balances at the Fed reprice immediately with changes to the Fed’s benchmark rate.Noninterest IncomeThe largest impact on the revenue side typically shows up in noninterest income.Fintech partner banks tend to have a higher ratio of noninterest income to total income relative to traditional banks as they earn a share of the interchange income.In a period of flat or declining interest rates, this diversification of revenue can help to offset net interest margin compression.For the tech-forward banks included in Figure 1 and 2, the median ratio of noninterest income to operating revenue was 29% in the trailing twelve
month period.Concentration RiskWhile fintech partnerships can be a source of growth, bank partners should be cautious about revenue or deposit concentrations. Fintechs can grow rapidly, and, as a result, a bank partner may develop a concentration within their deposit base or revenues.Banks must periodically renegotiate contracts with fintech partners, and there is a risk that the fintech will find another bank partner or demand more favorable terms.This single event could eliminate a major source of deposits or reduce noninterest income, causing a much greater impact than the ordinary loss of traditional bank customers.For example, Green Dot Corporation (GDOT) provides the Walmart MoneyCard product and offers other deposit account products at Walmart. Green Dot’s second quarter 10-Q discloses that approximately 21% of its operating revenue in the year-to-date period was derived from products and services sold at Walmart locations.Regulatory RiskRegulators have stepped up their scrutiny of bank-fintech partnerships this year, focusing on risk management controls.Many banks partnering with fintechs have less than $10 billion in assets, and banks that do not currently serve fintechs may not have the necessary compliance infrastructure to effectively manage potential fintech relationships. Compliance capability must be built over a long period of time and serves as somewhat of a barrier to entry for banks desiring to pursue this strategy.Additionally, certain fintech partnerships may present an added element of risk as the bank could be impacted by the regulatory and compliance practices of the fintechs or the evolving regulatory/compliance landscape.One recent example of this risk arose in the crypto fintech niche as the FDIC released an order to a crypto brokerage firm demanding that it cease and desist from making false and misleading statements about its deposit insurance status, while the FDIC contemporaneously issued an advisory to insured institutions regarding FDIC deposit insurance and dealings with crypto companies.2Valuation & PerformanceBank stocks’ underperformance in 2022 has largely been attributed to economic uncertainty and the potential for recession brought on by the Fed’s aggressive rate hikes. Fintech partner banks have been more volatile than the broader banking market.The business models entail certain risks, as detailed above, that do not pertain to traditional banks to the same degree.In addition, the earnings from fintech partnerships are less predictable and potentially further out in the future.As seen in figure 3, the range of valuation multiples observed for tech forward banks is wide, with forward P/Es ranging from 6.6x to 16.1x but most trade at 7x to 9x estimated 2023 earnings.It is important to note that the banks included in the table above represent a variety of sizes, strategies and niches, so comparability may be somewhat limited.Tangible book multiples likewise exhibit a wide range, but in general are high relative to the broader banking sector.In valuing fintech partner banks, investors weigh the growth potential provided by the partnership versus the risk that earnings growth does not materialize.Figure 3 :: Multiples and Price Change of Tech-Forward BanksClick here to expand the image aboveConclusionMercer Capital has experience valuing and advising both banks and fintechs.If you are considering partnership opportunities or have questions regarding their valuation implications, please contact us.1Tech-forward banks include AX, CCB, GDOT, LC, LOB, MVBF, CASH, SI, SIVB, TBBK, and TBK.Year-to-date performance through 10/27/222https://www.arnoldporter.com/en/perspectives/advisories/2022/08/regulators-crack-down-on-fintechs
Fall 2022 Middle Market M&A Update
For this week’s post, we take a look at recent trends in middle market M&A. Despite turbulent economic and geopolitical conditions in the first half of the year, valuations in the middle market continued to hold their ground.Still, whether looking to buy or sell, family business owners would be wise to act sooner rather than later, as declines in volume and value thus far in 2022 suggest tightening conditions in the middle market.Overall deal activity in the second quarter of 2022 fell from levels seen in the first quarter of the year and the second quarter of 2021. In aggregate, deal activity in the first half of 2022 also fell from aggregate deal activity in the first half of 2021.Despite the decline in U.S. deal value and volume, multiples on deals completed in the first half of the year remained in line with levels observed in 2020 and 2021, suggesting a potential “flight to quality” in the middle market in the first half of the year.U.S. Deal Value and Volume: Q1-2020 to Q2-20222U.S. Deal Volume by Industry: Q1-2020 to Q2-2022Click here to expand the image aboveBroader economic conditions in the U.S. negatively influenced deal value and volume in the first half of 2022 but did not stifle overall deal activity. In the second quarter of 2022, U.S. GDP declined for the second straight quarter, and annual and monthly inflation measures continued to hit record levels.In response to the rampant inflation in the U.S. economy, the Fed executed two sizable rate increases in the second quarter, including enacting the largest rate increase since 1994 at its June meeting. While the U.S. economy has not yet officially fallen into a recession (despite the two straight quarters of decline in GDP), most Fed watchers agree that Jay Powell and the FOMC won’t relent in their fight to bring down inflation even if it does cause a recession. In short, the Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growth.TEV/EBITDA Multiples: Financial BuyersYet despite these challenging macroeconomic conditions, deal activity did not come to a screeching halt in the first half of 2022, as seen in the middle of 2020. We believe this is a good sign for the overall health of the middle market, particularly when coupled with the fact that multiples on PE deals were relatively unchanged in the second quarter, as seen in the chart above. The prolonged “sellers’ market” of the past several years appears to be holding up to this point in 2022, as buyers continue to be willing to pay elevated multiples for well-positioned businesses coming to market. Deals in the $50-$100 million tranche of the middle market realized multiple expansions in the second quarter, growing from an average multiple of 8.5x to 9.2x. Multiples in other tranches were either unchanged or slightly down.EBITDA Multiples by Buyer Type: 2020 to 1H 2022Number of Deals by Buyer Type: Q1-2020 to Q2-2022Click here to expand the image aboveDebt multiples on PE deals fell in the second quarter of 2022. The drop in debt utilization in deal activity is likely a sign that rising interest rates are beginning to weigh on deal activity and financing terms. Rising interest rates equate to an increased cost of borrowing and overall cost of capital for businesses, increasing the discount rates used in buyers’ valuations of potential targets. While elevated discount rates, in theory, should lead to valuations (and hence multiples) coming down from levels seen over the past several years, corporate balance sheets and PE firms still appear to be flush with cash. We believe there is still a great deal of readily deployable capital on the sidelines that should continue to support elevated multiples and valuations in the middle market in the foreseeable future.Debt Multiples: Financial BuyersIn conclusion, while deal volume was down in the second quarter of 2022 (and in the first half of the year in general), activity did not come to a screeching halt despite a challenging economic environment in the U.S. and geopolitical strife abroad.In our opinion, there has been a “flight to quality” in the middle market, which has supported valuations and multiples despite reduced deal volume. This has created heavy competition among strategic and financial buyers for well-positioned businesses coming to market and, in the process, has helped maintain the elevated multiples and deal values seen in the middle market over the past year or so.While observed multiples remain elevated, owners looking to transact their business would be advised to begin the process sooner rather than later, given the prospects of further interest rate hikes, continued volatility in the public markets, ongoing geopolitical tensions globally, and the upcoming midterm elections.While the state of the middle market remained relatively placid in the first half of 2022, these and other factors will likely hamper deal activity in the middle market in the coming quarters and years.
Now Available: Mercer Capital's 2022 Energy Purchase Price Allocation Study
Mercer Capital is pleased to announce the release of the 2022 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data for four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2022 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2021.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<
Five Trends to Watch in the Medical Device Industry: 2022 Update
Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 40.3 million in 2021 (13% of the population). The U.S. Census Bureau estimates that the elderly will more than double by 2060 to 95 million, representing 23% of the total population.The elderly account for nearly one third of total healthcare consumption in the U.S.Personal healthcare spending for the population segment was approximately $19,000 per person in 2014, five times the spending per child (about $3,700) and almost triple the spending per working-age person (about $7,200).According to United Nations projections, the global elderly population will rise from approximately 608 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060.Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region.While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.1 trillion in 2020 to $6.2 trillion in 2028, an average annual growth rate of 5.4%.This projected average annual growth rate is faster than the observed rate of 3.9% between 2009 and 2018. Projected growth in annual spending for Medicare (4.3%) and Medicaid (5.6%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.However, growth in national healthcare spendinghas slowed in 2021 to 4.2%, down from 9.7% in 2020. Healthcare spending as a percentage of GDP is expected to remain virtually unchanged from 19.7% in 2020 to 19.6% by 2030.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018 and is expected to rise to 18% by 2028.Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2020.Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.Due to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services.Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $776 billion in 2020 and are expected to reach $1.5 trillion by 2030.The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs.While political debate centered around altering the ACA has been a continuous fixture in American politics since its passing, it is unlikely that material reform to the ACA occurs in the near future under the Biden Administration.Total Medicare spending is projected to grow at 5.6% annually between 2025 and 2030, compared to year over year growth of 11.3% in 2021 and 3.5% in 2020.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 35.8% of payments were tied to Category 3 and 4 APMs in 2018, compared to 32.8% in 2017.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the US without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. The plans materialized as the Abbreviated 510(k) Program later in the year.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022. Intended to begin in 2020, negotiations for MDUFA V were delayed due to the COVID-19 pandemic. The FDA and industry groups reached a deal for MDUFA V, slated to go into effect beginning fiscal 2023, which would generate up to $1.9 billion in fees to the agency over five years. The U.S. House of Representatives passed MDUFA V in June 2022 and the Senate is expected to follow suit by September 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive.Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market.This CE marking verifies that a device meets all regulatory requirements, including EU safety standards.A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. According to the WHO, middle income countries, such as Russia, China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their incomes increase.When countries grow richer, the demand for health care increases along with people’s expectation for government financed healthcare.Middle income country share, the fastest growing economic sector, increased from 15% to 19% of global spending between 2000 and 2017.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.Global medical device sales are estimated to increase 5.4% annually from 2021 to 2028, reaching nearly $658 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.
Storms Ahead? Best Practices for Forecasting Performance
Having transplanted from Tennessee to Florida, I’ve just now gotten up to speed on the weather. In the summer, afternoon showers can pop up without warning, and the low 80s is “cool” for the locals. I am not there yet.Hurricane Ian blew through southwest Florida in late September, which had my family and Floridians keener to forecast models, storm tracking, and cone watching. We were quite lucky in my neck of the woods, but the unpredictability of the storm’s ultimate landfall led to a lot of consternation.After the dust settled, the forecast models got me thinking about the difficulty in "forecasting" business performance. How do you approach your family business budget? Do you ask your managers to "reach" or to create targets you expect to meet? Do you measure your forecasting accuracy? What is your process?We’ve written previously on how to make your forecasts more useful with your P&L and cash flow statements, and below, we share three forecast reminders that may help you make better budgets: Measure yourself regularly, remember the law of averages, and adapt your roadmaps when needed.“If you can’t measure it, you can’t improve it.” – Peter DruckerWorking with clients year after year has given us perspective on forecasting styles. Some family businesses leave ample cushion for their teams to beat, while the aspirational others point to where management is heading.Some consistently hit their targets while others chronically "over-promise-and-under-deliver." British statistician George Box famously said, "All models are wrong; some are useful." To make your budget models useful, you should consistently evaluate your process relative to actual performance. Where are your blind spots? Where are we over/under-allocating expenses? What were the biggest surprises we had last year? Understanding where the forecast process went wrong, and right, will help you make better-informed budgets and forecasts in the future.“You are not special.” – Tyler DurdenWell, perhaps that’s harsh. Likely your family business is indeed unique and has a special story, but not that special.Remember the power of mean reversion and the law of averages when thinking about your family business forecastYour family business operates in a competitive market, and any competitors are always looking to lay siege over the moat you have dug around market share and profits. Abnormally high-profit margins have a way of drifting towards industry averages, and super-charged growth generally tampers to a steady state.A recent study of Wall Street analysts’ forecasts from 1997 to 2021 by Verdad, an asset management firm, found 3-year median forecast overestimation errors for revenue at 4.6%, EBITDA at 19.4%, and pre-tax earnings of 36.8% (!). From the piece:"Across the board […] estimated growth rates systematically overshoot the actual outcomes. Importantly, analysts’ forecast errors seem to be bigger precisely in the areas that should matter most for stock prices: earnings further down the income statement that go to equity investors, and earnings further out in time."Remember the power of mean reversion and the law of averages when thinking about your family business forecast. Working with entrepreneurial families, we see success manifest in optimistic innovators and business owners. Remember to splash just a little bit of cold water on next year’s view to maintain a margin of safety.“When the facts change, I change my mind. What do you do?” – Winston ChurchillThink about the last few years. The genesis of the COVID-19 pandemic, runaway inflation, and a war in Ukraine have all rattled financial markets and upturned how many companies operate. A forecast is a tool; to be a good tool, it must be adaptable to changing facts.A good budget process does not lend to blind adherence to well-laid plans made six months hence. For example, a capital expenditure project you previously forecasted to complete with debt financing may make a lot less sense with borrowing rates up considerably in 2022. Supply chain issues and inflation may lead you to reassess your projected gross profit for the year, as well as your working capital needs.Being able to pivot when needed keeps you dry in stormy weather and allows you to execute when opportunities arise.Cloudy with a Chance of Recession?As the public markets continue to reel and the chance of a recession "landfall" increases, now is the perfect time to review your budget process and prepare for what lies ahead.Learning from past budgeting mistakes (and victories), remembering the law of averages, and maintaining an adaptive forecast process can help develop actionable plans that your directors can rely on. But when an outside perspective can be helpful in your forecast process, give one of our family business advisory professionals a call to confidentially discuss your challenges.
How Waves Of Reality Are Swelling Upstream Returns
Upstream and oilfield service companies have bucked trends most of this year.While other industries have had stagnant to negative returns, the oil patch has outperformed them all, as I highlighted earlier this summer. Since then, market capitalizations have stagnated. Yet, the reality is that equity returns are soaring on a wave of cash flow right now.Operational cash flow for the sector was at its highest in the five year period since 2017 at $203 billion, according to the EIAs’ Financial Review of the Global Oil and Natural Gas Industry: Second Quarter 2022 report.This led to a 22% return on equity which was notable not only because it was the highest recorded return in the survey period, but also because it usurped U.S. manufacturing companies' returns on equity for the first time in the survey period.It has been a long time coming, but several realities have been coming to the forefront to build this wave: world realities, production realities, and capital realities.World RealitiesThe energy industry’s reality is one tethered to the zeitgeist. Few if any other industries are as sensitive to the volatility of politics, regulation, and events. A year ago, longer-term supply and demand trends were pushing tailwinds for upstream producers, but those winds blew up into a storm when Russia invaded Ukraine. Several of my contributing colleagues here at Forbes.com have done good work covering these developments. That has Russian oil production likely dropping around 20%, with an accompanying impact to prices. In addition, OPEC+ has reduced oil production quotas for October.The energy industry’s reality is that some unintended consequences regarding the scramble for energy transition away from fossil fuels have collided with “contingencies.” Aramco’s CEO Amin Nasser was very blunt about this in Switzerland last Tuesday (before the Nord Stream incident).Perhaps most damaging of all was the idea that contingency planning could be safely ignored“Perhaps most damaging of all was the idea that contingency planning could be safely ignored,” said Nasser, “Because when you shame oil and gas investors, dismantle oil- and coal-fired power plants, fail to diversify energy supplies (especially gas), oppose LNG receiving terminals, and reject nuclear power, your transition plan had better be right.”“Instead, as this crisis has shown, the plan was just a chain of sandcastles that waves of reality have washed away.And billions around the world now face the energy access and cost of living consequences that are likely to be severe and prolonged,” said Nasser.There has been a flurry of speculation as to who is responsible for the explosions emanating from the Nord Stream pipeline, but what is now concerning is Europe’s ability to keep warm this winter. The U.K. reversed its fracking ban to help secure its energy supply. It may be too little too late this winter for the Brits.In the meantime, Europe’s eyes look to the U.S. to stand in the growing energy gap, particularly gas. The U.S. has skyrocketed to become the top exporter of LNG in the world this year. This won’t change any time soon and is expected to continue to expand and grow.At the same time, U.S. domestic demand has been growing too, thus multiplying natural gas prices compared to two years ago.Production RealitiesWhile demand has resurged domestically and abroad, upstream production has not been keeping up the same way it has in the past. The good news is that production is growing and will continue to. However, there are several things limiting growth. As I have written before, producers have been cautious for a myriad of reasons and as such, new major investments in development and drilling have been stalled. According to the EIA Financial Review, Capex of the companies surveyed was $59 billion in the 2Q of 2022, only 8% higher than the 2Q of 2021.Rig counts are growing, but not at the same pace as they did the last time commodity prices were this high.DUC wells are at the lowest level in almost a decade, so drilling inventories continue to shrink.Another reality is that productivity at the individual rig level is waning. This comes in two ways: 1) the form of productivity for new wells drilled, and 2) existing legacy production is declining faster than before.Explanations for this are not entirely clear.
Perhaps it is the exhaustion of top-tier PUD well locations, continued permitting problems that Joe Manchin could not fix, or the flight of talent from the oilfield in the last few cycles. Costs increased for the seventh straight quarter in the Fed Survey – near historical index highs. Nonetheless – it is happening and fueling a bevy of comments like this from the Dallas Fed Survey:
“Uncertainty on the political front continues to be a major concern. The withdrawal of leases that have already been issued is an example. Inflationary pressure is eating significantly into discretionary cash flow, limiting the amount of money allocated to new projects.”
85% of survey participants expected to see a significant tightening in the oil market by the end of 2024 given the underinvestment in exploration.
Capital RealitiesIn the past several years there simply has not been enough capital deployed in the sector to defray some of the shorter-term event volatility such as Ukraine’s war with Russia.79% in the Fed Survey expect to see some investors return to the spaceWith the spike in prices, 79% in the Fed Survey expect to see some investors return to the space, attracted by superior returns. However, it may be some time for that to matter. In this business, measured in years and decades, investments that can move the world needle take time to come to fruition. In the meantime, 69% of respondents in the Fed Survey expect to see the age of inexpensive gas ending by 2025. Existing capital remains focused on paying off debt and dividends, not drilling. Cash flows from Operations of $203 billion and Capex of $59 billion clearly communicates this reality.In the long run, prices ultimately communicate reality in a commodity business, so the expectations of higher prices should be the instigator to change behavior to a more balanced energy policy for much of the developed world.In the short run, oil and gas investors are getting exceptional returns. That should not change any time soon.Originally appeared on Forbes.com.
From Antler Motel to the House of Representatives
The Wall Street Journal recently published an article on the life of entrepreneur Clarene Law. Clarene was a mother and a hotel bookkeeper in Wyoming’s Jackson Hole valley in the 1960s. Which led to a problem – who would take care of the kids? This question led her down the path of starting a family business. After hearing the Antler Motel was for sale, she borrowed money from her parents and put a down payment on the $125,000 asking price. Problem solved – Clarene switched hats from hotel bookkeeper to motel owner and innkeeper, and her family could live at the motel.Fast forward some years later and what started as a little-known town blossomed into a luxurious year-round hiking and skiing destination for visitors all over the country. While right place, right time played a part, it does not tell the whole story of how Clarene Law became one of the best-known entrepreneurs in Jackson Hole. Clarene expanded her reputation further as she served n the Wyoming House of Representatives for 14 years. Inspired by her story and the family business she built, we highlight three themes that can help build your family business: growth, diversification, and family business leverage.GrowthSteady, natural growth is a long-term commitment. Clarene realized early on there was no get-rich-quick formula – how could there be when rooms cost less than $10 a night? She understood that growth could be individually affected through her own efforts. Her energy was infectious, and her personal interactions with customers made them feel special. This feeling grew into loyalty, creating 30+ year relationships with customers as well as hotel employees. Clarene’s daughter, Teresa, shared why they kept coming back, “because mom’s here…just to be with her.” In 1973 Clarene married Creed Law, and while finding the right business partner doesn’t normally start with “I do,” Mr. Law helped Clarene take a step forward in growth. Mr. Law was a great builder, and together, they expanded the family business to include several more properties with a total of 477 rooms, now known as the Elk Country Inn.Growth in your family business may seem distant and slow-paced, but consistent, day-to-day efforts play a huge part in long-term growth. Clarene presents an example of someone who steadily influenced growth through her personality, decision making, and reliable hard work.DiversificationWe have written on asset diversification in the past, but Clarene’s story teaches us a good lesson on how the degree of diversification matters. Diversification is simply investing in multiple assets as a means of reducing risk. Warren Buffett states, “Diversification may preserve wealth, but concentration builds wealth.” As far as concentration goes, Clarene doubled down on hospitality, buying several inns around the area to add to the growing family business. Later, Clarene began to transition from building wealth to preserving it. She diversified into non-hospitality investments with a couple of farms and a dude ranch. Unfortunately, her other investments reportedly did not work out. Regardless of why the investments failed to deliver, we question whether Clarene’s approach to diversification was radical enough. Investing in multiple assets yields diversification benefits only if the assets behave differently; if the correlation between the assets is high, the diversification benefits will be negligible. We suspect that the correlation between Jackson Hole motels and other real estate investments in the same area was too high to generate significant diversification benefits.Diversification is simply investing in multiple assets as a means of reducing riskThis illustration is an important reminder for family businesses that diversification is important, but how you diversify your assets matters just as much. Understanding the degree of correlation among assets in the family business portfolio is essential to achieving real diversification.Leverage the Benefit of Being a Family BusinessHad it not been for family, Clarene might never have purchased the Antler Motel. Our colleague Atticus Frank reminded readers in a post earlier this year to distinguish a family business from a business family. Clarene involved her family in the business early on and gradually began passing the management of the business to her children as they grew older. Until earlier this year, she still came to work and was the first person customers would see. Clarene told The Jackson Hole News, “Whatever success I have, I owe to my family – my hardworking children, my husband, and a very loyal staff.” Loyalty, hard work, and focus on the best service are common hallmarks of successful family businesses.ConclusionClarene knew when to have the talk with her children so that when the day came, they would be ready to continue the business in her honor. Her concentration on steady, long-term growth allowed the business to develop naturally as a family business. While her diversification efforts may have fallen short of the ideal, her legacy of success is a valuable example to other enterprising families.
Mineral Interest Owners: How to Know What You Own
Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry. This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own.
We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1]
Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.” As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres. That is: 640 acres per section times ¼ times ½.
The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow:
“To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.”
This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at:
80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals. This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved. As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country. Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value. For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO
RIA M&A Update - Through August 2022
Year-to-date RIA M&A activity has surpassed last year’s record levels in 2022, even as macro headwinds for the industry continue to mount. Fidelity’s August 2022 Wealth Management M&A Transaction Report listed 155 deals through August of 2022, up from 112 during the same period in 2021. These transactions represented $212 billion in AUM, up 16% from 2021 levels. The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy, given that all these factors could strain the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. But despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with professionalization of the buyer market continuing to be a theme driving M&A activity. Serial acquirers and aggregators increasingly drive deal volume with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first eight months of the year. While the current market environment has prompted some serial acquirers to temper their pace of acquisition activity (CI Financial’s CEO Kurt McAlpine remarked on the company’s first-quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in reported deal volume. Multiples in the industry remain high, although the upward trend in multiples has reportedly leveled off. On the supply side, the current market environment is likely to have a mixed impact on bringing sellers to market. On one hand, some sellers may be reluctant to sell when the markets (and their firm’s financial performance) are down significantly from their peak. On the other hand, a concern that multiples may decline if the current market environment persists may prompt some sellers to seek an exit while multiples remain relatively robust.The current market environment is likely to have a mixed impact on bringing sellers to marketWhile market conditions play a role in exit timing, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve for succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record-setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions, as in most transactions. But how the deal is financed is often a crucial secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: Whatever the market conditions when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.
Middle Market Transaction Update Fall 2022
Overall deal activity in the second quarter of 2022 fell from levels seen in the first quarter of the year and the second quarter of 2021.
Private Equity Wants Your Family Business
For many family business leaders we talk with, “private equity” is a four-letter word. However, a September Wall Street Journal article highlights a recent thaw in the historically icy relationship between family businesses and private equity investors. In 2021, we predicted that non-family equity capital would grow increasingly common in family businesses. This WSJ piece confirms that our prediction is on point.Of course, family business suspicions of private equity were never completely ill-founded. There are some elements of the standard private equity playbook that don’t sit well with the ethos of many enterprising families. But the WSJ article shows that it’s more complicated than the longstanding caricatures would suggest. In this post, we identify a couple of potential “pros” for private equity that family business directors should be aware of and also confirm a couple of the well-known “cons” to accepting private equity investment.Pro: Access to Growth CapitalThere’s a large body of research literature documenting how family ownership correlates with superior business performance. While this is obviously great, it highlights a more subtle threat: family ownership can actually inhibit the growth of high-performing family businesses. We’ve written before about how family businesses are either “planting” or “harvesting.” For family businesses in “planting” season, the market opportunity may outstrip the family’s capital resources and/or willingness to use debt financing. In such cases, the family business may be prevented from reaching its potential (to the detriment of its employees, customers, suppliers, and other stakeholders) because of the capital constraints of the family. Bringing in a private equity partner can provide access to the growth capital needed to unlock the true potential of your family business.Pro: Ability to Retain Ownership & InfluenceMany private equity investors are willing to purchase less than 100% of the family business and may even want family members to remain in key management roles. Retaining ownership alongside a private equity investor allows the family to take some economic chips off the table but still benefit from the foundation for future growth laid by the family. When private equity investors grow the family business successfully, the value of the interest retained by the family can eventually exceed the value of the entire business at the time of the private equity investment. The WSJ article we linked above highlights an outlier case in which a founding family benefited from four successive private equity transactions; the family’s proceeds from the most recent transaction (for less than 5% of the company) exceeded that from the initial sale of a controlling interest in 2006.Con: MBAs Really Don’t Know It AllMoney buys influence. Private equity investors providing capital to your family business will, of course, want to make important decisions regarding your family business. The professionals tapped by private equity firms to manage portfolio companies often have great business acumen. However, being an expert about business, in general, does not necessarily translate into being an expert about your business. Greater capital resources – coupled with the hubris that often accompanies large pools of capital – create the opportunity for bigger mistakes.The WSJ article includes the cautionary tale of Sun & Skin Care Research, Inc., whose new PE-installed CEO promptly made a few key decisions that led swiftly to the demise of the once-stable family business. We suspect that one of the reasons all those academic studies find outperformance on the part of family businesses is that the company and industry-specific knowledge that accumulates and is retained in the business over the course of decades and generations is hard to match, no matter how fancy a newcomer’s degree (or pedigree) may be.Con: It’s All About the (Portfolio) ReturnWhile private equity firms have become more enlightened in recent years compared to the slash-and-burn attitudes of the early corporate raiders of the 80s and 90s, generating outsized returns is still the goal of PE investors. Doubtless, successful enterprising families are also profit-conscious. But private equity returns are not just about being profitable. Many private equity investors like to tout operational savvy as the key ingredient to their returns, but the real secret sauce continues to be the use of OPM: Other People’s Money.PE firms use financial leverage to generate a multiplicative return on their equity. So long as the operating reality matches the excel model, it all works out. Throw in an unexpected recession or another hiccup, and that debt load can quickly raise existential questions for the business. A family manages a business like its fortune depends on its continued existence (because it generally does); a private equity firm manages a business like it is one part of a diversified portfolio of winners and losers (which it is).Conclusion: What to Do When Private Equity Knocks On Your DoorPrivate equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.Perhaps the most important thing to keep in mind is the natural imbalance in the family-private equity relationship: they buy and sell businesses all the time, and you probably don’t. That is why it's essential that you have a trusted team of professional advisors to help you engage with potential investors. If you have received – or expect to receive – an investment proposal from a private equity firm, give one of our professionals a call for an independent, outside perspective.
Bakken Regains Its Footing
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) increased by 5% year-over-year in September. Bakken production, relative to the September 2021 level, plunged nearly 20% in April due to the impact of back-to-back blizzards but had recovered to the September 2021 level by June 2022. Production in the Eagle Ford and Permian were 13% and 8% higher, respectively than in September 2021, without the short-lived plunge seen in the Bakken. The gas-focused Appalachia region production relative to September 2021 levels was more stable than the oil-focused regions, with relative production only varying within a band of -1% to 4%, ending at a year-over-year 3% increase in September 2022.
As of September 16, 2022, 40 rigs were operating in the Bakken, marking a 74% increase from September 10, 2021. Eagle Ford, Permian, and Appalachia rig counts were significantly higher than year-earlier levels at 112%, 35%, and 24% increases, respectively. The Permian continued to command the largest number of rigs at 343, with the Eagle Ford and Appalachia closer in-line with the Bakken at 72 and 47 rigs, respectively.
Oil Climbs While Gas Shows Heightened VolatilityOil prices, as benchmarked by West Texas Intermediate (WTI) and the Brent Crude (Brent), rose from $72/bbl and $75/bbl, respectively, in September 2021 to $85/bbl and $90/bbl, respectively, as of September 16, 2022. While the rise in pricing was fairly steady through mid-February 2022, the Russian invasion of Ukraine spurred a series of ups and downs, with prices spiking to a high of $120/bbl (WTI) and $128/bbl (Brent) in early March, immediately followed by a plunge to $94/bbl and $96/bbl in mid-March. Subsequent spikes and dips were somewhat more muted, but prices remained volatile through early June. A general price decline during the third quarter resulted in prices at the $85/bbl and $90/bbl level.Henry Hub natural gas front-month futures prices dipped from a late 2021 high of $5.48/mmbtu to a low of $3.44/mmbtu near 2021 year-end as commodity markets incorporated indications of rising production levels and ebbing weather-driven demand. Pricing subsequently rose to as high as $9.29/mmbtu in June on weather-driven demand and lacking supplies due to a reduction in Russian exports. In mid-June Henry Hub pricing began a sharp decline on the announcement that prices recovered over the remaining two months of the September LTM period, albeit with some volatility, to end at $7.81/mmbtu.Financial PerformanceThe Bakken public comp group's latest twelve-month financial performance (stock price) analysis was reduced to two subject companies and the XOP SPDR, as a result of the Whiting and Oasis merger in March 2022. The combined Whiting/Oasis company, Chord Energy, appears in our analysis as CHRD.The Bakken comp group showed strong price performance from year-end 2021 through early June, with increases ranging from 63% to 83%, largely reflective of oil prices. The subsequent decline in commodity prices, which ran nearly un-checked for two months, slashed the analysis period performance to increases of only 3% and 46%, with Chord posting a decline that nearly wiped out its post September 2021 gains. Prices have recovered since July with one-year gains of 42% (Chord) to 61% (Continental).ConclusionThe Bakken showed a general increase in activity over the last year, albeit with a large winter storm disruption and subsequent production recovery along the way. Rig counts have risen on strong commodity pricing, despite the oil price decline in Q3 2022. Share prices generally increased early in the latest twelve-month period, with a sharp decline in Q3 tied to oil prices slipping. Share prices recovered enough in late Q3 to show reasonably strong year-over-year growth as of September.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Bakken M&A
Increased Transaction Volume Continues into 2022
Deal flow in the Bakken has been steady over the last twelve months, with 14 transactions announced since October 2021, up from nine deals during the same period in 2020-2021. Devon Energy’s $5.6 billion acquisition of assets from WPX Energy was the only deal in the twelve months prior to September 2021 that exceeded $1.0 billion in value. In comparison, five deals exceeded $1.0 billion during the twelve-month time period ended September 2022, led by the Oasis Petroleum – Whiting Petroleum merger, at $6.0 billion.Recent Transactions In the BakkenA table detailing transaction activity in the Bakken over the last twelve months is shown below. Despite an increase in the number of deals, relative to 2020 – 2021, the median deal size decreased by roughly $215 million, with five deals valued at less than $200 million. The median value per acre and value per Boepd, however, increased over 300% and 100%, respectively.Oasis and Whiting Combine In a $6.0 Billion MergerOn March 7, 2022, Oasis Petroleum and Whiting Petroleum announced a $6.0 billion merger, renaming the combined entity Chord Energy. The deal closed on July 5, 2022. Under the terms of the agreement, Whiting shareholders received 0.5774 shares of Oasis common stock and $6.25 in cash for each share of Whiting common stock owned. Oasis shareholders received a special dividend of $15.00 per share. At closing, Whiting and Oasis shareholders owned approximately 53% and 47%, respectively, of the combined entity on a fully diluted basis. Transaction highlights include:Production (2022 Q1) – 92,000 BoepdAcreage – 480,000 net acres in Montana and North DakotaThe deal creates the Bakken’s second-largest producer and the largest pure-play E&P
A pro forma table of the transaction is shown below:Devon Energy - RimRock Oil and Gas DealThe next largest deal exclusive to the Bakken is Devon Energy’s $865 million acquisition of a working interest and related assets from RimRock Oil and Gas (seven of the 14 deals analyzed included acreage or midstream assets in areas in addition to the Bakken, including the $4.8 billion Sitio Royalties – Brigham Minerals transaction and the $1.8 billion Crestwood Equity Partners – Oasis Midstream Partners transaction). The deal was announced on June 8, 2022 and closed on July 21, 2022. Deal highlights include:38,000 net acres in Dunn County, North Dakota15,000 Boep/d as of Q1 2022 (78% oil)88% working interestOver 100 drilling locations
Characterized by Devon Energy as a bolt-on acquisition, the 38,000 net acres are contiguous to Devon Energy’s existing position in the Bakken. Production from the acquired assets is expected to increase to approximately 20,000 Boep/d over the next twelve months.
RimRock Oil and Gas is backed by private equity sponsor Warburg Pincus, which has held a stake in RimRock Oil and Gas since 2016.ConclusionM&A transaction activity in the Bakken increased through year-to-date 2022 relative to the same time period in 2021 and consisted of a handful of large deals and numerous small deals. Deal activity in the Bakken will be important to monitor as companies continue to find significant opportunities to grow their Bakken positions.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
What’s Lurking on Your Family’s Balance Sheet?
If a cursory reading of the financial press is an accurate judge, it would appear those most bullish on the crypto and digital asset space are eating at least a small helping of crow before their quest to upend the global financial system. Bitcoin (BTC) is down over 65% from its all-time highs, and that’s relatively outperforming some more exotic holdings. Nonfungible tokens (NFTs) have fallen even more precipitously, with many NFTs, such as the “Bored Ape Yacht Club,” needing a downgrade to a dinghy.Compare that to the record-breaking sale of Andy Warhol’s ‘Shot Sage Blue Marilyn’ for a cool $195 million in May, or nearly 10,000 BTC or 1,700 Bored Apes for those keeping score. As an art and crypto ignoramus, these data points provide interesting watercooler talk but also have us thinking about you and your family’s collective balance sheet.Any good CFO or Controller worth their salt knows what’s on their business’ balance sheet, including cash, inventory, property, and debt. But for enterprising families, it is often necessary to go one step further and ask what’s on the family’s balance sheet? Maybe your family has resisted the siren song of cryptocurrency and monkey NFTs, but are there any other sizable assets or liabilities you aren’t considering? It may be your great uncle’s antique car collection, a ski chalet shared by you and your family, or rare art that adorns your office. Whatever it may be, and trust us, we have seen some big bogeys; there are three things we think you should consider regarding your more esoteric family balance sheet items: valuation, diversification, and allocation.What Is It Worth?Without stating the obvious – if you suspect some of your more unique assets have a meaningful impact on your total family balance sheet – it’s worth getting a professional opinion as to the value. Similar to our advice to understand your business’ worth, unique assets ultimately exist on your family balance sheet as it concerns estate planning, gifting strategies, and tax considerations. As noted by estate planner Matthew Erskine in a recent post, artwork can even be an effective asset for executing some estate tax planning strategies. A simple example includes failing to adequately plan your estate accordingly and your estate being hit with a large tax bill. If the majority of taxable assets left are illiquid, you will have to work creatively to meet (liquidity required) tax liabilities. The last we checked, the IRS is still not accepting fractional interests in NFTs.What Is Our Risk?In addition to understanding the value of the unique assets on their own, you need to understand how this asset compares to the rest of your family business balance sheet. Understanding the correlation between your business and other assets, including your more distinctive ones, is key to long-term family wealth preservation and business continuity. A client we work with runs an operating business in the hospitality space with thousands of employees across the county. The family also has a penchant for airplanes, and in that case, the total value of the air fleet is over 10% of the combined value of assets. While this represents diversification, perhaps you and your family business are more concentrated, such as running a family of car dealerships while also holding an antique car collection. Being cognizant of your diversification, or lack thereof can help you better plan for the ups and downs in particular markets.What Do We Want?Beyond knowing what your assets are worth and their impact on diversification, a fundamental question still lingers for members of enterprising families: do we want to own this asset? As we have asked previously, did we fall into/inherit this asset, or are we here on purpose? Like owning and running a business, understanding your shareholders’ preferences and how they view the overall family business is key in determining asset allocation and where your capital should be deployed, stored, or sold.The ski chalet that your parents gifted you and your siblings who don’t ski, the rare art collection that you don’t know what to do with, or the yacht your family owns that sits idly by. Many unique or rare assets have considerable carrying costs to maintain them, and markets can often fluctuate wildly. Your family may view these assets in a separate class worth holding on its own, or it may not know what to do with grandfather’s rare coin collection. While we won’t opine on the relative performance of these assets, asking your family if you want to own and hold them is a question worth asking.Understand the Whole PictureWhile we all wish to find that rare vase or Jackson Pollock painting in our mother’s attic, it’s not likely that there are such economic windfalls hiding in your family’s cupboard. Nonetheless, establishing an inventory of all your family’s assets and agreeing on an ownership philosophy for unique assets is important. Understanding what these assets are worth, their impact on diversification, and whether you and the family have a desire to hold them are some simple housekeeping steps you can take to better understand the holistic family balance sheet and its impact on your family business health.Give us a call to discuss these or any other family balance sheet issues today.
What Should We Do About Estate Taxes?
“Ohana” means family…family means nobody gets left behind or forgotten. Lilo & Stitch, the Disney film about a family and an alien, taught us this just over 20 years ago. This is especially true in a family business as family business directors need to work together to ensure they are moving forward together, as a business and more importantly, as a family. As seen on the big screen with Lilo & Stitch, in family business meetings, and maybe even at the dinner table, Ohana is easier said than done. Sometimes your family does, in fact, act alien to you. But at the end of the day, family is vital to who we are and what we do.What Should We Do About Estate Taxes?Most family business owners desire to provide financially for their family. Due to this, one of the widespread concerns of these owners is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the "decedent’s gross estate," less the taxpayer’s remaining gift and estate tax deduction, which in 2022 is $12.06 million per individual ($24.12 million per couple), as well as other specific deductions. A unique issue for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Keep in Mind Fair Market Value and the Level of ValueThe concept of fair market value is essential to understanding and evaluating any estate planning strategy. For brevity’s sake, fair market value, or “FMV,” is defined by the IRS as the price at which the property would change hands between a willing buyer and seller, not under compulsion to buy or sell, and both having reasonable knowledge regarding specific facts and circumstances regarding the transaction. The IRS is clear, per Revenue Ruling 59-60, that appropriate discounts, or reductions in value, are allowed to account for the fact that the shares in the family business are privately held rather than publicly traded.How does FMV, or the standard of value, intersect with the “level of value”? For example, if an estate owns a controlling interest in a family business (more than 50% of the stock), the FMV of those shares will reflect the estate’s ability to sell the business. In contrast, the owner of a small minority block of the outstanding shares in the family business cannot force the business to change strategy, seek a sale, or unilaterally compel any action. The level of value chart captures two common-sense notions: investors prefer control rather than not, and they prefer liquidity to illiquidity. The magnitude of a lack of control and lack of marketability adjustment depends on specific factors of the subject interest being transferred, but unsurprisingly investors prefer to have control and a ready market for their shares.It’s Not All TaxesMinimizing taxes is one possible objective of an estate planning process, along with asset protection, business continuity, and providing for loved ones. Families should be careful not to let the tax tail wag the business dog; families should consult legal, accounting, and valuation advisors who understand their business needs and family dynamics to ensure that their estate plan accomplishes the desired goals.Families should be careful not to let the tax tail wag the business dogAs an example, one objective of most estate planning techniques is to ensure that no individual owns a controlling interest in the family business at his or her death. However, is the patriarch/matriarch ready to hand the reigns to the next generation? Is the next generation ready? Management and business concerns may need to prioritize the tax/liability side of the equation based on the family and its dynamics.What Now?Some potential next steps include:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority). We are just a phone call or an email away.
Introducing the Family Business Director On Demand Resource Center
We are excited to announce the grand opening of our Family Business On Demand Resource Center. The Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family business. We’ve curated and organized a diverse collection of resources from our staff of family business professionals, including a 5 minute video series, articles, whitepapers, books, and research studies. There’s nothing else like it, and we look forward to your visit.The perspectives we offer at the Center are rooted in our experiences at Mercer Capital working with hundreds of enterprising families in thousands of engagements over the past forty years. Our focus is on the financial challenges faced by family businesses, which include:Capital budgeting. Managers and directors of family businesses are stewards of family capital. Capital budgeting is the disciplined process of allocating that capital to productive uses within the family business.Capital structure. Investment capital for family business comes in two forms: equity from shareholders, and debt from lenders. Capital structure is the relative proportion of debt and equity used by a family business and is one of the most consequential decisions directors are called upon to make.Dividend & redemption policy. Family shareholders may or may not read reports about the performance of the family business, but they always cash dividend checks. A coherent dividend and redemption policy establishes a framework for corporate managers and family shareholders to develop appropriate expectations regarding future dividends and opportunities for share redemptions.Mergers & acquisitions. Whether you are contemplating buying another business or selling all or a portion of your own, M&A transactions are significant events for enterprising families. Buying or selling a business is definitely a “measure twice, cut once” activity for family businesses.Shareholder engagement & education. The long-term sustainability of any family business is determined, in part, by how family shareholders view the family business. In our experience, educated family shareholders are engaged family shareholders.While doubtless a fact of life that cannot be avoided, managing the estate tax burden is one of several objectives considered by successful enterprising families when planning for ownership succession.The fact that most family businesses are not publicly traded does not mean that valuation is irrelevant for family businesses. The value of the family business affects each of the preceding topics.
If you’ve ever had any questions about the topics listed above – or know someone that does – please visit our Family Business Director On Demand Resource Center. Check out some of the content, meet our professionals, and give us a call. We look forward to helping you!
Themes from Q2 2022 Earnings Calls
Part 1: Upstream
In the post Upstream Reviews of Q1 2022 Earnings Calls, the common themes among the earning calls of both E&P operators and mineral aggregators included the role of U.S. production in the European market, industry confidence in continued favorable pricing, and the trend of increasing completions.This week, we focus on the key takeaways from the Q2 2022 Upstream earnings calls including strong balance sheets, the increasing role of share buybacks, and supply and demand in the global oil & gas commodities market.Strong Balance Sheets and Cash Positions to Weather Price Volatility and Gain Upside ExposureExecutives zeroed in on the importance of a strong balance sheet amid the continuing volatility of oil and gas commodity prices. Upstream players can utilize robust cash positions to weather different price cycles and increase operational flexibility. Additionally, upstream Q2 earnings calls underlined the greater exposure to the high cycles by minimizing firm debt burden.“My perspective [is] as long as our return objectives are being met, modestly building some cash on the balance sheet is a positive thing. We're obviously in a highly volatile commodity price environment [and] I'd like to have a minimum of $500 million on the balance sheet just to handle intra-month working capital swings. We do have a couple of debt maturities coming up… We intend to retire that debt with cash on hand, so preparing for that time when prices are strong, is a good thing. And then also, it provides us the flexibility… on accretive bolt-on acquisitions that can improve our portfolio… given the macro uncertainties [ and] the volatility. So having a very robust company with strong liquidity, I think is a plus… Our return to shareholder commitment is top priority, but also keeping a bulletproof balance sheet and ample liquidity is right alongside that in our conservative financial model.”– Dane Whitehead, EVP & CFO, Marathon Oil Corp.“We want the absolute debt levels to be at $2 billion or even lower than that. We'd like to approach $1.5 billion over the next kind of medium term… The one times and the $2 billion or less of debt allows us to have a balance sheet that positions us to [future] swings in commodity prices. So, for us it's not as much a mid-cycle price. It allows us to go low and it allows us to go high. And we have a balance sheet that we feel gets us through the different commodity price environments.”– Kevin Haggard, SVP & CFO, Callon Petroleum Co.“The way we think about it is the best hedge is to have a strong balance sheet coupled with the strategy that can pretty much work in [a] multitude of prices and operational environments. So, this allows us to execute through these different commodity cycles. At current prices, our balance sheet is improving rapidly, so I think that's positioned us well to achieve our long-term debt target.”– Tom Mireles, EVP & CFO, Murphy Oil Corp.Increasing Role of Share Buybacks in Capital AllocationE&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in 2021; companies started paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“So yes, like we’ve mentioned a bunch of different times. I mean, evaluating M&A, we are going to be selective and picky. I mean, we do look at this from an internal kind of risk-adjusted rate of return standpoint -- and as we’ve said before… it has to compete with our other capital allocation opportunities. And right now, at this current time, the best risk-adjusted meaningful for way to grow our free cash flow per share is buying ourselves… We’re always in the know of what’s going on in the M&A space, but with the low-risk opportunity to grow free cash flow per share, so visibly in front of us [by] buying ourselves, it’s hard to compete with that.”– Don Rush, Chief Strategy Officer, CNX Resources Corp.“We certainly think that there's a lot of value in our existing stock price, and we think that, that oil and public equity stocks [are] really undervalued right now… We spent about $500 million in the last 2 to 3 months repurchasing shares, and the Board just essentially doubled our authorization up to $4 billion. So, the base dividend still remains sacred, sustainable and growing followed by this environment share repurchases… [We will] make up the difference... returning at least 75% of free cash flow.”– Travis Stice, CEO & Chairman, Diamondback Energy Inc.“We're always assessing and evaluating bolt-on opportunities in basins where we have a competitive advantage and can generate value for our shareholders… We have a tremendous amount of confidence in our organic case, which delivers market-leading free cash flow and return of capital. And that is [how] we're going to assess all opportunities. So, the bar is quite high, and whatever we do, it's going to have to be accretive to that organic case… So, the same discipline that we show in our business is the same discipline we'll show in assessing inorganic opportunities. But to be clear, we like the assets in our core portfolio, and we're always looking to further improve our core positions.”– Lee Tillman, Chairman, President & CEO, Marathon Oil Corp.Beliefs of a Prolonged Imbalance of Supply and Demand in the Global Oil & Gas Commodities MarketExecutives of E&P companies and mineral aggregators underscored the economic effects of current global events as it pertains to the industry. Global demand for such commodities continues to grow despite the obstacles on the supply side. The current stream of Russian natural gas to Europe is not deemed to be reliable, OPEC+ is either unable or unwilling to meaningfully increase oil production, and U.S. E&P operators can only marginally ramp up production in the near-term. Meanwhile, demand shows no sign of dissipating as China re-opens from Covid-19 lockdowns and European officials attempt to secure enough natural gas in preparation for the winter so as to avoid rationing.“You think about US E&Ps, [and] the inability to really ramp up production because of the supply chain or the return of capital pieces… You think about the current potential issues in Russia and the potential embargo that's going to happen here at the end of December, the need to refill the SPR [Strategic Petroleum Reserve], because we've drawn down on those volumes significantly, and then really kind of the lack of OPEC’s ability to ramp up production here… [it] is really indicative to me of fundamental positives as we think about the second half and into 2023. So, I think you're going to see an improvement in energy markets going forward, and hopefully that yield compresses as well.”– Rob Roosa, Founder & CEO, Brigham Minerals Inc.“As China reopens further [the] utilization rate is expected to climb to the upper 80% range. This higher utilization rate, combined with an estimated 500,000 barrels per day of new PDH capacity coming online in China and over 100,000 barrels per day of new capacity in Europe and North America over the next 18 months, is expected to lead to a tightening propane market as we enter winter, with over 50% of our NGL volumes being exported.”– Dave Cannelongo, SVP of Liquids Marketing & Transportation, Antero Resources Corp.“I'm still very optimistic that the oil price is going to continue to march forward with probably more upside than downside. Demand is coming back. Around the world, people are flying more. China's going to come back and as you know there's not much supply [in] the OPEC agreement… OPEC+ announced a minuscule increase today… They just don't have the supply, [there is] very little left in UAE and Saudi.”– Scott Sheffield, CEO & Director, Pioneer Natural Resources Co.
Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
NIB Deposits Anesthetize Bond Pain
The August Bank Watch looks at unrealized losses in bank bond portfolios based upon Call Report data as of June 30, 2022. Our review of unrealized losses as of March 31 can be found here.Fed Chair Powell gave a short 8-minute speech on August 26 at the annual Jackson Hole, Wyoming economic summit that is hosted by the Federal Reserve Bank of Kansas City. The gist of Powell’s speech is that the Fed is solely focused on reducing inflation. Powell’s speech in 2021 discussed “transitory” inflation and the timing of when the Fed might begin to reduce its monthly purchase of $120 billion of U.S. Treasuries (“UST”) and Agency MBS. At the time consumer prices were then advancing around 5% vs 9% now.Last year, equity markets liked what it heard from Powell at Jackson Hole regarding the liquidity spigot; not so this year as the S&P 500 declined 3.4% and the NASDAQ declined 3.9% the day Powell spoke. The NASDAQ Bank Index declined 2.4% and is down 12.8% year-to-date through August 26.Interestingly, UST yields did not move much even though Powell said it would not be appropriate to stop hiking at a “neutral” rate. As such, bank bond portfolios did not incur additional losses. In fact, the peak loss for most bank bond portfolios was in mid-June when the yield on the 10-year UST rose to 3.49% compared to 2.98% on June 30 and 3.04% on August 26.Based upon our review of bank second quarter earnings calls and analysts’ write-ups, investors seem to be taking the losses in stride given solid growth in spread revenues as NIM expansion has been dramatic. Last spring that was not the case when the ~150bps increase in intermediate- and long-term rates produced significant losses in bond portfolios given little coupon to cushion the higher term structure.As shown in Figure 1, the Fed has hiked the Funds target rate much faster and by a greater magnitude than it did in 1994 when the Fed waylaid the bond market with 300bps of hikes. Bond portfolios were hammered as the hikes and an upturn in inflation drove longer-term rates higher by ~275bps. The curve became flatter but never inverted as investors assumed a recession would not develop.1Figure 1: 1994 Bond Bear Market vs 2022 Bond Bear Market
Powell’s comments last week imply short-term policy rates may go as high as 4% by next Spring based upon futures markets. Given little movement in UST yields, bond investors are pricing in slowing economic activity and possibly lower yields to come. If so, the inverted UST curve prospectively will become more inverted if the Powell Fed can stomach the seemingly probable fallout as it pushes short rates higher.
Figure 2: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveFigure 3: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveAs shown in Figure 2, unrealized losses as of June 30 were significant though losses and gains are excluded from regulatory capital for all but the largest banks.Unrealized losses in available-for-sale (“AFS”) designated portfolios ranged from an average of 5.7% of cost for banks with less than $100 million of assets to 8.0% for banks with $1 billion to $3 billion of assets. As a percent of tier one capital the range was from 11.3% for banks with $100 billion to $250 billion of assets to 22.5% for banks with $100 million to $500 million of assets.Figure 3 provides the same data as of year-end 1994 when the ten-year UST was near a cyclical peak of ~8%. The bear market of 2022 is far worse than the 1994 bear market. Unlike 1994, portfolios today have little coupon to cushion the impact of rising rates. Also, duration may be longer today.The “coupon issue” today is reflected in low portfolio yields. As an example, the average taxable equivalent portfolio yield for banks with $1 billion to $3 billion of assets was only 1.96% in 2Q22 compared to 1.80% in 4Q21 immediately before the Fed began to hike. By way of comparison, the yield on one-month T-bills as of August 26 was 2.21% and 30-day LIBOR was 2.49%. Cash yields more than bond portfolios and prospectively will yield much more if the Fed pushes the Funds target to 4% by next spring.The good news is that portfolio cash flow should be reinvested at much higher yields to the extent it is not used to fund loan growth or deposit run-off. The same applies to fixed rate loans, which are not marked-to-market but may have comparable losses given both higher rates and wider credit spreads.The exceptionally good news is that non-interest-bearing (“NIB”) deposits, which are the core of core deposits, are driving NIM expansion and growth in spread revenues. Rate hikes this year are inflating the value of NIB deposits. There is no mark-to-market report for a board to see this; rather, the value is in the income statement.The unknowable question is if the Fed can push short-term rates higher without producing a sharp downturn or serious credit event that forces the Fed to blink again. The downturn in bank stocks this year primarily reflects investor expectations about the potential impact a recession would have on credit costs next year; it is not about unrealized losses in bond portfolios. Figure 4: Credit Spreads WidenClick here to enlarge the image aboveAbout Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please call if we can be of assistance.1 The Fed rate hiking campaigns of 2004-2006 (425bps of cumulative hikes to 5.25%) and 2015-2018 (225bps to 2.50%) did not produce as great of losses as the current cycle and 1994. The curve was exceptionally steep in 2004 such that long-term UST rates rose less than 100 bps (Greenspan called it a “conundrum”) while it took a couple of years for long-term yields to peak in 2018 around 3% vs the “all-at-once” episode this year.
The Importance of Purchase Price Allocations to Acquirers
This is the final article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Growing up an avid sports fan, I always enjoyed picking up the paper and flipping to the sports section to see the box scores from the prior day’s games. While the headline score told you who won or lost, the box score gave more information and insights into who played well and the narrative of the game. For example, the box score might tell you that even though your favorite team won, they were dominated by the other team in all the categories except turnovers, or that the team that lost actually “won” each quarter except the fourth and their star player had a bad game.
In my view, a purchase price allocation is similar to a box score in that it provides greater detail from which to derive insights on a particular transaction. While a purchase price allocation (PPA) analysis is primarily an accounting (and compliance driven) exercise, it is also a window into the objectives and motivations behind the transaction. When used proactively and/or during the M&A process, the disciplines of PPA analysis can provide buyers with important perspective concerning the unique value attributes of the target’s intangible asset base, which can help rationalize strategic acquisition consideration or forewarn of potentially unstable or short-lived intangible asset value.
Below we explore PPAs further with a broad overview and then a deeper look into the pitfalls and best practices related to them.Introduction to PPAsAcquirers conduct PPAs to measure the fair value of various tangible and intangible assets of the acquired business. Any excess of the total asset value implied by the transaction over the fair values of identified assets is ascribed to the residual asset, goodwill.Intangible assets commonly identified and measured as part of PPA analyses include:Trade name - Trade name intangibles may be valuable if they enhance the expected future cash flows of the firm, either through higher revenue or superior margins. The relief from royalty method, which seeks to simulate cost savings due to the ownership of the name, is frequently used to measure the value of trade names.Customer relationships - Customer relationships can be valuable because of the expectation of recurring revenue.Technology - Technologies developed by the target business are valuable because the acquirer avoids associated development or acquisition costs. Patents and other forms of intellectual property may provide legal protection from competition and help secure uniqueness and/or differentiation.IPR&D - Ongoing R&D projects can give rise to in-process research and development intangible assets, whose values are predicated on expected future cash flows.Contractual assets - Contracts that lock in pricing advantages – above market sales prices or below market costs – create value by enhancing cash flow.Employment / Non-competition agreements - Employment and non-competition agreements with key executives ensure a smooth transition following an M&A transaction, which can be vital in reducing the likelihood of employee or customer defection.
The value of an enterprise is often greater than the sum of its identified parts (both tangible and intangible), and the excess is usually reflected in the residual asset, goodwill. GAAP goodwill also captures facets of the target that may be value-accretive, but do not meet certain criteria to be identified as an intangible asset. Notably, fair value measurement presumes a market participant perspective. Goodwill may also include acquirer-specific synergistic or strategic considerations that are not available to other market participants. Consequently, goodwill has tended to account for a significant portion of allocated value in truly strategic business combinations.Pitfalls and Best Practices of PPAsBelow we highlight some pitfalls and best practices gleaned from providing purchase price allocations to acquirers since the advent of fair value accounting.What are some of the pitfalls in purchase price allocations?Sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates for the acquirer.What are the benefits of looking at the allocation process early?The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. Similar to a coach who may look at the box score from the first half of a game during the halftime break, we view the dialogue we have with clients when we prepare a preliminary PPA estimate prior to closing as a particularly important part of the M&A project. This deliberative process results in a more robust – well-reasoned analysis that is easier for the external auditors to review, and better stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed.Can goodwill be broken into different components?If so, what are the different components and how are they delineated?In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to the sellers of a C corporation business.Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at both the corporate level, and again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, may mitigate the double taxation issue.The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.What other problems/issues beyond a PPA can you help acquirers navigate?As part of our full suite of services for acquirers, we can handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating internal projects vs. acquisitions for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for transactions.ConclusionAs the “box score” of transactions, PPAs can be an important tool for acquirers and provide greater insight into the motivations and narrative behind a transaction by illustrating the value of various intangible components of a business beyond the collection of tangible assets and how those compare to the purchase price being paid. Our purchase price allocations can be more robust with fewer surprises when we have also worked with the clients before the close of the transaction on elements such as financial due diligence or contingent consideration estimates, or even broader corporate finance and PPA studies.Mercer Capital has extensive experience valuing intangible assets for purchase price allocations (ASC 805), impairment testing (ASC 350), and fresh-start accounting (ASC 852) and assisting buyers during financial due diligence. Call us – we would like to help.1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z
The Importance of Purchase Price Allocations to Acquirers
In this article we provide a broad overview of PPAs and then a deeper look into the pitfalls and best practices related to them.
What We’ve Been Reading
We hope you are enjoying the last dog days of summer as the calendar turns to college football, the kids get back to school, and the mid-term political season kicks into high gear. In this post we share several pieces we have been reading that you may have missed over the last few weeks.Advisor CornerThe Family Business Consulting Group discusses how a non-family CEO and a family ownership team got on the same page regarding the financial goals of the company. Where did the CEO need to steer the company to meet the family’s financial objectives? The first step is to quantify and verbalize those goals beyond “be profitable.” The authors provide a simple roadmap for undertaking that process.How do you deal with a family member who needs to let go of the reigns but refuses to get out of the saddle? An article in Harvard Business Review identifies strategies to help family manage an impaired leader to avoid damaging the company — and the family.Are family businesses more resilient? Deutsche Bank recently published a study that showed many German family-owned businesses fare better in complex crises, such as the recent COVID-19 pandemic response. Reasoning included financial stability from more conservative capital structures, shorter (quicker) decision-making channels, and emotional anchoring focused on long-term success.A Fun Family Business StoryFamily Business Magazine recounts the history of Radio Flyer, a family-owned business who makes the iconic Radio Flyer wagon. Robert Pasin is the third-generation CEO (or as he prefers, “Chief Wagon Officer”) and the piece highlights the dramatic, decade long overhaul that was needed to rescue the company. My children and their Radio Flyer tricycle thank Mr. Pasin.Legislative Update: Inflation Reduction ActThe National Law Review did a good job listing the primary provisions of the Inflation Reduction Act, including important corporate tax provisions (stock buyback excise tax and corporate alternative minimum tax) as well as healthcare and alternative energy changes. While the changes in direct tax legislation were aimed at large public corporations, we can’t help but anticipate that the $80 billion in new funding won’t boost the current generationally low tax audit rate for individuals and businesses.Both the Tax Foundation and the non-partisan Penn Wharton Budget Model see little to no impact on near-to-mid term inflation. The Tax Foundation sees long-run GDP declining marginally (negative 0.2%) from baseline projections driven by the bill, while the PWBM sees a 0.2% increase by 2050.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of August 15, 2022
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of August 15, 2022Download Study
Review of Key Economic Indicators for Family Businesses in Q2 2022
With economic data for 2Q22 trickling in, we take a look at a few key trends that developed during the quarter. Volatile equity markets, ongoing inflationary concerns, and rising interest rates drove headlines in the second quarter of the year. The information in this post provides a concise and unbiased look at some of the trends that manifested themselves during the quarter. Data and commentary are largely sourced from Mercer Capital’s National Economic Review (subscription required), which is published on a quarterly basis and summarizes macroeconomic trends in the U.S. economy.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the second quarter of 2022 decreased at an annualized rate of 0.9%. The decrease was driven by declines in private inventory investment, residential and nonresidential fixed investment, and government spending (local, state, and federal). Mitigating factors to the decrease in GDP were increases in personal consumption expenditures and exports. Imports, which are subtracted from national income and product accounts, increased in the second quarter of the year, which also led to the decline in GDP growth in the second quarter of the year.Economists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecast. A survey conducted by TheWall Street Journal in July reflects an average GDP forecast of 1.5% annualized growth in the third quarter of 2022, followed by 1.1% annualized growth in the fourth quarter.Click here to enlarge the image aboveInflationEstimates from the Bureau of Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) was unchanged in July 2022 on a seasonally adjusted basis after rising 1.3% in June. On a year-over-year basis, the CPI increased 9.1% from June 2021 to June 2022, which is the largest year-over-year increase since November 1981. The index increased 8.5% on a year-over-year basis in July. Notably, the gasoline index fell 7.7% in July, which offset increases in the food and shelter indexes, leading to the unchanged overall index. The Wall Street Journal survey reveals the expectation that inflation will remain persistent through the balance of 2022, as respondents predicted, on average, an annual rate of 6.9% in December 2022 before falling back to 3.9% by June 2023. The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI decreased 0.5% month-over-month in July 2022 and increased 9.8% in the twelve months ended July 2022.Monetary Policy and Interest RatesThe Federal Reserve’s Open Market Committee, or FOMC, raised interest rates at both of its meetings in the second quarter. At its May meeting, FOMC members voted unanimously to raise the benchmark rate by 0.50%, placing the benchmark rate in a range of 0.75% to 1.00%. This was the largest such rate increase since 2000. Additionally, FOMC members approved a plan to shrink the Fed’s $9 trillion asset portfolio by allowing billions of dollars in treasury and mortgage bonds to mature each month through the balance of 2022 without reinvesting the proceeds into new securities. Following the meeting, Chairman Powell indicated that FOMC members broadly agreed that additional half-point rate increases could be warranted at the FOMC’s June and July meetings.The FOMC raised rates by 0.75% at its June meeting, leaving the benchmark federal-funds rate in a range of 1.50% to 1.75%. This was the largest rate increase enacted by the Fed since 1994. According to projections released after the June meeting, all eighteen members of the FOMC anticipated raising the benchmark rate to at least 3.00% by the end of 2022. Further, more than half of the FOMC members indicated that the fed-funds rate could increase to 3.375% by the end of 2022. Following the meeting, Chairman Powell acknowledged the increasing difficulty the Fed could face in executing a “soft landing” in which the economy slows enough to harness inflation without inciting a recession. Observers interpreted this acknowledgment as an implicit concession by the Fed of the downside risks that could manifest themselves as the economy acclimates to a rapidly tightening monetary policy environment.The Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growthWhile the U.S. economy has not yet officially fallen into a recession (despite two straight quarters of decline in GDP), most Fed watchers agree that Fed Chair Powell and the FOMC won’t relent in their fight to bring down inflation even if it does cause a recession. In short, the Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growth. All eyes will be on Mr. Powell this week as he delivers his remarks at the Fed’s annual economic conference in Jackson Hole, Wyoming, on Friday morning. Astute family business directors and management teams would be well-served to pay attention to these remarks, as they will likely shed light on the magnitude and timing of rate increases through the rest of the year, as well as the overall direction of the U.S. economy.
Stock Buybacks and Family Businesses
Stock buybacks were in the news last week as the newly-passed Inflation Reduction Act includes a provision levying a 1% excise tax on share repurchases by public companies. As we’ve noted in previous posts, we question Congress’s grasp of the basic economics of what a stock buyback is, but Congress is not our focus today.Privately held family businesses are exempt from the tax, but it is important for directors to understand the real economics of stock buybacks (or, in the case of family businesses, shareholder redemptions).Family business directors are stewards of family capital. Family shareholders entrust their capital to the family business and the directors and managers of the business use that capital to generate a return. Unlike money from a bank, the family business doesn’t owe interest to its family shareholders. However, that doesn’t mean that family capital is free. There is an opportunity cost associated with family capital. This means that if their capital was not invested in the family business, family shareholders would have the opportunity to invest it elsewhere to earn a return. We refer to that opportunity cost (i.e., what an investor could earn by making a different investment of comparable risk) as the cost of capital. The cost of capital is a critical concept for family business directors as they evaluate how to invest family capital within the family business. The cost of capital is the breakeven point for whether an investment is financially prudent: if the expected return from an investment is less than the cost of capital, the shareholders would be better off investing that capital elsewhere. In other words, outside the family business. The supply of capital projects dwindles as the level of expected return increases. In other words, there are a lot more capital projects that are expected to earn a 5% return than a 15% return. So one of the primary tasks of family business directors is monitoring the supply of attractive capital projects, those for which the expected return exceeds the cost of capital.For some companies, the supply of such projects far outstrips the amount of family capital available to invest. Directors of these companies are faced with a rationing decision: of all the financially acceptable investments that we could make, which ones will we make with our limited family resources? These are generally companies operating in new or growing industries.For others, the supply of capital projects with expected returns in excess of the cost of capital is small. Directors of these companies are faced with different decisions. Do we (1) return capital to family shareholders so they can invest to earn the cost of capital, or (2) do we hold on to the capital and try to find new avenues to invest to earn the cost of capital? Too often, however, directors make a third, ill-advised choice – they hold onto the capital without a compelling plan for how they can use it to earn the cost of capital. When directors elect to return capital, they can do so in two ways, by paying a dividend to all shareholders (pro rata to their ownership interests) or repurchasing the shares of select shareholders. From the perspective of the company, these paths are equivalent economically in that, under both strategies, family capital leaves the family business to be put to use elsewhere. While paying pro rata dividends might seem most “fair,” some family shareholders may prefer to keep their capital invested in the family business, while others might be more eager to put their capital to other uses. Still, other shareholders might be seeking a way to be out of business with their family members. In any of these cases, a share repurchase can be the right tool to both prevent “lazy” capital from accumulating on the family business’ balance sheet and realign ownership interests to better conform to shareholder preferences and risk tolerances. Your congressman may not understand what a share repurchase is, but you and your fellow directors should. If you suspect a share redemption might be in order for your family business, give one of our professionals a call to discuss your situation in confidence.
What Is a Fairness Opinion And What Triggers the Need for One?
For this week's post, we republish a prior post on the subject of Fairness Opinions. It's proven to be one of the most popular posts on the blog. If you missed it the first time, we hope you find it informative and helpful.What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important? There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability. In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions. The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials. Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith. Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction. In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best.” Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction. The financial advisor must look at pricing, terms, and consideration received in the context of the market. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial. This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a proxy.The reasonableness of compensation that may be paid to executives as a result of the transaction.
Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have four decades of experience in helping boards assess transactions as qualified and independent financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.
These Loafers Are Made for Walkin’
Italian Shoemaker, Tod's, Opts Out of the Public Markets
Last week, Tod’s – the Italian maker of luxury shoes – announced plans by the founding Della Valle family to take the company private. Under the proposed transaction, the Della Valle family would invest €338 million to increase its ownership interest from just under 65% to 90%. Following the transaction, the remaining 10% equity position will be held by luxury conglomerate LVMH.The proposed purchase price of €40 per share represents a 21% premium relative to the pre-announcement trading price for the shares of about €33 per share. From a pandemic low of approximately €18, Tod’s share price peaked at approximately €64 per share in June 2021, from which level shares have fallen steadily to the €30 to €35 range preceding the going private announcement.Motivation For TransactionHaving been a public company for more than twenty years, what is the family’s motivation for taking the company private now? According to the Wall Street Journal, the Della Valle family is taking the company private to “accelerate its development” and “free the company of ‘limitations’” resulting from its public status. The plan to “accelerate” development is interesting, given that it seems like the most common reason companies cite for going public is to improve access to capital to “accelerate” company growth.Most family businesses will never have to think about whether to list their shares on a public exchange, much less – having done so – to reverse course and take the family business private again. Nonetheless, we believe Tod’s transaction highlights two obligations of all family businesses, whether publicly listed or not. The first is the imperative to perform, and the second is the responsibility to report.The Imperative to PerformThe stock price chart presented above is uninspiring. Over the past five years (prior to announcing the going private transaction), Tod’s shares had shed approximately 50% of their value. In contrast, the shares of luxury conglomerate LVMH tripled in value over the same period, from €233 to €691 per share, while shares of Gucci parent Kering nearly doubled (from €313 to €553).A quick look at the income statement for Tod’s confirms that the underperformance of the shares mirrored underperformance operationally. Since acquiring the Roger Vivier brand in 2016, annual revenue at Tod’s has fallen at a 2.5% annual clip. Earnings have suffered as well, with the company reporting net losses in 2020 and 2021. The losses in 2020 and 2021 forced the company to discontinue dividend payments, which had already fallen with earnings from €2 per share in 2016 to €1 per share in 2019. In short, the company failed to deliver value to its shareholders, and the financial performance suggests that it may have been strategically adrift. Following the €400 million acquisition of the Roger Vivier brand (from a related party, no less), Tod’s invested approximately €220 million in capital expenditures and one small acquisition during the five years ended 2021 (less than 5% of revenue). Against a backdrop of weakening organic performance, the company had dwindling resources for significant capital investment to spur growth. Not being accountable to public investors frees family business leaders to consider a broader range of performance objectives other than profit alone. However, being privately-held does not free family business directors from the imperative to perform. Any non-financial goal to which a family may aspire, no matter how noble or laudable, is ultimately supported and underwritten by growing, profitable core business operations. One task of a director is to consider how best to allocate the family’s capital resources to earn a competitive return on capital.Being privately-held does not free family business directors from the imperative to performFamily shareholders may not have the flexibility of public investors in the short term, but in the long-term family capital will flow toward its highest and best use. Chronic underperformance will cause the highest and best use to be found outside the family business, which will likely undermine many of the non-financial goals and objectives of the family, often to the detriment of employees, suppliers, customers, and other stakeholders.We can’t quite envision how taking Tod’s private will “accelerate” its growth. That said, the family has recognized that the current trajectory is not sustainable and is attempting to address the company’s underperformance. Are you and your fellow directors holding yourselves accountable for generating sustainable competitive returns on capital for your family shareholders?The Responsibility to ReportThe second obligation is the responsibility to report. While the “limitations” of being a public company prompting the transaction were not enumerated, the burden of reporting results to public shareholders is time-consuming and sometimes requires companies to disclose what they believe is competitively sensitive information. While public companies in Europe are not on the quarterly reporting cycle faced by SEC registrants in the U.S., the annual (and semi-annual) reports of European companies are far more detailed than those of their U.S. counterparts, as you can see here.Having read through the most recent annual report, it is not hard to see why Tod’s management would be eager to get out from underneath that reporting burden. Privately-held family businesses save a lot of time and money by not being subject to onerous financial reporting obligations. However, that does not mean that shareholder reporting is not important for family businesses. In reality, shareholder reporting is more important for family businesses than public companies. After all, public companies are reporting their results and strategy to anonymous strangers and institutional investors, while family businesses report their results to grandparents, parents, siblings, aunts, uncles, and cousins.In our experience, many family businesses ignore the benefits of being intentional and strategic about how they report financial results to family shareholders. They do so at their own peril. Uninformed family shareholders eventually become suspicious family shareholders. And suspicious family shareholders often become disgruntled – or, even worse – litigious family shareholders.Uninformed family shareholders eventually become suspicious family shareholdersFamily business directors are stewards of the family’s wealth, and reporting is a fundamental obligation of stewards. No, it is not necessary to prepare SEC-worthy quarterly reports for your family shareholders. But that does not give directors license to ignore shareholders. Rather, it gives family business leaders the flexibility to report what family shareholders need to know, with the appropriate frequency and in the most relevant format. Any time and resources saved by shirking this responsibility will pale in comparison to the costs and distraction of dealing with suspicious and unengaged family shareholders.We will return to the topic of shareholder reporting for family businesses in a future post. In the meantime, check out our whitepaper on communicating financial results to family shareholders, which you can download here.
Buy-Side Solvency Opinions
n this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. s
Talk To The Hand: Upstream Industry Eyeing Returns More Than Rigs
Second quarter earnings for publicly traded upstream producers are trickling in, and profitability has returned to the energy sector. In the meantime, government officials have been sending mixed messages to the upstream sector, desiring temporary supply relief in the aim of lowering prices whilst remaining bearish on fossil fuels overall. The industry response: thanks, but no thanks (a polite way of putting it). Producers have largely been holding the course set years ago towards returns and deleveraging, snubbing pressure from the Biden administration. It has been tempting for producers to ramp up production amid $100+ oil prices and gas prices the highest they have been since 2008. However, with supply chain issues and labor shortages, the appeal has been dampened.Cash Flow Remains KingAccording to the latest Dallas Fed Energy Survey, business conditions remain the highest in the history of the survey. Concurrently, profits continue to rise. Analysts are pleased and management teams are eagerly talking about free cash flow, debt management, and stock buybacks. By the way, an interesting factoid from Antero’s investor presentation: most oil and gas companies are now much less levered than their S&P 500 counterparts. When it comes to Net Debt to EBITDAX multiples, the majors average about 0.9x while the S&P 500 averages 2.8x. Most independents that I reviewed were aiming towards around 1x leverage.The industry should be able to keep it up. Last year around this time, I was questioning how long this might be able to continue. I noted drilled but uncompleted well (“DUC”) counts as an inexpensive proxy for profitable well locations. However, at today’s prices, DUCs matter less than they did from an investment decision standpoint.I sampled current investment presentations of six upstream companies (randomly chosen) and read them to discern key themes that they are communicating to investors. Adding new rigs to the mix was not on any of their agendas. Not one has announced a revision to their capex plans from early in the year even amid the changes in the past five months.
There have been some companies accelerating plans, but not many. This quote from the Fed Energy Survey was representative of sentiment in this area:
“Government animosity toward our industry makes us reluctant to pursue new projects.”
There are 752 rigs in the U.S. currently, according to Shaleexperts.com. In early March, the week before the pandemic wreaked its industry havoc — there were 792. Yes - we still have not reached pre-pandemic rig counts. To boot, rigs are relatively less productive on a per rig basis, primarily because most new drilling locations are less attractive and productive than the ones already drilled. The capex calvary is not coming to the rescue either. Capex at the world’s top 50 producers is set to be just over $300 billion this year, as compared to $600 billion in 2013 according to Raymond James. 2013 was the last year oil prices were over $100 a barrel for the year. As has been said before, production should grow, but not at a particularly rapid pace.Energy Valuations: A Bright SpotThese industry and commodity forces have contributed to the energy sector having an outstanding year from a stock price and valuation perspective as well. Returns have outpaced all other sectors, and Permian operators have performed at the top of the sector. While the U.S. suffered its second quarter of GDP decline in a row, and the stock market has officially become a bear but energy returns stand out.
Some investors appear to be changing their tune towards the energy sector amid these kinds of results, and the valuations are reflecting this. There are some indicators that suggest we could be entering into a long “super cycle” for the energy sector whereby the industry could outperform for years to come. It bears out that to fruition the sentiment I quoted last year as well from the Dallas Fed’s Survey:
“We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.”
That prophecy has come true.Supply Chain WoesThe challenge for producers may be less about growth and more about maintenance. 94% of Dallas Fed Survey Respondents had either a slightly or significantly negative impact from supply-chain issues at their firm. Major concerns about labor, truck drivers, drill pipe and casing supplies, equipment, and sand are hampering the execution of existing drilling plans, to say nothing about expansion.“Supply chain and labor-shortage issues persist. Certain materials are difficult to access, which is hampering our ability to plan, absent a willingness to depart from certain historical practices relating to quality standards.” – Dallas Fed Respondent.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short-term energy outlook expects production to catch up, but it appears harder to envision that now and nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts.
Who knows how much longer upstream companies will continue to tune out the administration or finally try to rev up their growth plans in response to commodity prices? The December 2026 NYMEX futures strip is over $70 right now. There are a lot of potentially profitable wells to be drilled out there at $70 oil. However, management teams know all too well that prices can change quickly. We shall see.
Originally appeared on Forbes.com.
Buy-Side Solvency Opinions
Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment.
How to Have “The Talk” With Your Family Directors
As a parent, you have either already broached the discussion or will at some point: you need to have “The Talk” with your kids. You and your husband or wife do your homework, consult some books or websites for a refresher, and think about how to frame the discussion in a language your kids can understand. You might even ask for advice from a financial advisor or trusted attorney. Of course, “The Talk” I am referring to is on family finances and the family business.A recent Barron’s piece highlighted how parents struggle to discuss finances with their kids, and it got us thinking about having family business discussions with your kids and the dialogue among multi-generation family board members. For an overview on basic business vocabulary, Travis Harms, who leads our Family Business Advisory Services practice, has a great series of whitepapers I would encourage any family board member to review, no matter their individual financial proficiency.But as anyone with kids or family knows, it’s not just what you say but how you say it. And while we are not psychologists (we don’t even play one on TV), we do have experience in observing and leading discussions among family board members of varying generations and familiarity with the family business.In our experience, adhering to three simple rules can help promote impactful and productive dialogue between parents, children, and different generations in your family business: big picture first, be transparent, and remember priorities.Big Picture, Then Zoom InBefore you undertake an industry deep-dive, SWOT analysis, or financial study with your family board members, it’s helpful to take a big picture view of why the family is in business in the first place. James Hughes, family meeting facilitator, consultant, and author, explains his philosophy on family business and history in Family Wealth: Keeping It in the Family (see our full review here).Family stories give members a sense of the unique history and values they share.According to Hughes, one reason family businesses struggle is that they “fail to tell the family’s stories… Family stories give members a sense of the unique history and values they share…” (Hughes, 2004, p. 12). Family Wealth also offers guidance on how to craft a family mission statement, documenting the family’s purpose, vision, and values. These areas tie into the question we often ask here at the Family Business Director:What does your family business mean to you? Answering and reviewing these fundamental questions will help convey the shared mission and the “why” of your family business to your newer board members.Transparency Yields TrustNext generation board members shouldn’t be stuck at the kid’s table. Those short folding chairs are uncomfortable, and you can’t just eat mac-and-cheese and dinner rolls forever. To avoid “shirtsleeves to shirtsleeves” for your family business, you must take frank and direct communication seriously. What does that look like? It looks like treating your family shareholders as shareholders. As we’ve discussed, shareholders, regardless of age, deserve and are entitled to adequate financial disclosure and transparency. Educating them in how to understand disclosures and update letters is not only a benefit to your shareholders, but it creates a new set of “free” outside advisors able to form thoughtful questions from a new perspective that can help you run your business more effectively. This has the impact of staving off resentment or distrust often generated by secrecy within family hierarchies.Remember, It’s a “Family Business” Not a “Business Family”One aspect you need to often remember in your family board member relationships is…Family! Again, returning to Family Wealth, Hughes endorses an interesting habit he refers to as “hat work.” While Hughes recommends literally getting multiple hats, the key is to remember the proliferation of “hats” in your family business.When onboarding new directors, remember the dynamics and hats you wear with that person.It is not uncommon for more seasoned family members to wear multiple hats: parent, grandparent, boss, fellow board member, in-law, fellow trustee and/or trust beneficiary. When onboarding new directors, remember the dynamics and hats you wear with that person.>>>The Goal? Long-Term Business ContinuityOlder family members and parents are responsible for educating the next generation, as they will eventually be responsible for ensuring the continuity of the business enterprise. Getting off on the right foot in having these transitional and educational conversations is essential for family businesses. Unfortunately, multi-generation dialogue can often devolve, pitting “has-been-dinosaurs” against the “lazy-good-for-nothings.” Ultimately, remembering why you are in business together in the first place, being transparent and open, and acknowledging familial relationships will lead to better multi-generational conversations.If you need someone to help you lead these conversations, give one of our professionals a call today.
Strategic Benefits of Stress Testing in an Uncertain Economic Environment
Having gone on many a camping trip over the years, the only consistency between these trips into the woods is that there is no consistency. While some trips might have beautiful weather, others might be plagued with storms, cold fronts, heat waves, or strong winds. The campsite may or may not have amenities. And most importantly, contending with the wildlife adds another variable that can’t be predicted. However, the key element of how the trip goes is how prepared we are. The trips where we assumed blue skies were by far the most stressful. If we prepared for different outcomes and weather based on the uncertainty of going into the woods, the trip could always be salvaged.Banks and credit unions are currently facing a similar “into the woods” predicament, as the economic environment seems to grow more volatile and contradictory day by day. While hiring remains strong and unemployment continues to stay near historically low levels with the Bureau of Labor Statistics reporting 3.6% as of June 2022, other indicators are flashing warning signs.Inflation concerns continues to plague the economy after accelerating to 9.1% in June 2022, the highest increase since November 1981. Drivers of inflation in the past several months include rising food and gas prices as global supply remains disrupted from Russia’s invasion of Ukraine and the remnants of the pandemic. Economists are taking notice, with nearly 70% of economists surveyed by the Financial Times and the Initiative on Global Markets believing that the National Bureau of Economic Research (NBER) will make a call at some point in 2023 identifying a recession.These conflicting indicators are convoluting the economic forecast through the rest of 2022 and 2023, and the differing potential circumstances would have very different impacts on banks and credit unions. Though this uncertainty can certainly cause headaches and stress for banks and credit unions worried about their capital positions in a severely adverse economic scenario, stress testing can help to prepare your bank or credit union in the face of uncertainty and help to optimize strategic decisions.Stress Test OverviewA stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline and severely adverse scenario). The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.” 1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.” 2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.” 3There are a few different types of stress tests that banks and credit unions can utilize in estimating their financial position:Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.” 4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.By utilizing one or more of these stress testing exercises, banks and credit unions can better position themselves for multiple different economic scenarios in order to assure they have sufficient capital and financial strength to withstand an economic downturn if there is one.Economic Scenarios OverviewOne question that often arises is: Given the uncertainty, what economic scenarios should we consider in our stress testing? While it is difficult to answer this question, the most recent Stress Test scenarios prepared by the Federal Reserve are described in a February 2022 report, 2022 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule, and provide some guidance to assist with this decision. The scenarios start in the first quarter of 2022 and extend through the first quarter of 2025. Each scenario includes 28 variables, nineteen of which are related to domestic variables in the U.S.While the more global economic conditions detailed in the Fed’s supervisory scenarios may not be applicable to community banks or credit unions, certain domestic variables within the scenarios could be useful when determining the economic scenarios to consider. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices. The baseline scenario includes an economic expansion over the 13-quarter scenario period, while the severely adverse scenario is a hypothetical scenario that includes a severe global recession, accompanied by heightened stress in commercial real estate and corporate debt markets. Below, we have included charts of some of the more relevant domestic variables (GDP, unemployment rates, the Prime Rate, and commercial/residential real estate prices) and their historical levels through year-end 2021 as well as the Fed’s assumptions for those variables in the baseline and severely adverse scenarios. 2022 Supervisory Economic Scenarios OverviewBenefits of the Stress TestAs the U.S. moves into a more uncertain economic environment, a financial institution’s preparation for its trip “into the woods” of this uncertain economic environment can reap dividends. Improved valuation, performance enhancement from enhanced strategic decisions, and risk management are some of these benefits. Greater clarity into the bank or credit union’s capital position, credit risk, and earnings outlook under different economic circumstances helps management to make more informed operational decisions.ConclusionWe acknowledge that bank and credit union stress testing can be a complex exercise. The bank or credit union must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank and credit union management begin building their stress testing expertise sooner rather than later.In order to assist financial institutions with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests for your institution or reviewing ones prepared by the institution internally, to make the process as efficient and valuable as possible.To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.Endnotes1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.2 Ibid.3 “Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.4 OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
2022 Benchmarking Guide for Family Business Directors
Making Sense of 2021
Benchmarking is a powerful tool for family businesses. Done well, benchmarking provides managers and directors with valuable insight and context for evaluating the operating performance of the family business and the strategic investing and financing decisions made by their leaders. Comparison may be the thief of joy, but unfortunately for family businesses, ignorance is not in fact bliss.This blog post summarizes some of our findings related to financing, operating, investing, and distribution activities. For a comprehensive and detailed report on all the above questions, be sure to check out our 2022 Benchmarking Guide for Family Business Directors. For our benchmarking report, we have used the Russell 3000 Index Companies, excluding Financial Institutions, Real Estate companies, and Utilities. We also excluded companies with less than $10 million of revenue in 2021. We have also sorted the data into five quintiles based on company sizes as well as industries.How Much Money Do Companies Like Ours Make?While Wall Street often looks at earnings, EBITDA is the key earnings measure for family businesses. EBITDA serves as a proxy for discretionary cash flow available to service debt, pay taxes, fund reinvestment, and provide for shareholder distributions. EBITDA promotes comparability among firms with different capital structures, tax attributes, and fixed asset intensity.The following chart summarizes the influence of industry on EBITDA Margin for CY21.2021 EBITDA Margin by Industry The overall average EBITDA Margin for the entire group was 14.3%. However, as depicted in the preceding chart, there is significant variation among different industry sectors analyzed. Asset-Intensive industries, including Energy and Materials, earned higher EBITDA margins in 2021, buoyed by energy and commodity pricing. In Table 2, we summarize the effect of company size on EBITDA margin.2021 EBITDA Margin by Company SizeGenerally, comparing average EBITDA margins across different sized companies confirms the importance of economies of scale. Larger companies tend to earn higher margins and outpace the smaller companies.How Much Money Do Companies Like Ours Invest?One prominent question for family business directors is, “How much should we invest?” Our tip: it depends. We analyzed corporate investment in the form of capital expenditures and M&A activity relative to EBITDA (gauging investment relative to cash flow), revenue (removing the effect of profitability on investment), and invested capital (assessing investment relative to previous investments).Excluding maintenance capital expenditures, spending on acquisitions exceeded growth capital expenditures by 160%.The median level of capital expenditure relative to EBITDA ranged from 28% (consumer discretionary) to 57% (energy). Consumer discretionary firms allocated more net investment dollars to growth CAPEX, while M&A was the primary form of investment for health care, information technology, and industrial companies.Click here to enlarge this image How Much Money Do Companies Like Ours Distribute?Dividend policy is one of the most important decisions for a family business (see our Family Business Dividend Survey for more) Looking at benchmarking data can help you analyze the best strategy for you. Public companies generally prefer a sustainable level of dividends that can withstand temporary downturns in performance. As a result, aggregate share purchases exceeded dividends paid during the preceding five years. For the universe of companies we analyzed, total distributions (dividends + share repurchases) exceeded net investment by over 60% for the period.The following table summarizes aggregate distribution trends and compares them against available investment opportunities.In our sample of companies, 15% did not repurchase any shares nor did they pay any dividends, while 37% did both. Only 6% of companies only paid dividends, while 42% of companies only repurchased shares. Approximately one-fourth of the companies in our sample reported a net loss during CY21, however, 66% of these companies still made a distribution to shareholders. Of the profitable companies in our sample, approximately 22% made total distributions in excess of total net income in CY21, while about 9% chose not to make any distributions at all. Distributions also varied greatly by industry. Capital intensive industries such as communication services devote a smaller portion of cash flow to shareholder distributions. Relative to consumer staples companies, consumer discretionary companies hedge their higher volatility by relying more on share repurchases than dividends. Information technology companies were the most aggressive share repurchasers. How Much Money Do Companies Like Ours Borrow?“Debt” is often a four-letter word with family business directors, who often skew toward conservatism in their capital structure. But how do smaller public companies compare?Financial leverage can be measured by comparing total debt to invested capital (book values of debt and equity), market values, or relative to cash flow. On a market value basis, leverage at the end of 2021 ranged from 6% (IT) to 27% (Energy).There is little discernable size effect with respect to book or market values. However, lower EBITDA margins on the part of the smaller firms increase the aggregate ratio of debt to EBITDA for such firms. With respect to the companies in our sample, the use of debt is evenly distributed, with approximately 28% of companies having less than 20% debt in their capital structure, 46% between 20% and 60%, and 25% above 60%. Health care and IT firms are most likely to avoid debt, while companies in the communication services, energy, and consumer discretionary sectors are more likely to fund capital needs with larger debt. Assessing the annual change in debt and equity balances reveals how companies view the marginal costs of incremental financing needs. On a relative basis, the companies in our sample borrowed most aggressively during CY20 in the face of the economic slowdown resulting from the response to COVID-19. Companies relied on incremental equity financing at the margin in 2021.Download your complimentary copy of the 2022 Benchmarking Guide for Family Business Directors, which gives you an in-depth analysis of the topics discussed here as well as discusses additional questions, including:What are investment hurdle rates for companies like us?How fast should companies like us grow?What kind of return do companies like us generate for their shareholders?For more targeted insights and observations, give one of our professionals a call to talk about a more customized benchmarking analysis for your family business.
Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?
This is the eighth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make.
A board’s fiduciary duty to shareholders is encapsulated by three mandates:Act in good faith;Duty of care (informed decision making); andDuty of loyalty (no self-dealing; conflicts disclosed).
Directors are generally shielded from courts second guessing their decisions by the business judgment rule provided there is no breach of duty to shareholders. The presumption is that non-conflicted directors made an informed decision in good faith. As a result, the burden of proof that a transaction is not fair and/or there was a breach of duty resides with the plaintiffs.
An independent fairness opinion helps demonstrate that the directors of an acquiring corporation are fulfilling their fiduciary duties of making an informed decision.
Fairness opinions seek to answer the question whether the consideration to be paid (or received from a seller’s perspective) is fair to a company’s shareholders from a financial point of view. Occasionally, a board will request a broader opinion (e.g., the transaction is fair).
A fairness opinion does not predict where the buyer’s shares may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view.Delaware, the SEC and FairnessFairness opinions are not required under Delaware law or federal securities law, but they have become de rigueur in corporate M&A ever since the Delaware Supreme Court ruled in 1985 that directors of TransUnion were grossly negligent because they approved a merger without adequate inquiry and expert advice. The court did not specifically mandate the opinion be obtained but stated it would have helped the board carryout its duty of care had it obtained a fairness opinion regarding the firm’s value and the fairness of the proposal.The SEC has weighed in, too, in an oblique fashion via comments that were published in the Federal Register in 2007 (Vol. 72, No. 202, October 19, 2007) when FINRA proposed rule 2290 (now 5150) regarding disclosures and procedures for the issuance of fairness opinions by broker-dealers. The SEC noted that the opinions served a variety of purposes, including as indicia of the exercise of care by the board in a corporate control transaction and to supplement information available to shareholders through a proxy.Dow’s Sour PickleBuy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.For instance, The Dow Chemical Company (“Dow”), a subsidiary of Dow Inc. (NYSE: DOW), agreed to buy Rohm and Haas (“RH”) for $15.4 billion in cash on July 10, 2008. The $78 per share purchase price represented a 75% premium to RH’s prior day close. The ensuing global market rout and the failure of a planned joint venture with a Kuwait petrochemical company led Dow to seek to terminate the deal in January 2009 and to cut the dividend for the first time in the then 97 years the dividend had been paid.Ultimately, the parties settled litigation and Dow closed the acquisition on April 1, 2009 after obtaining an investment from Berkshire Hathaway (NYSE: BRK.A) and seller financing via the sale of preferred stock to RH’s two largest shareholders.Dow was well represented and obtained multiple fairness opinions from its advisors (Citigroup, Merrill Lynch and Morgan Stanley). One can question how the advisors concluded a 75% one-day premium was fair to Dow’s shareholders (fairness is a mosaic and maybe RH’s shares were severely depressed in the 2008 bear market). Nonetheless, the affair illustrates how vulnerable Dow’s Board of Directors or any board would have been absent the fairness opinions.Fairness and ElonBefore Elon Musk reneged on his planned acquisition of Twitter, Inc. (NYSE: TWTR) on July 8, 2022, one of the most recent contentious corporate acquisitions was the 2016 acquisition of SolarCity Corporation by Tesla Inc. (NASDAQGS: TSLA). Plaintiffs sought up to $13 billion of damages, arguing that (a) the Tesla Board of Directors breached its duty of loyalty, (b) Musk was unjustly enriched (Musk owned ~22% of both companies and was Chairman of both); and (c) the acquisition constituted waste.Delaware Court of Chancery Judge Joseph Slights ruled in favor of Tesla on April 27, 2022. Slights noted courts are sometimes skeptical of fairness opinions; however, he was not skeptical of Evercore’s opinion, noting extensive diligence, the immediate alerting of the Tesla Board about SolarCity’s liquidity situation and the absence of prior work by Evercore for Tesla. Tesla Walks the Entirely FairLine with SolarCityDownload Presentation
Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?
Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. Buy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.
Only 2% of Small Businesses Know This Key Fact
Do you know how much cash is on your family business balance sheet? How about receivable health and your debt position? Reading this blog, you likely answered “yes” to these questions. Do you also know how much your family business is worth? If you answered “Yes,” you are in a select company as 98% of small businesses polled by M&T Bank over the past two years didn’t know the value of their businesses. Knowing and understanding the value of your family business is essential to making critical decisions around dividends, capital structure, or capital budgeting that have long-term effects on your family business. Travis Harms, who leads Mercer Capital’s Family Business Advisory Services Group, spoke to CNBC recently on the importance of valuation and understanding the value of your business. This week’s Family Business Director post highlights the piece, and we hope you check it out below. Originally appeared as "Most Small Business Owners Don't Do the Math on Their Most Valuable Asset" on CNBC.com’s Small Business Playbook by Cheryl Winokur Munk.Many small company owners don’t know what their enterprise is worth, a practice that can amount to risky business. A whopping 98% of small businesses polled by M&T Bank over the past two years didn’t know the value of their companies. This is especially troubling, given that for most business owners, their company is their most valuable asset. “People whose home is their primary asset want to know what it is worth. If you open up a brokerage account, you want to know how much it’s worth. You’d never give your money to a financial advisor who told you to trust them while they invest it and never report back to you on what it’s worth,” said Travis W. Harms, who leads Mercer Capital’s family business advisory services group. “Just because your business is not liquid wealth, doesn’t mean it’s not real wealth.” Here are five points to help entrepreneurs understand the importance of valuing a business.Valuation is critical to running a business, and selling itMany business owners may be too overwhelmed with day-to-day operations to focus on having their company valued. Others don’t want to spend the money or simply don’t realize the importance of having an objective third-party measure of its worth.A valuation, however, can be critical for many reasons. These include an impending sale, the issuance of stock options, succession planning, tax and estate planning, capital raising, implementing a buy-sell agreement, insurance needs or to obtain business funding, said Robert King, partner on the investment banking team at Crewe.Say, for instance, you want to gift company shares to a family member. Understanding the company’s valuation is important for tax and estate-planning purposes. Another reason to value the business is as a checkpoint so partners are all on the same page. Even if there’s a buy-sell agreement, there can be disputes over how a business is valued for the purposes of separation. Having realistic expectations for the business along the way can prevent a prolonged and messy fight over the company’s worth if the time does come for owners to part ways, Harms said.Knowing your business’s up-to-date worth is also important because many owners don’t plan to sell their business until a suitor comes knocking, said Brett Dearing, partner and exit planning specialist with the wealth management firm Cerity Partners. If you don’t have a current valuation, you’ll be at a disadvantage from a negotiation standpoint. You could either have an overly rosy outlook for your business, or conversely, be grossly underestimating its potential.“A lot of business owners don’t understand the value of their business before they sit down with a buyer at the negotiating table,” Dearing said.Certified experts exist to value your businessOne of the best ways to find an expert to value your business is through one of three credentialing bodies.The Accredited in Business Valuation credential is granted by The American Institute of Certified Public Accountants to CPAs and qualified valuation professionals who meet the requirements. There’s also a business valuation certification by the American Society of Appraisers. And the National Association of Certified Valuators and Analysts offers the Certified Valuation Analyst designation.While having one of these certifications alone doesn’t guarantee an appraiser’s quality, it should be your baseline starting point given the level of expertise these designations require, business valuation professionals said.The cost of calculating a valuation will varyThere’s no single answer to the question of cost because it depends largely on the size and complexity of the business, the scope of work required, and the purpose and intended use of the valuation, Harms said.Given these parameters, an appraisal could cost anywhere from around $5,000 to around $50,000, according to valuation professionals. Be sure to be specific with the appraiser about the reasons you are seeking a valuation so they deliver what you’re asking for.Some of the assumptions that go into a valuation for estate planning purposes or issuance of equity compensation could be decidedly different than for raising capital or selling a business, said King. “One size does not fit all,” he said.Business owners should update this asset value regularlyDepending on what you need the valuation for, it can be something you do annually or every few years.It can also be done more frequently as you are trying to grow your business. M&T Bank offers a free digital platform that allows businesses to model how different outcomes would impact their valuation. It’s not an accredited valuation, but the service offers a baseline before you take that next step, said Jonathan Kolozsvary, director of new ventures at M&T Bank.Valuing the business regularly can help you determine weak spots and make improvements. “If you go through the valuation process and the value isn’t quite where you want it to be, you can improve the valuation based on the areas identified,” said Tami M. Bolder, director at CBIZ Valuation Group. “It’s also helpful for general planning purposes,” she said.
U.S. LNG Exports
Part 2: A Closer Look at Projected U.S. LNG Export Terminal Capacity
In Part 1 of our analysis on U.S. LNG Export Terminal Facilities, we examined trends in the number of LNG export facility applications and approval rates from 2010 through 2021 and examined the projected export capacity relative to the projected export volumes of U.S. LNG from 2022 through 2031. In Part 2 of our analysis, we take a closer look at the anticipated export capacity proposed to come online over the near and mid-term horizons to better understand the underlying factors that have spurred so many projects, seemingly far in excess of the projected level of LNG exports from the U.S.Excess Export Capacity?As noted in Part 1 of our analysis, the Federal Energy Regulatory Commission (“FERC”) received approximately 145 long-term applications for export facilities seeking to send liquified natural gas to countries both with and without free-trade agreements with the U.S from 2010 to 2021. Of these applications, 64% were approved, with the vast majority of approvals made from 2011 through 2016. What was particularly striking was the apparent excess capacity of all the export terminals, from both existing and proposed facilities, relative to the export levels as projected by the U.S. Energy Information Administration (“EIA”), as presented in the following chart:
What is not so apparent is that very few projects (ergo, capacity) have firm commitments from buyers to purchase the produced LNG, with even fewer projects having reached an affirmative final investment decision (“FID”). The nameplate export capacity from all proposed facilities skews the picture a bit, suggesting the U.S. is well able to ship out LNG as fast as natural gas can be extracted, without considering the financial support backing these major capital builds.
When stratifying the export capacities of all facilities for which an in-operation date has been put forth, all facilities for which an affirmative FID has been made, and all facilities which are currently in operation, it becomes clear that the capacity of the last group represents the boundary by which the projected LNG export levels anticipated by the EIA over the next 5 years are limited.
Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B at the end of this post (updated and revised from Part 1 of our U.S. LNG analysis).
Furthermore, we see that a total export capacity level is slated to be “operational” over the course of 2023 through 2027, while only a portion of that capacity has affirmative FIDs underlying such progress. In other words, quite a few projects are behind schedule. Far behind. For this reason, we will consider “reasonably-expected” LNG export capacity to be based solely on existing capacity and FID-supported capacity. In order to reasonably include any capacity levels for which an in-operation (but no FID) date is provided, the supporting engineering, procurement, and construction (EPC) activities for those projects would have to be either near completion or well underway. This simply cannot be assumed to be the case given the lack of clarity regarding the expected timing of any FIDs for these projects, and considering the greatly extended lead times on equipment deliveries due to increasing costs, supply chain constraints, and tight labor markets.
The projected capacity utilization over the next ten years is as follows:
Click here to expand the image aboveAt face value, the projected annual utilization rates indicate potential tightness in the ability to ship out LNG volumes over the next 6-18 months. While this possible bottleneck appears – based on current projections – to ease up over the following 2 to 5-year period, other factors should be considered aside from just export terminal capacity. After all, these facilities can only send out what they receive.Ancillary FactorsOn June 8, the failure of a safety valve caused a pipeline to burst at the Freeport LNG facility, releasing approximately 120,000 cubic feet of LNG. In addition to posing a “risk to public safety, property or the environment,” U.S. natural gas futures prices fell as the spigot was shut and natural gas slated for export had to remain in storage onshore. The EIA expects that the shutdown, projected to last for at least 3- to 6-months, will reduce the total U.S. LNG export capacity by 17%. Widening our focus from the Freeport LNG shutdown, this event reveals the potential risk and impact of total U.S. LNG exports stemming from a significant unforeseen or unplanned shutdown from any of the major (>1.0 Bcfd) 4 export terminals currently in operation. Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Further upstream, midstream O&G operators, such as Williams (NYSE:WMB), are setting up to help supply natural gas to LNG export terminals. On June 29, Williams announced its FID to proceed with its Louisiana Energy Gateway (LEG) project, which will gather and help deliver 1.8 Bcfd of natural gas from the Haynesville Shale to Gulf Coast export terminals by way of several existing and future intermediate trunklines.Beyond the physical capital infrastructure required to move gas volumes from the wellhead to the liquefaction terminal, support for LNG export activity remains constrained by political crosswinds as the Biden administration attempts to balance its initiative of supplying U.S. gas to Europe, in order to reduce its reliance on Russian-sourced fuel, while simultaneously addressing a greater public interest in lower domestic energy prices and progressing a platform to mitigate climate change, primarily by reducing the use of fossil fuels.In an attempt to appeal to the various parties with a particular interest in these respective goals, the Biden administration has sent mixed signals with countervailing rhetoric and actions. Increased LNG exports to Europe directly leads to increased domestic energy prices and does little in the way of improving the current trajectory of climate change. Keeping the supply of natural gas onshore helps mitigate high domestic energy prices, but falls short of helping fuel Europe, and still does little to curb climate change. In the pursuit of meaningful change with respect to transitioning away from fossil fuels, neither LNG exports nor promoting greater levels of natural gas production are truly viable policy options. In the pursuit of all goals, no goals are likely to be achieved. It's a stalemate. Given the factors at hand, it remains to be seen just how U.S. LNG export terminal projects develop. There are clear indications that demand is present, but nebulous political actions, words, and potential regulatory issues still cast a shadow on any perception of a clear path forward.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image above
RIA M&A Update - Through May 2022
Year-to-date RIA M&A activity has surpassed last year’s record levels so far in 2022 even as macro headwinds for the industry continue to mount. Fidelity’s May 2022 Wealth Management M&A Transaction Report listed 93 deals through May of 2022, up from 72 during the same period in 2021. These transactions represented $135 billion in AUM, up 12% from 2021 levels.The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy given that all of these factors could put a strain on the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. Despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with the professionalization of the buyer market continuing to be a theme driving M&A activity. Deal volume is increasingly driven by serial acquirers and aggregators with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first five months of the year. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquirers and aggregator models has led to increased competition for deals throughout the industry. This has contributed to multiple expansions and shifts to more favorable deal terms for sellers in recent years. While there are some signs that deal activity from these acquirers may slow down (CI Financial’s CEO Kurt MacAlpine remarked on the company’s first quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in the reported deal volume.On the supply side, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment, and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through May, transaction activity has remained steady or even surpassed last year.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for different levels of autonomy post transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.
Bond Pain and Perspective on Bank Valuations
Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.Figure 1 :: 1994 Bear Market vs 2022 Bear Market
The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value.
The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year.
Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”).
Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession.
To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages.
Figure 2 :: Unrealized Losses in Bank Portfolios as of March 31, 2022Figure 3 :: Unrealized Losses in Bank Portfolios as of December 31, 1994
We make the following observations for banks with $1 billion to $3 billion of assets:
Banks are better capitalized with average leverage and tier one capital ratios of 10.6% and 17.0% as of March 31, 2022 compared to 8.3% and 12.9% as of year-end 1994.Securities classified as available-for-sale (“AFS”) and held-to-maturity (“HTM”) averaged 19.0% and 2.5% of assets as of March 31, 2022 compared to 11.2% and 14.6% as of year-end 1994.The unrealized loss in the AFS portfolio equated to 4.7% of the cost basis and 11.3% of tier one capital (excludes the deferred tax asset adjustment) as of March 31, 2022 compared to 2.8% and 5.7% as of year-end 1994. 1
Unrealized losses in HTM portfolios in Figure 2 may appear too small even though many banks classify long-dated municipals as HTM because these illiquid bonds had not been adequately marked yet to reflect a rapidly declining market.Unrealized losses will increase once June 30 data is available because UST rates have risen ~75bps since March 31.
Banks are sitting on large unrealized losses today. Investors know that. The bear market in bank stocks (the NASDAQ Bank Index is down ~19% YTD) primarily reflects investor expectations about the potential impact a recession would have on credit costs next year even though NIMs will increase this year (excluding the impact of PPP loan fees) and next provided the Fed does not pivot and reduce rates. The current equity bear market is not about unrealized losses in bond portfolios; it is about the economic outlook.
From a valuation perspective, we primarily look to the impact of rising (or falling) rates on a bank’s earnings rather than how changes in rates have impacted the value of the bond portfolio and tangible book value. Assuming an efficient market, the unrealized losses represent the opportunity cost of holding bonds with coupons below the current market rate. If the underwater bonds are sold and immediately repurchased, then the bonds repurchased will produce enough extra income over the life of the bonds to recoup the loss (assuming an efficient market).
Further, the AFS securities portfolio is the only asset for most banks that is marked-to-market other than mortgage loans pending sale. Fixed rate residential and CRE loans would have sizable losses, too, if subjected to mark-to-market. Rates have risen, prepayment speeds have slowed and in the case of CRE credit spreads have widened.
Also not marked-to-market are deposits. Though a liability, core deposits are the key “asset” for commercial banks. Value for deposits—especially non-interest-bearing deposits—are soaring given a low beta to changes in market interest rates when loan-to-deposit ratios are low.
The monthly report that really matters is not the bond report but the asset-liability model (“ALM”). Banks manage net interest margin (price) and assets (volume) to drive earnings; and earnings (or cash flow) drive stocks over time. Earnings also build book value to the extent earnings are retained.
Rising rates—gradually rather than rapid—are a positive development given the commercial bank business model, assuming that credit quality does not deteriorate.
Having said that, we cannot completely dismiss the unrealized losses in the bond portfolios. Some investors focus on tangible book value, though we view it as a proxy for earning power because tangible book value is levered to produce net interest income.
Also, M&A is more challenging because day one dilution to tangible BVPS is greater to the extent unrealized bond losses are recognized via fair value marks applied to all assets. Of course, earnings then increase from accreting the discounts as additional yield.
Aside from the soaring value of core deposits, the glass half full view is bonds and fixed rate loans eventually mature. In the interim, cash flows should be reinvested to produce better yields.About Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please give one of our professionals a call if we can be of assistance.
Is Your Family Business Worthy of Its Name?
This week, McDonald’s was in the news with a new plan raising expectations for franchise operators. The more stringent renewal reviews will include an assessment of performance history and customer complaints. The company told its franchisees that “…receiving a new franchise term is earned, not given.”Franchisees pay handsomely for the right to use the McDonald’s name, expecting that the goodwill associated with the golden arches will generate attractive returns for them as owner-operators. For its part, McDonald’s is dependent on the operations of its franchisees to maintain and enhance brand goodwill. After all, consumer perceptions of the brand are driven by their experiences in franchise-operated locations far more than activities at the corporate office. In other words, franchise operators are stewards of the McDonald’s brand. The company intends a more intensive review process to ensure that poor-performing or non-conforming operators do not reduce the value of the brand.While it is rare for family businesses to license the family name for use, family business managers and directors are stewards of the family name and the family’s capital. Directors and managers use the family’s capital (both social and financial) to operate the family business with the goal of providing an attractive risk-adjusted return for family shareholders.If your family business had to go through a renewal process to continue using the family’s name and capital, what factors would determine whether the business was worthy of renewal?Stewardship ReportingPeriodic reporting to owners is a fundamental obligation of stewards. The content of that reporting will be unique to each family. However, there are some broad elements that should be considered for any stewardship reporting model.Capital allocation. How is the family’s capital being allocated? Is the family’s capital being invested in real estate, working capital, production equipment, rolling stock, or intangible assets like a tradename? How much of the family’s capital is allocated to assets that don’t directly support the operations of the family business? What is the rationale for the allocation decisions that have been made? How do those decisions further the company’s strategy?Risk. To what risks is family capital exposed? To what degree is family equity capital being blended with third-party debt capital to extend the reach and scale of the family’s resources? What are the economic, regulatory, and industry risk factors that could influence company performance in the future? What customer/supplier concentrations or key person dependencies could adversely affect the company? What steps are available to mitigate these risks, and are those steps financially feasible?Operating performance (over time). Is the family business growing or shrinking? Is it gaining or losing market share? Are there new products or markets that offer an attractive growth platform for the company? If the family business has momentum, what is it doing to keep it? If the family business doesn’t have momentum, what is it doing to gain it?Operating performance (relative to peers). How does the operating performance of the family business compare to available benchmark measures? What is the cause of significant variances – underperformance, overperformance, or a fundamental difference in the business model or strategy?Efficiency. How do operating results compare to the resources allocated to producing those results? While not perfect, return on invested capital (ROIC) is a useful performance measurement framework for many family businesses. How much revenue is the family business generating per dollar of invested capital? How much operating profit does the family business generate per dollar of revenue? What is the trend in these measures over time, and how do they compare with available benchmarks?Investment returns & valuation. Family capital could be invested elsewhere, so what investment returns are being generated by the family business over time? Calculating investment returns requires developing periodic estimates of the value of the family business – what are the controllable (company performance) and uncontrollable (market performance) factors influencing the value of the family business and investment returns?What returns are being generated by alternative investments? How does the risk of the family business compare to the risk of those alternatives? Does the resulting tradeoff between risk and return “fit” your family shareholders?ConclusionFamily business directors and managers don’t have to submit to a renewal process to secure the right to continue using the family’s social and financial capital. But pretending that you did have to is not a bad exercise for directors and managers. What factors could you cite to support your continued stewardship of the family’s capital? Do you have a periodic reporting process in place that addresses those factors?Designing a reporting process that is tailored to your family and business can help ensure that family capital continues to be put to good use. Give one of our family business professionals a call to discuss your reporting needs.
The Importance of a Quality of Earnings Study
This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Energy Valuation Insights blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring.
The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis
For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.
Considering Contingent Consideration
This is the seventh article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.What Do Earnouts Entail?The most common contingent payment is an “earn-out” that bridges the buyer’s bid and the seller’s ask by ensuring the business produces an agreed upon level of revenues and/or earnings (typically EBITDA) within an agreed timeframe before the payment is made.Earn-outs could be considered the ultimate form of confirmatory due diligence. From a buyer’s perspective, earn-outs reduce risk by reducing up-front cash and the likelihood of materially overpaying absent an adverse turn in the economy or industry conditions. From a seller’s perspective, contingent consideration allows sellers to obtain an acceptable price and sometimes a premium or stretch valuation if the Company attains the agreed-upon targets. Further, earnouts create an alignment of interests to the extent roll-over management and ownership is incented to optimize the company’s performance.In our experience, most buyers are willing to pay in a range of value that produces an acceptable return based upon conservative assumptions about the business’ future earning power (EBITDA or EBITDA less capex) and growth rate. Unless the business is viewed as having above average risk, most buyers’ required rate of return on an unlevered basis will be conservative but not ridiculously high. This reflects buyers’ natural aversion to risks that may not be readily apparent to most sellers. An earn-out is a means by which to close or narrow this gap.When earnouts are involved, buyers and sellers must understand the waterfall of post-closing events, and their respective timing and terms to gain a full understanding of transaction consideration. Earnouts are a form of purchase consideration where acquirers tender value to the target seller if certain future events occur. Earnouts provide sellers with potential value fulfillment or upside while simultaneously allowing buyers to defer payment of consideration with the possibility of recovering a designated portion of the purchase price if post-closing hurdles are not achieved.By its nature, contingent consideration adds complexity for both buyers and sellers, particularly when the features of the earnout reflect significant speculation on post-closing outcomes. These might include high growth, reversals of trend, or specific events such as new business developments or failed business retention.Despite the complexities, earnouts and other forms of contingent consideration can be critical to achieving a successful closing when market conditions are ebbing more than flowing or when winning the day requires the buyer to make a stretch offer.Mid-Market Deals Increasingly Reflect Up-Market Deal StructuresAccording to GF Data®, a firm that provides data on private equity-sponsored M&A transactions with an enterprise value of $10 to $250 million, 38% of 432 transactions in 2021 entailed either seller financing or earnouts compared to 44% of 329 deals in 2020. The reduction last year reflected a seller’s market that was characterized by too much capital chasing a limited pool of sellers. Given tighter financial conditions this year that may lead to a recession later this year or next, it would not surprise us to see the percentage of deals with an earnout increase because the risk to a target’s earnings and maybe long-term growth prospects will rise.A financial advisor can be an important intermediary for both buyer and seller to craft a well structured earnout to facilitate successful deal negotiations rather than letting a poorly crafted and/or poorly socialized earnout create a negotiation wedge that can delay or overwhelm momentum required to finalize a purchase agreement.Buyer Awareness and Financial ReportingWhile it should not impact the economics of a transaction, buyers face the added burden of accounting for contingent consideration per FASB’s ASC 805, which addresses business combinations. It requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, resulting in an increased amount of goodwill or other intangible asset depending upon how value is allocated to the acquired assets. Fair value also must be re-measured for each subsequent reporting period until the contingency is settled. Mercer Capital’s years of M&A purchase price allocation work for both strategic and financial acquirers gives us unique insight into the sometimes nettlesome issues of purchase price allocations in M&A transactions.Concluding ThoughtsWhile this article is an installment in our larger buy-side series of content, it is important to draw advice for buyers from our near universal advice to sellers.We often advise sellers to be content with the consideration they receive at closing and to assess contingent consideration with a healthy degree of skeptical risk, particularly when achieving the earnout represents a stretch in future outcomes.A logical extension of that advice for buyers is to be prepared to pay even if the benchmarks are deemed a stretch. The occasional extraordinary outcome can create significant buyer liability. Whether the net effect on the buyer is a beneficial deferral of payment or a deal premium (or otherwise) must be assessed in the context of the overall offering stack.Buyers should determine the reason for using an earnout and then determine an appropriate design for the earnout. Clear, unambiguous terms and measurements are recommended to minimize negotiating friction and incent smooth post-closing integration and alignment of interests both operationally and financially.If your development needs involve growth through acquisition, and you find the market for quality targets requires the thoughtful use of earnout consideration, Mercer Capital can provide useful insight while helping quantify the real-time financial equivalency of any earnout consideration offered.
Considering Contingent Consideration
Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.
The Importance of a Quality of Earnings Study
This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Family Business Director blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.
Permian Production Remains Strong
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production (on barrels of oil equivalent, or “boe,” basis) increased approximately 11.4% year-over-year through June. This is notably greater than the production increases seen in the Eagle Ford, Bakken and Appalachia (8.0%, 2.2% and 1.9%, respectively).
There were 345 rigs in the Permian as of June 10, up 49% from June 4, 2021. The Bakken, Eagle Ford, and Appalachia rig counts were up 131%, 106%, and 34%, respectively, over the same period.
In terms of production growth, the Permian has far exceeded the other basins, and Permian production is expected to continue increasing over the next several months based on anticipated increases in the rig count and new-well production per rig.
Commodity Prices Continue to RiseOil prices generally rose through the second half of 2021, although they started to decline in mid-Q4. The shale revolution had largely put geopolitics in the back seat as the key driver of commodity prices. However, geopolitics once again came front and center as Russia launched its invasion of Ukraine in late February. Western nations responded with a series of economic sanctions against Russia. Although the sanctions generally included carve-outs for energy exports, issues with financing and insurance, and the exit of Western oil companies and oilfield service providers from Russia resulted in a substantial decline in oil exports from the country. The exclusion of oil from Russia, the third-largest producer of petroleum and other liquids in 2020 according to the U.S. Energy Information Administration, from global markets led to a high degree of volatility in oil prices. WTI front-month futures prices began the latest quarter at ~$99/bbl and were floating around $121/bbl as of mid-June. With no indications of any near-term resolution of the Russian-Ukraine war, and a continued outlook of relatively flat production in the U.S., the upward trajectory of global energy prices has no foreseeable inflection point at the moment.
Natural gas prices fluctuated over the past year, albeit with slightly less volatility than oil prices, and have exhibited the same upward trend over the past quarter. Natural gas is becoming more globalized as Europe grapples with replacing imports of Russian gas. In late March, President Biden pledged to boost LNG exports to Europe, which may re-invigorate the advancement of U.S. LNG export terminal projects.
Financial PerformanceThe Permian public comp group saw moderately positive stock price performance over the past year (through June 10). The prices of Diamondback Energy and Laredo Petroleum rose 79% and 78%, respectively, and more than the broader E&P sector (as proxied by XOP, which rose 68% during the same period). Pioneer Natural Resources’ stock price rose 66% over the period, and Callon Petroleum rose a relatively tepid 24%.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey (the latest available as of mid-June), wells in the core plays of the Permian are positioned as some of the most economical in the nation.
Survey respondents indicated that the average WTI price needed to break even on existing wells in the primary Permian plays was $28/bbl to $29/bbl. This exceeds the average breakeven in the Eagle Ford ($23/bbl) but is still lower than other parts of the U.S. (over $30/bbl). The average breakeven price for new development in the Permian is in the middle of the pack at $50/bbl to $51/bbl, greater than the Eagle Ford’s breakeven ($48/bbl), but notably lower than in other parts of the country ($60/bbl to $69/bbl).
ConclusionProduction growth in the Permian continued to exceed growth in the Eagle Ford, Appalachia and Bakken over the past year as the basin remains one of the most economical regions in U.S. energy production. With the surge in commodity prices over the past quarter, it might have been expected that producers would start bringing more rigs online, leading to more production growth than what we saw. However, as upstream companies have signaled, it may not be realistic to expect such increased deployment of capital from public operators in the near future, though private operators may very well move to take advantage of the higher price environment. With greater emphasis on returning cash to shareholders, continued levels of relatively low investment in growth capital may be expected. However, its significantly large contribution to total energy production continues to make the Permian a steady source of growth for overall U.S. oil and gas production.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Tesla Walks the Entirely FairLine with SolarCity
Evaluating Fairness of the Tesla Motors, Inc. and SolarCity Corporation MergerIn March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.
Middle Market Transaction Update First Quarter 2022
In the first quarter of 2022, U.S. middle market deal value and volume experienced somewhat of a pullback from year-end 2021 levels.
Bear Market Silver Lining? An Estate Planning Opportunity
As we highlighted previously in the Family Business Director blog, companies are beginning to batten down the hatches and prepare for stormy weather. The risk of a recession continues to escalate, and inflation printed a new four-decade high in May. Former Fed Chair and current Treasury Secretary, Janet Yellen, appeared before Congress to answer questions regarding inflation, which she sees as staying elevated for an extended period. Gas prices hit a nationwide average of $5 a gallon for the first time ever in the United States, and little relief is on the horizon.The Fed expects to continue raising rates to battle inflation, and a new law was passed unanimously in the House and Senate to ban the word “transitory,” which awaits President Biden’s signature. Well, maybe the last one was just floated in committee.All to say, companies and consumers alike are feeling the squeeze, and markets are reflecting less-than-rosy expectations. At the time of this writing, the S&P 500 was down almost 16% year-to-date, while the Russell 2000 was down almost 19%. Outside the energy sector, stocks are bleeding red in 2022. Lower broad market pricing translates to lower valuations for family businesses.Click here to enlarge the imageSo what? Well, for family businesses undertaking long-term intrafamily transfers and gifting plans, a market downturn represents an opportunity to reduce estate and gift tax exposure by considerable margins. How? We explain below.Fair Market ValueIf you are reading this post, you are likely familiar with the gift and estate tax process in the valuation of private company stock. To consummate an intrafamily transfer (via gift or sale) companies generally must retain a business appraiser to determine the fair market value of shares. Appraisers use a two-step process:Appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them in the stock market.Appraisers consider an appropriate discount, or reduction in value, to account for the fact that the shares in the family business are privately held, rather than publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on several factors, including the expected holding period, yield, capital appreciation, and incremental risks associated with illiquidity.Based on the downturn in the market, the fair market value of minority shares in family businesses is likely lower today than it was just a couple of months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Long-Term Mindsets and Estate PlanningFactors leading stocks lower are real and are affecting public and private companies alike: continued supply chain bottlenecks, rising input prices and limited ability to pass along to consumers, distressed margins, and low consumer confidence all will cause pain in the short term. However, private family businesses have the benefit of time, and a resilient family business should return to form once issues plaguing markets subside. Exhibit 2 depicts the expected value trajectory for a family business, including a bear market downturn.The immediate impact is straightforward: the magnitude of the dollar gift for the same amount of ownership or stock is reduced relative to prior periods. Exhibit 3 shows a simple example of the current market downturn on transfers of private company stock.How does this benefit private companies engaged in estate planning?If the transfer is a gift, the debit against the lifetime estate and gift tax exemption of the gifting party is reduced, leaving more room to make future gifts (both estate and gift) tax-free. Since the ownership percentage transferred remains the same, the receiver’s resulting ownership percentage is unchanged.If the transfer is a sale, the buyer (likely a younger generation) can buy into the business at a more favorable price.Both of these strategies reduce the transferer’s total estate by a larger amount, assuming measurement of the estate (ie, death) comes later once the company’s valuation has recovered.Final Thoughts – Keep an Eye on Rates and the CalendarA couple of final thoughts you should also keep in mind related to estate planning in the current environment.Private Loan Rates: The IRS publishes monthly tables identifying what is known as the applicable federal rate or AFR. The AFR is significant for estate planning because it establishes the threshold interest rate for private loans. While rates have ticked up, rates are still well below commercially available rates. The Federal Reserve is, however, planning to aggressively continue hiking rates to battle inflation, making these “on-sale” prices unlikely to last.For family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026. The Treasury Department has confirmed the additional transfer tax exemption under current law is a “use it or lose it” benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced. The window to capture the current exemption is undoubtedly closing, and family businesses will likely only get so many more bites at this apple before it turns sour.The example in this post is simple and perhaps obvious, and our reminders may be old news. However, we understand it is hard to have a long-term mindset when things take a sudden downward turn. Being opportunistic in stormy weather makes for better sunny days ahead.
M&A in the Permian: Acquisitions Slow as Valuations Grow
Transaction activity in the Permian Basin cooled off this past year, with the transaction count decreasing to 21 deals over the past 12 months, a decline of 6 transactions, or 22%, from the 27 deals that occurred over the prior 12-month period. This level is in line with the 22 transactions that occurred in the 12-month period ended mid-June 2020. It is difficult to interpret the significance with any certainty. On one hand, it could indicate increased trepidation regarding production prospects in the basin. On the other hand, it could simply be a sign that regional E&P operators have started to "right-size" their inventories in the West Texas and Southeast New Mexico basin. Based on the evolving economics of the region, as we will examine further below, the latter case may be closer to the truth.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2020-2021, the median deal size nearly was $387 million, just 4% lower than the median deal size of $405 million in the prior 12-month period. However, the median acreage purchased over the past year was 21,000 net acres, just over 42% lower than the 36,250 acres among the deals in the previous year. Given the concurrent decrease in acquired acreage and relatively unchanged median transaction price, the median price per net acre was up 16% period-over-period. Looking at acquired production, the median production among transactions over the past year was 5,500 barrel-oil-equivalent per day ("Boepd"), a 39% decrease from the 8,950 Boepd metric from the prior year.Given the relatively unchanged level in the median transaction value in conjunction with a lower median production level, the median transaction value per Boepd, unsurprisingly, jumped 54% from $31,886 in the prior 12-month period to $49,143 in the latest 12-month period. This willingness to pay over 50% more per acre and/or per Boepd suggests that these targets' underlying economics have been, and remain, supportive. However, the marginal costs of these acquisitions may be approaching the perceived marginal returns projected for these properties, as evidenced by the decrease in the transaction count relative to last year.Click here to expand the image above. The approach to the marginal "equilibrium" appears to have been a pretty short runway to land on. Of the 21 transactions completed, 14 occurred from June to December, with the remaining 7 occurring from January 2022 to the present. One metric we analyzed, based on the deal value per production (annualized) per acre, indicates a sharp decline in the "bang for the buck" exhibited by the transactions before and after year-end 2021. As presented below, the median cost per production acre for the 14 transactions from June to December 2021 was $1.072. In contrast, the median metric for the seven transactions from January to June 2022 was $10.762, indicating a 10.0x increase in the cost per production acre.A deeper dive into the details of each transaction would be needed to discern any common causes for this movement, but this could indicate a shift in focus from proven reserves towards unproven acreages. In other words, acquirers may be putting increased value on the potential optionality for greater-but-yet-proven production presented by these targets.Click here to expand the image above.Despite the upward trend in energy prices over the past year, what we are seeing is a likely slowdown in M&A activity in what is generally considered to be the most economical oil and gas basin in the U.S. If the Permian is a bellwether of U.S. production in general, are we likely to see a slowdown in M&A activity in other basins soon? I would venture to say "yes."Earthstone Energy Acquires Bighorn's Permian PortfolioIn late January 2022, Earthstone Energy announced its agreement with Bighorn Permian Resources to acquire its Midland Basins assets for a total consideration of $639 million in cash and 5.7 million shares of Earthstone's Class A common stock (the "Bighorn Acquisition"). The effective date of the Bighorn Acquisition was January 1, 2022, and the deal closed on April 18, 2022. The Bighorn Acquisition included 110,600 net acres (98% operated, 93% WI, 99% HBP), primarily in Reagan and Irion counties, with an estimated production of 42,400 Boepd (57% liquids, 25% oil), and proved reserves of 106 MMBoe (20% oil, 34% NGL, 46% natural gas).Robert Anderson, President, and CEO of Earthstone Energy, commented, "The transformation of Earthstone continues with the announcement of the significant and highly-accretive Bighorn Acquisition. Combining the Bighorn Acquisition with the four acquisitions completed in 2021 and the pending Chisholm Acquisition, we will have more than quadrupled our daily production rate, greatly expanded our Permian Basin acreage footprint and increased our Free Cash Flow generating capacity by many multiples since year-end 2020. The proximity of the Bighorn assets to existing Earthstone operations positions us to create further value by applying our proven operating approach to these assets, primarily in the form of reducing operating costs. The addition of the high cash flow producing assets from Bighorn to the strong drilling inventory of Earthstone, including the Chisholm Acquisition, furthers Earthstone's transformation into a larger scaled, low-cost producer with lower reinvestment in order to maintain combined production levels."Earthstone Energy Acquires Midland Basin Assets from Foreland InvestmentsIn early November 2021, Earthstone Energy announced the completion of its acquisition of privately held operating assets located in the Midland Basin from Foreland Investments LP ("Foreland") and from BCC-Foreland LLC, which held well-bore interests in certain of the producing wells operated by Foreland (collectively, the "Foreland Acquisition"). The aggregate purchase price of the Foreland Acquisition was $73.2 million at signing, consisting of $49.2 million in cash and 2.6 million shares of Earthstone's Class A common stock valued at $24.0 million based on a closing share price of $9.20 on September 30, 2021. The Foreland Acquisition included approximately 10,000 net acres with an estimated production of 4,400 Boepd (26% oil, 52% liquids), and PDP reserves of approximately 13.3 MMBoe (11% oil, 31% NGL, 58% natural gas).Mr. Robert Anderson, President and CEO of Earthstone, commented, "This transaction will be our fourth acquisition this year as we continue to advance our consolidation strategy and enhance our Midland Basin footprint with additional scale. The acquisition of these low operating cost, high margin, producing assets at an attractive valuation is a nice addition to our production and cash flow base. The Bolt-On Acquisition also includes approximately ~10,000 net acres (100% operated; 67% held by production) in Irion County. We expect to benefit from additional operating synergies when production operations are combined with other assets in the area. As we have done in prior acquisitions, we look forward to applying our operating approach to these assets in order to reduce costs and maximize production and cash flows."ConclusionM&A transaction activity in the Permian declined at an increasing rate over the past year, with two-thirds of the 21 transactions occurring in 2021, and the remaining third transpiring in the YTD period ended in mid-June. But the overall upward trend in deal cost per unit (be it per-production level, acreage, or production-acre) indicates buyers' willingness to pay more to achieve their desired asset base. The overall story is one of the companies right-sizing their presence in the basin.We have assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Recession, Expectations & Value
The uncertain macroeconomic environment is causing corporate managers to consider how a recession would influence their businesses. Last week, the Wall Street Journalpublished comments from eleven public company CFOs discussing their expectations for how their businesses would fare if the expected economic downturn occurs.Perhaps not unexpectedly, the CFOs interviewed by the Journal were generally optimistic regarding the outlook for their companies in the event of a recession.Some focused on how recession-resilient their industries are, including Big Lots (discount retail), Match Group (online dating), Anheuser-Busch InBev (beer), and Olaplex Holdings (beauty products). The CFO of Tripadvisor anticipated that 2+ years of pandemic-induced cabin fever will put travel at the top of consumers’ wish lists even amid a recession.Others highlighted actions that they have already taken, or can take, to mitigate the effects of a downturn: ClubLending has tightened credit standards for hourly workers, the CFO of Williams-Sonoma cited the ability to cut expenses and reduce inventory and capital spending, PerkinsElmer indicated that a larger base of recurring revenue will put the company in good stead, and Krispy Kreme discussed the company’s strategy of expanding distribution points.Finally, the CFO of Applied Materials replied that – in terms of order flow – no slowdown in demand is evident yet, while the CFO of Whirlpool believes that pandemic-related demand will continue to outpace constrained supply. How realistic are these expectations? Only time will tell; however, since all eleven companies are publicly traded, we can see how investors are grading those expectations. Exhibit 1 summarizes year-to-date share price performance for each company.Consistent with general stock market trends, share prices are down for each company, with Anheuser-Busch InBev faring the best (-12%) and discount retailer Big Lots feeling the most pain (-51%). Investors seem to be on board with the thesis that beer consumption is recession-proof but less convinced about the prospects for Big Lots. Your family business doesn’t receive a daily grade from the market, but you do have expectations for the future. How will your family business fare if a recession sets in, and how are expectations affecting the value of your family business today? When discussing value, we find it helpful to group expectations into three primary categories: cash flow, risk & return, and growth.Cash FlowValue is not a “what have you done for me lately?” game – it is a “what will you do for me tomorrow?” game. How will stubbornly high inflation, tight labor markets, and persisting supply chain disruptions affect the cash flows for your family business over the next year?What effect will rising prices have on demand for your product or service? Are your customers net beneficiaries of rising price levels, or will rising prices put a dent in their propensity to spend on your product?How are labor availability and wage pressures influencing the cost of doing business for you? Are you able to pass higher operating costs along in the form of higher prices, or are your profit margins getting squeezed?Is maintaining an appropriate level of working capital tying up more of your cash flow? Have supply chain disruptions caused you to hold larger quantities of more expensive goods? Are any of your customers facing financial distress that could stretch out collections?Is the increasing cost of capital goods reducing cash flow that would otherwise be available for debt service or owner distributions?Risk & ReturnSince the end of 2021, yields on long-term treasury securities have increased from 1.94% to around 3.30%. Our colleague Brooks Hamner, CFA, ASA wrote about the inverse relationship between interest rates and valuation multiples several weeks ago. While Brooks was writing specifically about the value of investment management firms, his observations apply broadly to all companies. In short, all else equal, rising interest rates put downward pressure on the value of all financial assets.But thinking about your family business specifically, how have expectations regarding risk evolved as the economic picture has become murkier? Like A-B InBev, do you have a compelling case that your family business really is recession-proof? Or would investors be skeptical of the strategies at your disposal to counteract the negative effects of a broader economic slowdown?GrowthFinally, how would a prolonged recession change the ground rules for your industry and the effectiveness of your family business’s growth strategy? Would a downturn cause you to defer capital investment in support of the next growth engine for your family business? Or, would a slowdown allow you to capture market share at the expense of financially-weaker competitors? How could the structural changes that accompany economic disruptions alter the demand trajectory for your product or service?ConclusionCash flows, risk & return, and growth provide a helpful framework for evaluating expectations for your family business. If the Wall Street Journal had called you last week, what would you have told them about your plans?
The Importance of a Quality of Earnings Study
As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring.
The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis
For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.
Negotiating Working Capital Targets in a Transaction
This is the sixth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction.
Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business.
Defining Net Working Capital
Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal.
By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks.
In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price.
Why Are Net Working Capital Negotiations Necessary in a Deal?
Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller.
For example, a seller could aggressively collect accounts receivable in the months leading to closing in an effort to convert these receivables into cash. Conversely, a seller could let accounts payable inflate in the months leading to closing and theoretically retain a higher amount of cash. Even absent any sort of concentrated effort to impact the working capital, most companies have some level of fluctuation in their various balance sheet accounts. Setting a net working capital target negates the impact of these fluctuations and prevents the seller from “gaming” cash and working capital levels in anticipation of a transaction.
If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered.
The purchase price adjustment related to net working capital is typically applied after the close of the transaction – based on a final accounting as of the closing date. Usually, a defined amount of the purchase price is set aside in a short-term escrow specifically for any negative adjustment related to the final net working capital balance. If the final determination of net working capital comes in below the established threshold, then the buyer retains funds from the escrow to make up for this shortfall. If the final net working capital figure is above the threshold, the buyer makes an additional payment to the seller for the excess amount.
From the buyer’s perspective, it is important to negotiate an escrow amount that is large enough to cover any potential swings in net working capital that could result at closing.
Negotiating Net Working Capital Targets
The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction.
Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption. Since valuations are typically predicated on trailing twelve months EBITDA (or some other measure of earnings), it is typical that the lookback period for the net working capital target calculation coincides with the twelve-month period in which EBITDA is calculated. In other words, the calculation of a net working capital target should be on the same historical basis as that of the measure of earnings used to support the transaction value.
In situations where EBITDA from the most recent period is deemed to be unsustainable or if there is significant short-term growth underlying the transaction value, it might be necessary to calculate the net working capital benchmark by applying a percentage (based on historical averages) to an ongoing revenue figure in order to consider that net working capital needs will change as revenue either declines or increases post-closing.
While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period.
Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always approach any “excess” adjustment of this type with caution. It can be difficult to understand why the selling company would have operated with this “excess” when the capital could have been paid out to shareholders or invested in another way. With further analysis, there is often an explanation as to why the “excess” working capital has historically been carried on the company’s balance sheet.
As an example, the “excess” could have historically resulted from a quick turnover of payables such that the company has lower current liabilities than the industry average. The quick payments may have earned the company discounts from its vendors, which likely equated to higher profit margins. If the cash flow figures underlying the transaction value include the benefit of these discounts, then it could be double counting to adjust the net working capital to a “normalized” level.
One question that will arise in the negotiations is whether a specific dollar amount or a range should be utilized as the net working capital target. The logic of applying a range is straightforward – it prevents minor variances from creating a post-closing adjustment and reduces the likelihood of disagreements between the buyer and seller regarding the calculation of net working capital to the specific dollar. A word of caution on ranges: if the range is left too wide, it invites the same type of balance sheet “gaming” from the seller that the setting of a target was meant to prevent in the first place.
Our experience has been that, if a range is preferred, it should be tight enough that any amount that would be potentially gained from the closing working capital figure falling at the bottom or top of the range should be immaterial to both the buyer and the seller.
Concluding ThoughtsHaving a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer. Mercer Capital has acted in this capacity in hundreds of transactions over our 30+ years of existence. If you are looking for an experienced team of professionals to assist in the due diligence and negotiation process, please reach out to one of our Transaction Advisory Group professionals to assist.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of May 12, 2022
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of May 12, 2022Download Study
Negotiating Working Capital Targets in a Transaction
This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business.
A Look Into The Family Business Director's Summer Reading Catalogue
We at Family Business Director trust that all of you had a pleasant and relaxing Memorial Day Weekend. As this past weekend served as the unofficial kickoff to the summer season, our intent this week is to provide you with a thought-provoking portfolio of “summer reading” material. Don’t worry, there won’t be a test in August. We’ll return with our regularly scheduled programming next week. In the meantime, we hope you enjoy these pieces on a beach or by the pool somewhere, preferably with a tall cool beverage in hand. Happy reading!Estate Planning During A Bear MarketWith the major indices approaching bear market territory over the past several weeks, Matthew Erskine provides some practical tips and considerations for estate planning in bear markets. Despite short-term pain, bear markets can often provide potentially fruitful long-term planning opportunities.Click here to read.Building a Multidisciplinary Advising Team for Your Family EnterpriseSpeaking of planning, building a team of trusted advisors in a variety of disciplines is a crucial step to ensuring long-term continuity and positive outcomes for your family’s business. In this article from The Family Business Consulting Group, Wendy-Sage Hayward lays out benefits, challenges, and practical steps for building a multidisciplinary advising team to assist your family enterprise.Click here to read.Considerations in Merger Transactions
When considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, Mercer Capital’s Nick Heinz takes a comprehensive and practical look at mergers and the ways that these often overlooked types of transactions can provide long-lasting benefits to both parties.
Click here to read.Get the Most Out of Your BoardOf course, any transaction that your family business undertakes will be subject to board approval. Chris Yount lays out some excellent points regarding family business board dynamics in this recent article for Family Business magazine.Click here to read.
Themes from Q1 Earnings Calls
Part 2: Oilfield Service Companies
In a prior post — Themes from Q4 2021 Earnings Calls, Part 3: OFS — we noted common themes from OFS companies’ Q4 earnings calls, including macro headwinds, industry consolidation through M&A activity, and ESG activity.In Themes from Q1 2022 Earnings Calls, Part 1: Upstream, we explored key topics among the upstream segment of the oil & gas industry through the earnings calls of E&P operators and mineral aggregators. These themes included:The future role of U.S. production in the European market as European nations plan to phase out Russian oil & gas;Confidence of continued favorable pricing exhibited through shorter-term deals and unhedged positions;Increasing completion rates in Q1, with expectations of further growth in completions beyond Q1.
This week we focus on the key takeaways from the OFS Q1 2022 earnings calls.Short-Cycle Projects to Bolster Near-Term Production Are Those Most Sought AfterOFS companies have highlighted that — as E&P companies remain focused on returning near-term profits to shareholders — their investment efforts are sighted on capitalizing on short-cycle developments, rather than longer-term developments. Amid ESG headwinds and supply chain disruptions, OFS companies have been more commonly tasked with supporting active rigs, supplying marginal equipment, and other services necessary for E&P companies to capitalize on this commodity upcycle.“In addition, I expect an important change in our customers behavior and priorities will provide structural support to oil prices throughout this upcycle. I believe supply dynamics have fundamentally changed due to investor return requirements, public ESG commitments and regulatory pressure, which make it more difficult for operators to commit to long-cycle hydrocarbon investments and instead drive investment flexibility through short-cycle barrels.”
– Jeff Miller, Chairman, President & CEO, Halliburton“The shorter cycle [is] catching up, improving the situation around our very, very constrained supply chain challenges [and] meeting sort of the near-term demand of supporting rigs, frac fleets and stimulation equipment…both land and offshore, I think that's kind of the biggest near-term needle mover for NOV.”
– Clay Williams, Chairman, President & CEO, NOV“There have been episodic supply chain disruptions with our customers, where we've been on location waiting for another service company to arrive or complete a job, and that's becoming, unfortunately, more frequent. I think that you're seeing a lot of marginal equipment being deployed and you're going to see a lot more marginal equipment being deployed as we pass through the 700 level in the U.S. rig count on the way to maybe just under 800 by year-end.”
– Scott Bender, President, CEO & Director, Cactus Shifting Priority to Margin ExpansionThough the demand for oilfield services has particularly revolved around short-cycle projects to support production, executives note that total demand for these products and services has still increased across the board. Amid a plague of supply constraints and a tight market for their products and services, OFS companies have shifted their focus towards increasing margins, rather than gaining market share. Despite a surge in demand, margins face pushback as inflation and rising wages erode the pricing power of OFS companies.“It's probably fair to say that we're entering into a period of potential meaningful margin expansion. And I think that volume expansion in terms of shipments is going to be constrained. And unlike some of our peers, we have the capacity to manage increased volumes. So we could potentially benefit from [this].”
– Scott Bender, President, CEO & Director, Cactus“We are seeing increasing demand across all services. And I'd say, particularly on the well servicing side just because for a lot of operators, some of their cheapest incremental barrels are workover barrels. So we are seeing that demand. As Brandon indicated, we're now running 157 rigs and we would expect through the year that, that number starts to kind of trend up.We are being pretty diligent in maintaining margins, but we do think we can deploy additional rigs and maintain margins.”
– Stuart Bodden, President & CEO, Ranger Energy ServicesPrivate Companies Have an Increasing Role Within the Customer BaseA recurring theme, as mentioned in previous blog posts, is how private companies have been more active than public companies in ramping up production. As this relates to OFS, Q1 earnings calls have acknowledged that relationships with private operators are of greater importance than in the past. This shift comes in light of capital restraint from public operators. While perspectives differ about the future activity plans of the public E&P companies, OFS company executives commonly recognized increased activity from private operators, due to growth, consolidation, and greater capital freedom.“Our penetration of privates is undeniable. It's going to increase this year because I think the privates are becoming much more sophisticated. They're consolidating. And as they become more sophisticated and larger, then our product becomes far more attractive to them. They're not nearly restrained from a capital perspective. And we're doing our level best to call on those customers with whom it makes economic sense for us to pursue that business.”
– Scott Bender, President, CEO & Director, Cactus “Today, as I look at a combination of customer activity and inflation, my outlook has improved, and I now expect North America spending to increase by over 35% this year. With respect to activity, over 60% of the US land rig count sits with private companies and they keep growing, while public E&Ps remain committed to their activity plans. Activity and demand for our services are increasing, both internationally and in North America.”
– Jeff Miller, Chairman, President & CEO, Halliburton “As far as mix, I'd say it's twofold. We referred on the call that we are working for larger group of operators and I'd say the preponderance of that increase is probably in the private side ... so I think we will see growth in both sides, but two different dynamics driving this.”
– Kyle Ramachandran, CFO & President, Solaris Oilfield Infrastructure
Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the mineral aggregators with working and royalty interests in the underlying production. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
Buy-Side Considerations
Many observers predict that the market is rife for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market.Click the links below to read the articles in this series.1. Identifying Acquisition Targets and Assessing Strategic FitOur first topic in this buy-side series starts at the beginning. Whether your motivations to buy are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.2. How to Approach a Target and Perform Initial Due DiligenceThis is the second article in a series on buy-side considerations from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.3. Strategic Premiums: Can 2+2 Equal 5?Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this article, we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.4. Considerations in Merger TransactionsWhen considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, we discuss the key questions that must be addressed when considering a merger transaction, including, corporate governance, social issues and economic questions.5. The Importance of a Quality of Earnings Study
This is the fifth article in a series on buy-side considerations. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets.
6. Negotiating Working Capital Targets in a Transaction
This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business.
7. Considering Contingent ConsiderationThis is the seventh article in a series on buy-side considerations. In this article we discuss the many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.8. Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?This is the eighth article in a series on buy-side considerations. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. Buyside fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.9. Buy-Side Solvency OpinionsIn the ninth article of this series we discuss solvency opinions.Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment.10.The Importance of Purchase Price Allocations to AcquirersIn the last article of this series we provide a broad overview of PPAs and then a deeper look into the pitfalls and best practices related to them.
Strategic Premiums: Can 2+2 Equal 5?
This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.
When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition.
Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.What Is a Strategic Premium?A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.What Justifies a Strategic Premium?The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.Cost SavingsCost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.Revenue EnhancementsRevenue enhancements are another common justification for strategic premiums but are harder to model.There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.Process ImprovementsProcess improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.Should You Pay a Strategic Premium?Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.Concluding ThoughtsTo mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.
Considerations in Merger Transactions
This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.
A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.
Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition.
In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.
Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.
Considerations in Merger Transactions
This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.
A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.
Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition.
In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.
Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.
Strategic Premiums: Can 2+2 Equal 5?
Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this post we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.
Considerations in Merger Transactions
This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition.In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.
The Importance of a Quality of Earnings Study
This is the fifth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets.
Buy-Side Considerations
In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Read the articles in this series.
Peloton, Planet Fitness, and Family Business
Pedaling Too Close to the Sun
Think back to March 2020. Many businesses and operations saw immediate stoppages and closures with no idea when they could restart. The fitness industry was no exception. Planet Fitness, the gym operator, completely shut down its locations and its stock plummeted. Peloton Interactive saw sales surge for its at-home exercise spin-bike and its stock soar.In short: these two businesses entered very different seasons at the onset of the COVID-19 lockdowns and slowdown. Planet Fitness was facing a sudden and bitterly cold winter, while Peloton was spinning its way into summer. But as Barron’s highlighted recently, fortunes and seasons can change quickly. We often compare stock prices to scoreboards, and currently, the at-home-fitness company Peloton is receiving a drubbing. Its stock is down a dot-com bubble-esque 91% from its all-time high. Revenue fell in the most recent quarter, and EBITDA fell from near-break-even in fiscal 2021 to nearly a $1.2 billion EBITDA loss (a negative 31% margin). Meanwhile, Planet Fitness, the no-frills gym operator that franchises the majority of its locations, is ready to flex in 2022. Revenue and EBITDA are expected to surpass 2019 levels and the company plans to continue opening new gyms. But what can family businesses learn from this rapid change in fortunes for these two companies? We think there are three lessons that can prevent you from pedaling in place: understand what season your business is in, be prepared for slow-downs, and diversify prudently.What Season Is Your Family Business In?How you invest, or plant, and your decision to diversify and return capital, or harvest, depends in part on your family business season (Travis Harms expounds on this great analogy here). In short, just as any farmer worth his salt knows what time of year to plant and harvest, businesses need to have a keen understanding of where their business sits before making a major capital investment or allocation decisions.Planet Fitness saw a fast-approaching winter with the onset of the COVID-19 pandemic and cut costs drastically. It also worked with its franchisees to defer required equipment outlays in order to preserve capital for its operators. In an industry that saw 17% of all fitness studios and gyms fail in 2020, Planet Fitness’s CEO was proud to report none of its gyms closed over the course of the pandemic. As we highlighted in our 2021 Benchmarking Guide, many smaller companies curtailed capital expenditure and lowered distributions in the face of uncertainty to preserve capital. Family businesses need to make decisions that reflect both the sunny days and the coming squalls as they exist today, and be flexible enough to do so.Winter Is (Or Will Be) ComingWhile we have the benefit of hindsight, management at Peloton appears to have been dreaming of an endless summer. Revenue skyrocketed, with its bikes and treadmills perfect for people that were looking for ways to stay active at home. Peloton responded to its incredible growth by sacrificing margin to deliver more equipment quicker to its customers as well as committing to build a factory to speed up production. The company spent massively on marketing and its headcount rose precipitously.Where did this lead? Growth plans have now been cut in the midst of a demand slowdown, Peloton’s CEO stepped down, and production was halted as unsold inventory sat in warehouses. Its stock currently sits at all-time lows.While we do not wish to play Monday morning quarterback regarding Peloton’s decisions, perhaps a bit of temperance in its growth plans could have staved off the nasty hangover the company is currently experiencing. Protecting its margin and maintaining a sober view of notoriously fickle fitness spending trends, as well as holding more dry powder, could have all served the company well. Regardless of exact policy prescriptions, family businesses should manage their companies through long-term colored glasses, rather than assuming sunny days will always be with us.Keep Your Wardrobe VariedThe reversal of fortunes for Planet Fitness and Peloton highlights another old maxim: Don’t put all your eggs in one basket. Per BMO Capital Markets analyst Simeon Siegel, “[Planet Fitness] embraced an omnichannel offering, [Peloton] argued solely for At-Home. Even the most high profile digital-only retailers realized they need to meet the customer where the customer wants to be, and not restrict their options.”Peloton draws an almost cult-like following from its adherents and boosts high usage rates and low subscription churn. However, its end-users do represent a market niche, and Peloton overestimated the change in market dynamics brought on by the pandemic to expand its singular end-market. While the company is currently tightening its belt and looking to diversify its app offerings, whether new management can shift the company into the right gear remains to be seen.Planet Fitness, in addition to its non-ostentatious wardrobe and defensive posture, is using success to fund smart diversification. Its digital fitness app is the number two free app on the Apple Store, and the company is currently beta testing a paid version to take a slice of the digital fitness market. While likely not to convert to a digital-first company overnight, Planet Fitness sees this diversification to strengthen its core business: Asset-light, low-frills, and industry-leading pricing.Stuck in Colder WeatherNobel Prize-winning economist Paul Samuelson once said that Wall Street had predicted nine out of the last five recessions. And while some economists or perma-bears may sometimes overreact to the state of the economy, the fall from grace of Peloton has us thinking more about how family businesses can weather storms when they undoubtedly arrive.Family businesses think of their lifespans over generations, and we think this gives them the perfect perspective to face the current stock-market sell-off, rise in interest rates, and potential economic slowdown.Understanding your business season, preparing for the downside, and intelligently diversifying are all ways family businesses can traverse the middle way.
Have Reserve Reports Been Relegated To Investor Footnotes?
In the early part of my career, I vividly recall first learning about what was then arguably the most important document that an upstream company produced – the reserve report. Full of pertinent information, the reserve report struck at the heart of an oil and gas company’s economic relevance.The now discontinued Oil and Gas Financial Journal once described reserves as “a measurable value of a company’s worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s Proven Developed Producing (PDP), Proven Developed Non-Producing (PDNP), and Proven Undeveloped (PUD) reserves was key to understanding the fair market value of the company. Investors and analysts looked to the reserve report before reviewing the financials sometimes.Not these days.Consigned to back pages, footnotes, and appendices, the reserve report’s relevance has waned. Current investor presentations of four Permian-focused oil and gas companies (Pioneer, Centennial, Laredo, and Callon) exemplify this. What I found pertaining to reserve reports continues a years-long trend and was a far cry from what I saw for most of my career. Only one, Laredo, spent any meaningful discourse on their reserve report over the course of a few pages in their investor presentation. They were the smallest company of the group. As for the others: Centennial and Callon spent one whopping page each on their reserves; and the most valuable of them all, Pioneer, showed a single curt reserve figure just in front of their footnotes.Investor presentations are notable in that they represent a company’s current communication to investors, aspiring to highlight some of the most important information investors want to know. Under that argument, management believes investors don’t care to know much about reserve reports.For decades, an oil and gas company (all else being equal) often expected to have an enterprise value somewhat close to their PV-10 calculations in their annual reserve report.Not these days.The table below shows that current Permian valuations don’t track very close to their PV-10 figures at all. Remember, SEC pricing utilized in these PV-10 calculations below were $66.56 per barrel and $3.60 per Mcf. The enterprise values below reflect today’s prices of over $105 per barrel and over $7.50 per Mcf so price volatility is also a big factor considering that reserve reports reflect a snapshot in time, just like values. We also looked at the enterprise value relative to developed and oil reserve mixes. No clear pattern emerged there either. It begs the question: if Pioneer is lapping the others regarding this time-tested metric, why are they currently burying it next to the fine print? As of May 11, 2022 Source: S&P CAPIQ
The answer is because investors are focused on other things – namely the types of themes that show up in the big bold print of these investor presentations: returns to shareholders, free cash flow and deleveraging. Looking through that lens, we noticed a clearer picture of why Pioneer is valued so highly. Let’s quickly analyze these other metrics in the table below:
As of May 11, 2022 Source: S&P CAPIQ
Immediately Pioneer’s dividend yield and Debt/EBITDA ratio stand out on this table. Pioneer is also the only company on this list with an investment grade credit rating. This appears to be what investors notice. It can’t be understated that the return of capital theme is emphasized for the first ten pages of Pioneer’s investor presentation. Laredo, Callon and Centennial all centered their presentations on these themes too, sans the dividend yield that they don’t have. Valuations appear to be driven by: (i) near term cash flows, (ii) returns on capital, (iii) well margins, and (iv) deleveraging.
There are other ancillary things that analysts and management teams additionally reference frequently such as: held by production (margin related metric), cost per lateral foot drilled (margin related metric), and inventory (near term cash flow related metric). Reserve reports speak into some of those things, but certainly not all and not comprehensively. Stock prices suggest that investors are less concerned about having 15 years of reserves life, or what a company’s probable and possible reserves could be, but more about how profitable next years’ worth of wells will be. It’s also clear that investors do not want management teams beholden to their bankers for capital but prize the ability to operate more self-sufficiently going forward.
It is not that reserve reports are obsolete. They have valuable information, and the core components of value are still found within the walls of a detailed reserve analysis. Reserve reports give investors an idea of the possible production management can reasonably be sure of getting. That’s critically important. It also shows investors what production profiles look like for a company’s current (and perhaps future) wells. It also endeavors to measure near term well drilling and production costs. Bankers still utilize reserve reports as an input to lending decisions (although there has not been much reserve lending happening lately with the deleveraging trend).
Most of the elements I touched on above (near term cash flows, returns on capital, well margins) can be dug out of the details of a reserve report. What’s different now is that how production, costs, risk, and growth are analyzed have gotten more nuanced, detailed, and challenging. More layered analytical work needs be done in an increasingly complex, regulated, and integrated global oil and gas market. So, can an investor reliably breeze through a reserve report, look at proven reserves, an SEC pricing deck, and a 10% standardized discount rate to come up with the fair market value of an oil and gas company?
Not these days.
Originally appeared on Forbes.com.
Review of Key Economic Indicators for Family Businesses in Q1 2022
In this week’s post, we take a look at a few key macroeconomic trends that developed in the, shall we say, busy, first quarter of 2022. Between volatile equity markets, mounting global geopolitical tensions, raging inflation, and increasing interest rates, a lot went on in the year's first quarter from a macro perspective.We hope that the discussion below cuts through some of the “noise” and provides our readers with a concise and unbiased look at economic trends from the first quarter of 2022. Data and commentary are largely sourced from Mercer Capital’s National Economic Review, which is published on a quarterly basis and summarizes macroeconomic trends in the U.S. economy in each quarter.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the first quarter of 2022 decreased at an annualized rate of 1.4%. The decrease was driven by declines in private inventory investment, exports, and government spending (federal, state, and local). Mitigating factors to the decrease in GDP were increases in personal consumption expenditures, nonresidential fixed investment, and residential fixed investment. Imports, which are subtracted from national income and product accounts, increased in the first quarter of the year, which also led to the decline in GDP growth in the first quarter of the year.Economists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecastEconomists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecast. A survey of economists conducted by TheWall Street Journal in April reflects an average GDP forecast of 3.0% annualized growth in the second quarter of 2022, followed by 2.8% annualized growth in the third quarter. While these estimates call for GDP growth to resume in the next two quarters, respondents in the survey pegged the probability of a recession in the U.S. in the next 12 months at 28%, which is up from 18% in the January survey. The downgrade in GDP expectations and increased probability of a recession is primarily predicated on the surging rates of inflation seen in the first few months of 2022 and the Fed’s potential response to this rampant inflation. Still, a majority of survey respondents (63%) believe that the Fed will be able to rein in inflation without triggering a recession.Click here to enlarge this imageInflationEstimates from the Bureau Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.3% in April 2022 on a seasonally adjusted basis after rising 1.2% in March. On a year-over-year basis, the CPI increased 8.3% from April 2021 to April 2022 following an increase of 8.5% annual increase in March 2022. Individual indexes that saw the greatest month-over-month increases in April were the shelter, food, airline fares, and new vehicles indexes. The Wall Street Journal survey reveals the expectation that inflation will remain persistent through the balance of 2022, as respondents predicted, on average, an annual rate of 7.5% in June 2022 and 5.5% by December 2022 before falling back to 2.9% by late 2023.According to a Wall Street Journal survey, expectations are that inflation will remain persistent through the balance of 2022The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI increased 0.5% month-over-month in April 2022 and 11.0% in the twelve months ended April 2022.Monetary Policy and Interest RatesAt its March meeting, the Federal Open Market Committee ("FOMC") voted nearly unanimously to lift the benchmark federal-funds rate by a quarter percentage point to a range of 0.25% to 0.50%. After the meeting, Chairman Powell signaled the possibility of the FOMC raising rates in half-percentage point increments at some point in 2022 rather than quarter-percentage point increments, which the Fed has not done since 2000. The FOMC acted on this possibility at its recent May meeting, as it unanimously approved a rare half-percentage-point rate increase, which raised the benchmark federal-funds rate to a target range of 0.75% to 1%. Following the May meeting, Chairman Powell stated that FOMC members broadly agree that additional half-point increases could be warranted in June and July to continue to combat surging inflation in the economy.ConclusionIn summary, the broad consensus among economists is that inflation remains the primary macroeconomic risk in the U.S. This has caused the Fed to respond aggressively thus far in 2022, as the speed and magnitude of rate increases have outpaced prior expectations for 2022, and the Fed appears primed to continue to aggressively increase rates. The balancing act for the Fed going forward will be attempting to thread the needle between cooling the economy enough to rein in record levels of inflation, but not so much that it accidentally creates a pullback in consumer spending and increases in unemployment.Family business directors and management teams should keep an eye on upcoming FOMC meetings. Commentary from these meetings offers insight into the future direction of the U.S. economy.Family business directors and management teams would be well-served in the coming months to keep an eye on upcoming FOMC meetings and subsequent commentary in the wake of these meetings. While this appears to be neither a glamorous nor exciting suggestion, commentary following these meetings does offer a great deal of insight into the future direction of the U.S. economy, given that the FOMC’s primary goal in executing its rate increases is to rein in inflation, which is almost certainly having real and tangible effects on nearly all family businesses right now.
Is a Slowdown in RIA M&A Imminent?
RIA M&A activity and multiples have trended upwards for more than a decade now, culminating in new high watermarks for both activity and multiples set late last year. Deal momentum continued strong into the first quarter, but we sense at least initial signs of slowing as the macroeconomic backdrop has deteriorated.What Does the Future Hold for RIA M&A?On CI Financial’s first quarter earnings call last week, CEO Kurt MacAlpine remarked that the company’s acquisition pace has “absolutely slowed down” relative to 2021 as they focus on integrating existing firms and delivering. We suspect that other serial acquirers will follow a similar path as CI this year, particularly in light of rising interest rates and declining fundamentals for existing firms. Add to that the challenges of negotiating a deal when equity markets are swinging as wildly as they have been, and it’s easy to imagine at least a temporary slowdown in the pace of M&A in the coming months.The driving force in recent years has been strong demand and low supply for investment management firmsWill we look back at 2021 as the year RIA transactions peaked, or is the current slowdown merely a blip on the radar amidst a longer-term trend of consolidation and rising valuations? To look forward, it’s helpful to first consider what shaped the RIA transactions landscape over the last decade. In short, the driving force in recent years has been strong demand and low supply for investment management firms. On the demand side, the amount of capital and number of acquirer models has increased rapidly in recent years as investors have sought out the high margins, strong growth profile, and low capital intensity that the fee-based business model offers.At the same time, the number of RIAs in the market for a third party acquirer has remained limited, despite the industry’s often cited lack of succession planning. As the ratio of buyers to sellers has increased, so too have multiples and transaction activity.We don’t see those long-term supply and demand dynamics changing with the current market environment. Certainly, some buyers (like CI) will be sidelined temporarily, but they’re still around. When markets eventually stabilize, it’s more than plausible that transaction activity will return to the long-term trendline.What About Multiples?Supply and demand dynamics have certainly played a role in the rising multiples we’ve seen over the last decade, but the macroeconomic backdrop has added fuel to the fire as well. The era of extremely low interest rates lowered the cost of capital for acquirors and enabled consolidators to finance RIA acquisitions with cheap debt. And a persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deck.A persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deckSo far this year, margins for RIAs have been attacked on two fronts: falling equity markets eroded the fee base, while high inflation and a tight labor market threatened to drive up personnel costs and other overhead. There’s a lot that goes in to pricing, but it’s safe to say that on many recent transactions, the buyer’s projection model likely looked very different than what’s actually transpired so far this year. While many of these deals may work out in the long term, chances are there are sellers out there who feel they timed things perfectly, and some buyers that feel they’ve been left holding the bag.With the cost of capital for aggregators rising rapidly and the growth outlook for RIAs declining, we expect to see some multiple contraction relative to the high watermarks seen last year. And while private transactions for wealth management firms have historically been priced very differently than public asset/wealth management firms, it’s equally likely that at least some of the decline we’ve seen in the public firms will translate to the private markets.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance and transaction activity. As it stands, a near-term slowdown in transaction activity and multiples seems likely, but so too does a return to normal once markets stabilize.
Themes from Q1 2022 Earnings Calls
Part 1: Upstream
In Part 1 (E&P Operators) and Part 2 (Mineral Aggregators) reviews of Q4 Earnings Calls, prevalent themes among the E&P Operator calls included cost inflation, a shifting focus towards liquids, and policy headwinds towards the Oil & Gas industry. Among the mineral aggregators, common themes were capital discipline, flat production growth, and the strength in the position of aggregators amid the highly inflationary environment.This week, we take a holistic upstream perspective on the themes of both the E&P operator and mineral aggregator earnings calls for Q1.The Future Role of U.S. Production in the European MarketRussia invaded Ukraine on February 24, 2022. Global markets blinked, and commodity futures skyrocketed. In the weeks following the invasion, European nations discussed plans to phase out sourcing energy from Russia. With OPEC holding firm on its production plans, attention turned towards the U.S. — the world’s largest hydrocarbon producer and a vocal supporter of sanctions towards Russia. Upstream Oil & Gas companies recognize that their role in supplying European energy markets, and the global market generally will grow.“As the war in Ukraine and the resulting governmental sanctions continue, Russia's oil production is expected to be impacted by shut-ins, natural declines, storage limitations and lower exports, creating a global shortage of oil. Over the next few years, we will need to make up for this lost production, and we believe that the U.S. oil and gas industry is best suited to provide the low-cost environmentally-friendly barrels needed to ensure global energy supply. However, today, we are operating in a constrained environment with inflationary pressures continuing to increase across all facets of our business. Also labor and materials shortages are now present across the supply chain…[an] increase in activity now would result in capital efficiency degradation that would not meaningfully contribute to fixing the global supply and demand imbalance in the oil market today.”
– Travis Stice, Chairman and CEO, Diamondback Energy
“The reality is that energy markets were already tightening from supply and demand fundamentals before this Russian action, and the risk premium now embedded in commodities, including oil and gas has returned with a vengeance. Even in the unlikely event of a near-term resolution to this crisis, the die has been cast and actions, particularly by European countries are already underway to move away from Russian oil and gas and secure more reliable supply from the Middle East and the U.S. It has underscored the need for an orderly energy transition that includes oil and gas as part of all of the above strategy, and has recalibrated global views as to the current and ongoing role of U.S. oil and gas in the world economy.”
– Lee Tillman, Chairman, President and CEO, Marathon Oil“On the supply side, the shift towards maintenance capital plans and supply chain constraints led to moderated global supply growth. Then during the first quarter of 2022, this bullish fundamental backdrop was further strengthened by the geopolitical events in Europe. Unlike prior commodity price spikes, these events had a large impact on the futures curve, where we saw the natural gas strip move up 45% throughout the curve all the way to calendar year 2026. As Europe looks to strengthen its energy security, it has become clear that there will be a significant call on U.S. shale gas in the coming decades.”
– Paul Rady, Chairman, President and CEO, Antero Resources“Recent world events have highlighted the global strategic importance of U.S. gas reserves, and we believe the Haynesville shale is the best position play to benefit from continued growth in LNG export volumes over time.”
– Tom Carter, Chairman and CEO, Black Stone MineralsConfidence of Continued Favorable PricingIn Part 1 (E&P Operators) of the Q4 earnings call themes, we noted upstream companies’ strong desire to reap the full benefits of the pricing environment. Executives focused on shorter-term deals, unhedged positions, and a more opportunistic approach when it came to derivatives contracts. With fewer hedges in place or shorter-term contracts, operators continue to pursue maximizing their upside from continued price appreciation or a prolonged favorable pricing environment.“We’re happy where we are right now on shorter-term deals, whether it’s selling on the day or on the month. We’re not interested in longer-term supply deals unless we receive significantly higher premiums. There is too much optionality today to get in prematurely. We are virtually unhedged on all commodities in 2023. This attribute will allow us to capture the upside to growing LNG and LPG export demand.”
– Paul Rady, Chairman, President and CEO, Antero Resources“As we look to 2023, we have positioned the portfolio with a good base layer of hedges. With strength in the oil and natural gas, we’ll opportunistically add 2023 hedges over the remainder of this year. However, we expect to hedge less volumes, or said another way, a lower percentage of production than we have historically.”
– Kevin Haggard, Senior Vice President and CFO, Callon Petroleum“If oil prices were to average $60 for the remainder of the year, Pioneer's shareholders would receive approximately $17 in dividends per share. At $120, approximately $31. Shareholders have significant upside on higher oil prices as we have zero 2022 oil hedges.”
– Scott Sheffield, CEO and Director, Pioneer Natural Resources“While the Permian led all of the basins in terms of growth in rig count, we believe strong natural gas prices will compel improved activity in the Haynesville, Marcellus and Mid-Con as we continue through 2022.”
– Bob Ravnaas, Chairman and CFO, Kimbell Royalty PartnersCompletions Trending UpUpstream operators commonly noted that their Q1 completion rates increased, with expectations that completions will continue to increase throughout 2022. This is an encouraging sign for aggregate production.“[Regarding] completions, our field team continues to see really good improvements and they’ve increased their overall completed lateral per foot per day by 10% compared to 2021.”
– Jeff Leitzell, Executive Vice President-Exploration & Production, EOG Resources“As you mentioned, 11-wells went online earlier, and they are performing above the type curves. We still have six more to turn online, making 23 Eagle Ford for this quarter. And we have even more wells set to come online in the Eagle Ford through third quarter. It is very early, but we’re very excited about the wells coming online earlier and at higher results.”
– Molly Smith, Vice President of Drilling and Completions, Murphy Oil“The decrease in oil volumes was primarily a result of lower suspended revenue volumes received in this quarter as compared to last quarter. Our staff successfully worked with producers in the second half of last year to release suspended production volumes across our mineral position… Given the temporary nature of these items and combined with the generally positive industry environment and the ramp up in activity, we expect to see the Haynesville and Austin formation shock through our organic growth programs. We expect that growth trajectory to resume throughout the year.”
– Jeff Wood, President and CFO, Black Stone Minerals“Strong commodity prices during the quarter translated into increased activity on our acreage as evidenced by the 20% increase in the rig count actively drilling on our acreage at no cost to us. In addition, line of sight inventory from our major properties increased 6% sequentially to 5.03 net DUCs and permits. This is notable since we only need approximately 4.5 net wells completed each year to keep production flat.”
– Bob Ravnaas, Chairman and CFO, Kimbell Royalty Partners “Looking ahead, our net activity well inventory, which represents the combination of our drilled but uncompleted locations, or DUCS, in our permits was 11.7 net locations at the end of the first quarter, our net DUCs and inventory at the end of the first quarter stayed roughly flat versus the fourth quarter, despite our extremely strong aforementioned DUC conversions. We anticipate that PDC, Chevron, Pioneer, Oxy, and Diamondback will convert the majority of our DUC inventory.”
– Rob Roosa, CEO, Brigham MineralsConclusionMercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators in the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact a Mercer Capital Oil & Gas Team member for further assistance.
Case Review: Observations From a Recent Auto Dealer Litigation
A recent Appellate Court decision was released from a case (Thomas A. Buckley v. Grover C. Carlock, Jr. et.al.) that we were directly involved in back in 2019. The case centered around a shareholder oppression issue involving a minority owner of an “ultra-high-line” auto dealership. Mercer Capital was hired by the Defendant to serve as the expert witness.The company at issue, TLC of Franklin, Inc. (“the Company”), was an official auto dealer for Aston Martin, Alfa Romeo, Lotus, Maserati, Rolls-Royce Motorcars and Bentley. The valuation aspect of the case required both experts to determine the fair value of the oppressed shareholder’s 20% interest in the Company as of January 31, 2017.The Appellate Court upheld and affirmed the Trial Court’s determination of value of the 20% interest. A summary of each expert’s valuation opinion and the Court’s conclusion of value is as follows: The nature of the Company’s underlying operations created several valuation challenges in this case. First, the unique set of the brands offered by TLC, that are referred to as “ultra-high-line,” is not as prevalent in auto dealerships across the country. Among the nearly 17,000 auto dealers in the U.S., there are very few that retail the premium brands offered by TLC of Franklin. Because of this, there is little published data on these franchises – from details of their historical profitability to market multiple representations of their value in transactions. The other challenge presented in this case was that the Company’s historical operations did not report consistent profitability during the reviewed period. In this post, we highlight the differences in the assumptions and conclusions of both valuation experts, as well as provide observations regarding some of the commentary provided by the Trial and Appellate Courts in arriving at the ultimate conclusion of value. We also touch on normalization adjustments, valuation methodologies, and the way in which the Court decided its determination of value.Normalization Adjustments to EarningsWhat Are Normalizing Adjustments?It is important in the valuation of an auto dealership to review the company’s financial statements to determine if any normalization adjustments should be made. Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Typical normalizing adjustments to the income statement are made to non-recurring items, as well as discretionary expenses related to current management that would not necessarily be incurred by a hypothetical owner of that business. As mentioned previously, the actual historical operating performance of the Company was inconsistent during the reviewed period. In some years, the Company reported operating losses, making the determination of these adjustments difficult.The Experts’ Application of Normalizing AdjustmentsThe experts disagreed with respect to the magnitude of normalization adjustments, though they agreed such a normalization adjustment would be necessary. For example, after directly identifying several adjustments to earnings, Mercer Capital selected a 1.5% normalization factor of pre-tax earnings-to-revenue based on the Company’s actual operating performance, similarly sized auto dealerships, and our experience valuing luxury and ultra-high-line dealerships. The Plaintiff’s expert determined a normalization factor of 5% of pre-tax earnings-to-revenue based on their experience valuing ultra-high-line dealerships.The Trial Court’s DeterminationThe Trial Court selected a normalization factor of 2.8% - 2.9% of revenue based upon historical data for 2015 and 2016 as published by the National Auto Dealers Association (“NADA”). Specifically, the Court cited annual historical profitability for “Luxury” and “Import” brands noting they were the best comparison to TLC of Franklin. Until October 2021, NADA published monthly profitability data referred to as Dealership Financial Profiles for categories of auto dealerships, including average, domestic, import, mass market, and luxury, and the Trial Court relied heavily on this data.The Use of Industry Comparable DataThe use of comparable data to compare a subject company to industry averages can be important to the valuation process. While NADADealership Financial Profiles is more specific than general industry profitability data, such as the Annual Statement Studies provided by the Risk Management Association (“RMA”), no single comparison is perfect, and appraisers should be careful in applying average percentages to their subject company.The use of comparable data to compare a subject company to industry averages can be important to the valuation process.TLC’s ultra-high-line brands were not included in the descriptions of the NADA Dealership Financial Profiles classifications, even among luxury dealerships, despite connoting a similar type of consumer. In reality, the representative average data in these studies is comprised of many dealers performing at higher or lower levels than the ultimate average. A rigid comparison to the average could potentially ignore the fact that the subject company has been performing below average since its operation or in recent history.The other caution against a rigid normalization adjustment to an industry benchmark is the implied level of the resulting adjustment. In other words, by normalizing a company to a certain % of pre-tax earnings, what is the resulting dollar amount of the adjustment? Take, for example, a company with revenues of $35 million. To normalize earnings to a 5% pre-tax earnings level would imply that there are $1,750,000 of expenses to be normalized or added back.The Plaintiff’s expert offered no evidence or specific expenses that would rise to that level in their review of the historical financial statements. Mercer Capital determined several normalization adjustments to earnings after reviewing the Company’s financial statements and discussions with management before making an overall normalization adjustment of 1.5% of earnings based on our experience with similar dealerships to TLC.Valuation Methodologies UsedIncome ApproachThe income approach is a general way of determining the value indication of a business or ownership interest using one or more methods that convert anticipated economic benefits into a single present amount. The income approach allows for the consideration of characteristics specific to the subject business, such as anticipated earnings, level of risk, and growth prospects relative to the market.Mercer Capital ultimately determined the value of the subject interest through the use of a capitalization of earnings method. Historical earnings were adjusted through a combination of direct normalization adjustments and an industry adjustment to 1.5% of revenues. The resulting value under the income approach represents the overall value of the dealership, both tangible and intangible. The difference between the overall value of the dealership under the income approach and the value of the dealership’s net tangible assets represents the implied value of the dealership’s intangible or Blue Sky value. Therefore, Mercer Capital’s income approach included and quantified the Blue Sky value of TLC.The application of the income approach assumes that the company possesses the appropriate level of assets and liabilities to produce the level of anticipated earnings in the income approach. Only non-operating or excess assets are added to the value determined under the income approach. For example, some dealerships carry much more cash than needed for operations before eventually distributing it to owners. In such cases, the excess cash is added back on top of the indication of value under the income approach.Mercer Capital did not identify any non-operating or excess assets owned by TLC. Therefore, no assets were added to our conclusion of value under this approach.The Plaintiff’s expert did not employ an income approach in his determination of value.Market Approach – Recent TransactionsOne method under the market approach is to examine any transactions within the subject company's stock. Appraisers will often examine whether any transactions have occurred, when they occurred, and at what terms they occurred. There is no magic number, but as with most statistics and data points, more transactions closer to the date of valuation can often be considered better indicators of value than fewer transactions further from the date of valuation.Three transactions occurred within the stock of TLC in the three to five years prior to the date of valuation. A summary of those transactions and their indicated equity values are as follows: The Plaintiff’s expert used the internal transactions as one of his three valuation methods but only relied upon the first and third transaction in the figure above. All three transactions occurred in relatively similar proximity but obviously indicated materially different implications of overall value. Ironically, the second transaction that the expert excluded involved the plaintiff’s buy-in to the company. The third transaction involved a minority sale to a celebrity, and no evidence was provided as to the motivations of the buyer and seller in that transaction or whether any financial information or due diligence was performed by the buyer. As such, it may be reasonable to consider this transaction less reliable as an indication of value than the other two. The first transaction was for a 75% interest, which represents a controlling interest basis, which is a different level of value than the other two transactions. Since the subject interest is non-controlling, the level of value would be more comparable to the last two transactions in the table above.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. Suppose there have been multiple internal transactions, such as with TLC of Franklin. In that case, appraisers must determine the appropriateness of which transactions to include or exclude in their determination of value possibly. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to consider all of the transactions or exclude all of the transactions with a stated explanation.The Trial Court was critical of the Plaintiff’s expert’s exclusion of transaction #2 and noted the material impact it would have on concluded values.Mercer Capital observed the internal transactions of TLC but did not place any reliance on this method.Market Approach – Blue Sky MethodUnder the market approach, the Blue Sky method determines value by applying a brand-specific multiple to pre-tax earnings. This method estimates the intangible value or franchise rights of the specific brands they retail.Blue sky multiples are published quarterly by two sell-side advisory firms in the auto dealership industry: Haig Partners and Kerrigan Advisors. Specific multiples are calculated and presented for each represented brand by quarter based on observed transactions. It should be noted that neither Haig nor Kerrigan publishes any multiples for ultra-high-line dealerships or any of the brands retailed by TLC.The Plaintiff’s expert concluded a Blue Sky multiple of 8x based on reported multiples for luxury brands and applied that multiple to two different income streams. First, he applied the Blue Sky multiple to normalized earnings based on his 5% pre-tax figure described previously. Secondly, he applied the Blue Sky multiple to projected earnings based on figures from a management presentation.The Trial Court was especially critical of the use of projections for TLC since it was not a start-up entity. Projections are rarely used in the valuation of auto dealerships. It should also be noted that no evidence was provided as to where the management projections came from, who produced them, and for what purpose. Blind or rigid reliance on management forecasts should be avoided especially if they are not discussed with management. Projections should be viewed with caution, especially in instances where projected results greatly exceed historical operating results or if the company has historically performed below previous projections or budgets. If projections must be used, appraisers typically account for this by using more conservative multiples to balance these lofty projected earnings.To these approaches, the Plaintiff’s expert added back the net tangible assets of TLC since these methods estimate the intangible value or franchise rights of the brands represented by the dealership.Mercer Capital did not rely on a direct Blue Sky method to value TLC since no published multiples exist for the brands represented by TLC. When applicable, we employ the use of a similar methodology to value dealerships in conjunction with or to support the valuation determined under another method, such as the income approach. The transaction multiples reported by Haig and Kerrigan are derived from negotiations between buyers and sellers. The ultimate consideration paid is determined by the buyer’s assessment of expected cash flows, the growth potential of those cash flows, and the anticipated rate of return. The multiple reflects the price paid in relation to a financial metric, in this case pre-tax earnings.Courts’ Determination of ValueThe Trial Court ultimately determined value through several calculations. The Court utilized the profitability data provided by the NADA Dealership Financial Profiles for luxury and import dealerships for 2015 and 2016 and applied profitability factors of 2.9% and 2.8% to TLC’s historical revenue for those years.The Court concluded the use of an 8x multiple or factor to normalized pre-tax earnings to estimate value for TLC. The Court’s final conclusion of value for the subject 20% interest was $1,745,500. This conclusion included an average of those four calculations along with half of the adjusted net assets to reflect the inclusion of market and income methods. The Appellate Court affirmed the concluded value and methodology used by the Trial Court in this case.ConclusionAs evidenced by this litigation case, the valuation of auto dealerships can be very challenging and complex. The subject company, in this case, provided additional challenges given the unique specialty of the brands that they retail, combined with their inconsistent and lack of historical profitability.Mercer Capital provides valuation services to auto dealers and their advisors all over the country for litigation and non-litigation purposes. Contact a Mercer Capital professional today to learn more about the value of your dealership or if we can assist you in a litigation issue involving the value of your dealership.
Your Family’s Guide for the Next 100 Years
How does your family business think about success? James Hughes poses a question to the reader early on in Family Wealth: Keeping It in the Family that likely reorients our focus relating to successful family enterprises.“The Question: Can a family successfully preserve its wealth for more than one hundred years or for at least four generations?” – (Hughes, 2004, p. 4)In our need-it-now, two-day-shipping-is-too-slow modus operandi of 2022, the thought of thinking in centuries seems almost quaint. But Hughes successfully supports the importance of this mindset in a way that would make even the most “next quarter’s numbers” advisor or family board member think twice.Long-Term Wealth PreservationHughes is now a retired sixth-generation counselor-at-law, prolific author, and renowned multi-generation family meeting facilitator. He has advised numerous wealthy families on how to maintain and grow their wealth over time. Hughes views “shirtsleeves to shirtsleeves in three generations” plaguing family businesses not as destiny but as a cycle family businesses can overcome with thoughtful practices and patience over many years.Wealth is more than what your business is worth or the size of your brokerage account.“Wealth,” according to Hughes, is more than what your business is worth or the size of your brokerage account. A family’s wealth includes the family's human, intellectual, and (purposely placed last) financial capital. Families struggle to preserve wealth over generations due in part to not focusing on two of the three sources of family capital, failing to realize that human capital (health, well-being, and happiness) and intellectual capital (education and life experience) lead to an expansion of financial capital.In practice, families should aim “over a long period of time, to make slightly more positive than negative decisions regarding employment of their human, intellectual, and financial capital” (Hughes, 2004, p. 36). This series of positive decisions includes creating effective family governance structures, supporting each member’s pursuit of happiness, and a consistent reaffirmation of the family’s governance and vision. Only with constant reaffirmation, inculcation, and cultivation can a family hope to sustain itself over multiple generations.Practices for Your Next Family CouncilA strength of the book is its mix of real-world examples with philosophy, economics, and political theory. Homer, Aristotle, psychology, and pedagogy all make it in Family Wealth, making it both an informative and practical look at how we should view family businesses and enterprises.For example, chapter 3 on “Ritual” includes a short summary review of “rituals” as they relate to ancient families and tribes. Hughes then provides modifications and applications of these “rituals” for modern businesses and family enterprises. The chapter is couched in anthropologist Arnold van Gennep’s framework from The Rites of Passage in discussing rituals. Chapter 10 on “Beneficiaries” discusses how beneficiaries to familial trusts should handle and view their responsibilities and role as a beneficiary, as well as beneficiary education. Hughes leans on his practical experience with aggrieved and unhappy beneficiaries to provide a simple list of roles and responsibilities for beneficiaries to ensure familial harmony and happiness.Most of the book follows this style, highlighting in bite-sized 5-to-10-page sections, various practices and questions that affect family businesses and boards. These include crafting a family mission statement (chapter 2), the family bank (chapter 7), family philanthropy (chapter 12), and the roles of aunts and uncles (chapter 16) to name a few. Chapters are woven within common themes, but each has the weight to stand alone and act as a springboard at a family council or advisory board meeting.You Have No Time to WasteThere is a common, inconvenient thread throughout the book in its lessons and applications: there are no shortcuts. Besides saving for retirement or raising a child, the difficulty of making up for lost time reveals itself in the power of compounding. Failing to inculcate your family’s values or educate the next generation on the family business may not rear itself head early on or even over the next generation. Rather, the consequences manifest in the "shirtsleeves to shirtsleeves" adage that spells the end of many a successful family enterprise.Failing to inculcate your family’s values or educate the next generation on the family business may not rear itself head early on or even over the next generation.But family businesses are not powerless. Hughes’ book serves as a helpful guide to drive conversations and lays a roadmap for your family business for years to come. Other families have done it, with names synonymous with wealth and longevity such as the Rothschilds and the Rockefellers. Hughes shows that your family is capable of such longevity with careful planning, deliberate practice, a solid governance structure, and a long-term focus.Hughes’ favorite metaphor for long-term wealth preservation is the tree that adorns his book’s cover: the copper beech tree. This tree is found in the northeastern United States, takes 150 years to mature, and no one who plants a seed of a copper beech tree will see it fully grown. Years of nurturing and protection are needed from those who will not fully be able to appreciate its grandeur – but early planters have a perspective beyond even their lifetimes.The famous French General Mashal Lyautey, who served under Napoleon, is said to have had the most beautiful garden in France. He told his gardener he wanted to plant a copper beech in his garden, to which his gardener protested, given the work and time it would take. Lyautey is said to have replied without hesitation, “Then we must plant today – we have no time to waste.” Indeed, your family business has no time to waste. The next 100 years start today.
Three Reasons to Hold Cash on the Family Business Balance Sheet
For one weekend a year, the spotlight of the financial world shifts from New York to Nebraska. The annual meeting of the Berkshire Hathaway company has developed a cult following among shareholders and financial journalists alike. A compound annual return of 20% over 55 years (!) will do that for you.Actuarially speaking, the number of opportunities to see Warren Buffett, 91, and his longtime partner Charlie Munger, 98, on stage together at the annual meetings is dwindling. One area of particular interest for the Oracle of Omaha’s followers in recent months has been Berkshire’s overflowing war chest. At the end of 2021, Berkshire’s balance of cash, equivalents, and short-term treasuries stood at nearly $144 billion, compared to $71 billion at the end of 2016, and “just” $34 billion ten years prior.The consummate value investor, Mr. Buffett attributed the growing cash stockpile to an absence of compelling investment opportunities. Better to hold cash than make bad investments, after all. Market volatility in the early months of 2022 did loosen the purse strings a bit as Berkshire made a large acquisition (Alleghany Corp) and built large positions in three publicly traded companies (HP, Occidental Petroleum, and Chevron). All told, the first quarter investing activity drew cash down to approximately $105 billion, which is still enough to cover payroll for a while.Mr. Buffett certainly doesn’t need us to remind him of the perils of “lazy capital” on the corporate balance sheet – the yearend cash stash represented approximately 20% of Berkshire’s overall market capitalization. Giving Mr. Buffett the benefit of the doubt (which he has probably earned at this point in his career), are there any good reasons for family businesses to hold some cash in reserve? In our view, there are three potential benefits to keeping some cash on the balance sheet.Reduce RiskAs the adage goes, no one goes bankrupt holding cash. While modern finance theory suggests that public company managers should not be willing to sacrifice much return to reduce bankruptcy risk, family business directors cannot be so sanguine. Since the family business often represents a significant portion of overall family wealth, corporate bankruptcies are catastrophic for the family. Some families can leave a bit of marginal return on the table if it helps push the likelihood to financial distress to a negligible level. There is no single right answer that will fit every family; however, directors need to acknowledge the tradeoff, calculate the decrement to return from holding cash, and be deliberate about the decision they make.Fund Opportunistic InvestmentsCash is the contrarian’s friend. You can keep wealth by staying in the middle of the investment pack, but you only get wealthy by venturing away from the pack, buying when prices are depressed and other investors are afraid to invest. Or, don’t have the liquidity to invest. While describing the stock market as a “gambling parlor” at Saturday’s meeting, Mr. Buffett acknowledged that the attendant market volatility allowed Berkshire to identify attractive investments saying, “We depend on mispriced businesses.” Unfortunately, credit availability is inversely related to the volume of attractive investment opportunities. To take full advantage of market dislocations, sometimes it helps to be your own banker. Ample cash on the balance sheet can afford your family business that luxury.Be Strategic About OwnershipIn addition to making opportunistic investments, Berkshire has also used its cash hoard to repurchase over $50 billion of shares during 2020 and 2021. So long as markets are efficient, share repurchases are, by definition, a zero net present value project. While Mr. Buffett would prefer to make investments in other businesses, when he believes that attractive opportunities are not available, he has not been averse to buying Berkshire shares.Berkshire doesn’t really care about the identity of its owners. Shareholders come and shareholders go. When Berkshire repurchases shares, it does so in open market transactions, not knowing – or caring – who the selling shareholders are. Family shareholders can be described in many ways, but anonymous is not one of them.DNA is not a reliable indicator of whether an individual will be an effective family shareholder. As a result, there is – for many families – a significant difference between what the shareholder list is and what the shareholder list should be. The capacity of many families to “muddle through” with suboptimal ownership for years and even decades is remarkable. But other families elect to make ownership a strategic priority. It is much easier for families to be intentional about who owns shares in the family business when there is enough liquidity on the corporate balance sheet to repurchase shares from departing shareholders.ConclusionWe have previously sounded the warning about allowing excess cash and other non-operating assets to accumulate on family business balance sheets. We stand by that warning, but the example of Berkshire Hathaway does highlight that – in addition to its (opportunity) costs – cash has its uses. Is there a purpose behind the cash on your balance sheet? Have you accumulated cash with intention or through inattention? What is your cash doing for you?
U.S. LNG Exports
Part I: The Current State of U.S. LNG Export Terminal Facilities and Projected Export Capacity
Up To This Point…From 2010 to 2021, the Federal Energy Regulatory Commission (“FERC”) received approximately145 long-term applications for export facilities seeking to export liquified natural gas to countries both with and without free-trade agreements (“FTA”) with the U.S. Of these 145 applications, 93 (or 64%) have been approved, with approximately 80% of the approved applications coming from submissions made from 2011 through 2016.Up to this point, we have seen applications either submitted or reasonably anticipated to be submitted for approximately 25 export facilities.
To be clear, a significant portion of these applications pertain to capacity expansions to either existing or proposed export terminals where the initial application for a proposed facility was approved, and another application for expanded output volume was later submitted prior to the actual construction of the facility. Additionally, there are separate applications for exporting to FTA and non-FTA countries; if a facility seeks to export to both types, there is one application for the FTA markets and one for the non-FTA markets. In other words, 145 applications received do not directly translate to 145 LNG export facilities.
The number of submitted applications dropped in 2017 and has since remained far below the annual numbers seen in 2011 through 2016. This was primarily caused by the massive decline in LNG export prices starting in Q1 of 2015. The subsequent decline in the applications submitted, which was not very evident until 2016, was not as steep. This was most likely due to project sponsors either hedging against sustained lowered natural gas export prices, or playing into the sunk cost fallacy of submitting an application after already having expended the time and resources necessary to prepare it in the first place.
Further expanding on the element of LNG export prices, the following chart presents the monthly prices of LNG exports from January 2005 through January 2022, with annual 2010-2016 average prices also presented over the time period.
In light of the clear increase in LNG export prices during mid to late 2021, it may be slightly surprising that the number of applications in 2021 and in 2022 (so far) has not picked back up. However, a prior Energy Valuation Insights post noted that there were massive pullbacks in 2020 and 2021 capital expenditures throughout the oil and gas sector. Real growth projections for projected capital outlays in 2022 are modest as upstream operators remain focused on returning capital to shareholders, paired with maintenance level capital expenditures that will keep overall oil and gas production relatively flat or modestly higher. In addition, there are a number of outstanding final investment decisions (“FIDs”) to be made regarding the construction start for proposed facilities that have already received FERC approval. There are drilled but uncompleted (“DUC”) wells in the field – wells that are queued up to be put into action. Similarly, one may think of FERC-approved export terminal projects with outstanding FIDs as, “ready to roll”, relatively speaking, as compared to LNG export projects that still need regulatory approval.
Approved LNG export terminal projects loom over potential new projects that may or would otherwise pursue FERC approval. In essence, the U.S. LNG export terminal market is relatively saturated with projects that could be started and put into operation fairly quickly as compared to new entrants still in the pre-application or pre-approval stages of project development. The development of already-approved projects would increase the capacity to supply global demand for U.S. LNG exports. This would likely tank the underlying economics supporting any new (yet-to-be-approved and pre-FID) projects; and not by virtue of poor planning on the part of project sponsors at the micro level or weak energy prices at the macro level, but rather due to the total timing of the approval process, an affirmative FID, and the construction and commissioning phases of project development. They would be showing up to register for the race right as everyone else was already taking off from the starting line.
On that front, it’s worth taking a look at existing export capacity, total FERC-approved export capacity, and how that capacity may satisfy the demand for U.S. LNG exports.
The Current State of AffairsHistorically, the U.S. has exported LNG to European markets, East Asian markets, and other markets, including within South America, the Caribbean, and within the past six years to parts of the Middle East, including Egypt, Israel, Jordan, and even Kuwait and the U.A.E. As presented in the following two charts, growth in export volumes to the Asian and European markets has far outpaced export volumes to the other markets.
On a forward looking basis, projections of global natural trade by the EIA in its International Energy Outlook 2021 report indicate a natural gas deficit may be the norm over the next 30 years. (Negative values represent net exporters, with positive values representing net importers.)
As it stands, total U.S. LNG export capacity is projected to grow approximately 13% from 14.0 Bcf/d at year-end 2021 to 15.9 Bcf/d by year-end 2022. LNG export volume at year-end 2021 was 9.8 Bcf/d (or 70% of capacity) and is projected to increase 17% to 11.5 Bcf/d by year-end 2022 (or 72% of projected export capacity). Regarding the export terminals themselves, eight were operational at year-end 2021, with one additional facility (Venture Global Calcasieu Pass) expected to be operational and delivering cargo by year-end 2022.Beyond 2022, export volume capacity is anticipated to increase rather sharply, reaching 38.5 Bcf/d (nearly 145% from year-end 2022) in 2027, indicating a compound annual growth rate of approximately 19% in export volume capacity over the prospective five-year period. These projected volumes only consider the 18 export facilities for which the project sponsors have provided an anticipated date of the projects’ operational status; they do not consider the incremental volumes stemming from a new terminals or capacity expansion projects for which it is unclear as to when the additional export capacity might come online. Clearly, the export capacity of U.S. LNG is primed to take off. But take off to where?As we saw in the chart above concerning global natural gas trade projections, with the U.S. presented clearly as a net exporter of natural gas, export volumes are anticipated to rise quickly to just over 18 Bcf/d by 2030, then slowly tick up annually, topping out at around 20 Bcf/d in 2045-2050.To put this in better context, the following chart summarizes the projected export capacity by region and year of anticipated operational status, as well as the projected annual LNG export volumes through 2031.
Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B.
Based on the eye-ball test, it’s pretty clear that projected export capacity could far outstrip demand for U.S. LNG, based on the EIA’s export projections (as of early 2021), only if all that capacity were to come online. Free Market Economics 101 theory would indicate, rather decisively, that such excessive capacity would clearly not be worth building out given the export volumes projected as of early 2021. Then, on February 24, 2022, Russia – the largest supplier of LNG to Europe – invaded Ukraine.
In Part 2 of our analysis on U.S. LNG Exports, we will take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change.
We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the chart aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick Here to Read Part 2 of This SeriesIn part 2 we take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change.
Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences
Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts.When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.Transactional ValueFair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.The accounting profession defines fair value in ASC 820 as:The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.The IRS defines fair market value in Revenue Ruling 59-60 as:The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2Expropriated ValueStatutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.In 1950, the Delaware Supreme Court offered this interpretation of fair value:“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:Unaffected stock price immediately before the transaction announcement in an efficient market (with regards to both volume and information) is the best indication of valueDeal price is a reliable indicator if the analysis excludes the benefit of synergiesNo recognized valuation methods have been ruled outThe discounted cash flow method is generally one of the preferred valuation methods if unable to observe efficient transaction prices that occurred before the transactionThe observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:Immediately before the effectuation of the corporate action to which the shareholder objects excluding any appreciation or depreciation in anticipation of the corporate action objected to;Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; andWithout discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to §281302 (a)(5).Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:Strategic Control Value is best described as Investment Value, based on individual investment requirements and expectations. The strategic control level of value is not generally consistent with FMV, in that it considers the motivations of a specific buyer as opposed to a hypothetical buyer. In other words, the “strategic control premium” is often deemed to be outside both the fair market value and statutory fair value standards. Most bank M&A deals take place at this level of value given cost save assumptions that are common in the industry. In a statutory fair value appraisal, deal value generally may not include the benefit of synergies.Financial Control Value is most often consistent with the fair market value and statutory fair value standards because (i) the underlying premise is a going concern; (ii) it typically does not include any premiums that might be paid by a buyer with specific motivations and the ability to implement synergistic structural and financial changes; and (iii) no minority interest or marketability discounts are applied.Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.ConclusionMercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)
E&P Capital Expenditures Set to Rise, but Remain Below Pre-Pandemic Levels
The upstream oil and gas sector is highly capital intensive; production requires expensive equipment and constant maintenance. Despite higher oil and gas prices, E&P operators have refrained from increasing capital investment and instead, are delivering cash to shareholders. This post explores recent capex trends in the oil & gas industry and the outlook for 2022 through 28 selected public companies.Historical and Projected Capital ExpendituresCapital expenditures, as measured by spending on property, plant, and equipment (PPE) has varied widely during the last five years. After the recent high in capital investment in 2019 of $138 billion, guideline group capex dropped 33.5% in 2020 to $91 billion. After minor growth from 2020 to 2021 on the order of 1.8%, capital expenditures are expected to ramp up investment to about $109 billion in 2022, representing a growth of 17.5% but still below pre-pandemic levels.
Leading this growth, Exxon (XOM) is expected to increase capital expenditures by 44.0% to $17.4 billion in 2022, up from $12.1 billion in 2021. Chevron follows Exxon with an estimated $11 billion in capital spending for 2022, up 37.5% from 2021’s level of $8 billion.
All in all, global integrated companies and E&P companies are expected to experience capex growth on the order of 26.3%, up from $71 billion in 2021 to $89 billion in 2022.
The global guideline companies account for the lion’s share of total forecasted growth in capital spending, as summarized in the chart below.
Appalachia Is Regional Leader in 2022 Capex Growth EstimatesThrough the lens of our company groups by region, the Appalachian Basin is expected to see the largest upswing in capital expenditures.
This is by no means an exhaustive indication of growth by region, but it is indicative of the industry environment in Appalachia — capital expenditures are expected to total $5.4 billion in 2022 from the five major operators active in the area, up from $3.9 billion in 2021. As shown below, 2022 is set to be the first year of significant capital investment growth since 2018.
Companies in the Eagle Ford are expected to increase capital spending modestly by about 12.6% to $5.1 billion, up from $4.5 billion in 2021. On the other hand, companies in the Bakken and Permian have lowered their capital plans after relatively high spending in 2021, representing a decrease of 52.8% and 15.0%, respectively.
Cost Inflation Baked into 2022 Capex BudgetsWhile the expected rise in 2022 capital investment levels from 2021 is encouraging for the global supply of oil & gas, spectators need to acknowledge the effects of cost inflation in the estimates. According to the Bureau of Labor Statistics ' March Consumer Price Report, inflation has reached a four-decade high in March 2022 as the Consumer Price Index (“CPI”) rose 8.5% over the last 12 months. Cost inflation, by definition, will detract from operators’ “bang-for-the-buck,” and it is no secret that this is baked into 2022 capex estimates.“In this upcycle, investors have made it clear they wanted to see discipline from all players. So far, E&Ps for the most [part] are exhibiting capital discipline. A significant part of E&P capital spending growth this year (2022 versus 2021) will be consumed by cost inflation as the cost for all inputs continues to increase…” – Dallas Fed Respondent, Q1 Dallas Fed Energy SurveyMoreover, estimates are directly tied to operators’ budgets and management forecasts — which also commonly attribute rising capital expenditures levels within their budget to, among other things, inflation — a theme we covered in a previous blog post. This helps bridge the divide between rising capital investment budgets and the common industry theme of “capital discipline”.ConclusionCapital expenditures fluctuate as operators react to global marketplace demand for Oil & Gas commodities. After a recent low in 2020, capital investment is expected to pick up — rising by about 17.5% in 2022, after relatively stagnant growth in 2021. Rising capital expenditures are generally a precursor to increased production, which will likely help to alleviate the current imbalance of supply and demand of oil & gas in the global marketplace at some point. However, capital expenditures for 2022 are expected to trail pre-pandemic levels still, and rising inflation is eroding the value generated by those investment dollars.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss. your needs in confidence and learn more about how we can help you succeed.Appendix A – Selected Public Company Capital ExpendituresClick here to expand the chart above
Would Elon Musk Want to Buy Your Family Business?
"Twitter has extraordinary potential. I will unlock it." – Elon Musk Elon Musk, in Elon fashion, tweeted his SEC filing to acquire 100% of Twitter for $54.20, a 38% premium above the pre-announcement price. This is after Musk’s 9.1% stake in the company was revealed, followed by his rejection of a board seat, all accompanied by the public fanfare and consternation that generally follows the CEO of Tesla and SpaceX. The board of directors adopted a poison pill to prevent a takeover if Musk’s share in the company rises above 15%. Musk subtweeted a Goldman Sachs "sell" rating and price target of $30.00 on Twitter stock. Just another week at the office for Elon. What can family businesses learn from the current saga unfolding on social media and in the B-section of the Wall Street Journal? Through the memes and tweets, we see two areas family businesses should keep top of mind related to Musk’s offer to take the helm of what he sees as a sinking ship: 1) don’t stay stagnant and 2) stay true to your business meaning.Don’t Stay StagnantHow does your family company avoid being left behind? We have written on diversification numerous times at the Family Business Director. We understand you have to focus on your core competencies, no matter your business, and too many new initiatives can distract you and your company’s key proposition to the market. Twitter has a robust digital infrastructure and owns the "breaking news" space for quick online dissemination. It’s the de facto "public square" for debate in the digital age, and even a begrudging social media user (like myself) has an account in order to be plugged into the most up-to-date news.But there is a balance – a look at Twitter’s diversification reveals a surprising lack thereof for a tech company whose peers include Facebook, Instagram, Tik Tok, and non-social media FAANG stocks. Over nearly a decade, the platform has remained essentially unchanged, with its most significant innovation being doubling the number of characters permitted per tweet. Family businesses with a strong core offering/product are often tempted to rest on their laurels, but unless they diversify intelligently around the core, they will not be able to fully unlock the potential value in the business.Stay True to Your Business MeaningIn our experience, families tend to assign one of four basic meanings to their family business:Economic growth engineStore of valueSource of wealth accumulationSource of lifestyle Readers of Family Business Director will be familiar with these concepts, but in sticking with the Twitter theme of TL;DR (that’s "Too long, didn’t read"), the idea is that your family business’ appetite for growth and investment relative to current income and capital preservation depends on what meaning your family assigns to the business. Twitter shareholders likely view their investment as a growth engine – or at least a part of their "growth" portfolio. Taking a look at the scoreboard (stock price), returns from Twitter have failed to materialize. From its IPO price of $26 in 2013 to today ($48 at writing time), Twitter has had stock appreciation of over 7% annually. If you didn’t snatch up any IPO shares and bought in at its closing day one price ($44.90), you’ve had almost no return. Dropping the recent Elon meme-induced buzz, the return drops to negative. In terms of returns to investors – Kevin O’Leary, aka "Mr. Wonderful" of Shark Tank fame, leveled this nuanced take on Twitter’s performance, "You know there’s Dante’s Hell, and at the very bottom of that is Twitter." Facebook, Instagram, Tik Tok, and other social media peers have far exceeded Twitter's performance because they have focused on diversifying their offerings, freshening their platforms, and investing in R&D – all characteristics of growth engines. Operating your family business as an economic growth engine for future generations requires a different attitude toward risk, investment, and innovation than "store of value" or "source of lifestyle" businesses. Growth engine companies take advantage of investment opportunities and focus on the future. Musk sees that Twitter has failed to do that. We understand that for many enterprising families, a greater focus on capital preservation and current income provides a better fit. In any event, the same general rule applies: Family businesses should make capital allocation decisions that fit their company’s meaning. For example, is your company in a mature manufacturing space with a shareholder base focused on dividends? Then don’t finance a risky acquisition with debt that restricts returns to shareholders. Remembering what the family business means to the family keeps your decisions grounded within a framework that ultimately benefits the company and its shareholders.Where Can We Unlock Value?Beyond the more grandiose ideas of free speech and censorship, Musk is a savvy investor and wants to buy Twitter because he thinks it is poorly run. The world’s richest man sees locked-up value in the business, but management and leadership won’t get out of the way. Sound familiar? We hope not.Family business directors: Where would Musk see opportunities to run your family business better?Give one of our family business professionals a call today for help with unlocking value for your shareholders today.
Oilfield Water Markets
Update, Trends, and the Future
The Oilfield Services (“OFS”) industry has long been known for its cyclicality, sharp changes in “direction” and demand-driven technological innovation. One segment of the OFS industry that is among those most subject to recent, rapid change is the Oilfield Water segment – including water supply, use, production, infrastructure, recycling and disposal. In this week’s Energy Valuation Insights blog, we look to key areas of the Oilfield Water segment – oilfield water disposal and oilfield water recycling – and address both recent trends and where the segment is going in the near-future.Oilfield Water DisposalThe oilfield water disposal (saltwater disposal) industry remains dynamic with numerous forces driving change. Key among those forces are volume demand, growth in water recycling and rising seismic activity in key shale basins. With the rebound in oil prices since 2020, demand for oilfield water disposal has rebounded as well. While oilfield water recycling continues to grow rapidly in volume, there remains a very significant imbalance between produced water and recycling volumes. The portion of produced water that is being recycled was estimated at 20%, per Dr. Chris Harich, Chief Operating Officer at XRI during his presentation at the recent Oilfield Water Markets Conference (“OWMC”).Additional recent factors impacting the saltwater disposal (“SWD”) industry, particularly in prominent U.S. shale plays in Oklahoma, Texas and New Mexico, is the distinct increase in seismic events that are attributed to oilfield production and waste disposal activity. In September 2021, the Texas Railroad Commission initiated added reporting, permitted volume reductions and even cessation of operations of certain SWDs near high seismic activity areas, referred to as seismic response areas (“SRA”). As a result of the rising demand for oilfield water disposal capacity and reduced disposal availability in certain areas, Kelly Bennett, CEO & Co-Founder of B3 Insight, expects (i) disposal capacity to remain far below produced water volume through 2026, (ii) increased demand for additional SWD facilities and a race for development of shallow SWDs, (iii) more produced water being transported outside of production areas for disposal, and (iv) a resulting rise in water management costs to producers.In regard to the use of shallow SWD wells, one OWMC panel (including Gauri Potdar, SVP Strategy Analytics at H2O Midstream; Laura Capper, President of Energy Makers Advisory; Max Harris, Director at EIV Capital; and Ken Nelson, President & Co-Founder of Blue Delta Energy) noted that shallow depth SWD activity can interfere with production activity in the immediate area, inherently leading area producers to push back against shallow SWD development projects.Finally, how to finance projects providing additional oilfield water disposal capacity comes with challenges not faced in many other industries. Bennett noted that as a dynamic industry that seems to be becoming even more dynamic, financing considerations are becoming even more complicated in recent years.Oilfield Water RecyclingOn the recycling side of oilfield water management, the complications aren’t any easier to deal with. While demand for oilfield water recycling is certainly on the rise, the headwinds to providing recycling services are many and naturally push upward on the cost of recycling services. However, as with most challenges in the oilfield services industry, new technology and innovation are expected to drive industry participants to overcome the inherent barriers.Notable among the oilfield water recycling headwinds are cost, lack of detailed information as to needed recycling volumes, the need for disposal of certain by-products of recycling, and landowners that are economically predisposed against recycling. The cost of recycling services likely needs no explanation; however, the logic as to the other headwinds may not be quite as obvious.The OWMC’s panel on the Mechanics of Recycling at Scale (including Jason Jennaro, CEO of Breakwater Energy Partners; Dr. Chris Harich; David Skodak, SVP Water Treatment at CarboNet; Ryan Hassler, Senior Analyst with Rystad Energy; and Joseph De Almeida, Director Water Strategy & Technology at Occidental Oil and Gas), noted that currently there are no oilfield water recycling reporting requirements. As such, potential recycling project developers have to deal with somewhat rough estimates as to demand volume, rather than a more concrete indication as to the recycled water volume potential in a particular production area. As with any potential investment, less specificity as to the potential market for services is “read” as greater risk, thereby providing greater uncertainty to project investment.As to byproducts of oilfield water recycling, one only has to go as far as the industry name for the liquid being recycled – saltwater. Yes, by volume, salt is logically one of the primary byproducts of saltwater recycling. In the Permian Basin, already known for its high produced water to oil cuts, salt content is higher than found in other basins resulting in higher recycling costs due to the sheer volume of salt byproduct and driving up the cost of capital for development.The last headwind referenced is the economic motivation of landowners in the production area. The OWMC’s panel on Engaging Landowners (including Rick McCurdy, VP-Innovation & Sustainability at Select Energy Services; Brian Bohm, Sustainability Manager with Apache Corp; Nate Alleman, HSE and Water Infrastructure Specialist at ALL Consulting; Matthias Bloennigen, Director – Consulting with Wood Mackenzie; and Jason Modglin, President of Texas Alliance of Energy Producers) noted that landowners are often compensated to supply water for oilfield exploration and/or production use, or for use of their property in the disposal of saltwater. As such, these landowners naturally aren’t in favor of the development of water recycling projects that are viewed as cutting into the fees they are being paid under existing contracts.Recycling SolutionsDespite the abundance of recycling headwinds, expectations are that all will be successfully addressed and overcome by the innovation of industry participants. Costs can be reduced by various means including the extraction of certain rare metals commonly found in produced water, use of flare gas as an inexpensive energy source for recycling operations, the development of recycling equipment that can be readily relocated, and greater cooperation in water management asset “sharing” between basin operators. In addition, increased recycling reporting requirements can assist in reducing some of the risk inherent in recycling projects and landowners can be educated as to recycling being a complementary service to existing water supply and disposal operations, thereby decreasing the natural resistance to recycling projects.ConclusionAs has always been true of the OFS industry, change brings challenges – and that is no different in the Oilfield Water segment. The dynamics of oilfield water disposal and oilfield water recycling continue to evolve, but the OFS industry has a long history of addressing and conquering its challenges, and there’s no reason to doubt the current challenges will also be conquered.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Is Redemption a Four-Letter Word?
As recently noted in the Wall Street Journal, large public companies are announcing share repurchase programs at a record pace. And, yes, the article includes the usual hand wringing about whether buybacks are “good.” We tend to think that – for public companies – share repurchases are neither good nor bad in themselves. Individual share repurchases may, of course, be ill-advised if, for example, the repurchase price proves to be too high, the resulting leverage imperils the company’s future, or the repurchase crowds out other uses of capital that would generate a superior return. But there is nothing inherently good or bad about share repurchases as such. Repurchasing shares is one of two options companies have for returning capital to shareholders and doesn't need to carry any philosophical or emotional weight beyond that. For some reason, we don’t recall ever seeing articles bemoaning the level of dividends being paid by public companies.For both public and private companies, share repurchases occupy the same place in the cash flow waterfall, as depicted in Exhibit 1 below. The operating cash flow of any business (after being either supplemented or depleted by net borrowings or repayments of debt) will be used to do one of three things: (1) add to the company’s cash reserves, (2) be reinvested in productive capital assets, or (3) provide a return of capital to shareholders. The relative proportions of these three uses depend on many company-specific factors including the risk tolerance of the shareholders, the available capital investment opportunities, and the return preferences of shareholders. Whether paid as a dividend to all shareholders, or used to repurchase the shares of some, both strategies are essentially a return of capital. As the news stories consistently point out, share redemptions compete for cash flow with capital investment and cash accumulation. So do dividends. Like many issues, what is straightforward for public companies becomes a bit more complicated for family businesses. Two factors in particular increase the degree of difficulty for family businesses. First, the motivation for redemptions can be complicated by personal relationships. Second, price is not a given as it is for public companies.Motivation for RedemptionsWho is the villain here? Too often, families assume that a redemption transaction is a sign of failure and that if there is a redemption there must be a “bad guy.” This does not need to be the case. Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences. While those differences are occasionally rooted in some lingering irrational emotional baggage, our experience is that such cases are less common than one might assume. Those circumstances grab the headlines, but most redemption transactions are far more mundane.Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences.As family businesses mature and shareholders multiply, it is only natural that being a member of the family doesn’t necessarily mean it makes sense for someone to be a shareholder. Taking the emotion out of redemption transactions is the first step to arriving at a healthy outcome: a share redemption is a targeted return of capital that allows family businesses to provide a better “fit” to the economic characteristics of family shareholders. No shame in that.Price, Value, and the Art of the PossibleThe terms of any shareholder redemption transaction include, at a minimum, the number of shares to be redeemed and the price per share to be paid. For public companies, the price is uncontroversial, because the market provides the price every day. The company is no different than any other buyer. In fact, sellers don’t even know if they are selling their shares to another investor or back to the company. And they don’t care.Without the daily market mechanism, family businesses face a bigger challenge in setting prices. Not only is there no market transparency regarding the value of the company, but the absence of a liquid market for the shares means that the value of the shares to the shareholder is different than the value of the shares to the company.All else equal, investors prefer ready liquidity. From the perspective of individual minority shareholders in the family business, such liquidity is lacking, which means that the value of those shares to them is impaired relative to the value if the company were publicly-traded. We refer to this decrement to value as the marketability discount, and these discounts are often on the order of 20% to 40% of the “as-if-freely-traded” value of the shares. But the family business is not just any other buyer for the shares – unlike individual family shareholders, the corporate treasury doesn’t really bear the economic burden of illiquidity. So, the shares are effectively worth more to the company than they are to the selling shareholders. Viewed positively, this opens up a range for fruitful negotiations; viewed negatively, this opens up a range for family dysfunction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction. It is up to the family business and the selling shareholders to identify the optimal price within the negotiating range at which to execute a share redemption that accomplishes the goals of the redemption transaction. This moves the discussion from the “science” of valuation approaches, methods, and inputs to the “art” of the possible.In a future post, we will offer some thoughts on the “art” of the possible, but for now, it will have to suffice to say that successful share redemptions in family businesses are not as rare as you might think, but do require a heavy dose of good faith, a short memory for personal slights (real or perceived), and the ability to keep the end goal in mind throughout the process.
Private Oil Company Values Are Readying For Take Off: While Publics Remain On Runway
As the term “energy security” comes back into the public lexicon, the values of U.S. oil companies are rising. This comes at the delight of some and chagrin of others. Regardless, it represents a foreshadowing of a potential longer-term cycle; whereby U.S. oil production being able to meet energy demands will be increasingly important. Many believe the U.S. is now the world’s “swing” producer (although John Hess disagrees), and it is not due to government action (or inaction). Biden’s third SPR release in the last six months is largely symbolic and more of a political gesture than a meaningful macro-economic needle mover. Demand and supply were drifting apart before Russia’s invasion of Ukraine and this geopolitical dynamic has only widened that gap. The market participants best positioned to seize upon this unexpected gap are private U.S. operators.The current price expectations of oil make a lot of reserves economically attractive. The rate of return on capital deployed for drilling is going to (if not already) outstrip the demand for other capital deployment options such as dividends or debt repayment. However, most U.S. public companies are not shifting their strategies.Domestic Dynamics (Not Russia’s) Keeping Public Valuations Relatively GroundedAs I have written before, shareholders have demanded returns from oil companies for years now in forms other than production growth. Oil company valuation in its fundamental form is a function of the present value of future cash flows. Therefore, if capital available today is best served in drilling more wells tomorrow, then production growth is the most efficient path to a higher value. At historical prices from a year ago, the decision to return more capital to shareholders (as opposed to deploying it in capex) made sense. It doesn’t now. However, public companies have yet to change the courses they’ve been setting for the past several years. That’s partly why the public sector (using XOP as a proxy) only rose 62% in the past year while prices nearly doubled.
Demand is strong with the anticipated depletion of Russian oil on world markets. U.S. capital budgets would have to quadruple by the end of 2024 for shale to replace Russian oil exports to continental Europe according to Wells Fargo. In addition, break even prices in most basins for new wells are still around where they were a year ago according to the Dallas Fed Survey. That cost is going up and will continue to, but there is still lots of room for profitability at over $100 per barrel. Also, as I have mentioned before as well, DUC wells continue to shrink. In summary, there are a lot of signals to public companies to “drill baby drill”, yet they aren’t.
To be fair there are some caution signs on the horizon that should be considered and are baked into these public valuations. First, the futures curve is still backwardated, meaning that prices are anticipated to fall in the future (not rise). However, even the long-term NYMEX curveis still over $70 in four years, which is still profitable for a lot of reserve inventory. Second, new wells drilled today appear to be less productive. The EIA’s drilling productivity report shows that new well production per rig is going down (although they acknowledge that metric is “unstable” right now). Lastly oilfield services markets have become very tight:
“ Labor and equipment shortages, along with inflation in oil country tubular goods and shortages of key equipment and materials, will limit growth in our business and U.S. oil production. In particular, truck drivers are in critical shortage, perhaps due to competition from delivery services.” – Dallas Fed Survey RespondentPrivate Companies Take To The FrontEnter the private oil companies. If forecasts suggest the U.S. can add between 600,000 and 800,000 barrels of oil by the end of the year (EIA says this can be 760,000) then the path to get there will be through the drill bits of private and private equity backed producers. According to an Enverus Report cited by Hart Energy, these types of operators have assumed the vast majority of new rig activity since the summer of 2020. With fewer external concerns, less ESG pressure, and lower regulatory costs, the private sector’s flexibility and nimbleness allow it to surge in front in search of the growth that the fundamental economics suggest is lurking.As an example, Mercer Capital’s latest merger and acquisition discussion focused on the Eagle Ford shale suggested that the market have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere.Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed, mostly by private buyers or small-cap producers such as SilverBow Resources.These implied valuation metrics in the table above suggest that there are outsized returns to be made on incremental new wells at the present time. Lots of eyes are turning to watch U.S. production, not only in the Permian, but South Texas, Oklahoma, and the Bakken as well. What they are seeing right now is public companies remaining grounded with their capital, while private companies could be leaving them behind - and quickly.Originally appeared on Forbes.com.
Practical Considerations for Operating in an Inflationary Environment
In recent months, inflation has overtaken labor market measures as the most headline-grabbing macroeconomic indicator in the financial press. Inflation typically moves the needle more than other economic measures because of its effects not only on businesses of all sizes but also on consumers.The current inflationary environment has contributed to shifts in consumer behavior thus far in 2022, and it is important that family businesses build responses to changing consumer behavior into their budgeting and forecasting processes. In this week's post, we take a look at key considerations family businesses should be thinking about in their response to the current inflationary environment.Current Inflation and Consumer Spending DataThe U.S. Bureau of Economic analysis revealed in its March 31 news release that U.S. household spending rose 0.2% in February from the previous month, down from January’s revised rate of 2.7%. While consumer spending on services such as dining out, hotel stays, air travel, and recreation increased 0.9% in February given the significant decline in COVID-19 infections, consumer spending on goods dropped by 1% in February after increasing by 6.5% in January. The recent slowdown in consumer spending on goods is likely attributed to inflation. Consumer prices in February rose 0.8% from the previous month and 7.9% for the year ended February 2022 as measured by the Bureau of Labor Statistics consumer price index, representing a new 40-year peak. With these recent spending and inflation measures in mind, it is crucial for family businesses to be able to integrate an effective response to the current environment into the forecasting and budgeting process—both in the short-run and for the long-run.Short-Run ConsiderationsShort-run considerations and consequences of inflation are more straight forward than the long-term impact (discussed below). Many of our clients have enacted price increases over the past six months aimed at combating rising input costs and protecting margins. For consumers, inflation has led to brand switching, both out of pricing concerns and availability due to ongoing supply-chain issues.While these are the “headline symptoms,” perhaps one overlooked consideration for family businesses is the need for continuous, real-time budgeting and forecasting. In an ever-changing pricing environment, simply compiling quarterly and annual operating forecasts may not be sufficient. More advanced modeling tools, such as what-if scenarios and Monte Carlo simulations, can help management and finance teams plan for any number of inflationary situations and be aware of the potential implications for operating results under a variety of different scenarios. Constant vigilance is now more important than ever in allowing family businesses to respond to inflationary pressures in a timely and adroit manner.All that to say, recent inflationary pressures have made the already difficult task of preparing operating budgets even more complex. Maintaining a greater degree of discipline in updating operating budgets and awareness of the various scenarios that could unfold is one practical step that family businesses can take in the short-run to head off potential inflationary pressures at the pass.Long-Run ConsiderationsWhen thinking about long-run consequences of inflation on the capital budgeting process, family businesses should look beyond the simple fact that a new piece of machinery, equipment, etc. is more expensive today than it was last month or last year. While this is true, family businesses must also consider the effects of inflation on the cost of capital, which is the minimum return that an investment must generate to create value (for more information on the cost of capital and capital structure, see Mercer Capital’s “Capital Structure in 30 Minutes” whitepaper). A business’ cost of capital is comprised of two components: a cost of debt and a cost of equity. The most readily observable effects of inflation on a company’s cost of capital bear themselves out in the cost of debt, which is the effective interest rate that a company pays on its long-term debt obligations.With the Federal Reserve’s stated goal of using interest rates hikes to combat inflation in mind, the effect of inflation on the cost of debt then becomes clear. Increases to the fed-funds rate enacted by the Federal Reserve flow through to most interest rates in the U.S. economy. For simplicity and reference, we’ll look at the Moody’s Seasoned Baa Corporate Bond Yield, which is a good approximation of the cost of debt for many private companies. At year-end 2021, the observed yield on this debt instrument was 3.37%. The yield had crossed 4% by mid-February and reached 4.51% on March 15 when the FOMC announced that it would raise the benchmark rate for the first time since 2018 in an effort to combat the persistent inflationary environment.The practical implication of this policy stance is an increase to the cost of debt via Fed policy actions, raising the return threshold that capital investments must cross to generate a positive net present value. On the flip side, current fixed debt instruments appear more attractive as dollar payments needed to cover borrowing costs decline on a real inflationary basis (i.e., fixed rate debt payments avoid inflation). While there are countless other considerations and factors that affect a company’s cost of capital, family businesses should consider inflation as it relates to long-term capital needs and financing decisions.For privately held family businesses, inflation has greater consequences than paying an extra dollar per gallon at the pump or the price of a loaf of bread increasing by a few cents. Family business managers and directors should be pursuing active long and short-term strategies aimed at mitigating the effects of inflation, as this pervasive macroeconomic phenomenon can have greater implications than immediately meets the eye.
Modest Production Growth for Eagle Ford
With More on the Way
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post, we take a closer look at the Eagle Ford.Production and Activity LevelsEstimated Eagle Ford production (on a barrels of oil equivalent, or “boe,” basis) increased approximately 4% year-over-year through March. This is in line with the production increases seen in the Bakken and Appalachia (4% and 5%, respectively) but lags behind the Permian, where production increased 14% year-over-year.
There were 56 rigs in the Eagle Ford as of March 25, up 75% from March 19, 2021. Bakken, Permian, and Appalachia rig counts were up 162%, 48%, and 21%, respectively, over the same period.
One may wonder why the Eagle Ford has lagged the Permian in production growth despite a larger increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration (“EIA”), the Eagle Ford needs ~40-45 rigs running to offset existing production declines, and only recently (starting in January) had more rigs running than this maintenance level. The Permian has generally been operating with more than the maintenance level of rigs, so it has seen a higher level of production growth despite a smaller increase in rigs. However, with 56 rigs now running in the Eagle Ford, more production growth should be on the way.
Commodity Prices Rise Amid Geopolitical TensionOil prices generally rose through the first two months of the quarter as increased demand was met with continued producer restraint. While the shale revolution had largely put geopolitics in the back seat as a key driver of commodity prices, geopolitics once again became front and center as Russia launched its invasion of Ukraine. In response, Western nations launched a series of economic sanctions against Russia. While the sanctions generally included carve-outs for energy exports, issues with financing and insurance, as well as the exit of Western oil companies and oilfield service providers from Russia, have resulted in a substantial decline in oil exports from the country. Russia was the third-largest producer of petroleum and other liquids in 2020, according to data from the U.S. Energy Information Administration, behind the U.S. and just shy of Saudi Arabia. The potential for that much oil to no longer be available for global markets has led to a high degree of volatility in oil prices. West Texas Intermediate (WTI) front-month futures prices began the quarter at ~$75/bbl and reached $120/bbl in March. Prices have swung dramatically based on actions in Ukraine and the progress of peace talks.
Natural gas prices did not exhibit the same level of volatility as oil prices, given the more localized nature of the commodity. However, natural gas is becoming more globalized as Europe grapples with how to replace Russian imports. One obvious source is the United States, as President Biden pledged to boost LNG exports to Europe, despite these same exports being demonized by Democratic Senator Elizabeth Warren just a few short months ago. Administration officials aim to increase European LNG exports to 50 billion cubic meters annually, up from 22 billion cubic meters exported to the E.U. last year.
Financial PerformanceThe Eagle Ford public comp group saw relatively strong stock price performance over the past year (through March 28). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like SilverBow and Ranger, whose stock prices increased 326% and 147%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 62% during the same period). Larger, less leveraged EOG was a laggard, with its stock price rising 61%, slightly behind the broader E&P sector.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey, Eagle Ford wells are among the most economic in the nation.
Survey respondents indicated that the average WTI price needed to break even on existing Eagle Ford wells was $23/bbl. This is below the average breakeven in the Permian ($28-$29) and other parts of the U.S. ($30+). While the economic advantage diminishes somewhat for drilling new wells, the Eagle Ford also had the lowest average breakeven for new development, with producers needing WTI at $48/bbl to profitably drill new wells, besting the Permian ($50-51) and other parts of the country ($54-$69).
The Eagle Ford’s economic advantage comes from both its geology and geography. The basin’s proximity to Gulf Coast refining and export markets gives it a leg up relative to more inland basins.
ConclusionEagle Ford production growth was relatively muted over the past year as capital discipline led to producers running rigs largely at maintenance level. However, with the recent surge in commodity prices, producers are finally starting to bring more rigs online, which should lead to more production growth. However, this growth can’t fill the void left by Russian exports, so commodity prices will likely remain volatile until there is some sort of resolution in Ukraine.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Purchase Price Allocations for Asset and Wealth Manager Transactions
In recent years, there’s been a great deal of interest in RIA acquisitions from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. Due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer, these acquirers have been drawn to RIA acquisitions. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill. Transaction structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2017 and 2021, Focus completed 130 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 51% was allocated to customer relationships. Most of the remainder (48%) was allocated to goodwill.TradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. The ability of employees to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of a assembled workforce is valued as a component of valuing the other assets. Under current accounting standards, the assembled workforce value is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional clients, assets, or product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquiror that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.
First Quarter 2022 Review: Volatility Resurfaces
The first quarter of 2022 marked the most volatile period since the first quarter of 2020.The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.Equity IndicesIndex data per S&P Capital IQ ProBroad market indices contracted through February 23, 2022, driven by valuation concerns for growth stocksBank stocks remained stable through February 23, 2022, as valuations remained reasonable relative to historical normsSince February 23, 2022 bank stocks have experienced modest pressure, primarily among larger banks that may have some exposure to RussiaWhile markets were volatile after the Ukraine invasion, broad market averages reported a robust recovery in the week of March 18, 2022 and continued gaining into last weekTreasury RatesTreasury yields per FRED, Federal Reserve Bank of St. LouisTreasury rates increased during 1Q22, with a greater share of the expansion occurring prior to February 23, 2022The yield curve flattened in 1Q22Yields on 3- and 10-year Treasuries were virtually identical as of March 24, 2022, relative to a 55 bps spread as of year-end 2021Debt SpreadsCorporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis
CMBS spreads per ICE Index PlatformCorporate debt and commercial MBS option-adjusted spreads widened in 1Q22Prior to the Ukraine invasion, high yield bond spreads widened to a similar degree, regardless of rating.However, since the invasion, BB-rated issuers have outperformed B- and CCC-rated issuers1Q22 spread widening in BBB-rated corporate bonds (40 bps) is the largest since 1Q20Although commercial real estate may appear somewhat more insulated from geopolitical considerations than the corporate bond market, CMBS spreads widened to a greater degree than corporate bond spreads in 1Q22CommoditiesOil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis
Corn & wheat prices per BloombergCommodities experienced higher price appreciation than other asset classes in 1Q22Wheat prices, already rising prior to the invasion, leapt after it.This reflects potential production disruptions in Ukraine, sanctions on Russia, and transportation issues in the Black SeaOil prices dropped in the weeks after the invasion of Ukraine but still notched a 49% increase in 1Q22Our agriculturally-oriented banks still expect U.S. farmers to fare well in 2022, despite higher input prices and difficulty obtaining some supplies like fertilizerResidential MortgagesThe 30-year mortgage rate, as reported by Freddie Mac, exceeded 4.00% in the week ended March 18, 2022.This is the first time the mortgage rate has exceeded 4% since May 2019.For the week ended March 25, 2022, the 30-year mortgage rate climbed higher to 4.42%Mortgage rates widened to a greater extent than long-term Treasury rates in 1Q22UWM Holdings, the largest wholesale mortgage lender, in its March 1, 2022 earnings release projected that 1Q22 originations would decline by 24% to 40% from 4Q21 originations.Mortgage rates have increased further after it provided this estimate
Nine Characteristics of Successful Family Wealth Plans
Recently we had the opportunity to attend (virtually) the Johns Hopkins All Children's Foundation 24th Annual Estate, Tax, Legal & Financial Planning Seminar. This year's keynote speaker was Pamela Lucina, Chief Fiduciary Officer and head of the Trust & Advisory practice for Northern Trust Wealth Management, one of the country's largest trust companies. Her keynote presentation highlighted the characteristics of successful families and provided practical strategies to avoid mistakes commonly seen in the administration of multigenerational wealth plans and trust structures. We summarize Ms. Lucina's nine key observations below.1. Don't Buy Into Shirtsleeves to Shirtsleeves in 3 GenerationsEchoing what we've said and highlighted at the Family Business Director, the saying "Shirtsleeves to Shirtsleeves in 3 Generations" is less fate and more myth. Family companies and trusts that operate from a place of fear ("We will fail unless we do something") often fail to make sound, long-term decisions and revert to more short-sighted thinking. Focusing on the positives of the family business (long-term focus, generational wealth creation) induces better decision-making and outcomes.2. Resist Ruling from the GraveWealth creators and first-generation founders often find themselves, usually with the best intentions, attempting to ensure that they will continue to control the business or assets of their beneficiaries from the grave. This manifests itself in incentive trust structures and strict rules-based criteria for distributions or asset allocation. Ms. Lucina warns against this thinking. Beyond creating animosity and resentment, if beneficiaries are solely focused on checking boxes created by others (i.e., get a degree, hold a job, sign a pre-nuptial agreement), they will often do the bare minimum to meet the standard. Instead of relying on such extrinsic motivation, families and trust documents should aim to effectuate the grantors' intent while tapping into the intrinsic motivations that will cause beneficiaries to genuinely thrive.3. Consider a Statement of IntentThe best family businesses and trust structures contain a statement of intent. The purpose of the statement of intent is to clarify the purpose of the trust. Statements of intent provide guardrails for the trust and help keep the beneficiaries and trustees on the same page. From this view, the modern estate planner's job is, in part, to serve as amanuensis for the grantor or wealth creator, turning the desires of the trust grantor into a prudent and workable plan. Having a statement of intent can often demystify the seeming ambiguity of trust language and best effectuate the grantor's wishes.4. Attend to ConcentrationsDiversification is a common topic on the Family Business Director blog. Ms. Lucina notes that strong families aim to address concentrations within trusts and long-term wealth plans. This can come in the form of having outside investment management of trust assets or the sale of concentrated, long-held stock. A common pitfall for families arises when the grantor of beneficiaries becomes "attached" to stocks, whether because they are what created the family's wealth or provide income to meet beneficiary needs. On the flip side, a trust may have been created, in part, to maintain a family's ownership in a private business. Understanding that goal can provide clarity to the beneficiaries and help them to level expectations on asset allocation and distributions in the future.5. Clarify Roles and ResponsibilitiesJust as it is important to have clear roles and responsibilities for family members in your family business, families need to clarify each member's responsibilities in their long-term planning and trust structures. Trustee and administrative roles need to be specific, and families should identify possible pain points in trust structures. This includes avoiding ambiguous language and providing clarity to the who, what, where, and why. Clarifying roles can help to stave off future family squabbles and tough conversations.6. Provide for an Exit and AutonomyTrusts are often put in place as a means to achieve tax efficiency and maintain family wealth. They also can act to maintain family harmony and togetherness when the grantors are no longer in the picture. This can be achieved through annual family meetings or owning common private assets (private company stock, a vacation home). However, Ms. Lucina notes that creating an exit mechanism and establishing autonomy at outset of the long-term wealth plan is key to family harmony. Similar to shareholder redemptions in your family business, you need to understand the 'outs' for beneficiaries in your trust structure to prevent family resentment and feelings of entrapment.7. Develop CompetenciesStrong family businesses educate the next generation not just in the family business, but the intricacies of their family's trust structure and broader wealth plan. Working to build key competencies, either through education from advisors or real-life learning opportunities (participating on investment committees, overseeing donor advised funds, etc.) gets beneficiaries involved and prepares them for their future role as primary stewards of the family's wealth.8. Cultivate the Entrepreneurial SpiritFamily wealth often comes about through the entrepreneurial spirit of the founders of a family business. Successful families inculcate this spirit and encourage each generation to contribute to the overall wealth of the family. Families can act as the 'family bank' and underwrite investment ideas and business ventures or create new divisions or entities to house these ventures.9. Communicate, Communicate, CommunicateMs. Lucina's final takeaway is one we are all familiar with: the importance of communication. We have discussed how much you should communicate with your family shareholders previously, but how do you handle discussions on wealth from a holistic family perspective? Often, mum is the word regarding high-net worth families and their wealth. Second and third generation members may know there is wealth, but not understand how it fits into the family wealth plan or what governs their access to it. This silence is often motivated by a desire to not corrupt children or disincentivize their work ethic. However, not communicating with family about your business or wealth planning can seriously damage the trust of family members. While every family is different, we tend to lean to the side of over-communication regarding family wealth planning conversations.Family businesses and advisors would be wise to keep a number of these practical rules in mind when crafting or advising family wealth plans and documents. As valuation professionals, we aim to be a helpful partner in the tax planning process alongside estate attorneys and other advisors for businesses and high-net-worth individuals. Give us a call to see what we can bring to your estate planning team.
How to Approach a Target and Perform Initial Due Diligence
This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform?
All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth.
In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access).
However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition.
Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing.
Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.
How to Approach a Target and Perform Initial Due Diligence
This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.
Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform?
All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth.
In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access).
However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition.
Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing.
Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.
How to Approach a Target and Perform Initial Due Diligence
This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.
Does RIA Consolidation Work?
Show Me the Money
RIA group-think has been pro-consolidation for the past decade, and increasingly so. You've read the headlines about the pace of deals reaching a fever pitch last year and continuing into this year. We've been skeptical of the believed necessity for RIA consolidation in this blog in the past, and have yet to be dissuaded from our position. But opinions are only opinions, and facts are facts. This seems like an opportune moment to check our feelings against reality. How is RIA consolidation performing so far? The verdict from the public markets isn't very encouraging. We look at three publicly traded consolidators of wealth management businesses, Silvercrest, CI Financial, and Focus. Over the past five years, Silvercrest Asset Management Group (SAMG) showed cumulative share price appreciation of less than 65%, underperforming the Russell 3000 by over 2200 basis points. To be fair, SAMG pays a reasonable dividend, and its wealth management clients are probably not 100% invested in equities. Nevertheless, we think of RIA returns as being leveraged to the market, and in an era of strong markets a wealth management firm with organic growth plus an acquisition strategy should – in theory - be able to outperform broad indices. SAMG didn't beat the market, but it outperformed a couple of rivals. Focus Financial Partners trades less than 25% above its IPO price from the summer of 2018, in spite of a tremendous number of acquisitions and sub-acquisitions. Focus doesn't pay a dividend so 22% cumulative return is the total return for FOCS shareholders since going public. CI Financial has fared even worse, as the Canadian shop revered for its willingness to pay top dollar hasn't posted a positive return over the past five years, even if you count dividends. Keep in mind, all of the above happened in an era of strong equity markets and low interest rates – what should be optimal conditions to consolidate the RIA space.Obligatory Car StoryThe business climate of the late 1990s was one in which consolidation was rife in nearly every industry. Rollup IPOs were the SPACs of the day, newly minted dot-coms were trading their highly inflated equity currency for other companies' highly inflated equity currencies, and old economy manufacturers were teaming up to share branding, technology, and overhead. Sometimes this worked very well, and sometimes it didn't.It's often said that most M&A results in failure. The free-wheeling, mass-market managers at Chrysler could never agree on expectations with the hierarchical, engineering-led team at Daimler-Benz. The loveless marriage resulted in unfortunate offspring like the Pacifica crossover and the R-class. Less than a decade after the 1998 merger, Daimler unloaded Chrysler to Cerberus for about 25% of the $36 billion it had originally paid.At the same time, a more unlikely pairing actually worked. The 1998 sale of Lamborghini to Volkswagen's Audi division turned out to be wildly successful. Italian styling and German build quality make a good combination, and today Lamborghini sells almost fifty times as many cars annually as it did before Audi bought it. It hasn't caught up with Ferrari yet, but it's close enough to make the guys in Modena pay attention.Investment ThesisLooking back on the two auto industry transactions sheds some light on the expected performance of RIA deals. One way to compare Daimler-Chrysler and Audi-Lamborghini is to consider why they happened in the first place.Daimler-Chrysler was a bulking-up, bigger-is-better, merger-of-equals. The logic was driven by internally-focused economies of scale, and it wasn't clear who was in charge. That left an environment that was unusually hospitable to culture clashes that undermined opportunities, synergies, and (ultimately) sales.Audi-Lamborghini was product-focused, and it was clear from the beginning who acquired who. Huge increases in Lambo sales and the opportunity to equal or surpass their old rival with the Prancing Horse kept internal dissent at bay.Which transaction looks most like the typical RIA deal? The investment thesis for investing in RIAs (whether asset management or wealth management) is straightforward: sticky revenue and operating leverage produce a sustainable coupon with market tailwinds. In an era of ultra-low yields, it's the best growth-and-income trade available, and it's become a crowded trade with a diverse array of institutional investors and family offices. As we've said many, many times in this blog, it's easy to see why one would invest in investment management.Consolidation ThesisInvesting in RIAs is one thing; consolidating them is quite another. Still, the themes that drive industry consolidation are equally well-rehearsed:Scale. With 15,000 or so RIAs in the United States alone, solving for fragmentation seems like an obvious play. Consolidation wonks tout the financial leverage that comes with economies of scale, enhancing margins, distributions, and value.Access. Larger firms theoretically are able to source more sophisticated investment products, technology stacks, and marketing programs.Problem Solving. Sellers have to have an impetus to give up control over their own destiny, and consolidation is often seen as the solution for aging leadership (or at least aging ownership) without a compelling succession path.Financial Engineering with Debt. Covenant-light debt at low rates has made capital widely available for public and private acquirers alike. Banks will typically lend at 3x and non-bank lenders at as much as 6x. With Libor near zero, even premiums on the order of 500 to 600 basis points make LBOs compelling.Financial Engineering with Equity. Multiple arbitrages has been the handmaid of cheap debt. At one point, it was "buy at five to six times, sell at eight to nine times." Then the spread was 9 to 12. Then it was 12 to 15. Then it went further. The whisper numbers usually outpace reality, but the logic is the same. All the above is widely accepted in the industry, and it's easy to see why. But if Fed activity stalls equity, while at the same time raising the cost of borrowing, things could change abruptly. This wouldn't just threaten industry consolidation for financial reasons, it might also expose some flaws in the consolidation thesis.Diseconomies of ScaleIf you put ten RIAs together that each makes $5 million in EBITDA, your combined operation will make $50 million in EBITDA. Your holding and management operation, however, will probably need an executive team with a C-suite, an accounting department, a marketing department, legal, compliance, investor relations, and a couple of pilots for your jet. They'll all need office space in a nice building, even if they mostly work from home. The subsidiary level profitability will inevitably be eroded by monitoring costs.Some of this expense may be replacing functions that would previously have happened at the subsidiary RIA level, but not all of them. Is there enough expense synergy in consolidation to cover the overhead costs of a consolidator? I doubt it.In the asset management space, there is an argument that AUM can be added faster than overhead, and margins can expand almost infinitely (we've seen some big ones). In wealth management, it's a tough slough. When Focus Financial went public, we thought that, even with massive growth, it would be hard to get their adjusted EBITDA margin above 25% - the level we're very accustomed to seeing on a reported basis at wealth management firms of more modest proportions. A publicly traded consolidator might have more than 100 souls on board at the management company level. That's a lot of payroll to cover with subsidiary-level synergies.AccessibilityAre small firms disadvantaged when it comes to necessary products and services? With custodians eager to accommodate all manner of investment products, outsourced compliance, subscription-based tech, and scalable marketing, it's easier than it has ever been to compete as a sub-billion dollar RIA. Scale enables firms to have positions to manage these functions, but it doesn't provide the functions themselves. We aren't experts in RIA operations, but we haven't yet seen a small firm struggle because it couldn't get what it needed (or wanted).Exit and SuccessionConsolidators offer exit capital for RIA founders. In that regard, they can resolve the standoff between generations of leadership and pay senior members a price that next-gen staff either cannot or will not pay. But a cheaper source of capital (or greater appetite for risk) is not a surrogate for succession.Since most of the consolidators in the industry are relatively new, we don't know a lot about whether these models are sustainable. RIAs are not capital intensive, but they are highly dependent on staff to manage both money and relationships. Often the staff who will generate returns for the consolidator in the future don't get a lot of equity consideration in the transaction. And will the founding generation work as hard for their new boss as they did for themselves?These conundrums have led many consolidators to structure earnouts or develop hybrid ownership models that share equity returns in some form or other with subsidiary RIAs. One touts promising to never turn "an entrepreneur into an employee" – which sounds reasonable. Ultimately, though, the staff at subsidiary operations are sharing equity returns with the parent company, and the principal/agent dilemma is less a dichotomy and more of a spectrum.As such, the consolidator will be paying for a firm run by highly motivated founders and getting a firm that will ultimately be run by differently motivated successors. RIA consolidation is the act of simultaneously acquiring the operating asset and accepting the succession liability.Financial De-EngineeringMost RIAs, by far, operate on a debt-free basis. Usually, this is for the obvious reason that there isn't much of an asset base to finance, so why bother. Consolidators, on the other hand, frequently rely on debt financing and, as deal prices have increased, so have leverage ratios. Financing a cash flow stream that is in many ways leveraged to Fed activity works very well in the era of declining and low interest rates – as we have seen.Rising rates and falling (or stagnant) markets lead to higher debt burdens and lower cash flows to service that debt. Add to that the threat of inflation increasing payroll burden. In normal times, there would be enough equity cushion to protect against default. With higher deal multiples – based on highly adjusted EBITDA measures - and the massive leverage available from non-bank financing, we could be in for some nasty surprises.If coverage starts tightening, deal activity will fall off, and multiples will drop. If multiples drop, acquirers won't be able to exit on satisfactory terms. Without equity compensation as a carrot, producers will find an exit for themselves. The unfortunate reality of leveraged RIAs is that their assets get on the elevator, but the liabilities never leave.Climate ChangeI'm not calling it the end of the RIA consolidation trend. For many reasons, it could continue for years to come. But the performance of publicly traded consolidators has been lackluster, in spite of very favorable conditions in which those business models should thrive. Now that we have the prospect of RIA stagflation, it could become very difficult to maintain a land-grab mentality that operates as if the acquirer is valued on the basis of price-per-press-release.
Eagle Ford M&A
Transaction Activity Over the Past 4 Quarters
Deal activity in the Eagle Ford increased over the past year as energy prices recovered from a tumultuous 2020. As we noted in June of last year, production in the Eagle Ford remained relatively flat over the prior year despite 146% growth in the regional rig count, suggesting the significant increase in drilling activity was just enough to offset the decline in already-producing wells, but not economical enough to spur production growth meaningfully. This may also have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere. Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed in the Eagle Ford over the past four quarters, up from eight transactions closed in the prior four quarters.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. The median deal value in the past four quarters ($370 million) was approximately $282 million higher than the median deal value from Q2 2020 to Q1 2021, excluding Chevron’s acquisition of Noble Energy in July 2020. The average deal value over the past year ($573 million) was more than double the average value ($274 million) over the prior year (excluding the Chevron-Noble Energy deal). Also notable, larger positions were transacted over the past year, with a median size of 45,000 net acres as compared to 26,500 net acres in the prior year (excluding Chevron-Noble Energy), and an average deal acreage of nearly 80,000 net acres this past year which was more than double the average of 34,775 net acres in the prior year.SilverBow Resources Builds Up Its Eagle Ford AssetsOn October 4, 2021, SilverBow Resources announced the closing of its purchase to acquire oil and gas assets in the Eagle Ford from an undisclosed seller in an all-stock transaction. The aggregate purchase price for these assets was $33 million, with the transaction consisting of approximately 1.5 million shares of SilverBow’s common stock. In late November 2021, SilverBow announced another transaction closed with its purchase of oil and gas assets from an undisclosed seller for $75 million, including $45 million in cash and approximately 1.35 million shares of SilverBow’s common stock.Of this second transaction, Sean Woolverton, CEO of SilverBow, commented, “This is the third acquisition we have closed in the second half of this year. This transaction represents SilverBow’s largest to date. As we look to 2022, the Company is set to grow production by double digits in part from the incremental development locations and a full year’s worth of contribution from the acquired assets. With greater cash flow and liquidity, SilverBow remains well-positioned for strategic M&A and further de-levering.”Callon Petroleum Divests Non-Core Eagle Ford AssetsOn October 5, 2021, Callon Petroleum – one of the upstream companies we follow regularly in our quarterly review of earnings call themes from E&P operators – announced it had entered into an agreement to sell non-core acreage in the Eagle Ford as part of its acquisition of leasehold interests and related oil, gas, and infrastructure assets in the Permian basin from Primexx Energy Partners. Total cash proceeds from the divestiture were approximately $100 million. The Eagle Ford properties included approximately 22,000 net acres in northern LaSalle and Frio counties. Net daily production from the properties was approximately 1,900 Boe/d (66% oil) on average in the third quarter through month-end August. Callon noted in its press release that the sale would eliminate approximately $50 million in capital expenditures related to continuous drilling obligations over the next two years, allowing for redeployment of capital to higher return projects.ConclusionM&A activity in the Eagle Ford has picked up over the past year in terms of both deal count and the amount of acreage involved. The ten deals noted over the past year were split evenly between property/asset acquisitions and corporate transactions, such as the Desert Peak Minerals-Falcon Minerals Corporation merger announced in mid-January of this year. This signals a notable increase in corporate-level activity as only one of the eight transactions in the prior year involved a corporate transaction, possibly foreshadowing greater industry consolidation in the Eagle Ford moving forward.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of March 15, 2022
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of March 15, 2022Download Study
The Perils and Pleasures of Forecasting in Family Businesses
The list of forecasting cliches is long (thanks, Yogi Berra!), but we were recently reminded of a good one: there are only two kinds of forecasts – lucky and wrong. That reminder came from an article by Joachim Klement 10 Rules for Forecasting published on the CFA Institute website.Klement’s list is focused on macro level economic forecasting, but several of his rules apply equally well to the micro level of individual family businesses. In this post, we consider four of Klement’s rules in the context of family businesses.Rule #1 – Data MattersIf it is hard for professional managers at public companies to remain dispassionate when predicting the future, it is doubly hard for managers and directors at family businesses. Humans are story-seeking animals, but the desire to craft a simplistic narrative that both neatly explains the company’s historical performance and extrapolates that performance into the future may prove counterproductive. It’s not that narratives are bad, but the temptation to make the data “fit” a preferred story can be overwhelming. Far better to adjust one’s narrative to “fit” the actual data, even if elements of that story are uncomfortable. Allowing the data to tell the real story opens up the space needed for a meaningful conversation about where the real and preferred stories diverge, the sources of those divergences, and whether those divergences are permanent or capable of being closed.Rule #3 – Reversion to the Mean is a Powerful ForceOdds are that your family business is indeed special, but not that special. Twenty percent growth rates have a habit of eventually giving way to 10% growth rates, which in turn, eventually deteriorate to 5% growth rates. Likewise, lucrative profit margins tend to attract the sort of competition that corrodes lucrative profit margins. Outside of regulated utilities, business is competitive, and forecasts that assume existing – or new – competitors will stand idly by while you execute your strategic plan are not realistic. While past success may reveal what your family business has done well, one should be wary of simply assuming the formula that worked so well in the past will continue to work equally well in the future. As Amazon founder Jeff Bezos is reputed to have said about his competitors: “Your margin is my opportunity.”Rule #9 – Remember Occam’s RazorOccam’s Razor is the principle that in explaining a thing no more assumptions should be made than are necessary. Accuracy is a more desirable attribute in a forecast than precision. Identifying the appropriate level of complexity in a financial projection is one of the biggest forecasting challenges facing family business directors and managers. For what it’s worth, we tend to value parsimony a bit more when projecting operating expenses than revenue.A zero-base “build-up” approach for forecasting revenue can be a helpful corrective to overly optimistic trend extrapolation. Total revenue, whether for a segment, division, or the consolidated family business, can often be modeled as the product of unit volume and effective pricing. In other contexts, market share and aggregate market size can be useful benchmarks for forecasting revenue.Predicting growth rate trends for operating expenses is often a sufficiently reliable approach. Operating expenses are often somewhat fixed, and while individual expense categories may exhibit more volatile behavior, keeping an eye on implied operating margins can help in assessing the overall reasonableness of operating expense forecasts.Rule #10 – Don’t Follow Rules BlindlyKlement’s final rule is a good reminder for writers of blog posts about making forecasts. There is a genuine difference between helpful discipline and blind rigid adherence to any set of abstract forecasting rules. Hopefully, your family business is making forecasts for a business purpose, not simply for the sake of mastering the art of making forecasts. Keep that business purpose front and center, and feel free to discard the prescriptions and proscriptions of arm-chair quarterbacks when they undermine that purpose.ConclusionFollowing Rule #10, it may be important to distinguish between a goal and a forecast. Goals express what we want the future to look like, whereas a forecast presents an unbiased picture of what the future will look like. The rules that make sense when crafting a forecast may not be appropriate when setting goals for future performance. Goals serve a valuable purpose for family business managers and employees, but when making capital budgeting, dividend policy, and capital structure decisions that can affect the family for generations, directors need unbiased forecasts.Does your family business have a disciplined process for separating fact from fiction and developing actionable forecasts that your directors can rely on? Sometimes an outside perspective can be helpful when you need to prioritize data over hopeful narratives, instill respect for reversion to the mean, keep things simple, and distinguish discipline from blind devotion to a set of forecasting rules. Give one of our family business advisory professionals a call today to discuss your challenges in confidence.
Themes from Q4 Earnings Calls
Part 3: Oilfield Service Companies
Last month, we reviewed Q1 through Q3 2021 earnings call themes from oilfield service companies. Commentary regarding the progress of ESG efforts, whether initiated by the OFS companies themselves or in support of their customers' ESG programs, was prevalent throughout the year. OFS management teams also noted their anticipation of increased industry consolidation by way of M&A activity. Perhaps most poignantly over the first three quarters of 2021, OFS companies signaled increasing leverage in their ability to either start commanding higher prices of their customers, or the expectation they would be able to do so in the very near term.In Part 1 of our Themes from Q4 Earnings Calls, we examined key topics among E&P operators, including:Projections of moderate cost inflation, typically in the upper single digits;Shifting focus towards liquids, including crude oil and NGL streams; andIndustry headwinds stemming from macro energy policies in the U.S.
In Part 2 of our Themes from Q4 Earnings Calls, key topics among mineral aggregators included:Greater scrutiny and discipline regarding the execution of M&A deals;Expectations of relatively stagnant production in the near-term; andGreater insulation from price inflation relative to the impact on E&P operators.
With this background in mind, we focus this week on the key takeaways from the OFS operator Q4 2021 earnings calls.Macro HeadwindsLabor shortages and supply chain constraints have been a common topic in the daily news cycle regarding the macroeconomic environment in the U.S. Suffice it to say, the OFS industry has not been immune to these factors."You know the story of tubulars people are struggling to get the right tubulars on time. They are having to make substitutions. We are seeing some rig efficiencies begin to deteriorate, which is attributable to several factors. Part of that, of course, is the basins. Different basins have different efficiency profiles. But I think our view is activities at the rig side have slowed down, all things being equal, strictly because of problems with personnel breakdowns. I think the industry is a bit stressed right now." – Scott Bender, President & CEO, Cactus Wellhead"Beyond activity trends, we see a continuation of many of the same things from 2021. Operators will continue to look for ways to improve efficiency and sustainability. We see the current constraints in many critical areas such as labor, sand, and trucking also continuing for the near term." – William Zartler, CEO & Chairman, Solaris Oilfield Infrastructure"Productivity and efficiency was broadly encumbered by 2 significant factors. First, the tightening labor market we faced in the U.S. was exacerbated by COVID outbreaks in certain plants during the fourth quarter. As skilled workers recuperated safely at home, their work was performed by less experienced, less efficient crews or by other skilled workers working overtime. Labor shortages led to higher product costs and scheduling headaches. Second, our manufacturing scheduling headaches were compounded by component and raw material shortages and late deliveries from our vendors who are facing the same sort of challenges that we are. Some businesses report supply chain challenges are getting a little better, but mostly these disruptions are persisting or getting more challenging in the near-term." – Clay Williams, CEO, National Oilwell VarcoIndustry Consolidation through M&A ActivityIn our Q1 through Q3 2021 OFS earnings call themes post, we noted anticipation of greater M&A activity and industry consolidation in 2022. This continued in Q4, with the ongoing expectation of consolidation activity in the near future."We have not given up on industry consolidation. That's our number one priority. And importantly, I don't think the industry has given up on industry consolidation. Yes, the valuations are going to be higher today than they were this time last year, but our currency is also more valuable today than it was this time last year. I don't really consider that to be an impediment to getting a deal done. The impediment is finding the right deal. ... Private equity has decided maybe now is the time to monetize after they've probably given up hope over the last couple of years." – Scott Bender, President & CEO, Cactus Wellhead"As I've stated many times, I believe consolidation is very important for this industry. Through a combination of cash and stock consideration, we closed on the acquisitions of Complete Energy Services, Agua Libre Midstream, HB Rentals and UltRecovery during 2021. Additionally, we are set to close on the acquisition of Nuverra Environmental Solutions. In doing so, we've added nearly $300 million of run rate revenues to an already growing base business and acquired strategic portfolio of infrastructure assets, including gathering and distribution pipelines, disposal facilities, and landfill operations." – John Schmitz, President & CEO, Select EnergyESG ActivityThe Q4 OFS earnings calls were peppered with commentary regarding ESG, including recognition of OFS operator initiatives from outside the industry, the mitigation of environmental impacts on local communities at present, and projections of continued demand for ESG-focused services."We announced our science-based emission reduction targets, added 11 new participating companies to Halliburton Labs and were named to the Dow Jones Sustainability Index, which highlights the top 10% most sustainable companies in each industry." – Jeff Miller, CEO, Halliburton"Overall in 2021, we recycled 25 million barrels that produced water through our fixed facilities, and we expect to continue driving these volumes higher. This recycling alleviates demand for freshwater sources in water stress regions, while also limiting waste disposal which is particularly important in areas of seismicity concerns." – Nick Swyka, CFO, Select Energy"On the technology and sustainability front, we continue to advance our water recycling efforts. We've invested in six facilities during 2021 which are backed by long-term contracts. This sets the stage for a significant growth in our recycled volumes for 2022." – John Schmitz, President & CEO, Select Energy"We're busy upgrading Tier 2 fleets to Tier 4 dual fuel fleets that can utilize up to 85% natural gas. And we expect the pursuit of ESG-friendly operations, efficiency gains and the industry's existing tired fleet of equipment will lead to continued demand for such rebuilds." – Jose Bayardo, CFO, National Oilwell Varco
Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
Identifying Acquisition Targets and Assessing Strategic Fit
Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.
Identifying Acquisition Targets and Assessing Strategic Fit
Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.
Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.
For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.
This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.
Identifying Acquisition Targets and Assessing Strategic Fit
With aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations. This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.
Family Business Director’s Reading Roundup
Here at Family Business Director, we are focused on the numbers of family business: measuring and assessing financial performance, establishing dividend policy, setting capital structure, making capital budgeting decisions, and structuring shareholder redemptions. We believe these topics are crucial, and that many of the conflicts that enterprising families experience are avoidable when these tasks are done well and communicated effectively to family shareholders. In our experience, well-informed shareholders are engaged shareholders.All that said, we also recognize that family business leaders face many other critical challenges. In this week’s post, we provide a quick roundup of some of the best pieces we’ve come across recently dealing with management succession, governance, attitudes toward wealth, family relationships, board dynamics, and more.Winning at management succession must be a priority for family businesses focused on long-term sustainability. In this article, John Ward and Stephen McClure of The Family Business Consulting Group offer a comprehensive list of 15 guidelines for family business succession.Family businesses aren’t always great at drawing boundaries. Family and business tasks can become intertwined, and the burdens of family governance can fall on too few shoulders. Marion McCollom Hampton and Nick DiLoreto of Banyan Global examine the effect of “Overloaded Structures” here.The pandemic may be easing, but the use of virtual platforms for at least some family meetings is probably here to stay. Katelyn Husereau of CFAR offers some timely tips, tricks, and best practices for on-line family meetings here.Inheriting wealth is very different from creating wealth. Coaching the next generation of the family on how to view, and become responsible stewards of, inherited wealth is a common concern of family business leaders. In this article, Sarah Schlesinger of Continuity Family Business Consulting identifies six ways members of the rising generation can productively integrate wealth into their lives.Genuine, healthy family relationships are based on solid connections among family members. Steve Legler writes about the need for enterprising families to look beyond the org chart to discern whether the right kind of human relationships are in place. Check out Steve’s insights here.Is your family business board having genuinely productive conversations featuring different perspectives, or does everyone just go along to get along? Allen Bettis explores the hidden costs of prioritizing artificial harmony in the board room in this article.Speaking of boards, recruiting and retaining quality independent directors that can help guide your family business to the next level is an investment. Are your expectations regarding compensation for directors reasonable for today’s market? Bertha Masuda, Bonnie Schindler, and Susan Schroeder of Compensation Advisory Partners summarize some key findings from their most recent survey on the topic here.
Happy reading!
Mercer Capital’s Value Matters® 2022-03
All in the Family Limited Partnership
Three Questions to Consider Before Undertaking a Capital Project
From time to time in this blog, we take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.What are the most important qualitative factors to consider when evaluating a proposed capital project?Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects. While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second. To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.1. Market OpportunityThe market opportunity question is simply this: Why does the proposed capital project make sense? Management must be able to provide a simple, straightforward, and compelling answer to this question. The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need. Under no circumstances should the answer to this question reference a net present value or internal rate of return. If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.2. Strategic FitOnce the market opportunity has been demonstrated and vetted by the board, the next question is this: Why does the proposed capital project make sense for us? In other words, how does the proposed capital project relate to the family business’s existing strategy? Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable. Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities. If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved. If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders. Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.” If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business. Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.3. ConstraintsThe final question is this: Can the proposed capital project be done by us? Management's time and attention, infrastructure and systems, and human resources are limited. Will undertaking the proposed capital project divert scarce resources away from other areas of the business? In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business. While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run. Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.ConclusionDoes your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible? If it does, that’s great. But the approval process cannot end with a green light on the financial side. Family business directors need to be diligent to answer the qualitative questions identified in this post.Originally posted on Mercer Capital's Family Business Director Blog April 29, 2019
Acquire or Be Acquired (AOBA) 2022: Review & Recap
After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.AOBA’s emphasis has evolved.When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.AOBA 2022 sought to unify several discordant themes.The first theme is fracturing and convergence.While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.The second theme is threat and opportunity.Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.We’ll cover four themes from AOBA 2022.1. FinTech Competitors/Partners & the Nature of CompetitionFinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.The last FinTech theme related to “partnerships.”This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.2. Traditional Bank M&A:Tailwinds & HeadwindsMercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch.Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.Several headwinds to activity exist though:Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.With the banking industry consolidating, fewer potential buyers exist.Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.Another trend to watch is M&A activity involving non-traditional buyers.Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.In a reversal of roles, FinTech companies now have entered the scene as acquirers.In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.3. Subordinated Debt:Act Now?The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.Pricing tightened throughout 2021.Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.4. The Regulatory Wild CardSome attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.ConclusionWe sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.Future conferences will reveal the extent to which traditional and non-traditional competitors converge.Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.
Themes From Q4 Earnings Calls
Part 1: E&P Operators
InPart I of our Themes from Q3 Earnings, topics included increased global demand for U.S. LNG exports and the divergence in the value proposition of E&P operators. Some opted to focus on using free cash flow to either pursue share repurchase programs and/or increase dividends instead of seeking out acquisition opportunities.On the other end of the spectrum, Continental Resources announced an agreement to purchase Delaware basin assets from PioneerResources to the tune of $3.25 billion. Technically, this acquisition was announced in Q4 (on November 3rd), but Continental’s management team made a point of mentioning it in the Q3 earnings call. Still, some companies, like EOG Resources, signaled setting their sights on pursuing more organic, exploration-driven growth and footprint expansion.In the last round of earnings calls for 2021, cost inflation was discussed with a bit more granularity than in recent quarterly calls, strengthening oil prices sparked a shift in focus towards the liquid hydrocarbon streams, and commentary regarding macro policies targeting hydrocarbons were prevalent in E&P management discussions.Cost InflationIn our Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls post from late January, we noted that OFS operators were likely hitting an inflection point in mid- to late-2021, with greater command of the prices they charged their E&P customers than in recent history. While service cost inflation was certainly on the minds of some E&P operators, costs for various industry inputs were mentioned in the Q4 earnings calls.“On the service side, on the rig and the frac crew side, because the way that we've contracted those services we've been somewhat isolated so far, in any kind of cost inflation along those lines. Where we've seen the bulk of the inflation so far in our business has been materials, particularly with respect to steel related material. Probably half of the inflation that we’ve baked into our '22 forecast [5% to 10%, year over year] is almost entirely in either steel or tubular. The rest of it, would it be spread across the multitude of materials that we use in our business." – Chad Griffith, Chief Operating Officer, CNX Resources“Our drilling and completion capital budget of $675 million to $700 million reflects an impact of approximately 5% from service cost inflation. This inflation includes the net benefit of expected sand savings from our regional sand mine.” – Paul Rady, President & CEO, Antero Resources“On the cost side, structural operating efficiency gains in 2021 continue to drive our average cost per foot down by approximately 7% on average, year-over-year. In our 2022 budget, we expect modest cost inflation.” – Jack Stark, President, Continental ResourcesShifting Focus Towards LiquidsIt is not newsworthy at this point to say energy prices bounced back over the course of 2021 as compared to the subdued levels seen over 2020. However, despite the significant increase in U.S. natural gas production (with no countering decrease in gas prices), several E&P management teams noted a shift back towards liquids in the latest earnings calls.“While our 2022 lease operating cost per barrel-oil equivalent guidance is modestly above our 2021 level, this reflects our pivoting towards greater oil activity…” – John Hart, CFO, Continental Resources“My comments today will focus on our current view of the liquids markets, more important than ever given we are fully unhedged on all oil and NGL production as of the start of 2022. The past few months, we have seen crude prices reaching their highest levels since 2014, with Brent and WTI touching these 7-year highs supported by global supply concerns and geopolitical tensions across several key regions. At the same time, demand has surprised to the upside and market demand forecasts have been revised upward, primarily due to the more muted impact of Omicron on global consumption compared to previous COVID variants. NGL prices have also benefited in the current bullish price environment.” – David Cannelongo, Vice President – Liquids Marketing & Transportation, Antero ResourcesPolicy HeadwindsIn our Energy Valuation Insights coverage of Appalachia, we noted a strongly worded letter sent from Massachusetts Senator Elizabeth Warren to natural gas E&P operators for the purpose of “turning up the heat on big energy companies who are gaming the system by raising natural gas prices for consumers to boost profits and line the pockets of executives and investors.” Controversy regarding the perception, whether real or imagined, that the U.S. E&P industry holds enough power to materially or unilaterally guide global energy prices is nothing new. However, several comments made in the Q4 earnings calls suggested a deeper underlying sentiment from E&P management teams that certain industry headwinds are the direct result of certain national policies.“We are proud to play our role in supporting U.S. energy security, which protects the U.S. consumer and serves as a powerful tool of foreign policy providing options for both the U.S. and our allies. We must take on the dual challenge of meeting the world's growing energy needs while also prioritizing all elements of our ESG performance, including efforts to address climate change. This is not an either/or proposition and failure on either front is not acceptable. However, our approach must be pragmatic and grounded in the free market, innovation and an ‘all of the above energy’ approach. We are unfortunately experiencing firsthand the impacts of misguided energy policy and the dramatic role it can play on energy affordability as well as geopolitical stability.” – Lee Tillman, President & CEO, Marathon Oil“I may add one other thing that I know you would have seen some of the comments from the Federal Reserve, if I can, this morning about, ‘Do you want to go and target industries?’ [We note that the referenced comments from the Fed could not be readily verified], and so I think that's why you're seeing us and probably the industry at large being very focused on getting that net debt down, because there is potentially a targeting of this industry to not be friendly toward lending money term.” – Bill Berry, CEO, Continental Resources“What you've got right now, not just within Appalachia, but nationally, is a policy that is designed basically to not have a natural sort of [pipeline] investment occur to match something like the supply of natural gas to the demand centers. I don't know if, at last, we're starting to see some problems manifest with respect to that type of policy.” – Nick Deluliis, CEO, CNX Resources
Mercer Capital has its finger on the pulse of the E&P operator space. As the Oil & Gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
A Primer on a Growing Breed of Bank Acquirers
Credit Unions & FinTech CompaniesWhile still making up a small proportion of overall deal activity (<10% of total deal volume in 2021), acquisitions of banks by both Credit Unions and FinTechs have been increasing in recent years.The first credit union to acquire a bank occurred in 2011/12.Since then, approximately ~55 whole bank transactions have been announced with the peaks occurring in 2019 (14 transactions) and 2021 (13 transactions announced).The first announced FinTech acquisition of a bank was Green Dot’s purchase of a small bank back in 2010 for $15 million. There were also several online brokers that acquired banks from the late 90s to mid-2000s. In 2021, there was a marked increase with six announced transactions whereby FinTechs announced acquisitions of banks.This emerging breed of bank acquirers (CUs and FinTechs) provides bank sellers with an additional pool of potential buyers to consider when evaluating strategic options and liquidity events.Mercer Capital's Jay D. Wilson and Honigman's Michael M. Bell presented this session at the 2022 Acquire or Be Acquired Conference sponsored by Bank Director.
Breaking Up Is(n’t) Hard to Do
Kicking off with the inspired lyrics, “Down dooby doo down down,” Neil Sedaka assured legions of teenage girls in 1962 that “Breaking Up Is Hard to Do.” Sixty years later, the actions of the Follett family are telling family business directors that maybe breaking up is not so hard after all.Tracing its roots to a Chicago area used bookstore opened by Charles Barnes (who later partnered with Clifford Noble) in 1873, the Follett Corporation has been owned by the Follett family since 1923. Soon thereafter the company began to focus on the educational market, with publishing, wholesaling, and retail operations on college campuses. Continued expansion over the decades culminated in the operation of three business segments:Follett School Solutions, a K-12 software and content companyBaker & Taylor, a distributor of physical and digital books and services to public and academic librariesFollett Higher Education, an operator of collegiate retail storesStarting in 3Q21, the Follett family began to “break up” the family business, selling each of its three operating divisions to a different buyer.In September 2021, Follett announced the sale of Follett School Solutions to Francisco Partners.Two months later, Follett announced the divestiture of Baker & Taylor through a management buyout.Earlier this month, Follett announced the sale of Follett Higher Education to an investor consortium led by a family office, Jefferson River Capital.We don’t know what motivated the decision of the Follett family to exit its legacy businesses. Whatever the cause, the series of transactions over the past six months provides a timely reminder that to thrive, businesses need the right owners. Even though the broad theme of books and education would seem to have provided better "glue" for the three business units than many conglomerates we see, the businesses were sold to three different buyers. Although no financial terms were disclosed for any of the transactions, we can only assume that selling the divisions to different owners generated greater net proceeds to the Follett family than a selling to a single buyer would have. What are some possible explanations for that? Why do different businesses sometimes need different owners?Risk ProfilesSome businesses are inherently riskier than others. All else equal, selling large-ticket discretionary items that consumers can easily defer or substitute is riskier than selling staple items that consumers need regardless of economic conditions. That is why the beta (a general measure of risk for public companies) of General Motors is 1.20x while that of General Mills is 0.50x. Return follows risk, and some shareholders are better equipped than others to stomach greater risks in hopes of earning greater returns. That is why some investors own General Motors while others own General Mills. Owning a General Motors-type business while having General Mills-type family shareholders is not a sustainable situation. Both the business and the family are likely to suffer.Return PreferencesShareholder returns come in two forms: current income and capital appreciation. Some investors seek current income, while others desire capital appreciation. Some businesses are better positioned to provide current income, while others more naturally provide capital appreciation. As with risk profile, if the return attributes of your family business don’t “fit” with the return preferences of your family shareholders, there is likely trouble ahead.Capital NeedsBusinesses are either in “planting” or “harvesting” mode. Businesses with a strategy for tackling a large market opportunity often require more investment capital than the operations of the business can provide. As a result, they need to seek out external sources of capital, whether debt or equity. For many families, owning these businesses can be challenging if there is a reluctance to undertake significant borrowings or to admit non-family investors into the shareholder group.On the other hand, some families are flush with capital that needs to be put to work and can grow restless with mature businesses that are perpetually in “harvest” mode. Pushing incremental capital into a business that cannot use it effectively can also breed serious problems for enterprising families.Portfolio CompositionFinally, some businesses may be worth more to a particular investor because of the composition of the rest of that investor’s portfolio. The traditional “strategic” acquirer scenario is the most obvious case, but not the only one. Even what are typically classified as “financial” acquirers often seek out certain types of companies, as illustrated by Francisco Partners, the acquirer of Follett School Solutions. The press release for that transaction notes that “FSS will join Francisco Partners’ growing portfolio of K-12 education-focused businesses and technologies, including Renaissance Learning, Discovery Education, Freckle, myON and Mystery Science.”A legacy operating business often demands – and receives – the lion’s share of the family’s attention, but it is important for family business leaders to occasionally step back and take a broader portfolio view of the family’s wealth. Taking an inventory of the overall wealth of the family can help leaders to assess what businesses make sense for the family to own and which businesses might make more sense for someone else to own.Conclusion: Getting Back to WhyWhy is your family in business together? From an economic perspective, what does your family business mean to your family? Breaking up may be hard to do, but for some family businesses it may be the right thing to do. Selling a family business – or a piece of the family business – does not mean that the broader family enterprise is failing. There are plenty of other businesses to be acquired and/or philanthropic objectives to be pursued. The Follett family illustrates this point well, as described in the press release for the Follett Higher Education sale: “The Follett family and its Board of Directors have enjoyed being part of improving the world by inspiring learning and shaping education for the past 150 years and the Follett family will continue to drive education through advocacy with future projects. The next steps for the Follett Family legacy will be to enhance its effects with future family business education and the Follett Educational Foundation.”Do your family businesses have the right owners? Does a careful analysis of risk profile, return preferences, capital needs, and portfolio composition reveal a good “fit” between your family shareholders and the various businesses your family owns? If not, do you have a strategy for moving toward a better fit? Your enterprising family’s long-term sustainability may depend on it.
Oilfield Services 2022
The Rise of the OFS Bulls
In our Energy Valuation Insights post from last week, Bryce Erickson focused on Oilfield Services (OFS) company valuations. This week we follow the same OFS theme, but with a focus on OFS “expectations” and the question: “Has the OFS industry turned the corner to a more prosperous outlook?”Enthusiasm Among ExpertsOne can’t come away from a review of current OFS industry musings without feeling that, in the endless battle between OFS Bulls and OFS Bears, the Bulls have gained the advantage and are on the rise.From Bloomberg Intelligence – and under the noteworthy heading of OFS Recovery to Reach Cruising Altitude in 2022 – we find that oilfield services industry revenues are expected to grow by ten to fifteen percent in 2022, compared to nearly flat revenue growth in 2021. North American OFS is expected to lead the way with likely 20% revenue gains.Representatives of investment banking firm Evercore’s E&P and OFS groups noted in a recent Natural Gas Intelligence piece that the E&P and OFS groups’ expectations for 2022 remain bullish as they believe we are in the early stages of a long, strong, multi-year E&P spending upcycle.In its recent industry outlook, Zacks noted that the OFS industry is bright again and that the business environment for E&P activities has shown drastic improvement. That improvement is reflective of oil prices having returned to the “glorious days,” thereby leading drillers to return to the oil patch, resulting in significantly improved demand for oilfield services.Many more significantly optimistic references are available, but suffice it to say that expectations for the OFS industry (due to E&P industry activity) have changed a lot, for the better, in the last year.Basis for OptimismSo, what are the industry experts seeing that is leading to this optimism? In short:oil demand rising as the Covid pandemic recedes and the world begins the return to normal levels of activities that require energy use,significant potential for an oil supply shortage, andrecent under-investment in the new production needed to sustain supply.
In light of the factors above, industry analysts are detailing some very positive expectations for the OFS industry. Such as:
The Energy Information Administration (EIA) forecasts that global consumption of petroleum and liquid fuels will average 100.6 million b/d for all of 2022, which is up 3.5 million b/d from 2021 and more than the 2019 average of 100.3 million b/d. On top of which the EIA forecasts that global consumption of petroleum and liquid fuels will increase by 1.9 million b/d in 2023. So, for the first time since Covid reared its head in early 2020, global oil consumption is expected to rise to a level materially higher than pre-Covid consumption.
Mizuho Securities USA LLC indicates in a January 2022 NGI article (U.S. E&Ps, OFS Players Expected to Reset in 2022, with Eyes on Inflation, Supply Chains) that in order to generate sustainable oil volumes through 2022 based on current production volumes, the rig count across the five major U.S. oil basins would have to increase by 100 rigs, compared to a 178 rig increase since January 2021.
Mizuho further indicated that the rate of completions in the major U.S. basins is probably sufficient to support growth. However, the drilled but uncompleted (DUC) inventory is at a historically low level, so more drilling activity will be required. Otherwise, the needed 2022 growth in the U.S. supply could be materially held-back.
Early Indications Favoring the BullsAs to early evidence supporting those expectations, Baker Hughes’ most recent North American rig count is at 854, a level not seen since the onset of the Covid pandemic in March 2020.According to Bank of America, due to the draw-down in global oil inventories in 2021, the oil market is anticipated to move from a steep deficit to a more balanced market. With that in mind, BofA is predicting that WTI and Brent will average $82 and $85 over the course of this year.Other industry analysts, including Goldman Sachs Group, are indicating that oil prices could reach $100 during 2022, while forecasting average 2022 oil prices at $85.
Employment in the U.S. oilfield services and equipment sector rose by an estimated 7,450 jobs in December, according to the Houston-based Energy Workforce & Technology Council.
Zacks Equity Research summarized how all this ties in to the OFS outlook: “The price of West Texas Intermediate (WTI) crude is trading higher than $89 per barrel, marking a massive improvement of more than 50% in the past year. Strong fuel demand across the world and ongoing tensions in Eastern Europe are aiding the rally in oil prices. The massive improvement in oil price is aiding exploration, production and drilling activities. This, in turn, will boost demand for oilfield service since oilfield service players assist drillers in efficiently setting up oil wells.”
Potential HeadwindsOf course, there are also headwinds for the OFS sector that will have to be dealt with, including inflation being a key consideration. As detailed in our January 14, 2022 Energy Valuation Insights post, industry analysts are projecting over 30% average OFS revenue growth in 2022, although average EBITDA margins are expected to edge downward from 13% toward 12%. Inflationary factors are pushing up OFS costs, but such increased costs are expected to only partly be passed through to their E&P clients.In addition, the Biden Administration is clearly adamant about getting the country moving rapidly away from hydrocarbon-based energy, despite the public already complaining mightily about fast-rising energy prices and more general inflationary pressures. Where those political winds will carry the matter is anyone’s guess.In SummaryAs indicated, the companies that comprise the OFS segment – at least those that survived 2020 – experienced some stabilization in 2021, and are now facing what appears to be a market that has the industry analysts feeling fairly bullish. Influenced by rising oil demand, an existing shortage, and recent E&P investment well below the sustainable level, expectations have moved from OFS stabilization to strong multi-year OFS growth in 2022 and likely beyond.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Additional Considerations for Your Buy-Sell Agreement
Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile – but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x – a multiple which is unlikely to be considered reasonable in any market conditions.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.
Review of Key Economic Indicators for Family Businesses
Family business directors are often afforded a luxury that their publicly traded counterparts are not: the ability to focus on and plan for the long term rather than solely the next quarter’s earnings report. While this dynamic can provide some respite from having to keep the TV tuned to CNBC theatrics all day, it is important that family business directors not totally insulate themselves from the surrounding macroeconomic environment outside of their industry. Family business directors should be aware that their operations are subject to the same macroeconomic effects that often steer the results of the public companies in their respective industries.While family businesses may not have the in-house economists and research departments of the larger public, it is crucial for the management and boards of family businesses to keep tabs on the overall economic environment in which they operate, as an understanding of the metrics and trends driving or hampering growth in the economy can inform effective and relevant strategic, tactical, and operational planning and decision making aimed at maximizing long-term shareholder returns. With that, we take a look at a few of the broad trends that bore themselves out in the U.S. economy through the end of 2021 and the first months of 2022.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the fourth quarter of 2021 measured 6.9% over the third quarter. This increase was driven by gains in private inventory investment, exports, personal consumption expenditures, and nonresidential fixed investment. Mitigating factors to the increase in GDP were decreases in government spending (federal, state, and local) and imports, which increased and act as a deduction from the national income and product accounts. Overall, GDP increased 5.7% in 2021, which compares favorably to the 3.4% decline in GDP in 2020 and growth of 2.3% in 2019.Overall, GDP increased 5.7% in 2021. Economists expect GDP growth to continue into the next two quarters.Economists expect GDP growth to continue into the next two quarters. A survey of economists conducted by TheWall Street Journal in January reflects an average GDP forecast of 3.0% annualized growth in the first quarter of 2022, followed by 3.8% annualized growth in the second quarter. The forecasted growth in GDP of 3.0% in the first quarter of 2022 is down from previous estimates from the October survey, in which forecasters surveyed by the Journal estimated first quarter GDP to be 4.2%. This downgrade in expectations was the result of higher-than-expected inflation in the final months of 2021, ongoing supply chain constraints, and concerns surrounding the spread of the Omicron variant, which threatened to put a dent in consumer spending and exacerbate labor shortages, as workers are forced to call in sick.Click here to enlarge the imageInflationEstimates from the Bureau Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.6% in January 2022 on a seasonally adjusted basis. On a year-over-year basis, the CPI increased 7.5% from January 2021 to January 2022. This annual increase was the largest since February 1982 and was well above the December year-over-year increase of 7.0%. For context, in the pre-pandemic days of 2019, the CPI increased at an annual rate of 1.8%. Economists generally agree that the recent record increases in inflation reflect not only supply constraints in the goods market, but also still elevated levels of demand for goods and services from U.S. consumers. The Wall Street Journal survey reveals expectations for some tapering in the annual rate of inflation, as economists surveyed forecast the year-over-year increase in June 2022 to be 5.0% and the December increase to be 3.1%.The Wall Street Journal survey reveals expectations for some tapering in the annual rate of inflation.The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. While January 2022 estimates for the PPI were not available at this writing, the PPI increased 0.2% in December 2021 and 9.7% in 2021, which is the largest annual increase in PPI since the data were first calculated in November 2010. The most practical application of the current inflationary environment for family business owners and directors is the potential for price increases (perhaps in excess of those already no doubt put in place in 2021) aimed at protecting margin.Labor MarketsTotal nonfarm employment rose by 467,000 in January 2022, and the unemployment rate (U-3, total unemployed, seasonally adjusted) measured 4.0% according to the Bureau of Labor Statistics’ January release. For context, the unemployment rate was 6.4% in January 2021 and 4.7% in September 2021.The unemployment rate was 4.0% in January 2022 (6.4% in January 2021 and 4.7% in September 2021).The January 2022 employment figures outperformed expectations, as hiring demand continued to be high even as the Omicron variant surged. Still, the variant put a dent in the January employment figures. Nonfarm employment would have risen even higher if not for the surge in Omicron cases, as the Labor Department reported that nearly two million workers were prevented from looking for a job in January due to the rise in cases. With unemployment falling and wages increasing on inflationary effects, Fed watchers expect the FOMC to stay the course with regard to the potential for interest rate increases in 2022, which we discuss below.Monetary Policy and Interest RatesThe FOMC met for the first time in 2022 in late January. Since the beginning of the pandemic in March 2020, Fed officials have pledged to hold interest rates near zero until inflation was forecast to moderately exceed 2% and labor markets returned to conditions consistent with maximum employment. In the aftermath of the January meetings, Fed officials signaled that these conditions have been met and that interest rate increases would begin in March. In his press conference following the meeting, Fed Chairman Jay Powell stated, “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that we put in place to deal with the economic effects of the pandemic ... I think there’s quite a bit of room to raise interest rates without threatening the labor market.” These remarks led investors in interest-rate futures markets to fully anticipate a March rate increase of at least one-quarter of a percentage point. The CME Group also forecasts a nearly 70% chance of a second interest rate increase the Fed’s meeting in early May. If both of these rate increases come to pass, it will be the first time since 2006 that the Fed has raised rates at consecutive meetings.The cheap financing environment of the past two years may be coming to an end.As we saw earlier, inflation has easily surpassed the 2% target set out by the FOMC in recent months, but the sharp drop in the unemployment rate and widespread wage gains in labor markets have created greater urgency by the Fed to raise rates sooner than previously anticipated. With the conditions for rate increases achieved, family business directors and management should be keenly aware that the cheap financing environment of the past two years may be coming to an end. Various interest rates already reflect the prospect of increases to the fed funds rate, as the yield on 20-year treasury bills measured 2.37% last week, which is up from 1.77% at the beginning of December. Corporate borrowing rates have also increased in recent weeks, as the Moodys Baa Corporate Bond Yield measured 3.94% at its last reading. This is up from approximately 3% in early December.ConclusionThe broader economic environment has certainly been more, shall we say, active, in recent months than even at times during the height of the pandemic. Now more than ever, family businesses directors and management must make informed decisions in the context of overall economic conditions. We hope this piece, and future posts, can be a resource and tool for doing just that.
Oilfield Service Valuations: Dawn Is Coming
Most people who know me know that I have loved movies most of my life. One favorite is 2008’s The Dark Knight, where Harvey Dent proclaims hope to a skeptical media, “The night is darkest just before the dawn. And I promise you, the dawn is coming!” This comes to mind as I observe valuations and prospects for oilfield service companies. It has been tough sledding for OFS companies during COVID. Many shuttered their doors, equipment, or people. At the end of 2020, rig counts were around 350 and DUC counts were high.However, as we’ve been talking about for the past several weeks, things have changed for the positive as far as the industry is concerned, and it’s going to get better according to people like Marshall Adkins of Raymond James, who spoke at the NAPE Global Business Conference in Houston. The current U.S. rig count is now at 613 and, according to Mr. Adkins, may be heading to 800 this year if OFS companies can fill a real labor shortage gap.However, when it comes to valuations, assuming oilfield service companies will join the recovery has not always been true in the shale era. That said – this time may be different.What’s Old Is New: Cycle Could Be PivotingOFS is well documented to be one of the most cyclical industries. Financial performance tends to lag customers in the E&P sector. As an example, despite the expectation for strong revenue growth in 2022, analysts project that EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%, to a current figure of 12.2%. However, what if that growth continued beyond 2022 and into the following years? Many think this will be the case as global demand for oil and gas continues to grow amid the surge in renewables. Industry research analysts at IBISWorld project growth of 2.4% compounded for the entire $85.4 billion revenue industry (that’s over $2 billion of revenue growth every year for the next five years). Adkins sees this as the beginning of a multi-year bull run for energy on the tail of sector underinvestment, low supply, inflation, and demand growth rising to pre-COVID levels.Past Oilfield Service PerformanceOilfield service providers, drillers, pumpers, and equipment providers enabled E&P companies to ramp back up. So, where do they stand today? One lens through which to view things is the OSX index–a popular metric to track sector performance.
Since the end of 2020, the OSX index has bounced around but has generally moved back up as demand has risen. In addition, this will almost certainly go higher if rig counts go back up to 800, which hasn’t been the case since 2019. From Adkins’ perspective, his question is: will the OFS industry be able to handle getting back up to 800 rigs? This is particularly acute from a labor perspective. The oilpatch has long been challenged to attract workers because of seasonality, remote operations, camp life, and the expectation that you will continue working regardless of the weather.
It compensated with high wages, interesting and challenging work, and endless opportunities for advancement in a growing industry. But that’s not the case in 2022. The young generation that the industry has always managed to attract is increasingly urban, pampered, and has grown up in a society that has a negative impression of fossil fuels and is produced by an industry that some perceive to have no future.
All the while the demand grows. Part of the reason for this growing demand is the steady depletion of drilled but uncompleted (DUC) well inventory in the past year or so. DUCs will eventually deplete to the point that more new wells must be drilled, thus increasing demand for OFS. E&P companies will, out of necessity, rediscover great respect for their suppliers. And the service sector will enjoy rewards for surviving the past seven years – perhaps not bigger, but certainly much better.
Current Oilfield Service PerformanceHigher oil prices, coupled with competitive breakeven costs for producers, are making drillers, completers and a host of other servicers busy. Capex budgets for E&P companies, known as lead indicators for drillers and contractors, have cautiously been increasing, even amid the capital discipline drumbeat over the past several years.IHS Markit released a report early this month titled, “The Great Supply Chain Disruption: Why It Continues in 2022.” In the introduction, Vice-Chairman Daniel Yergin wrote, “There is no recent historical precedent for the current disruption in the modern highly integrated global supply chain system that has developed over the last three decades … [resulting in] delays and disruptions for manufacturers and deliveries on a scale never recorded in our 30 years of PMIs (Purchasing Managers’ Index).”In the meantime, the oil patch will need its supply chain to be working. According to Rystad Energy, the average productivity of new wells in the Permian Basin is set to hit a record high in 2022, breaching past 1,000 BOED due to a surge in lateral well length. The only way that this can be done is with more OFS services.Valuation TurnaroundNow that utilization rates and day rates are both trending upward, valuations should logically respond and by certain aspects, they are.Take, for example, a selection of guideline company groups: onshore drillers and pressure pumpers (fracking companies). One way to observe the degree of relative value changes is to look at enterprise value (sans cash) relative to total book value of net invested capital (debt and equity) held by the company or “BVIC”. Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm, which for drillers and pumpers is a notable threshold.
In 2019-2020, with a multiple well below 1.0x, investors didn’t expect to get an adequate return on the capital deployed at these companies. However, in 2021 and continuing in early 2022, that trend has reversed. This suggests that the market is recognizing intangible value again for assets such as developed technology, customer relationships, trade names and goodwill.
For pressure pumping and fracking concentrated businesses, which are more directly tied to DUCs, the trend is clear. Intangible asset valuations have grown even faster, more heavily weighted towards pumpers’ developed technology that is driving demand for these companies’ services.
ConclusionOverall rig counts have shifted downward since 2014 and are currently nowhere near levels back then, however, this cycle may resemble pre-shale eras when fundamentals like inflation, supply issues, and related factors pushed commodity prices upward for extended periods. Oil and gas are fundamental economic building blocks in the world economy. If the longer-term cycles are pivoting towards the direction they appear, values of OFS companies may be increasing for a longer cycle this time.
What Publix Supermarkets Can Teach Family Businesses
When something as innocuous as a grocery store has a cult following, sometimes it is helpful to pay attention. When that store also has net income margins 2x to 3x those of its peers, you should definitely pay attention.Barron’s recently featured Publix Super Markets. Founded in 1930, Publix operates about 1,300 stores and more than 800 of them in its home state of Florida. And as Barron’s points out, if you are chomping at the bit to own the stock, you’ll have to grab a green apron: Publix is privately held and is owned by employees, board members, and the founding Jenkins family. According to Barron’s, Publix had a valuation in November 2021 of approximately $45 billion.Other than enjoying the free cookies (which my daughters insist upon as we enter the parking lot), what can we take away from Publix? While there are likely dozens of lessons to be learned from Publix, family business owners and leaders should consider three areas key to Publix’s success over the last 90 years: long-term planning, smart diversification, and strong family culture.Long-Term PlanningManagement succession is often a hiccup in a family business’s long-term planning. Estate plans may be in order and stock secured in tax-advantageous trust entities, but who is actually going to drive the boat once current leadership cycles out of the captain’s chair? We highlighted previously that the majority of family businesses have no succession plan at all.What about Publix? Its CEO, Todd Jones, started with Publix 41 years ago and began as a store clerk. Jones has a reputation as a workaholic and exhibits many of the values of the family and the company. Additionally, Jones is the first CEO not to be a member of the Jenkins family. It is apparent the Jenkins family and ownership have fostered a management program that builds its leaders from within while maintaining the company’s long-term vision. While many family businesses may struggle with handing control over to a non-family CEO, Publix and its shareholders appear to have a solid understanding of what the business means to them and have decided having a Jenkins family member at the helm is not a requirement for the family.Smart DiversificationSo how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business means to the family, the potential for diversification benefits may take priority over absolute return.Part of Publix’s success is owed to its ownership of a considerable amount of real estate, including its distribution centers and manufacturing facilities, signaling a priority on diversification over absolute expected returns. While real estate may not be a “core competency,” holding many of its facilities and hard assets diversifies its fortunes away from its operating grocery business. This has been accomplished while building a strong balance sheet: virtually no debt, $2 billion in cash, and over $13 billion in investments.Strong Family CultureAn unfortunate myth that has perpetuated itself regarding family businesses is the “shirtsleeves to shirtsleeves in three generations” adage damning the fate of family businesses. Josh Baron and Rob Lachenauer, whose Harvard Business Review | Family Business Handbook we reviewed previously, illuminate a number of findings that fly in the face of this axiom. You can read the full article here, but to simplify, “The data suggests that, on average, family businesses last far longer than a typical public company does.”So it would appear family businesses may have an advantage over their publicly traded counterparts regarding longevity. As we have repeatedly highlighted on Family Business Director, while public companies plan for the next quarter, successful family businesses plan for the next decade.So what is Publix doing to maintain a strong family culture? One, over 90% of the company’s 225,000 employees own stock through its ESOP (something we here at Mercer Capital, an employee-owned company, understand well). Shares are granted annually to staff, and employees can also purchase shares from the company. And while Publix does not share its average employee ownership, the figure is estimated at more than $150,000 in stock, adjusting for the $8.8 billion stake reportedly held by the Jenkins family. Many longtime staff members are millionaires. The company’s ownership structure is conducive to multi-generational value creation, aligning employee incentives with long-term thinking. Despite having outgrown “mom-and-pop” status years ago, the business still exhibits characteristics typical of smaller family businesses that keep the focus on the long haul.Final LessonsThe share price is many times seen as the ultimate “scoreboard” for a company. Publix’s stock price (per internal reporting) has risen from $47.10 in November 2019 to $66.40 in November 2021, a 41% increase over the period. This, coupled with its quarterly dividend of $0.37 cents a share ($1 billion of annual payments to shareholders), large cash and investment balance, and little debt, gives a strong case that whatever they are doing at Publix appears to be working. Family businesses have multiple areas to consider when looking at the Publix success story. It would be wise to heed some of the characteristics they exhibit. Give one of our professionals a call today to discuss how we can help you guide your company to long-term value creation.
Mercer Capital’s Value Matters® 2022-02
Bear Market Silver Lining? An Estate Planning Opportunity
Transaction Outlook 2022
Dealmakers logged record levels of merger and acquisition activity in the middle market (deal values between $10 million and $500 million) in 2021. In this post, we highlight a few of the trends that bore themselves out in middle-market M&A activity in 2021 that family business owners and directors should keep in mind when evaluating potential transactions in 2022.1. Widespread Liquidity2021: One of the key factors that drove M&A to levels observed in 2021 was companies’ elevated liquidity positions and cash balances relative to pre-pandemic levels. Both public and private companies built up large cash balances in 2020, as large discretionary capital spending projects were often deferred until the uncertainty initially brought on by the pandemic was resolved. Many companies also generated better-than-expected earnings and cash flows throughout 2020 and 2021, adding to the already accumulating war chests on corporate balance sheets. Many companies put these inflated cash balances to work pursuing M&A opportunities in 2021, as the practical difficulties (in-person diligence, etc.) associated with closing deals in 2020 were generally alleviated in 2021. 2022: We expect this trend to continue into 2022, as cash-rich companies will continue to look for favorable M&A opportunities that competitors could otherwise potentially pursue. While some observers believe pricing for deals in the middle market is at an unsustainably high level, growing corporate cash balances may well continue to support elevated deal values and multiples in 2022. These dynamics are likely to extend the favorable environment for sellers in the middle-market that has persisted for the past several years.2. Ease of Financing2021: Companies that chose to finance deals rather than pay cash in 2021 benefitted from historically low interest rates thanks to continued quantitative easing pursued by the Fed in response to the pandemic. “Easy money” policies accelerated the use of debt across the middle market, as seen in the chart below. Total debt to EBITDA multiples in the third quarter of 2021 reached 4.1x, the highest level over the past two years. 2022: As the economy continues its recovery and inflationary pressures persist, Fed Chairman Jay Powell has signaled that the Fed plans to raise interest rates by 25 basis points at least three times in 2022. While these increases will still leave rates at relatively low levels, buyers looking to take advantage of the current credit environment may look to accelerate deals - closing sooner rather than later in 2022.3. Increased Levels of Private Equity Activity2021: As seen in the chart below, private equity (financial) buyers were increasingly active in 2021, and we expect that the data from the fourth quarter of 2021 will show a continuation of this trend when released. During 2021, the prospect of an increase in capital gain tax rates loomed large over the middle market. This helped bring some corporate assets to market, as sellers looked to take advantage of the current tax environment. Private equity firms deployed capital across the middle market, capitalizing on the buying opportunities brought on uncertainty surrounding future tax policy.2022: Private equity buyers are expected to remain active in the middle market in 2022. According to S&P Global Market Intelligence, PE firms ended 2021 sitting on record amounts of dry powder (committed, but unallocated capital). We expect PE firms to be anxious to deploy this capital in 2022, which will increase competition for deals and could drive multiples even higher.The trends outlined above contribute to a continued positive outlook for potential sellers of well-positioned businesses in 2022. Elevated levels of liquidity, relatively cheap debt financing, and increased levels of private equity activity all signal that the seller’s market of the past several years will likely persist in 2022. While we believe these trends to be instructive as to the potential transactional climate in the middle market in 2022, we also recognize that every family business has a unique “meaning,” which we have outlined on this blog before. When pursuing a transaction on either the buy side or the sell side, it is crucial for family business owners and directors to first develop consensus regarding what the family business means to the family. In short, what may be a favorable transactional opportunity for one family business could turn into a boondoggle for another. Evaluating M&A opportunities on both the buy side and the sell side through the lens of your family business’ “meaning” is crucial to creating value for your family business through M&A. As seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. Give us a call if you want us to take a look at an acquisition target or LOI from a potential acquirer of any part of your family business.
Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls
Nuances of the Upstream PerspectiveAs our readers are well aware, Mercer Capital tracks and reviews themes from the quarterly earnings calls ofE&P operatorsand mineral aggregators, providing key insights into the upstream perspective on U.S. oil and gas. In this post, we look at oilfield service (OFS) company earnings calls for the first three quarters of 2021. Looking forward, we will likely incorporate OFS earnings calls in our quarterly survey of themes from the public oil and gas sector, using this post as a reference point for the upcoming round of Q4 2021 calls.We typically review earnings calls for 3 to 8 companies among the E&P operators and mineral aggregators each. Likewise, we look forward to reviewing calls for a roster of approximately 7 OFS companies that operate in the primary onshore U.S. basins covered by Mercer Capital. In this inaugural survey, however, we focus on Q1 through Q3 earnings calls for just two OFS companies – Halliburton and Ranger Energy Services. We follow the earnings call themes for these two companies, who represent some of the largest and smallest (by market cap) public OFS companies, through the first three quarters of 2021 to get a sense of how OFS industry dynamics have evolved over the past year.Promoting ESG InitiativesIn our review of Q1 2021 earnings call themes among E&P Operators, we saw a continued trend (from Q4 and Q3 2020 E&P operator earnings call themes) of emphasizing and discussing the progress of various ESG initiatives. This theme was absent in the Q2 2021 E&P earnings calls, and not a significant theme in the Q3 2021 E&P earnings calls. However, OFS operators were clear to point out their contribution towards various ESG initiatives throughout the first three quarters of 2021.“We're excited about the progress of Halliburton Labs, our clean-energy accelerator. In the first quarter, we announced Halliburton Labs' inaugural group of participating companies. They are working on solutions for transforming organic and plastic waste to renewable power; recycling of lithium-ion batteries; and converting carbon dioxide, water, and renewable electricity into a hydrogen-rich platform chemical.” – Jeff Miller, President & CEO, Halliburton [Q1]“We have successfully completed gas processing jobs for both dual fuel and e-frac fleet and anticipate more to come. There are several rewarding attributes to this transition. We are tangibly contributing to the ESG efforts of our industry.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“On the Processing Solutions side, we continue to expect our customers' ESG mandate to drive an uptick in both the traditional flare gas capture use and newer fracturing dual-fuel and e-fleet generation fuel supply. We continue to have pilot program success on fuel supply projects, but have yet to sign that elusive long-term contract. Stay tuned here as stronger commodity pricing, incremental flare gas, emission regulation and the build-out and adoption of dual fuel and electric frac fleet are all tailwinds for our Processing Solutions segment.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“In the third quarter, Halliburton completed an all-electric pad operation on a multi-year contract with Chesapeake Energy in the Marcellus Shale.” – Jeff Miller, President & CEO, Halliburton [Q3]Opportunistic Acquisitions & Increased Consolidation of Smaller OperatorsWhile mineral aggregators were active on the M&A front in Q3 2021, with a favorable sentiment towards expanding their holdings since Q1, E&P operators were relatively quiet in the Eagle Ford and Appalachian basins, a bit more active in the Bakken, and chomping at the bit in the Permian. OFS operators, particularly those for whom incremental expansions carry more weight, kept their eyes on the horizon over 2021.“Our acquisition strategy has been fixed and simple. We are focusing on potential counterparties with top-tier assets, who have a reputation for best-in-class service quality. We are looking at both bolt-ons to our existing service lines and complementary service lines that extend our current core service offerings. Tactically, we believe in being opportunistic.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“As we said in the prepared remarks, many of these small operators, frankly, we believe, lived and died on the PPP. They priced things that keep them alive and trade dollars. We think by signaling, and more than signaling that there's consolidation, and we think there'll be other players that will try to consolidate.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]Leverage to Increase Service PricingThe greatest theme of 2021 from the perspective of E&P operators and mineral aggregators was the upward trajectory out of the crude abyssfrom 2020. What a difference a year makes, both in hindsight and for the road ahead. This was probably most present with OFS operators, which likely hit an inflection point from riding the wave as price-takers to potentially commanding the wave as price-makers in the near-term or at least being able to take more than what they can just get.“Service pricing improvement is the final step. We're not there yet, but we see positive signs of market rebalancing that should drive future pricing improvements. Total fracturing equipment capacity has limited room to grow in the current pricing environment.” – Jeff Miller, President & CEO, Halliburton [Q1]“I believe equipment availability will tighten much faster than most people think. In multiple product lines, we believe that equipment supply will fall behind anticipated demand. Today, both drilling and completions equipment are nearing tightness in North America.” – Jeff Miller, President & CEO, Halliburton [Q2]“Our primary near-term objective is driving margin expansion. Our largest near-term lever here is pricing.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“I'll give you two anecdotes. One customer was a smaller customer, that we went and said that these need to be the new rig rates for us to continue, working beyond what we had committed to. They were pretty upset. Used some pretty colorful language. And we said, we're going to okay, well, we will finish up our jobs that we committed to, and we'll walk away. Half an hour, they call back and agreed to it, right? So clearly, our view is that they got on the phone, called around, and realized that there wasn't anything available. And another one with a much bigger customer said that they wanted to add additional rigs. They were trying to use that as a bargaining chip for basically a volume discount. We very quickly said we'll talk about additional rigs only, until we get our first pricing, basically the first wave of price increases. It's been a multiple conversation event, but I think we’re getting there.” – Stuart Bodden, President & CEO, Ranger Energy Services [Q3]ConclusionMercer Capital has its finger on the pulse of the oil and gas sector. As upstream operators, mineral aggregators, and the OFS operators that support them regain their footing, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team.
2022 Credit Market Outlook for Family Businesses
In this week's Family Business Director, we feature Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, a veteran banking analyst, and an editorial contributor to SNL Financial. He regularly is featured in American Banker, Bloomberg News, and other industry outlets.Barring a change in the economic backdrop, the availability of debt financing for most family businesses in 2022 should be good; however, the cost of borrowing probably will rise in 2022. Market participants are highly certain the Fed will raise short-term policy rates to address high inflation that massive growth in monetary aggregates since March 2020 unleashed on financial markets initially and now the broader economy.As shown in the chart below, the yield on two-year and ten-year US Treasury (“UST”) notes have been trending higher for some time. The two-year note is sensitive to short-term policy rates the Fed sets (e.g., the rate the Fed pays banks for reserves that are deposited with it). It has rapidly increased in yield (i.e., the price has declined) since last September when it became obvious that inflation was not “transitory” and the Fed faced a political as well as economic issue of having not acting sooner. Click here to expand the chart below.Source: Market Yield on U.S. Treasury Securities at 2-Year Constant Maturity (DGS2) | FRED | St. Louis Fed (stlouisfed.org)The yield on the 10-year UST is not directly tied to where the Fed sets short-term policy rates. Theoretically, the rate reflects economic growth expectations, inflation, and a term premium for long lending. If short-term policy rates are kept too low, then all else equals the yield on the 10-year would be expected to increase as growth and inflation expectations rise. Conversely, once the Fed starts hiking, long-term UST rates initially tend to rise less than the Fed hikes and later often decline as investors wager the Fed will hike until something breaks.This is what occurred in 2018. The yield peaked in October and fell sharply as investors concluded the anticipated December rate hike would be ill-advised. The yield on the 10-year continued to trend lower in the first half of 2019 before the Fed was forced to reduce short-term policy rates three times to about 1.50% during the third quarter.Since late March 2020, short-term policy rates have been near zero when the Fed cut rates to address illiquidity in markets and the economic shock from policy actions taken in response to the COVID-19 pandemic.It is these short-term policy rates that are now poised to increase, which in turn impact short-term benchmark rates banks and other lenders use as a base rate to charge businesses, most notably 30-day and 90-day LIBOR and now the secured overnight funding rate (“SOFR”) for floating rate borrowings. (Note: LBIOR is in the process of being phased out and will be replaced by SOFR, AMERIBOR, and other less well-known overnight borrowing rates.)Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.Fixed borrowing rates that track UST and swap rates for various maturities have already begun to rise somewhat and will increase further in 2022 provided UST yields continue to track higher.Competition among lenders determines the margin over the base rate whether short-term floating or intermediate-term fixed the borrower will be charged. Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.As shown below, market participants are pricing in about four 25bps hikes in short-term policy rates by the Fed given about 100bps of increase in 30/90-day LIBOR based upon rates that are observed in the highly liquid Eurodollar market. Likewise, the forward SOFR curve also is pricing in about 100bps of increase over the next year. Over the next two years, the market is pricing in about 175bps of hikes, which would equate to seven 25bps hikes by the Fed compared to nine during the last hiking cycle that ended in December 2018.If market expectations are fully realized, borrowing rates for family businesses should remain very low by historical standards, just not as low as 2020 and 2021. Our sense is that most businesses will not be materially impacted given the market projects' low terminal rate. Higher rates will only be an issue if the borrower’s industry or broader economy falls into recession.An unanswered question is whether financial markets can stand the prospective increase given the massive leverage employed for speculation and to fund “carry trades” in which leverage is used to increase the amount of income produced from low-yielding bonds. If markets cannot tolerate much increase, then the question will become at what point will the “Fed put” or “Powell put” be triggered in which further hikes are precluded or even reversed?No one knows, but this link provides an interesting perspective on the accuracy of forwarding curves. Since the Fed experimented with very low policy rates in the early 2000s when the Fed Funds rate was set at 1%, market participants have projected hikes would commence sooner than occurred. Also, once hiking cycles began, market participants projected less hiking than occurred.In effect, investors believed rates were too low once reduced to near zero; and once the hiking began, the Fed did not have as much latitude as it thought it had to raise rates given the build-up of debt in the economy and markets.
Desert Peak to Go Public via Merger With Falcon After IPO Attempt
Desert Peak Minerals and Falcon Minerals Corporationrecently announced an all-stock merger, forming a pro form a ~$1.9 billion mineral aggregator company. This comes in the wake of Desert Peak’s attempted IPO in late 2021. In this post, we look at the transaction terms and rationale, the implied valuation for Desert Peak, and implications for the mineral/royalties space.Transaction OverviewThe merger will combine Falcon’s ~34,000 Eagle Ford and Appalachia net royalty acres with Desert Peak’s ~105,000 acre Delaware and Midland position, resulting in a combined company with ~139,000 net royalty acres. Approximately 76% of the company’s acreage position will be in the Permian, with 15% in the Eagle Ford and 9% in Appalachia. Pro forma Q3 2021 production was 13.5 mboe/d, which moves Falcon from the smallest (by production) publicly traded mineral aggregator in Mercer Capital’s coverage to number four, leapfrogging Dorchester and Brigham.The transaction is expected to close during the second quarter of 2022, at which time legacy Falcon shareholders would own ~27% of the company, while legacy Desert Peak shareholders would own ~73%. The combined company will be managed by the Desert Peak team and headquartered in Denver.Going forward, one of the key strategies of the company appears to be M&A. The company seeks “to become a consolidator of choice for large-scale, high-quality mineral and royalty positions” and touted its “strategic, disciplined, and opportunistic acquisition approach” in presentation materials.The company also highlighted its ESG credentials, noting the diversity of its workforce and structural economic disincentives for flaring gas. However, most ESG discussions focused on the often-neglected G – governance. Management incentive compensation is expected to be 100% in the form of equity with an emphasis on total shareholder returns, rather than relative returns or growth metrics.Desert Peak Implied ValuationDesert Peak was pursuing an IPO in late 2021, looking to raise $200 to $230 million at an implied enterprise value of $1.2 to $1.4 billion, based on Mercer Capital’s analysis of Desert Peak’s S-1 filing. However, the deal was postponedin November and ultimately withdrawn in January.Based on Falcon’s stock price immediately preceding the announcement, the merger terms imply an enterprise value of $1.4 billion for Desert Peak, slightly higher than the valuation implied by the top-end of the IPO range. However, Falcon’s stock price has slid since then, bringing Desert Peak’s implied valuation back in line with the mid-point of the IPO range.Implied valuations and relevant multiples are shown in the following table.IPO stock price reflects midpoint of $20 to $23 range indicated in Desert Peak’s S-1. Merger stock price reflects Falcon's closing stock price as of 1/11/2022 (immediately preceding merger announcement). Current stock price reflects Falcon's closing stock price as of 1/19/2022.IPO shares pro forma for anticipated IPO offering. Other figures reflect the number of Falcon shares to be issued to Desert Peak.IPO net debt pro forma for anticipated transaction proceeds, as indicated in Desert Peak’s S-1. Other figures reflect net debt as disclosed in the transaction press release.Metric per transaction press release (as of 9/30/2021).Metric per transaction presentation (as of 9/30/2021). Multiple calculated on a dollar per flowing barrel equivalent basis ($/boe/d).Metric per Desert Peak S-1 (pro forma as of 12/31/2020). Multiple calculated on a dollar per barrel equivalent basis ($/boe).Metric per Desert Peak S-1 (pro forma as of 12/31/2020).Metric per transaction presentation.ImplicationsDesert Peak's inability to complete its IPO highlights the lack of appeal of oil & gas assets among generalist investors, which is not welcome news for an industry facing capital headwinds and a dearth of IPO activity. However, Desert Peak was able to structure a new deal at essentially the same valuation should give mineral and royalty owners confidence that logical buyers can be found.ConclusionWe have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Middle Market Transaction Update Second Half 2021
In this issue of Mercer Capital’s Middle Market Transaction Update, we take a look back at the trends that drove middle market deal activity to record levels in 2021 and whether we expect these trends to continue into 2022.
2022 Tax Update for Estate Planners and Family Businesses
Where Are We With Tax Policy?Entering 2021, tax worries and changes in tax policy were at the forefront of discussion in the political, business, and estate arenas. Changes including removing the step-up in basis on capital gains at death, increasing the corporate tax rate, eliminating valuation discounts, neutering GRATS, increasing the capital gains rate on high incomes, and lowering the gift and estate tax exemption were all on the table as part of the Biden Administration’s agenda upon taking office.As 2022 kicks off, tax policy largely remains unchanged from a year ago. President Biden’s Build Back Better (“BBB”) Act went through numerous iterations over the year and was politicked down from a headline program cost of $3.5 trillion to $1.7 trillion before ultimately being kiboshed by Senator Joe Manchin (D-WV) publicly pulling his “Yea” from the bill in late December.But where does that leave estate planners and family businesses? There are three things estate planners and business advisors need to keep top of mind regarding tax policy in 2022.1. Major Tax Overhaul Less Likely…A short column from Bloomberg Tax highlighted the President’s herculean task of resurrecting BBB heading into a contentious 2022 midterm election cycle, with multiple purple state Democrat Senators not named Joe or Kyrsten facing tougher reelection battles. The likelihood of major tax changes diminishes as the calendar approaches November 2022, and the polling would suggest Democrats may be less willing to pass sweeping changes in the face of a ‘red wave’ in the midterm elections. Watch closely: if nothing transpires early in the legislative calendar, the likelihood of major tax changes will likely dissipate until at least January 2025.According to a report from The Hill, Democratic aides say the BBB bill won't be ready for floor action any time soon and predict the wide-ranging legislation may have to be completely overhauled. Senate Majority Leader Chuck Schumer (D-NY) informed colleagues the Senate will begin focusing on voting rights legislation in the New Year, further signaling a shift from tax policy. After a year of tax consternation, it might be nice to ring in the new year with less tax anxiety immediately on the horizon.2. Changes Still LurkingSpeaking during a radio interview, Senator Manchin offered a path to revive a skinnier version of President Biden’s BBB bill. Senator Manchin said the legislation should go through Senate committees in order to examine any economic impacts and focus on rolling back the 2017 Tax Cuts and Job Act (“TCJA”) tax cuts.What parts of TCJA is Senator Manchin referring to? Hard to say, but the largest changes in the TCJA included a decrease in individual income tax rates, a decrease in the federal corporate income tax rate from 35% to 21%, and the qualified business income deduction to pass-through entities. The law also increased the estate tax exemption for single and married couples (discussed below) to their current schedule.Senator Manchin has also indicated he is willing to support some version of a tax targeting billionaire wealth via a wealth tax mechanism, a cause generally supported by the more progressive wing of the Democrat party. While this may not affect as many readers here, it does reflect the Senator’s willingness to entertain more aggressive tax increases (while maintaining his issue with the spending programs outlined in BBB). While less vocal moderate Democrats are likely concerned with voting on any tax increase in 2022, this may be the President’s only shot to pass broader tax policy changes if a ‘red wave’ does transpire in 2022.3. Remember the Transfer Tax Law SunsetFor family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026 (as well as current income tax rates). Per The National Law Review, the Treasury Department has confirmed the additional transfer tax exemption under current law is a use it or lose it benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced.As we’ve written previously the current estate and gift tax exclusion is an opportunity for privately held and family businesses to accelerate their gifting strategies. In 2022 the gift and estate tax exemption increased to $12.06 million ($24.12 million for a married couple), allowing families and estate planners to maximize lifetime gifts in a tax advantageous environment. As an added bonus, federal tax laws allow for an annual exclusion that avoids the estate/gift tax exemption entirely. This level was set at $15,000 per recipient for 2021 and will increase for inflation to $16,000 in 2022.ConclusionAs we have written previously in Family Business Director, don’t let the tax tail wag the business dog. Estate tax planning efforts should be opportunistic while remaining focused on the bigger goal, which is ensuring a successful transition of the ownership of the family business from one generation to the next in a way that promotes the long-term sustainability of the family and the business.Keeping a semi-regular eye on Washington D.C. can be beneficial to estate attorneys and family businesses looking to avoid legislative pitfalls that can torpedo an estate plan. Just remember that predicting the future is perilous: the BBB act may be mortally wounded, but like any good political drama, you have to remember the evil twin brother who has been lurking out of frame. Contact a professional at Mercer Capital with your valuation needs in support of your estate planning.
What a Difference a Year Makes: Part II
Analyst Projections
In our prior Energy Valuation Insights post – What a Difference a Year Makes – Mercer Capital’s Bryce Erickson dug into the key aspects of the energy industry during 2021, including oil and gas pricing, stock price performance, rig counts, production levels, capital spending, and LNG facility development. It’s well worth a read!In today’s post, we continue the “what a difference a year makes” theme, but now with a focus on analyst projections, then-and-now (then being as of year-end 2020, and now being as of year-end 2021) and energy stock valuation multiples.For the purpose of our analysis, we utilized the Capital IQ system and identified publicly traded energy companies, trading on the NYSE and NASDAQ exchanges, and operating in three broad areas – exploration and production (E&P), oilfield services (OFS), and midstream.The resulting pool included 44 E&P, 32 OFS, and 29 midstream companies1,227 forward (i.e., for the next year) revenue estimates were included in the analysis – 666 as of year-end 2020, and 561 as of year-end 20211,735 forward EBITDA (earnings before interest, taxes depreciation and amortization) estimates were included in the analysis – 854 as of year-end 2020, and 881 as of year-end 2021Potential survivor bias was eliminated by including the same set of companies as of both year-end 2020 and 2021So, What Are the Analysts Expecting?Exploration & ProductionWe’ll start at the drill bit end of the industry – the E&P companies. Revenue growth expectations (233 and 201 analyst estimates as of year-end 2020 and 2021, respectively) actually didn’t change significantly. As of year-end 2020 the median estimated 1-year revenue growth was 25.8%, with only a small increase to 29.7% as of year-end 2021. An improvement certainly, but by no means earth-shaking. A bit more significant for the E&Ps was a 7.5 percentage point increase in the median estimated EBITDA margin, from 57.7% to 65.2%. The real “move” in E&P estimates came from the combination of slightly improved revenue growth estimates and EBITDA margin estimates, buoyed by the rise in commodity prices. Those two estimates “teamed-up” for a mere 17.0% median EBITDA growth estimate at year-end 2020, but a very significant 119.8% median EBITDA growth estimate at year-end 2021.Oilfield ServicesNext up we look to the service and machinery providers to the E&Ps – where we find a much more positive outlook today relative to a year ago. Last year’s median revenue growth estimates sat in negative territory at -6.3%. Sentiment was much improved at year-end 2021 with a median revenue growth estimate at 23.9%. However, OFS EBITDA margins paint a different picture. Despite the expectation for strong revenue growth, EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%,d to a current figure of 12.2%. This implies that while demand and utilization will be strong, pricing power for oilfield service companies will slip somewhat. The combination of revenue growth and EBITDA margin estimates, though, show a strong improvement in EBITDA growth expectations, from a median expected decline of 5.3% at year-end 2020 to a median expected growth of 34.0% at year-end 2021. This is not as strong as EBITDA growth expectations among the E&Ps, but a very welcome increase all the same.
MidstreamMidstream operators of course are the “Steady Eddies” of the energy industry – that in large part is due to the very nature of the services provided and the more contractual/commitment orientation of the midstream business. As one would expect, the difference between 2020 and 2021 median analyst estimates are much less material for midstream companies. Median revenue growth estimates were quite low at only 1.0% at year-end 2020, but improved to a median growth estimate of 7.5% as of year-end 2021. EBITDA margin estimates actually declined a bit more than those for OFS companies, with a 3.3 percentage point dip from 42.5% at December 2020 to a 39.2% median at December 2021. In combination, the revenue growth and EBITDA margin estimates result in the median EBITDA growth estimate of 2.1% in December 2020 and a median estimated growth of 9.0% as of December 2021.
Valuation MultiplesLastly, in our comparison of year-end 2020 and year-end 2021 within the energy industry we look to valuation multiples across the three energy sectors. Here we see how the combination of uncertainty of future operating results (risk) and growth expectations combine in the form of enterprise value multiples of EBITDA, on both a trailing (latest twelve months – LTM) and 1-year forward EBITDA basis. Starting with the midstream companies, we see that modest improvement in revenue expectations and slight reduction in EBITDA margins combine with risk perceptions for fairly modest changes from 2020 to 2021 LTM and forward valuation multiples. LTM midstream multiples edged up from 9.0x to 10.0x, while the Forward multiples showed an even more modest increase from 8.7x to 9.0x.The negative 2020 EBITDA growth expectations and much larger (than Midstream) 2021 EBITDA growth expectations result in a very different combination of 2020 to 2021 and LTM to forward OFS multiples. Here we see the median LTM multiple jumping 34% from 2020 to 2021, while the forward multiple decreased by 24%. That with 2020 forward multiples 32% greater than 2020 LTM multiples, and 2021 forward multiples 50% below 2021 LTM multiples.By far the largest swing in 2020 to 2021 and LTM to forward multiples comes from the E&P companies. With only modest EBITDA growth expectations as of 2020, the E&P LTM and forward multiples are quite similar at 5.8x and 5.2x, respectively. However, the 119.8% median estimated EBITDA growth at year-end 2021 results in a much larger LTM to forward differential of 6.7x – 9.7x LTM compared to 3.7x forward. That high level of EBITDA growth expectations in 2021, compared to the much more modest growth expectation as of 2020 results in a 3.1x differential between 2020 LTM multiples and 2021 LTM multiples (5.8x versus 9.7x). As with OFS forward multiples, the E&P forward multiples decreased markedly from 2020 to 2021, from 5.2x to 3.7x.
In SummaryThe energy industry that was hammered in 2020 by the combined OPEC+ induced oil glut and COVID related oil demand decline showed a mixed bag of marginal and tepid operating result growth expectations at year-end 2020, but is showing much greater expectations as analysts look ahead into 2022. However, it is the energy industry – so, be ready for the next cycle shift.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
What a Difference a Year Makes: Part I
Key Aspects of the Energy Industry in 2021
The close of 2021 marked the end of a long upward march for the energy sector. With oil closing up the year at $75 (compared to $48 at the end of 2020) and gas at nearly $4 per mmbtu (compared to $2.36 at the end of 2020), the commodity markets driving the energy sector were much more economically attractive to producers. Stock indices such as the XLE, which primarily tracks the broader energy sector, was up over 50% for 2021 and was by far the best performing sector. Rig counts, although with more cautious deployment than in the past, rose along with prices and increased by 235 for the year (586 at year-end 2021 vs. 351 at year-end 2020). Crude production rose to 11.7 million bbls/day with room to grow as inventories were about 7% below the five-year average. OPEC+ also has signaled it will continue its scheduled output growth.All of this growth is coming alongside the ascent of wind and solar. The Omicron variant raises uncertainty about the markets and took a cut into prices in December. However, while COVID may dampen demand growth, most analysts believe it won’t stop it.Prices & Production“We expect Brent prices will average $71/b in December and $73/b in the first quarter of 2022 (1Q22). For 2022 as a whole, we expect that growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants. We expect Brent prices will remain near current levels in 2022, averaging $70/b.” – EIA – December 7, 2021
The steady climb of prices in 2021 reflected a rebound in demand that exceeded earlier expectations. It also reflected a more cautious approach to bringing more production online and the curtailed capital environment as well. However, that may not last much longer as more estimates accumulate that suggest capital spending for upstream producers will pick up in 2022.
Perhaps even more impactful for upstream producers has been the rise of natural gas prices in 2021 as well. After languishing for so long, prices not only exceeded $3.00 per mmbtu they rose to over $5.00 for a brief period.
These price levels have been unseen for many years and are anticipated to remain near $4.00 mmbtu in 2022, however, volatility is expected to be higher as well. Production has increased, particularly in Appalachia and has now reached pre-pandemic levels.
Perhaps in 2022 the restraint will come off on production efforts more than the past few years. According to the Dallas Fed Energy Survey 75% of companies surveyed plan to spend more in 2022 vs. 49% in the same survey given at the end of 2020. Cowen & Co. says the E&P companies it tracks plan to spend 13% more in 2022 vs. 2021 after significant drops of 48% in 2020 and 12% in 2019. Much of this growth vigor is fueled by smaller E&P companies that have struggled so much in recent years. However, there is still a lot of uncertainty with inflation and other issues which are keeping larger companies more conservative with their capital as reflected in comments like this:
“Supply-chain issues continue to create logistical challenges, and it is difficult to plan and/or coordinate upstream operational activity. Labor shortages have contributed to this issue as well. Pandemic worries are definitely impacting the oil demand side, with resultant uncertainty with respect to commodity pricing and supply forecasting.” – Dallas Fed Respondent
For larger companies, debt reduction and quality asset acquisitions are a higher priority as opposed to riding the drill bit.
LNG Delays - But Rest Assured, It Is ComingOne of the outlets for production growth has been the development of LNG facilities along the Gulf Coast. At the end of 2020, there were five (5) facilities under construction. Unfortunately, as of the end of 2021, only one of those terminals got finished. There are still four (4) terminals under construction and no other approved terminals (there are 13 of those) have gotten going as well. This has inhibited production growth for natural gas as LNG is a major global demand growth outlet for U.S. production. The pandemic has delayed bringing online over eight (8) Bcfd of processing capacity. The Biden administration has also not made it any easier either. However, more should come online in 2022 which should help continue the growth trend for gas in the U.S.Regulatory PrognosticationsSpeaking of the Biden administration, last year around the election we were discussing some potential policy and impacts of a Biden administration. Several of those potentials have come to pass such as permit rejections, the stoppage of the Dakota Access Pipeline, and a decline in drilling on federal lands.One thing that has not borne out is the projection by some of a decline in oil production of as much as two million b/d by 2025. Production has held strong so far as prices increased in 2021. Considering the volatility in both regulation and markets, that’s pretty good in the prediction department.
Deciding What to Decide
Capital Allocation in Family Businesses
Browsing through the archives of the Harvard Business Review, we recently discovered an article from 2013 that we had previously missed. In “Deciding How to Decide,” authors Hugh Courtney, Dan Lovallo, and Carmina Clarke advocate using a broader set of tools to make difficult capital budgeting decisions. While the entire article is well worth reading, we were especially struck by how the authors categorized the different types of capital budgeting decisions facing corporate managers.The authors identify five different types of capital budgeting decisions, distinguishable based on how familiar the decision is and how predictable the outcomes are.The easiest decisions are those that are familiar and have predictable outcomes. Because the company has a long track record of making similar decisions, there is a good understanding of what ingredients contribute to a successful outcome. In other words, the company has developed a reliable model for making the decision. Furthermore, the inputs to the model can be specified with confidence, resulting in a high degree of certainty as to the outcome. According to the authors, a domestic site selection decision by McDonald’s illustrates this type of problem.At the other end of the spectrum are novel decisions for which the company has little or no basis for predicting future outcomes. The company has no history from which to construct a good model, which is perhaps beside the point, since there are no reliable model inputs to be found anyway. The example cited by the authors for this type of decision is deciding how McDonald’s should respond to potential backlash over the fast-food industry’s role in obesity. There is no precedent action that managers can readily draw on to formulate a model, and it is nearly impossible to predict how consumers and society will respond to various actions.
The authors then proceed to identify which capital budgeting tools are most appropriate for which situations. Their comments and suggestions are insightful and worthy of consideration by family business directors. For additional perspective on capital budgeting techniques, you can download our whitepaper “Capital Budgeting in 30 Minutes” here.... the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide.Yet, we walked away from reading the article with a nagging sense that perhaps the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide. In other words, what types of capital projects should be going into your capital budgeting funnel? For example, before deciding whether to lease or build a new distribution facility, family business directors must first – whether explicitly or implicitly – decide that enhancing distribution is a more appropriate use of family capital than acquiring a competitor, or investing in research & development, or securing supply, or any of a host of other potential decisions having varying degrees of difficulty.It is at this level of “meta” capital budgeting that we suspect family business directors could benefit from the decision classification scheme outlined by the authors of the HBR article. The “easy” capital budgeting decisions entail less risk, but also promise less return. Multi-generational business transformation arises from making “hard” capital budgeting decisions. What is the appropriate mix of “easy” and “hard” capital budgeting decisions for your family business? Net present value, internal rate of return, and the other traditional capital budgeting tools are not really equipped to answer this question.We suspect that deciding “what” to decide is yet another manifestation of what your family business “means” to your family.In our experience, there are four basic “meanings” a family business can have for a family. Knowing what your family business “means” maybe the best path toward deciding “what” to decide.For some families, the business exists to drive economic growth for future generations. With this forward-looking perspective usually comes a desire for higher absolute returns and a willingness to accept more risk. For these families, the ideal mix of capital budgeting decisions is likely tilted more toward the types of transformational capital budgeting decisions having low degrees of familiarity and predictability.Other family businesses serve as a mechanism by which to preserve the family’s capital. A prominent concern for these families is that all their economic eggs are in a single basket, so they want to build a stout fence around that basket. As a result, they will be best served by focusing on capital budgeting decisions having a high degree of familiarity and predictability.In contrast, other families respond to the “single basket” problem by seeking to find more baskets. The focus for these families is maximizing the harvest from the family business to enable family shareholders to store some eggs in different, uncorrelated, baskets. These families may be more willing to accept risk once an acceptable number of other baskets have been filled. Making a large volume of “easy” capital budgeting decisions that serve only to increase the size of the existing basket is not a suitable meta-capital budgeting strategy for these families.Finally, some families view the business principally as a source of lifestyle. The primary concern for these families is maintaining the current level of real, per capita distributions. Depending on the biological growth of the family, doing so is likely to require making some capital budgeting decisions that are either less familiar or have less predictable outcomes.
How are you and your fellow directors deciding what to decide? Is there consensus around the economic meaning of your family business to your family? Gaining consensus around the meaning of your family business can be a crucial first step to making all the strategic finance decisions you make line up with one another.
Is Your Family Business READY for 2022?
Our family business clients naturally want to know what their business is worth today. But an even better question asked by many of them is what they can do today to make their family business more valuable tomorrow. While the specifics of value creation are unique to each business, we like to use a common framework to help our clients identify pathways for creating value.The framework was developed many years ago by the founder of our firm, Chris Mercer. Chris has an inordinate affection for acronyms rivaled only by his enthusiasm for pickleball. So, with a big hat tip to Chris, we’ll use this first post of the year to ask whether your family business is READY for 2022.Risk. Investors don’t like risk. Given the choice between two investments that offer the same reward, investors will always choose the one with less risk. The best way for investors to manage risk is through diversification, but family shareholders are often not very well diversified. As a result, family business directors need to be especially vigilant about managing risk within the family business. The most common risks facing family businesses relate to concentrations, which can take many forms: management, customer, supplier, geographic, product, etc. What strategies are available to reduce the risk of your family business in 2022?Earnings & cash flow. Investors like cash flow. In fact, investments are valuable because of the expectation that they will generate cash flow, whether in the next week or the next decade. Cash flow is rooted in earnings. Earnings depend on revenue and margin. Revenue measures how much business your company is doing, and margin measures how efficiently your company conducts its business. While earnings are the wellspring of cash flow, they are not cash flow. Among the most important decisions family business directors make is how to allocate earnings between cash flow to shareholders today and reinvestment to fuel greater cash flow to shareholders tomorrow. Is your family business profitable enough to provide current cash flow to shareholders and make appropriate investments for the benefit of future generations?Attitudes, aptitudes & activities. Investors like discipline. Founder-led businesses can be highly profitable, but not necessarily very valuable if the “secret sauce” is tied up in the personality and unique gifts of the founder. Family businesses that have successfully converted the unique attributes of the founder into repeatable and transferable business processes are worth more than those that cannot, or do not, make that leap. Do you have the right people in the right places doing the right things over time? To borrow an overused cliché from the popular business press, how “scalable” is your family business?Driving growth. Investors like growth. Yesterday’s earnings and cash flow are, strictly speaking, irrelevant to investors, who care only about the future. The value of your family business is determined by the view through the windshield, not the rearview mirror. What are you and your fellow directors doing to prepare for the future? Does your family business have a disciplined process for identifying, evaluating, and paying for investment opportunities that will generate growth in future cash flows?Year-to-year comparisons. Investors like a clear story. Hollywood is obsessed with making prequels to satisfy the curiosity of moviegoers for the “backstory” of their favorite characters. Historical financial results comprise the “backstory” for your family business. Is there a coherent narrative arc from what your family business has been in the past to what you are planning for it to be in the future? This is where strategy becomes critical. What aspects of past strategies will you carry over into the new year? What pieces of your current strategy should be cast aside? What new strategies will be necessary for your family business to thrive in 2022?
The new year is upon us whether we are READY or not. Give one of our family business professionals a call today to kickstart a conversation about how to increase the value of your family business in 2022.
Mercer Capital’s Value Matters® 2022-01
2022 Tax Update for Estate Planners and Family Businesses
Bank M&A 2022 | Gaining Altitude
At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.Should and will are two different verbs, however.One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.A Recap of 2021As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1.Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.Public Market Multiples vs Acquisition MultiplesClick here to expand the image aboveFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:Acquisition pricing as measured by the P/TBV multiple peaked in 1998 (when pooling-of-interest was the predominant accounting method) then bottomed in 2009 (as the GFC ended) and trended higher until 2018.Since pooling ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition P/TBV multiple relative to the average index P/TBV multiple, has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.The reduction in both the public and acquisition P/TBV multiples since the GFC corresponds to the adoption of a zero interest rate policy (ZIRP) by the Fed during 2008 that has been in place ever since other than 2017-2019.P/E multiples based upon LTM earnings have shown little trend with a central tendency around 20x other than 1998 (1990s peak), 2018 (tax reform implementation) and 2020-2021 (COVID distortions).Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but as noted what really matters is the P/E based upon pro forma earnings with expense saves. To the extent the pro forma earnings multiple is 7-10x, the pay-to-trade earnings multiples typically are below 1.0 to the extent buyers are trading above 10x forward earnings.Click here to expand the image aboveClick here to expand the image abovePremium Trends SubduedPublic market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.
Mercer Capital's 2021 Energy Purchase Price Allocation Study
In Case You Missed It
Did you miss Mercer Capital's 2021 Energy Purchase Price Allocation Study? If you did, before we move into 2022, take a look at the 2021 Study.This study researches and observes publicly available purchase price allocation data for three sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; and (iii) midstream and downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2021 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2020.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<
2021: The Year of the Used Car
What Does This Mean for Dealers and Consumers?
2021 was an interesting year for many businesses, and it was certainly interesting for auto dealers. While automotive retailing may be an attractive space for purely financial investors, many dealerships are owned by the same folks that run the business. So while inventory shortages and other headwinds played a role in heightened profits in 2021, the return on investment achieved came with many operational headaches.Just about everyone we’ve talked to acknowledges that current performance is not indicative of ongoing expectations. The question has largely been focused on when we’ll revert to the mean, but this post touches on what things will look like when we return to a more “normal” operating environment. Specifically, what negative equity from used car buyers in 2021 may mean for dealerships.Used Car PricesIn a recent whitepaper, KPMG warned that used vehicle prices could fall abruptly and raise negative equity issues once new vehicle supply rebounds. Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth. We’ve all heard about a vehicle losing value once you drive it off the lot and it's true. Compounding this problem is the expectation that values today will materially decline in a year or two which increases the likelihood of negative equity.Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth.In April 2020, during the depths of the pandemic, 44% of trade-ins carried negative equity – more than double the amount seen a decade earlier. The average negative equity then was $5,571. A year later, vehicle prices increased significantly, but average negative equity only declined by a little more than $1,000. More importantly, the proportion of trade-ins with negative equity was relatively constant, meaning nearly half of buyers were looking at their trade-ins adding to the price of the vehicle they were looking to buy.According to our analysis of NADA data from 2011 to 2020, used vehicle retail prices increased at a compound annual rate of 2.7%, just above the 2.6% increase for new vehicles. In 2021, used vehicle prices lurched forward faster than new vehicles. New vehicle prices increased 7.5% in the last twelve months due in part to supply shortages. Consumers who couldn’t get the new vehicle they wanted or realized they needed a car, but prices were too high, may have turned to used vehicles, whose prices increased 19.1% due to increased demand.The ratio of used-to-new vehicle prices was 62.5% through October 2021, notably higher than the 56.5% observed in October 2020 and above the long-term average (2011 to 2020) of 57.1%. Used-to-new retail volumes were also 91.9% for the first ten months of 2021, higher than any full-year since at least 2011. Used vehicles have become increasingly important to dealers, as this figure has steadily increased from a recent low of 73.9% in 2015.What will happen if new vehicle supply is restored and used vehicle prices crater?As KPMG warns, what will happen if new vehicle supply is restored and used vehicle prices crater? Applying the long-term average used vehicle price appreciation of 2.7% to the $22,027 average used vehicle retail price in 2020, it would take until 2027 to reach $26,000. As of October 2021, the average retailed used vehicles cost $25,904. If used car prices revert to the long-term relationship of new car pricing (57.1% of $41,421 for new vehicles as of October ‘21), we would see a decline of 8.7%. KPMG indicated “a 20-30% plunge in used vehicles costs is within the playing cards.” This would almost certainly wipe out any consumer's equity who elected to finance their purchase.Consumers are able to buy more expensive cars when they get what they perceive to be a good deal on their trade-in, and higher used vehicle prices mean trade-ins are more valuable. However, this important source of cash for buyers will evaporate if used vehicle prices plunge, and negative equity just adds on to the price of a vehicle, putting pressure on how much consumers can pay up for a new vehicle. As noted previously, through April 2021, a significant number of buyers still had negative equity despite advantageous pricing on used vehicles. This could spike if prices crater.What It Means For DealersGiven the long life cycles of vehicles, dealership performance tends to ebb and flow with the economy. Executives of public retailers harp on the importance of touchpoints with the consumer, meaning they return to the dealership to get their car serviced. Dealers also hope customers return to their showrooms when it’s time for another vehicle, and the experience from the last purchase will likely play a big role.If consumers are unsatisfied with their purchase because prices were elevated when they bought in 2021 and decline significantly thereafter, they may feel aggrieved and choose to go with another dealership. While this situation is largely unavoidable for most dealerships, it could have negative ramifications down the line. Consumers may also choose to hold onto their vehicles longer to not recognize the loss by trading in. While it’s unclear how this will shake out down the road, dealers will need to prepare themselves for difficult conversations.Through the first ten months of 2021, the average dealership has already made nearly $3.4 million.As we alluded to previously, profits are up for dealerships in 2021. According to the NADA, the average dealership earned average pre-tax profits of $1.4 million from 2011 to 2020. Average pre-tax profits reached above $2.1 million in 2020, which was the first time above $1.5 million since 2015. Through the first ten months of 2021, the average dealership has already made nearly $3.4 million with two more months to add to these totals.The value of auto dealerships is communicated through Blue Sky values, which are based on a multiple of pre-tax earnings. While dealers aren’t likely to get a high multiple on peak earnings, we note both Blue Sky values and multiples are up since before the pandemic. However, once performance normalizes, dealerships may not be worth as much as they are now, much like the vehicles they sell. This would likely explain the record amount of M&A activity seen in 2021 with some of the largest dealer groups opting to sell.According to the Q3 2021 Haig Report, the average franchise has a Blue Sky multiple of 5.24x and adjusted pre-tax earnings of $2.08 million for a Blue Sky value of about $10.9 million, up 61% from year-end 2019 to all-time highs. At these prices, buyers must be optimistic that the good times will continue, multiples won’t crater, and/or the new normal of profits will be higher than historical levels.Source: Haig Partners Haig’s estimated pre-tax earnings of $2.08 million as an ongoing figure today is about 46% below current levels based on our calculations of NADA figures. However, according to NADA, it coincidentally represents a 46% increase over the 2011-2020 average for the average dealership. While that makes the ongoing figure appear reasonable, the chip shortage universally viewed as a temporary problem is far from “normal.” Suppose current estimates of ongoing earnings end up being overly optimistic, with an increased focus on recent outperformance. In that case, the values of dealerships, like the vehicles they sell, are likely to decline.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
A 2021 Review of Family Business Director
We hope you had a great Christmas and a happy holiday season. To end the year, we summarize some themes and most read pieces from Family Business Director you may have missed throughout the year.Tax PolicyThe more things change, the more things stay the same. Several themes from 2020 were back: COVID-19 was still a part of our lives, political divisions seemed to only widen, and Alabama is still in the college football playoff.Tax overhauls from Washington were on theme too: big plans, followed by horse trading, name calling, special elections, and an infrastructure bill. In January (and April, August, September, and October) we did our best at the Family Business Director to summarize and digest the numerous proposed tax changes. But, at the end of the day, as of this writing, the Build Back Better (BBB) omnibus bill appears dead on arrival. Senator Manchin (D-WV) has publicly pulled support for the bill, leaving capital gains taxes, removal of the basis step-up, estate tax changes, and income taxes unchanged from the beginning of the year. After a year of tax consternation, it might be nice to ring in the new year with less tax anxiety immediately on the horizon. But rest assured, the fight is not over.Lessons from the Public MarketsFamily Business Director featured several articles and studies on public market data and meaningful stories for family business owners and directors. We summarize your favorites below:The 2021 Benchmarking Guide for Family Business Directors – How small companies fared relative to large caps in 2020.Can You Hear Me Now? Lessons from a $20 Billion Family Business Fight – A made-for-TV family business drama… in real life.Getting to the Top – The top 750 family companies and how it impacts you.Sanderson Farms Case Study – Lessons from a family business acquiring a public company.Built Ford “Family” Tough – How Ford’s investment in Rivian can help us think about diversification.2021 Dividend SurveyThis summer, we partnered with Family Business Magazine to conduct our inaugural survey of dividend practices at family-owned businesses. We featured an article that we wrote for the magazine summarizing the survey results and presented the detailed results to survey respondents.A headline statistic from the survey indicated while about half of public companies pay dividends to shareholders, over 80% of the family businesses responding to our survey indicated that they do. However, nearly half of respondents reported not having a formal dividend policy. In other words, a significant group of family businesses are paying dividends, but they’re not sure why.Read more and check out our detailed write-up and summary results.That Is the Right QuestionFamily business owners don’t stay on top by having all the answers, but by having the ability to ask the right questions. Family Business Director posed a few questions to spark important conversations. Readers’ favorite questions include:Why Do Buy-Sell Agreements Rarely Work as Intended? – How you should think about your buy-sell to stave off potential pitfalls, litigation, and unhappy shareholders.How Long Will It Take to Sell My Family Business? – A short overview of the sales process for a family business.Family Business Director’s Top Ten Questions Not to Ask at Thanksgiving Dinner – Avoid family squabbles over turkey with these questions not to ask.Should Your Family Consider a Family Office? – What are the benefits of a family office, and should your family consider opening one?Five Questions with Paul Hood – Interview with long-time estate planner focusing on taxes and achieving good estate planning results.As we enter 2022, feel free to email anyone at Family Business Director with ideas, complaints, praise, or content ideas. We would love to hear from you, and we thank you for your continued readership.
‘Twas the Blog Before Christmas…
2021 Mercer Capital RIA Holiday Quiz
‘Twas the blog before Christmas, when all through the house
Every laptop was purring, every keyboard and mouse;
The stockings were hung by the chimney with care,
So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter,
I refreshed my Bloomberg to check on the matter.
Then what to my wondering eyes did appear,
But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick,
I listened, engaged, to his every stock pick.
More rapid than eagles his recommends came,
And he whistled, and shouted, and called them by name:“Buy Bitcoin! Buy Apple! Buy Tesla and Google!
’Cause shorting the future will always prove futile!
To the top of the charts, for the big money haul,
Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around,
Down the chimney John Templeton came with a bound.
He was dressed like he owned just a few private jets,
Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back,
Like an entrepreneur with a new public SPAC.
He spoke not a word, but went straight to his work,
And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry!
As he talked a new strat that would guarantee carry!
And out-money calls bought to cover the shorts,
Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head,
Made me want to get all of his thoughts on the Fed –
And vaccines and rates and bullion and more,
But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard,
And up the air-stairs sprang the RIA bard.
But I heard Sir John claim, as he flew out of sight -
"Let your best winners run, and all will be right!"...How much do you know about the RIA industry? Put your knowledge to the test with our RIA Holiday Quiz. Fill out your contact information and if you get a perfect score you will win a prize. Good luck!(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd_2BAEZcRHJHwtJp1wzgq96QNl8Vvqh42MIevvuINzlilE.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey
Appalachian Production Stable Despite Price Volatility
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post we take a closer look at the trends in the Marcellus and Utica.Production and Activity LevelsEstimated Appalachian production (on barrels of oil equivalent, or “boe,” basis) decreased approximately 1% year-over-year through December. Production in the Permian and Eagle Ford increased 14% and 4% year-over-year, respectively, while the Bakken’s production declined 1%. Despite a much-improved commodity price environment, Appalachian production was very stable, driven by producers’ capital discipline and the fact that the region was largely unaffected by Winter Storm Uri that disrupted power supplies throughout Texas in February 2021.
There were 41 rigs in the Marcellus and Utica as of December 10th, up 37% from December 4th, 2020. Bakken, Eagle Ford, and Permian rig counts were up 145%, 91%, and 74%, respectively, over the same period.
One may wonder why Appalachia production has been relatively flat while the region’s rig count has increased. The answer has to do with legacy production declines and new well production per rig. Based on the U.S. Energy Information Administration (“EIA”) data, the Marcellus and Utica need roughly 37 rigs running to offset existing production declines. Relative to last year, most of Appalachia’s additional rigs came online in January and February. Since then, the total rig count has generally ranged between 36 and 40 (in line with the maintenance level). As such, production growth will likely be modest without additional rigs.
Commodity Price Volatility ReturnsOil prices slowly and steadily rose through the first two quarters of the year as the vaccine rollout, and lower COVID case counts spurred economic activity. Oil prices were more volatile in the third quarter as the Delta variant caused an increase in COVID cases and concerns regarding the economic recovery. U.S. COVID cases peaked in early September, giving oil prices a boost during the latter part of the quarter. The net result is that WTI front-month futures prices began and ended Q3 at about the same place – approximately $75/bbl. In October, the upward price momentum continued in the fourth quarter as WTI futures prices nearly reached $85/bbl.This optimism was short-lived as the discovery of the new Omicron variant sent oil prices plunging in November. Prices rebounded in December as research has shown that, while highly transmissible, the Omicron variant typically results in less severe illness relative to previous variants. As of December 14th, WTI front-month futures price settled at $70.52/bbl. Going forward, the EIA expects prices to be flat to down in the near term as “growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants.”
Natural gas prices steadily increased during the first three quarters of the year, which the EIA primarily attributes to “growth in liquefied natural gas (LNG) exports, rising domestic natural gas consumption for sectors other than electric power, and relatively flat natural gas production.” So far in the fourth quarter, natural gas prices have been relatively volatile as inventories are lower than recent averages. However, recent mild weather has resulted in less gas used for heating.
Financial PerformanceThe Appalachia public comp group saw relatively strong stock price performance over the past year (through December 14th). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like Antero Resources and Range Resources, whose stock prices increased 230% and 155%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 59% during the same period). Larger, less leveraged players like EQT and Coterra (formerly Cabot) were laggards, with their stock prices increasing by 53% and 16%, respectively.Senator Warren Lashes Out Over High Natural Gas PricesMassachusetts Senator Elizabeth Warren wrote a strongly worded letter to eleven natural gas producers, including Appalachia E&Ps EQT, Coterra, Antero Resources, Ascent Resources, Southwestern, and Range Resources. According to Senator Warren’s press release, the purpose of the letter was to “[turn] up the heat on big energy companies’ greed as they jack up natural gas prices, exporting record amounts to boost profits while Americans foot the bill” despite the fact that natural gas producers are simply price-takers, selling a commodity into a competitive market with essentially no control over prices.It is true that LNG exports from the United States have increased dramatically over the past several years. However, that has been driven by the construction and completion of LNG export facilities, resulting in part by continued resistance to pipelines that would connect the Marcellus and Utica regions to East Coast population centers. And while Senator Warren criticized producers for their greed, “putting their massive profits, share prices and dividends for investors … ahead of the needs of American consumers,” she did not thank E&P companies for their previous largesse (or lack of capital discipline) in which natural gas prices were often below $2/mmbtu and numerous natural gas producers went bankrupt.EQT publicly responded to Senator Warren’s letter. Despite the recent run-up in natural gas prices “as the economic engines of the world have reignited,” the company cited that current prices are “significantly below the 20-year average of approximately $5.70 per Mcf.” As a result of the shale revolution, “the United States consumer has benefited from, and continues to benefit from, some of the lowest natural gas prices in the world.” The remainder of EQT’s response was primarily focused on natural gas’s green credentials. Toby Rice, EQT’s CEO, wrote that the United States led the world in CO2 emissions reduction from 2005 to 2020 largely as a result of replacing coal power plants with natural gas power plants. If the world wants to reduce emissions, there are no alternatives with the scale and speed of switching power generation from coal to gas. But with 91% of coal-fired power generation located outside the United States, the transition will require exports of U.S. natural gas to countries without their supply.ConclusionAppalachia production was largely unaffected by the wild commodity price ride we’ve experienced, driven by investor emphasis on capital discipline, the current rig count, and uncertainty. However, with higher natural gas prices, global demand for a lower-carbon alternative to coal, and political pressure, it will be interesting to see if Appalachia producers maintain their restraint.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and worldwide. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
RIA Margins – How Does Your Firm’s Margin Affect Its Value?
An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin”?We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors).
At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risks of client concentrations, underperformance, and key staff dependence are significant.
Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can pour in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be robust as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers.
At the lower end of the margin spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key person risk is also less, because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less of a problem, because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well.
Does a Firm’s Margin Affect What It’s Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will sustainably be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time.
The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid. For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 32.8%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher.
The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers – while they can have very high margins – tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry.
Margin and ValueHigh margins are great, but what really matters to a buyer is how durable those margins are. A variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II).Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.
Charlie Munger, Elon Musk, Kenny Rogers and Your Family Business
"He thinks he's even more able than he is and that's helped him. Never underestimate the man who overestimates himself. Some of the extreme successes are going to come from people who try very extreme things because they're overconfident. And when they succeed, well, there you get Elon Musk." - Charlie Munger"If the objective was to achieve the best risk-adjusted return, starting a rocket company is insane. But that was not my objective." - Elon Musk"You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run." - Kenny Rogers
Long-time Warren Buffett confidant and business partner Charlie Munger was in the news this week for giving frank interview responses on a wide range of topics. Among his comments was the quote about Elon Musk's productive overconfidence cited at the top of this post. Return follows risk, and the only way to earn outsized returns is to take outsized risks. As Musk himself acknowledges, hewing to textbook notions of prudent risk management would have derailed SpaceX before it ever got off the ground (literally or figuratively).
Attitudes toward risk are hard to quantify and are unlikely to be uniform across a family. It is reasonable to assume that investors in public companies have similar views of risk. After all, they all chose to be there. Family shareholders, on the other hand, likely have not designed their investment portfolios from scratch, and the family business often represents a far larger portion of the overall portfolio than modern investment management theory would deem prudent.
Most mature family businesses that we know do not have an appetite for taking on the sort of outsized risks for which Mr. Musk is famous. Instead, they adopt a more cautious posture of calculated risk-taking like that espoused by the late, great Kenny Rogers in his immortal song, "The Gambler."
Confidence and Capital BudgetingAs 2021 draws to a close, family business directors are busy evaluating capital spending plans for the coming year. Capital budgets are influenced by the availability of capital to invest in the future, the availability of projects in which to invest, and the willingness of shareholders to forego current returns in the hopes of greater future rewards.So, just how confident should family business directors feel when forecasting business results in 2022? The Organization for Economic Cooperation and Development, or OECD, publishes a Business Confidence Index ("BCI"), which is based upon survey responses related to developments in production, orders and stocks of finished goods in the industrial sector. Readings above 100 indicate increased confidence, while measurements below 100 correspond to a pessimistic outlook. After dipping into bearish territory in 2H19 and bottoming out in the early months of the pandemic, the measure has given an expansionary reading since July 2020.Chart 1: OECD Business Confidence Index (2019 - 3Q21)
Responding to survey questions is one thing, cracking open the corporate checkbook is another. We examined capital investment data for small- and mid-cap public companies over the same period to get another perspective on corporate confidence.
Chart 2: Capital Investments for Small- and Mid-Cap Public Companies (2019 - 3Q21)
Corporate investment spending corroborates the OECD confidence index. M&A activity is more volatile, but corporate managers also slowed capital expenditures materially during the middle quarters of 2020. Circling back to the confidence of Elon Musk, we can track capital expenditures for Tesla over the same period.
Chart 3: Tesla Capital Expenditures (2019 - 3Q21)
In contrast to most of the companies examined above, Mr. Musk was hitting the accelerator on capital spending during the pandemic, spending 134% more on capital expenditures during the middle quarters of 2020 than in the same period of 2019.
Clearly, Musk is a "unicorn" and most family businesses are not blessed (or cursed, depending on your perspective) with a personality like his. So what lessons can family business directors take from his confidence and disregard for normal risk management (as embodied by Mr. Rogers' Gambler)?
No Blind "Confidence Premium"For public markets, share price performance is the ultimate scoreboard. As summarized in Table 4, confident investors (defined here as those companies that did not reduce capital expenditures during the middle quarters of 2020), on balance, did not fare as well as their more cautious counterparts. Knowing when to fold 'em appears to have paid off for most companies.Table 4: Post-COVID Stock Appreciation of "Confident Investors"
Reality is messy, so easy answers don't work. The data in Table 4 suggests that closing one's eyes and being aggressive for the sake of being aggressive is not a great strategy. Our analysis of the data indicates that there is no automatic "confidence premium" available to more aggressive companies.
For family business directors, this means that there is no substitute for careful analysis of the available investment opportunities. We have previously proposed that – in addition to the financial metrics that serve as a gating function for potential investments – directors carefully evaluate the market opportunity, strategic fit, and constraints associated with a potential capital investment.
Rewarding ConvictionsThere may not be a "confidence premium," but there is a clear reward for maintaining one's investment convictions in the face of discouraging market returns. We wanted to see what impact, if any, prior stock price changes had on companies' willingness to invest during the pandemic. For the most part, the companies that invested the most during the pandemic had experienced favorable stock price movements during 2019. In other words, the "confident investors" were to some degree chasing momentum, as shown in Table 5.Table 5: Post-COVID Stock Appreciation of "Confident Investors"There are two notable exceptions to this momentum story. Shares of the most confident investors in the Consumer Staples and Information Technology sectors had underperformed those of their industry peers during the pre-COVID period. These "conviction" investors bucked the broader trends in post-COVID returns in Table 4, generating premium returns of 12% (Consumer Staples) and 43% (Information Technology), respectively.Contrarian investing requires thick skin and a steady stomach. In our experience, successful family businesses are often the best-suited players in their respective industries to invest at opportune times. Not being subject to the public stock market's reaction to next quarter's earnings release frees many family businesses to invest when others are holding back. Over generations, such enterprising families reap the rewards of investing with strategic conviction.So, where does your family business find itself during the current planning cycle? Are there investing convictions that your family business should double down on like Elon Musk, or is it time to follow the Gambler's advice and take some chips off the table? Sometimes an outside perspective can help bring clarity; call one of our family business professionals to discuss your investing outlook in confidence.
November 2021 SAAR
The November 2021 SAAR was 12.9 million units, down 0.7% from October and 19% from November 2020. This month’s SAAR came in below expectations as the industry experienced only slight inventory improvement from the historic lows of September and October. This seems like old news, as persistently limited inventory on dealer lots has affected the industry for months now and has been the principal issue concerning auto dealers. In this environment, vehicle prices remain elevated, with the average transaction price paid for a new vehicle reaching a November record of $44,000 this month. Light trucks continue to be red hot, representing more than 80% of all new vehicles sold and leaving dealer lots at a record pace. The average number of days a vehicle stays on the lot fell to a record low of 19 days in November, down from 48 days in November 2020.
It is no secret that inventory issues at the dealer level are a consequence of production stoppages and supply shortages by OEMs. OEMs have all been subject to supply chain disruptions for some time, and these challenges have been met with a wide range of responses. Jeff Schuster, president of J.D Power’s Americas operations and global forecasts recently addressed these responses by saying:
“The supply shortage is being managed in very creative ways, from building vehicles without certain content, to bringing chip development and production in-house for better supply chain visibility. However, the improvements in vehicle production are inconsistent around the world. China and India both saw stronger vehicle production in October, but North America and Europe remain constrained. Even as plants restart after being down for several weeks, they are not running near-normal levels. While the solutions are intended to minimize the disruption now or in the future, consumers will continue to find it difficult to purchase the exact vehicle they want for several months to come."At least partially as a result of these “inconsistent” conditions across countries, the market shares of certain manufacturers have fluctuated a bit over the last month. Toyota, Hyundai-Kia, Honda, Nissan, and Mazda are among the manufacturers that experienced market share growth in November, while American manufacturers Ford, Stellantis, and General Motors all saw market share losses. This trend in auto public equities has been around for a few months now, but it shouldn’t take long for American and European manufacturers to catch up with their counterparts in other parts of the world by establishing in-house microchip development and securing a consistent pace of production going forward.What Could 2021 Mean to the Industry’s Future?For the last SAAR blog of 2021, we thought it might be valuable to reflect on the unique year that auto dealers and manufacturers have had. This is not a comprehensive recap of a year, but instead a commentary on what seemed to work well in 2021 and what changes might be around for a while.2021 defied nearly everyone’s expectations.While 2020 presented its own set of challenges and opportunities, 2021 defied nearly everyone’s expectations. Analysts following the industry watched as OEMs and dealers reacted to unprecedented conditions in almost every phase of their businesses. We saw dealer principals shepherd their auto dealerships through a choppy market environment and thrive in the current pricing and inventory environments. As the second half of the year wound down, new records were being set every month relating to low stocks of vehicles, elevated, and persistently rising gross profits, and consumer demand for autos of all classes. We also saw a red hot M&A market, with elevated Blue Sky multiples and record-high earnings driving mass amounts of industry consolidation by the public auto dealers like Asbury, AutoNation, Group 1, and Sonic Automotive.The motivation behind a chunk of the sales volume in 2021 seems unique to the times.On the other side of vehicle-buying transactions, vehicle scarcity and inflated sticker prices have left many consumers feeling uncertain about the future of car-buying and when they may choose to make that big purchase. Prospective buyers on the margins may have decided to hold off on buying their next vehicle in the hopes that prices will fall as inventory levels normalize. Others have chosen to take the opportunity to cash in on high trade-in values for their used vehicles that won’t stick around for long. In either case, the motivation behind a chunk of the sales volume in 2021 seems unique to the times we are living through. Many consumers are under the assumption that when things “get back to normal” the car-buying experience will closely resemble what it was pre-pandemic. While that will surely be true for many aspects of the sales process, auto dealers and manufacturers would be remiss not to take the lessons learned in 2021 and make some of the changes permanent in how they do business going forward.We aren’t likely to see high margins on vehicle sales persist.Could pre-orders on many models become more commonplace as dealers find the perfect inventory balance on their lots? Absolutely. Could record low dealer incentives persist in an effort to assist dealers in competitively pricing their vehicles when sticker prices inevitably fall off? Perhaps. But for changes like these to stick, factors like test drive availability and matching model-specific production volumes with the pent-up demand that exists will have to be addressed. It is also important to note that many local, full-service dealerships seek to gain loyalty through providing as great a personal experience for the buyer as possible. Repeat customers and parts and service revenues are very important to these dealers, and making customers feel like they are getting gouged is not in anyone’s best interest. For that reason, we aren’t likely to see high margins on vehicle sales persist. However, dealers and OEMs certainly learned there’s been money left on the table in the past due to the relative inelasticity of demand for vehicles.ForecastWhile December is typically a big selling month for dealers, we don’t see much changing the supply issues in the next couple of weeks to close out 2021. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.
Insurance Valuation Services for Financial Sponsors
In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.Key areas where Mercer Capital can help include:Valuations of Shares/Units for 409A / ASC 718 Compliance - If you anticipate granting equity to founders or key management at acquired companies, using rollover equity as part of a growth strategy, or issuing options or RSUs as part of your employee compensation plans, supportable and defensible valuations are critically important.Valuations for Financial Reporting – Acquisitive growth strategies will likely necessitate ASC 805 purchase price allocations, earn-out liability measurements, and goodwill impairment testing.Financial Due Diligence – We provide financial due diligence and quality of earnings reports on target companies, including analysis/trending of the pro forma P&L, potential earnings adjustments, working capital assessments, unit economics analysis, and other areas of financial analysis.Financial Opinions (Fairness and Solvency Opinions) – Certain types of transactions, related-party issues, or fiduciary concerns can lead a board to seek an independent opinion of fairness or solvency as it pertains to a transaction involving the subject company. These situations might include going-private transactions, special dividends, and leveraged recapitalizations.Portfolio Valuation for ASC 820 Compliance – We provide a range of services to assist fund managers with the preparation and/or review of periodic fair value marks. These services are cost-effective and include a series of established procedures designed to provide both internal and investor confidence in the fair value determinations.
To discuss any of these services in confidence, please contact a Mercer Capital professional today.
M&A in Marcellus & Utica Basins
Activity in 2021 Was Muted Relative to 2020
The three transactions in the Marcellus & Utica basins over the past year were just a trickle compared to the 16 transactions reported in the prior year for the Appalachian basins. The number of transactions in 2020 was more than double the seven transactions in 2019, driven in part by the relative price stability of natural gas as compared to oil which would naturally tend to favor M&A activity in these gas-heavy basins. One key observation of the transactions in 2020 was that companies were making critical decisions regarding where to operate on a forward-looking basis. Companies, such as Shell, took the position of divesting their Appalachia assets, while other companies, such as EQT, chose to augment their Appalachian footprint. The following table summarizes transaction activity in the Marcellus & Utica in 2020:
Appalachia transactions announced so far in 2021 are shown in the following table:
The decline in transaction activity in 2021 most likely indicates that anyone looking to get into or out of the Appalachian basins effectively did so in 2020, or was concerned with natural gas price volatility, which increased sharply in 2021 after several years of relative calm. However, that is not to say that the activity in 2021 was any less interesting. Notable changes in the statistics between the transactions in 2020 and 2021 include a sizable increase in the median and average deal values, price per acre, and price per production unit. Based on the much smaller sample size of 2021, the magnitude of these differences probably doesn’t mean too much. But one metric, production per acre (or MMcf/Acre), on an annualized basis, could be indicative of a greater focus on obtaining more productive assets in 2021 than the transactions observed in 2020.
The following table summarizes the estimated annualized production per acre, including the median and average values, for the transactions in 2020 and 2021:
Buyers in 2021 seemed to target producing rather than prospective, assets, as indicated by, as indicated by the median and average annualized MMcf/Acre metrics. Irrespective of the smaller transaction count (sample size) in recent history, the minimum production density metric in 2021 (0.71 MMcf/Acre) was nearly 9% greater than the maximum metric observed in the 2020 transactions (0.65 MMcf/Acre), and 52% and 82% higher than the median (0.47 MMcf/Acre) and average ( 0.39 MMcf/Acre) metrics, respectively, observed among the transactions in 2020. Again, this back-of-the-napkin statistical analysis may fall far short of being arguably significant, technically speaking, but it’s pretty interesting as far as an eyeball test is concerned.
EQT Corporation Adds to Core Marcellus Asset BaseOn May 6, EQT Corporation (NYSE: EQT)announced that it entered into a purchase agreement with Alta Resources Development, LLC (“Alta”), pursuant to which EQT would acquire all of the membership interests in Alta's upstream and midstream subsidiaries for approximately $2.93 billion. EQT intended to finance the acquisition with $1.0 billion in cash, drawing upon its revolving credit facility and/or through one of more debt capital market transactions, and stock consideration consisting of approximately 105 million EQT common shares, representing $1.93 billion. The asset was comprised of approximately 300,000 core acres positioned in the northeast Marcellus region. Net production as of the transaction date was approximately 1.0 Bcfe per day, comprised of 100% dry gas. The transaction also included 300-miles of owned and operated midstream gathering systems and a 100-mile freshwater system with 255 million gallons of storage capacity. Toby Rice, President and CEO of EQT, stated that the acquisition represents an attractive entry into the northeast Marcellus while accelerating the company’s deleveraging path, providing attractive free cash flow per share accretion for EQT shareholders and adding highly economic inventory to the company’s robust portfolio. Mr. Rice also noted the transaction increases the company’s long-term optionality, and should accelerate its path back to investment grade metrics while simultaneously achieving its shareholder return initiatives.Northern Oil and Gas, Inc. Acquires Non-Operated Appalachian AssetsOn February 3, Northern Oil and Gas (NYSEAM: NOG) agreed to acquire certain non-operated natural gas assets in the Appalachian basin from Reliance Marcellus, LLC (“Reliance”), a subsidiary of Reliance Industries, Ltd., for total consideration of $175 million in cash and approximately 3.25 million warrants to purchase shares of NOG common stock at an exercise price of $14.00 per share. The transaction was expected to be funded through a combination of equity and debt financings and anticipated to be leverage neutral on a trailing basis and leverage accretive on a forward basis. At the effective date of July 1, 2020, the acquired assets were producing approximately 120 MMcfe/d of natural gas equivalents, net to Northern Oil and Gas. The assets were expected to produce approximately 100?110 MMcfe/d (or approximately 19,000 Boe/d) in 2021, net to Northern Oil and Gas, and consisted of approximately 64,000 net acres containing approximately 102.2 net producing wells, approximately 22.6 net wells in process, and approximately 231.1 net undrilled locations in the core of the Marcellus and Utica plays. Furthermore, an inventory of 94 gross highly-economic, work-in-progress (“WIP”) wells was slated for completion over the following five years by EQT. As of the transaction announcement, approximately $50 million of net development capital had already been deployed on the WIP wells, which was not subject to reimbursement by Northern Oil and Gas. The acquisition complemented Northern Oil and Gas’s then-existing approximate 183,000 net acreage portfolio in the Williston and Permian basins. As of year-end 2020, the acquired assets held an estimated 493 Bcf of proved reserves, of which approximately 55% were comprised of PDP reserves, with PV-10 of $269 million (at strip pricing as of January 20, 2021).Nick O’Grady, Northern Oil and Gas’s CEO, commented, “This transaction furthers our goal of becoming a national non-operated franchise with low leverage, strong free cash flow and a path towards returning capital to shareholders. With this transaction, we expect increased opportunities to efficiently allocate capital and diversify risk, our commodity mix and geographic footprint.”ConclusionM&A transaction activity in the Marcellus & Utica shrank in number in 2021 relative to 2020. However, the relatively greater magnitude of production density represented by the transactions in 2021 could prove to be a bellwether of more “transformational” transactions to come in 2022 as companies stake their claim in the gas and gas liquids rich basins of Appalachia.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Q3 2021 Earnings Calls
Third quarter earnings calls across the group of public auto dealers began with similar themes from the prior two quarters: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit or revenues.Supply chain disruptions caused by the microchip shortages continue to impact inventory levels on new and used vehicles for all auto dealers. The public auto dealers are not immune from these conditions as well. Average days’ supply for new and used vehicles for the six public auto dealers as of September 30 are as follows:
We have focused previous blogs on the conditions impacting new and used vehicles and their contribution to overall profitability. While those themes still existed for the Q3 earnings calls, we will focus on other areas of profitability for the public auto dealers, including Fixed Operations and Finance and Insurance (F&I). Additionally, the M&A market for the entire industry continues to accumulate transaction volumes at record levels. While much has been discussed regarding the pricing of those transactions in terms of multiples paid and which historical earnings to consider for ongoing performance, we will discuss some of the other factors public executives consider when making acquisitions.
Will inflation be the next disruptive force to impact the auto dealer industry as we close out 2021 and head into 2022? Find out how public executives view inflation to the auto consumer and how that might affect new and used vehicle transactions.
Finally, we will examine some of the themes and performance enhancements that public auto dealers continue to experience from the digital and omnichannel platforms outside the obvious digital transactions of new and used vehicles.
Theme 1: Public auto dealers report improvements in Fixed Operations and Service stemming from recovery in vehicle miles driven post-pandemic. Customer pay has continued to improve while collision work has lagged. “Consumers are approving more work than they had in years past, and they’re spending more dollars per order […] We do see more opportunity to be more digital and be more engaged and transparent with the consumer […] and mainly our source is text messaging. We’re communicating through text message.”
– David Hult, President & CEO, Asbury Automotive Group“The strong areas, obviously being areas of customer pay have continued to perform well versus both 2020 and 2019. The one area that continues to be a little bit of a laggard is collision, we do anticipate as miles continue to improve that will fully recover.”
– Joe Lower, Chief Financial Officer, AutoNation“Our customer pay continues to ramp -up following a very strong first half of the year with 19% same-store dealership gross profit growth compared to the third quarter of 2019 […] despite continued headwinds in warranty and collision, both of which we believe will reverse in time.”
– Daryl Kenningham, President U.S. and Brazilian Operations, Group 1 Automotive“Our service and parts […] it’s a huge tailwind for us. Our warranty was only off 9% […] our customer pay was up 21%”
– Jeff Dyke, President, Sonic AutomotiveTheme 2: Public executives report strong results in the F&I department fueled by escalating transaction prices and low-interest rates. The lower volume of new vehicle units retailed is also affecting the mix of F&I revenue as penetration from product sales is outpacing warranty and reserve components.“Our strong, consistent and sustainable growth in F&I delivered an increase of $155 to $1,955 per vehicle retail from the prior quarter […] We like the fact that 70% of our F&I number is product sales and only 30% is reserve […] [regarding our recent acquisition] Larry Miller group has better penetration numbers than we do. So we’re certainly excited to learn from them and grow as well.”
– Dana Clara, SVP of Operations, and David Hult, President & CEO, Asbury Automotive Group“The real driver for us [on F&I] has been increased penetration […] about two-thirds of F&I for us comes out of product versus financing.”
– Joe Lower, Chief Financial Officer, AutoNation “22% increase in F&I income […] The adjacency that we are furthest along with is Driveway Finance or DFC […] Driveway Finance earns three times the amount earned than when we arrange financing with a third-party lender […] Driveway Finance can penetrate 20% of our financed retail sales.”
– Bryan DeBoer, President & Chief Executive Officer, Lithia MotorsTheme 3: Supply chain disruptions have affected all industries including the auto dealer industry. Executives are watching how inflation and rising interest rates might impact the purchase of new or used vehicles in the coming months.“We’re watching inflation and the CPI […] what they’ve missed is the consumers are very happy with that pre-owned valuation that they own, that the 275 million vehicles on the road in America are worth more. That has made the consumer happy, not unhappy […] so once you see the other side of the coin, that consumers are not unhappy with this, they don’t consider it inflation [….] [consumers say] oh I made a pretty good investment […] it’s worth more. And if I want to sell it, I can get a nice check. And if I want to trade it, I have a reasonable difference. As soon as you realize that the consumer doesn’t view that as inflation, but as a win for them, then you understand our optimism and our confidence about the future of automotive.”
– Mike Jackson,Chief Executive Officer, AutoNation“I don’t think there’s any doubt that inflation is a business factor […] I don’t think we can call it transitory or anything like that […] the costs are going to go up on everything, but the affordability of vehicles is more dictated by retail financing and leasing. And with high used car values, and low interest rates, I don’t see this inflation raining on the vehicle sales parade in the foreseeable future."
– Earl Hesterberg, Chief Executive Officer, Group 1 AutomotiveTheme 4: M&A continues to dominate headlines. 2021 will see more transactions than any year in recent history. “I think fragmentation provides an opportunity for consolidation. With the investment required today, I think there’s a number of smaller dealerships that will become available. I think the deals that we see, the bigger deals are expensive. And many of them require CapEx and also then would provide some input from the standpoint of framework agreements with the manufacturers.”
– Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“So we visited all of the RFJ stores […] the entire management team is coming along for the ride […] we kind of walk into one of their stores and if feels like a Sonic store, they run their playbooks very similar to us. […] They are a fantastic leadership team. […] This is a perfect fit for us.”
– Jeff Dyke, President, Sonic Automotive“[Regarding the Greeley Subaru, Kahlo CDJR, and Arapahoe Hyundai announced transactions] The brand mix is about 50% luxury and then mostly, import with one domestic store as well. It’s a really a very strong group with the right brand mix in a market that we’ve been trying to grow.”
– David Hult, President & Chief Executive Officer, Asbury Automotive GroupTheme 5: Digital/omnichannel advancements are happening to meet consumer demands and enhance the retail experience. Improvements consisted of more than just unique digital visitors and increased online transactions. Improvements include average deal time, used vehicle procurement, headcount efficiency, and the ability to serve consumers with all credit scores.“I think the reason you are seeing higher credit scores and higher down payments on the tool [Clicklane] is it’s simplistically someone with a 750-Beacon score understands that they’re not worried about financing and understands that they can get what they want […] [we] certainly see [sic] lower credit scores as well on there […] there’s a broad mix, but again, the score average is certainly higher.”
– David Hult, President & Chief Executive Officer, Asbury Automotive Group“We’ve demonstrated that we can operate the business at a lower relative cost than was done historically in large part by the deployment of digital tools that are making our sales and service associates far more effective […] we’ve been able to continue to operate with 3,000 plus fewer heads within the store environment on a same-store basis year-over-year.”
– Joe Lower, Chief Financial Officer, AutoNation“We’ve increased the productivity of our salespeople by 30%, pre-Covid versus today […] selling 13 or more units a month instead of 10 […] nearly 40% of our customers are scheduling appointments online these days”
– Earl Hesterberg, Chief Executive Officer, and Daryl Kenningham, President of U.S. and Brazilian Operations, Group 1 Automotive“The average Driveway consumer is averaging exactly 50 points lower on their FICO scores. So there are 671 versus 721 in Lithia […] We did finance a higher percentage of customers in Driveway at 75% and only financed 67% of Lithia customers.”
– Bryan DeBoer, President & Chief Executive Officer, Lithia Motors“Omni-channel is just not selling vehicles. You think about service appointments, online payments – that is key.”
– Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“EchoPark is all about buy the car, transport the car, recon the car, merchandise the car and moving like 12 days to getting on the frontline, it’s gone […] EchoPark model is a one-to-five year old model under 60,000 miles”
– Jeff Dyke, President, Sonic AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
Five Thoughts on Turning Your RIA’s Success Into Momentum
Knowing why you’re successful is a key to sustaining success. Porsche made its mark in auto racing in the 1950s by turning the race for better power-to-weight ratios on its head. While most automakers focused on the numerator, building bigger cars with more powerful engines, Porsche worked to keep the car's light - not only to improve acceleration, but also braking and handling. The formula worked both on the track and in the showroom, and Dr. Ferry Porsche never lost sight of what made his cars competitive and sought after. On roads that are a monotonous sea of SUVs, the 8th generation 911 Carrera stays true to an identity that Porsche established in the 1950s with the 550 Spyder and the model 356. Although the weight has crept up over the years, power increased even faster. Engineering advances have added double-clutch gearboxes, all-wheel drive, four-wheel steering, ceramic-disc brakes, and (to the horror of the Porsche faithful) water-cooling to Porsches. However, the core identity of the product has remained intact and forms the intangible that Porsche has monetized for over 70 years. Today, the waiting list for a new one is impressive.Despite the recent volatility, it’s been another very good year for the RIA community. Markets, on the whole, are strong, tax rates didn’t skyrocket, margins are thick, and transaction activity continues unabated.Success, alas, can be fleeting. While some in the industry are focused on continued opportunities and upside in the years ahead, it’s hard to ignore calls that corporate earnings growth is slowing, the yield curve is flattening, commodity prices are worrisome, emerging markets are uneven, fee pressure is growing, and the world is bracing for another round of COVID. Whatever brings about the rollover in industry trend lines, we all know it’s coming at some point.So if, indeed, 2021 is the peak of the cycle for the investment management industry, what will you one day wish you had done now?1. Know What Got You HereThere’s an old proverb that says something to the effect of every ship has a good captain in calm waters. If your RIA has grown in AUM, revenue, and profitability over the past decade, you’re not alone. Think about why your firm grew. Did you add productive financial advisors to your wealth management practice? Did you add attractive asset management strategies? Did your assets under management increase because you broadened your appeal to a larger range of clients? Did you develop deeper relationships with existing clients? Did you grow organically or was most of your growth the result of acquisitions? Are your effective fees charged steady or increasing?Most revealing is to look at whether or not your AUM grew because of market tailwinds or because of new clients. Bull markets come and go, of course, so building the fundamental value of your investment management firm is really contingent on having an asset acquisition strategy (i.e. marketing) to bring in new clients and new client assets net of terminations and client withdrawals. You will always face some client terminations – you don’t want to do business with everyone anyway. Even good wealth management clients will eventually spend their money, and institutional asset management clients will reward your outperformance by rebalancing their commitment to you. We all know that some attrition is unavoidable and, ultimately, healthy. You just can’t rely on favorable markets to keep your revenue base stable or growing.2. What Will Your Firm Look Like in Five Years?Corporations can be perpetual, but the people who work at them eventually leave. Because investment management is necessarily labor-intensive, your firm is a function of the career cycles of your staff. Five years from now, everyone who is still at your firm will be five years older. Stop for a minute and think about what that looks like. The RIA industry is, as a whole, facing demographic challenges, and by some measures, there are more financial advisors in the career wind-down stage than there are in the career development stage.So what will your staff look like in five years? Will any of them have retired? Will any have new skills and/or credentials? How will titles, roles, and responsibilities change? What turnover are you likely to have? Will you need to replenish turnover from experienced hires or will you train people who are new to the industry? In other words, as you look at the changes that will likely happen to your staff over the next five years, will those changes grow your firm, maintain it, or are you at risk for attrition to your collective intellectual capital.3. Stress Test Your MarginsIt’s more than a little ironic and unfortunate that there are so many forecasting tools for individuals but so few for businesses. Just like wealth management firms run Monte Carlo simulations on portfolios to model likely outcomes for clients given different market scenarios, so too you need to think about how your firm will fare during unfavorable external circumstances.Profit margins have a very real business continuity function that is easy to forget after long stretches of upward trending markets. If your firm currently boasts a 25% pre-tax margin, for example, you could suffer the loss of a quarter of your revenue stream and, theoretically, not have to cut your expenses. This isn’t pleasant to contemplate, but if a sustained bear market cut your AUM by 20%, and then client financial stress caused a greater than usual rate of withdrawals, you could see a considerable decline in your top line. Since the only way to meaningfully reduce expenses in the RIA business is to cut staff, responding to unfavorable financial market conditions can have a long-lasting impact on the scale and value of your firm. It’s worth considering such a likelihood, and it’s much easier when you aren’t under the stress of the event itself.4. Consider Your Exit OptionsWith M&A on the rise, private equity increasingly interested, and new consolidation schemes emerging on a weekly basis, there has never been a more interesting time to consider how you might liquefy an interest in an RIA. Remember, though, that most ownership transitions in investment management firms are still internal because transacting staff, clients, and culture is difficult, even with favorable industry conditions. Outsiders don’t always “get it,” and insiders don’t want them.If you had to sell right now, how would you do it? If you don’t think your firm is ready to take to market, what changes need to be made? If you intend to transact internally, do you foster a culture of succession? There’s no room here for an exhaustive analysis of exit planning for RIA owners, but suffice it to say that you should always be aware of your possibilities. If you can’t find the door in good times, what will your plan be following the next correction?5. Remember That Long-Term Industry Trends Are FavorableAt some point, things are going to get rough, and the performance of your RIA is going to deteriorate. When market valuations tumble, clients get nervous, and staff stress rises, it can feel like at least your professional world is coming to an end. Broad industry trends, though are very favorable to the investment management community. New retirees make up the largest source of new clients for wealth management firms (and, in turn, asset managers), and the number of retired persons in the U.S. will continue its upward trajectory for decades to come. Assets continue to flow away from wirehouses and toward independent advisory practices. And last but not least, markets are – over time – upward drifting. None of that is going to change with the next bear market.So while the fundamentals of your firm may appear to deteriorate during bear markets, the fundamentals of the industry will continue to drive success for a long time. Today, the fundamentals of your firm are probably the best they’ve ever been. That’s why this is the perfect time to consider your formula for success, prepare for the next downturn, and build the competitive momentum you’ll need to ride the industry trends to greater success in the future.
5 Questions with Dennis Hinton
An Interview with the Managing Director of a Private Investment Firm Focused on Non-Controlling Equity Investments in Family Businesses
Previously on the Family Business Director Blog, we shared our prediction that the number of family businesses raising non-family equity capital will grow dramatically in coming years.In this week’s post, we share excerpts from a discussion with Dennis Hinton, Managing Director at North River Group, a private investment firm focused on non-controlling equity investments in family businesses. Mr. Hinton shares some common reasons family businesses seek non-family equity and how family business owners can achieve liquidity and diversification.Your firm, North River Group, makes non-controlling equity investments in family businesses. What are the most common triggers for the family businesses that are looking for non-family equity capital?Dennis Hinton: The most common trigger for a family business to get connected to us concerning non-controlling (minority) capital is around growth capital, or where the capital goes onto the company’s balance sheet to fund a specific initiative. However, this is not the ideal situation for North River Group. We seek to invest non-controlling equity capital into family businesses where they do not need capital. Stated differently, our capital is used for “liquidity,” or cash goes into the shareholder’s pocket.
Most business owners, especially family businesses, do not know this is an option. They think their options are to either sell 100% of the company or do nothing. Selling less than 50% of a business provides a sort of “hybrid” liquidity event for a family-owned business.Do you find that family business owners are becoming more receptive to the idea of having non-family shareholders? If so, why do you think that is the case?Dennis Hinton: Yes and No. As traditional private equity becomes more mainstream, I think many family-owned businesses are uncomfortable with how they operate.
Specifically, many family-owned businesses that have been around for a long time usually have done so through the avoidance of debt. Adding a lot of debt to a company’s balance sheet changes the dynamics of how a family-owned business operates. For example, many family-owned businesses pay their bills to their vendors as soon as they receive an invoice. However, a private equity owned, debt burdened business might view this as an opportunity to “squeeze” a bit more cash flow by delaying paying invoices for 30, 60, or even 90 days. Short term these gimmicks work but long term they lead to an erosion of trust with key stakeholders.
Second, most entrepreneurs simply don’t like taking orders from others. While a strategic or private equity buyer talks about “partnering” with such a family-owned business, in reality, many times, this partnership turns into a dictatorship. Many times after an acquisition, a buyer will come in and micro-manage the prior owner operator(s).
In a non-controlling equity investment transaction, these dynamics do not exist.What sort of governance rights do non-family investors typically require when they invest?Dennis Hinton: There are really only 3 governance provisions we require when doing these types of transactions:Agreement on annual CPA audit firm.Agreement on any family compensation increases above 2 or 3% annually.A Put Right or Redemption Right.
Of the 3 provisions, the Put Right or Redemption Right is the only one that has any detail to it. While we never make a non-controlling investment intending to exercise such a Right, a preset and prenegotiated separation agreement is beneficial for both parties should a difference of opinion ever arise.Many families are leery of private equity funds because of their relatively short (4-7 year) investment horizons. Are there investors out there that are not tied to the fund cycle treadmill?Dennis Hinton: Yes, there are more and more investment firms with longer investment horizons. However, most are focused on the change of control investments or minority growth equity investments. We believe we are quite unique in that we don’t have any preset time horizons for investments. Additionally, we focus on providing family business owners liquidity by purchasing less than 50% of their business.What advice do you have for an enterprising family that is considering whether outside capital might be appropriate for them?Dennis Hinton: Chemistry matters. Specifically, when a family is deciding whether or not to partner with an investment firm in a minority capacity, there has to be a high degree of trust between both parties as it is a true partnership. While legal documents can provide high level parameters for how a partnership will operate post-closing, they can never include all situations that arise when running a business. When such a situation arises, both parties need to have confidence that the other party will work towards a fair and just outcome (which can sometimes conflict with one’s own financial interests). Finally, aside from business matters, we have always enjoyed working with business owners that we like personally – it makes the partnership much more fun.
Mercer has experience working with family businesses to evaluate outside investment opportunities. Give us a call if you have an offer you want us to analyze alongside you.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of November 29, 2021
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of November 29, 2021Download Study
Top Considerations for Acquirers When Evaluating a Potential Bank Acquisition
With year-end approaching, we are starting our annual process of recapping 2021 and considering the outlook for 2022. In doing so, we turned our attention to the bank M&A data to see what trends were emerging. While the number of bank and thrift deals is on pace to roughly double from 2020 levels (117 deals in 2020 vs 199 deals through 11/22/21), the number of deals still remains well below pre-pandemic levels. Valuations at exit illustrate a similar trend with the median price/earnings nationally for announced deals at ~15.0x earnings and the average price/tangible multiple at ~1.54x for the YTD period through mid-November 2021. These valuation multiples implied by YTD 2021 deals are up relative to 2020, roughly in line with 2019 levels, but are still down relative to 2017 and 2018 levels.A bank acquisition could present an opportunity for growth to acquirers that are facing a challenging rate and market environment. Some recent data confirmed this as almost half of survey respondents in Bank Director’s 2022 Bank M&A Survey say their institution is likely to purchase another bank by the end of 2022 — a significant increase compared to the previous year, and more in line with the pre-pandemic environment.For those banks considering strategic options, like a sale, 2022 could also be a favorable year, should the improving trends experienced in 2021 continue. These trends include a continued increase in buyer’s interests in acquisitions, a continued expansion of the pool of buyers to include both traditional banks and non-traditional acquirers like credit unions and FinTechs, and the tax environment for sellers and their shareholders remaining favorable relative to historical levels.Against this backdrop of the potential for an active bank M&A environment in 2022, we consider the top three factors that, in our view, should be considered by bank acquirers to help make a successful bank acquisition.1. Developing a Reasonable Valuation Range for the Bank TargetDeveloping a reasonable valuation for a bank target is essential in any economic environment, but particularly in the current environment. We have noted previously that value drivers remain in flux as investors and acquirers assess how strong loan demand and the rate environment will be. In addition to those factors, evaluating earnings, earning power, multiples, and other key value drivers remain important. Bank Director’s 2022 Bank M&A Survey also noted the importance of valuation in bank acquisitions as pricing expectations of potential targets were cited as the top barrier to making a bank acquisition (with 73% of respondents citing this as a barrier).Determining an appropriate valuation for a bank requires assessing a variety of factors related to the bank (such as core earning power, growth/market potential, and risk factors). Then applying the appropriate valuation methodologies – such as a market approach that looks at comparably priced transactions and/or an income approach focused on future earnings potential and developed in a discounted cash flow or internal rate of return analysis. While deal values are often reported and compared based upon multiples of tangible book value, value to specific buyers is a function of projected cash flow estimates that they believe the bank target can produce in the future.Price and valuation can also vary from buyer to buyer as specific buyers may have differing viewpoints on the future earnings and the strategic benefits that the seller may provide. For example, 2021 has seen an emerging trend of non-traditional acquirers such as credit unions and FinTech companies entering the mix. They often have different strategic considerations/viewpoints on a potential bank transaction.2. Appropriately Consider the Strategic Fit of the Bank TargetAs someone who grew up as an avid junior and college tennis player, I have always admired the top pros and found lessons from sports to apply in my personal and business life. With fifteen grand slam titles and fifteen years as the top doubles team globally, the Bryan brothers – Bob and Mike – are often held out as the most successful doubles teams of all time and offer some lessons that we can learn from, in my view. Their team featured a unique combination of a left-handed and right-handed player, which provided variety to challenge their opponents and expand their offensive playbook. It also had many similar intangibles, such as how they approached practicing and playing since they were twins and taught by their father (Wayne) from a young age.Their success illustrates the importance of identifying both the key similarities and differences of a potential partnership to strengthen the chances for success once combined. Key questions to consider regarding strategic fit and identifying the right partner/opportunity for a bank acquisition include: Does the Target expand our geographic footprint into stronger or weaker markets? What types of customers will be acquired (retail/consumer, business, etc.) and at what cost (both initially and over time)? Is there a significant branch/market overlap that could lead to substantial cost savings? Is the seller’s business culture (particularly credit underwriting/client service approach) similar to ours? Will the acquisition diversify or enhance our loan/deposit mix? Will the acquisition provide scale to expand our business lines, balance sheet, and/or technology offerings? What potential cost savings and/or revenue enhancements does the potential acquisition provide?3. Evaluating Key Deal Metrics Implied by the Bank AcquisitionA transaction that looks favorable in terms of valuation and strategic fit may flounder if other key deal metrics are weak. Traditional deal metrics to assess bank targets include capital/book value dilution and the earnback period, earnings accretion/dilution, and an internal rate of return (IRR) analysis. Below we focus a bit more on some fundamental elements to consider when estimating the pro forma balance sheet impact and internal rate of return:Pro Forma Balance Sheet Impact and Earnback PeriodTo consider the pro forma impact of the bank target on the acquirer’s balance sheet, it is important to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma balance sheet at closing as well as future earnings and capital/net worth after closing. In the initial accounting for a bank acquisition, acquired assets and liabilities are marked to their fair values. The most significant marks are typically for the loan portfolio, followed by intangible assets for depositor customer relationship (core deposit). Below are some key factors for acquirers to consider for those fair value estimates:Loan Valuation. The loan valuation process can be complex, with a variety of economic, company, or loan-specific factors impacting interest rate and credit loss assumptions. Our loan valuation process begins with due diligence discussions with the management team of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio. We also typically factor in the acquirer’s loan review personnel to obtain their perspective. The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates. Problem credits above a certain threshold are typically evaluated on an individual basis.Core Deposit Intangible Valuation. Core deposit intangible asset values are driven by market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.Internal Rate of ReturnThe last deal metric that often gets a lot of focus from bank acquirers is the estimated internal rate of return (“IRR”) for the transaction. It is based upon the following key items: the price for the acquisition, the opportunity cost of the cash, and the forecast cash flows/valuation for the target, inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the acquirer’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the acquirer.Mercer Capital Can HelpMercer Capital has significant experience providing valuation, due diligence, and advisory services to bank acquirers across each phase of a potential transaction. Our services for acquirers include providing initial valuation ranges for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the buyer’s management and/or board, and providing valuations for fair value estimates of loans and core deposit before or at closing.We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit. Feel free to reach out to us to discuss your community bank or credit union’s unique situation and strategic objectives in confidence.
Family Business Dividend Survey Results
This summer, we partnered with Family Business Magazine to conduct our inaugural survey of dividend practices at family-owned businesses. This week, we feature an article that we wrote for the magazine summarizing the survey results. We hope you enjoy and gain some insights that can help you and your family evaluate your current policy and make plans for the future.Determining what portion of earnings should be distributed to family shareholders each year can be perilous.Few decisions faced by family business leaders are as perilous as determining what portion of earnings should be distributed to family shareholders each year. Pay too little, and shareholders having no other source of liquidity from their shares may grow restive. Pay too much, and attractive opportunities for growth may wither on the vine, imposing a hard to define, but very real, cost on future generations. As a result, maintaining the appropriate balance between current income for existing shareholders and reinvestment for future generations can feel like a tightrope walk for family business leaders.When embarking on such a high-stakes endeavor, prudent leaders want to learn as much as they can from others in similar situations. To help family business leaders learn from one another, Mercer Capital partnered with Family Business Magazine to administer a survey on dividend practices at family businesses. Nearly 300 enterprising families responded, and we provide a summary of what we learned in this article.Are There Any Families Like Mine?The respondents to the survey represent a diverse group of family businesses, in terms of age, industry, size and geography. The median age of the family businesses in our sample was about 70 years, with nearly half being founded prior to 1950. The largest industry concentrations were in manufacturing (30% of respondents) and real estate (12% of respondents). About half of respondents reported revenue of less than $100 million, and approximately 10% reported more than $1 billion of annual revenue.What’s the Plan?Unlike shareholders in public companies, family shareholders can’t easily access the value of their shares by selling on the open market. Dividends are the most tangible expression of what can often feel like merely “paper” wealth. It’s nice to be rich; it’s even better to have money. Given this dynamic, it is not surprising that family businesses are more likely than public companies to pay dividends. Whereas about half of public companies pay dividends to shareholders, over 80% of the family businesses responding to our survey indicated that they do. However, nearly half of respondents reported not having a formal dividend policy. In other words, a significant group of family businesses are paying dividends, but they’re not sure why.Those who do have a formal dividend policy reported a few different policy objectives. As shown in Exhibit 1, the most common dividend policy identifies a target payout ratio of earnings (net earnings for C corporations, or earnings after tax distributions for pass-through entities). While family businesses prioritize paying dividends, overall payout ratios tend to be modest, with the target payout ratio for 60% of respondents at less than 25% of earnings. This suggests to us that most family businesses are wary of killing the golden goose.Exhibit 1 Dividend Policy Objectives
Nearly 30% of dividend policies prioritize the investment needs of the business and treat dividends as a residual amount after attractive investment opportunities have been funded. Finally, a smaller minority of respondents prioritize shareholder returns in the form of establishing a target dividend yield (generally on the order of 2% to 4% of value).
What Signal Are You Sending?Dividends are powerful signals about management’s outlook for the family business. Annual reports and shareholder letters may or may not get read, but dividend checks always get cashed. Because of this “signaling effect,” public company managers are loath to cut dividends in the face of a short-term earnings crunch and are hesitant to raise dividends beyond a level that they are confident they can maintain. In contrast, nearly half of the family business survey respondents indicated that dividends fluctuate from year to year, and only 20% reported having a mechanism in place to smooth out dividends amid volatile earnings. Without strong, well-cultivated shareholder consensus and engagement around the dividend policy, dividend volatility can reduce the “value” of the dividend stream to shareholders. Uncertainty regarding the dividend stream makes it harder for shareholders to make reliable personal financial plans. Dividend uncertainty also presents challenges for family business managers who need to plan significant capital investments years in advance.Public companies can emphasize dividend stability amid volatile earnings using share repurchases. Buying back shares and paying dividends are both tools to return capital to shareholders. Public companies tend to allocate more capital to share repurchases than to dividend payments. There are likely several reasons for this, one of which is that when earnings are down and capital is scarce, slowing the pace of share repurchases is less of a negative signal to investors than cutting the dividend. In other words, share repurchases serve as a release valve for volatile earnings at public companies. However, only 21% of our survey respondents reported having a formal share repurchase program available to provide liquidity to family shareholders. Without this release valve in place, it should not be too surprising that families report a higher degree of dividend volatility. We suspect that more family businesses will institute share repurchase programs in the future.Pandemic BluesThe COVID pandemic presented a (hopefully) once-in-a-generation challenge for family businesses. Much like the broader economy, the pandemic did not affect all family businesses in the same way. We asked survey participants to describe what effect the pandemic had on the performance of their family businesses and their dividend decisions. Exhibit 2 summarizes the responses.Exhibit 2 Effect of Pandemic on Family Business DividendsJust over half of respondents indicated that the pandemic had no adverse effect on the financial performance of their family business. As a result, a significant majority of these respondents did not modify their dividend practices in response to the pandemic. Nonetheless, nearly 15% of those family businesses reporting no ill effects from the pandemic on financial performance reduced dividends, presumably to preserve family business capital in the face of grave economic uncertainty.Among family businesses that did see their financial performance suffer during the pandemic, there was a mix of dividend responses. Approximately 27% of such family businesses elected to maintain their dividend, signaling to family shareholders that they were confident in the long-term prospects of the family business. The remaining companies either cut dividends or suspended them entirely.Nearly 20% of all survey respondents reported suspending dividends altogether because of the pandemic. Given the significance of dividend payments to family shareholders, the decision to suspend dividends reveals the gravity of the threat the pandemic posed to some family businesses. Deciding when and how to reintroduce dividend payments will be a significant challenge for these families.What’s It Mean to You?Crack open a standard finance textbook, and dividend policy will look easy. Simply invest in all available positive investments with a positive net present value, maintaining an optimal mix of debt and equity financing, and distribute what is left over. Unfortunately, that theory assumes that shareholders are economic robots. However, most family shareholders are people. Unlike robots, people invest things (including family businesses) with meaning. We asked survey participants to describe what their family business means to them, and the responses are summarized on Exhibit 3.Exhibit 3 Family Business Meaning
In our experience, the most successful (and peaceful) enterprising families are those in which there is consensus regarding what the family business means to the family. When there is alignment on meaning, it is easier to find alignment on dividend practices. This is borne out when we examine the median target payout ratios for businesses sorted by the different family business meanings noted in Exhibit 3. As shown in Exhibit 4, there is a clear correlation between what the family business means to the family and dividend practice.
Exhibit 4
Family Business Meaning and Target Payout Ratio
If the family business serves as a source of wealth accumulation and diversification for family members, it makes sense that payout ratios would be relatively high. In contrast, if the family business is perceived as an economic growth engine for future generations, large dividend payments will detract from that goal. Misalignment on meaning can trigger shareholder discontent: Individual shareholders who want the company to be a source of wealth accumulation will likely be frustrated if the rest of the family views the company as an economic growth engine and makes dividend decisions accordingly.
The Last WordMany survey respondents provided additional comments that were illuminating. We will close with one that we think expresses the sentiments of many family shareholders: “I feel that maybe some businesses don’t discuss dividends openly. I feel that we are one of these. It is ‘undiscussable.’”Don’t let dividends be an “undiscussable” in your family. We hope the results of this survey can provide a starting point for healthy dividend discussions at your family business.
SUMMARY RESULTS
2021 Family Business Dividend Practices SurveyDownload Summary
Posturing for a Successful Succession
Failing to Plan is Planning to Fail
A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders, with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:“The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.”Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning:Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms may not always pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal-making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect them to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option typically involves less up-front proceeds and higher risk retention than the ones above, it is often an ideal path for owners seeking short-term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes significant time and financing, as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the entire transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered.
If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.
Major Acquisitions of Alternative Asset Managers Signal Continued Outperformance
As we wrote in our most recent investment manager sector highlight, Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year, alternative asset managers have outperformed all other investment manager sectors in the RIA post-pandemic rebound. According to Institutional Investor, eight of the world’s ten largest investment management firms by market capital are now alternative asset managers. Most notably, the private equity firm Blackstone surpassed the world’s largest investment management firm by AUM, Black Rock, as the most highly valued stand-alone investment management firm back in September of this year.The demand for investment management firms continues to reach new highs and has culminated in a number of prominent acquisitions over the past year. In the past month alone, three deal announcements of alternative asset managers by larger, traditional asset management firms and diversified financial institutions suggest the sector remains bullish.Franklin Templeton to acquire Lexington Partners acquisition – Nov. 1, 2021. At the time of the announcement, Lexington Partners managed $34.0 billion in AUM primarily in secondary private equity investments and co-investment funds. The deal marks Franklin Templeton’s second private equity acquisition in the past three years after acquiring Benefit Street Partners in 2019.T. Rowe Price to acquire Oak Hill Advisors – Oct. 28, 2021. The alternative credit provider, Oak Hill Advisors, currently manages about $52.0 billion in AUM. The $4.2 billion acquisition marks T. Rowe Price’s first in more than a decade.Macquarie Asset Management to acquire Central Park Group – Oct 21, 2021. Central Park Group is a private equity and real estate investment firm located in New York and has AUM of approximately $3.5 billion.Demand Drivers for Alternative Assets vs. Demand Drivers for Alternative ManagersThe deals listed above are indicative of strong demand for both alternative assets and the firms that manage them. While the niche investment expertise and narrow market presence of alternative asset management firms can sometimes complicate transactions, traditional investment managers are nevertheless finding value in the alternative asset management models which have proven to be highly profitable, resilient, and may be bolted on to existing asset management teams. Below, we look at several factors driving investor demand for alternative assets and for alternative asset management firms.Alternative Asset Demand & Performance Drivers:A low yield environment. When interest rates fall, investors are encouraged to take higher degrees of risk to maintain prior levels of return. Certain alternative assets such as private equity and venture capital are generally considered higher risk, higher reward investments. Interest rates have remained at historic lows since the Great Recession and dipped further during 2020.Heightened volatility. In times of heightened market volatility, investors flock to real assets and private equity which is less prone to price swings. Additionally, certain options-heavy investment firms are also positioned to benefit as the volatility on the underlying is directly related to the options value. The historic market volatility throughout the pandemic era has benefited hedge fund performance and left investors flocking to “safer” asset classes.Robust exit activity. While markets have been exceedingly volatile over the past year and a half, they have more than recovered from the lows at the onset of the pandemic. Asset inflation has run rampant, particularly in the private equity and venture capital space which is now well positioned to benefit from strong exit activity in the coming years.Inflation. According to data from Trading Economics, annualized inflation in October 2021 was 6.2%, the highest level in decades. Certain alternative asset classes are widely considered to be inflation hedges. Real assets such as commodities and private real estate traditionally outperform in times of high inflation because returns are tied to capital appreciation.Demand Drivers for Alternative Asset Manager Acquisitions:Positive Fund Flows. According to PWC’s midyear outlook for private equity, investor appetite for private equity has outpaced traditional investment manager fund flows over the past five years. Sector AUM increased nearly 20% in 2020 alone, and the trend seems to be gaining momentum. Currently, PE dry powder is at an all-time high at $150.1 billion, which is reflective of strong fundraising and investor demand.Fees. Alternative asset managers seem to be somewhat immune to fee compression which has been one of the strongest headwinds for asset management for over a decade. The widespread consensus among money managers is that alternative assets justify premium fees due to purported diversification benefits, higher return, and expertise needed to execute such strategies. The opaque nature of the investment strategies and asset classes employed by alternative asset managers may also help these firms avoid fee compression.Diversification. Implicit in most asset management models is operating leverage. Because revenues are directly tied to the performance of the market and expenses remain somewhat fixed to compensation and overhead, diversifying firm exposure by broadening product offering may smooth out the bottom line. For this reason, alternative asset management firms can make strong acquisition targets for traditional asset managers.
While fund flows may taper off if systemic tailwinds subside, alternative asset managers will likely remain strong acquisition targets for traditional asset managers due to diversification benefits and superior fees. Additionally, demand for alternative asset managers from other financial institutions such as banks and insurance companies looking to gain exposure to the investment space will also likely remain strong.
EV Start-Up Rivian IPOs at Valuation of $86 Billion
What It Means for Ford, Other OEMs, and Auto Dealers
The stock market is near record highs despite the global economy still working on climbing out of a once-in-a-century pandemic. A couple of themes for high-flying equities are ESG and companies that have yet to turn a profit. Rivian Automotive takes this a step further, as its prospectus indicates it will lose $1.28 billion in the third quarter while revenue will range from $0 to $1 million. However, as of its opening price, Rivian is already worth more than Ford and GM. From a valuation perspective, all the value is clearly placed in the terminal value with minimal production to date.Amazon and Ford are backing the electric vehicle startup, and investors are clearly betting the company can grab a meaningful amount of the burgeoning EV market. Rivian has beat Tesla, GM, and Ford to market with a fully electric pickup truck, the R1T. While this is expected to launch in December, it remains to be seen how meaningfully the company can scale production—if it can’t, being first may not mean much.Rivian indicates its factory in Illinois has the capacity to produce approximately 65,000 pickup trucks/SUVs and 85,000 commercial delivery vans, the latter of which is why Amazon is interested. Amazon owns 20% of Rivian and has ordered 100,000 Rivian vehicles to be delivered by 2030. Ford was also interested in collaborating on production for its EV business. The investment increased to become a meaningful part of Ford’s market capitalization, regardless of synergistic opportunities. However, on Friday, it was announced that Ford and Rivian had canceled their plans to jointly develop an EV.There are numerous potential reasons for this split, and Rivian indicated the decision to split was mutual. When Ford invested in Rivian in 2019, it was likely viewed as a way to jump-start its EV initiatives. Since then, Rivian’s production has been de minimis while Ford sold about 22,000 Mustang Mach E's alone in 2021, which was named Car and Driver’s Electric Vehicle of the Year. While Ford will continue to benefit from its investment in Rivian, it doesn’t “need” Rivian to be successful in EVs.Below, we have included a recent blog from my colleague Atticus Frank on Mercer Capital’s Family Business Advisory Services team, highlighting the decision to invest in Rivian from Ford’s perspective.Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) startup that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car startup, giving it an implied stake of over $18 billion. Not bad, given its sub-$1 billion of invested capital. If one were to do a “back-of-the-envelope” sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization.
We don’t highlight the current irrational exuberance to spur you into investing in an EV startup or give you a case of ‘FOMO’, but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why?
What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is a correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation.
We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article.
When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative.
However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the startup) is yet to be seen.
Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different ‘who’ regarding diversification and a different ‘why’ to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business.
Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the ‘why’ for significant investment decisions.
How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision.
Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures
And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.“If I had asked people what they wanted, they would have said faster horses.”“Any customer can have a car painted any color that he wants so long as it is black.”Takeaways From RivianAuto dealers are unlikely to be able to invest in the next Rivian, but that doesn’t mean there are no lessons to be learned here. The market is clearly indicating it believes EVs are the future, so dealers should be positioning themselves accordingly. With heightened margins in 2021, auto dealers need to decide the best way to reinvest their capital. That may mean using profits earned in the past years and investing in infrastructure to support EVs. Local markets will still be necessary and there won’t be a one size fits all solution, but Rivian making headlines should get auto dealers thinking about what it means for them.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.In addition to auto dealers, Mercer Capital also provides financial education services and other strategic financial consulting to family businesses. Click here to learn more about our Family Business Advisory Services.
Family Business Director’s Top Ten Questions Not to Ask at Thanksgiving Dinner
For most of us, Thanksgiving is a time to disregard normal dietary restraint in the company of extended family members that one rarely sees. For some enterprising families, however, Thanksgiving quickly devolves from a Rockwellian family gathering to a Costanza-style airing of grievances. So, in the holiday spirit, we offer this list of the top ten questions not to ask at Thanksgiving dinner. If you have trouble distinguishing between the board room and the dining room, this list is for you.1. Why can’t I work in the family business?Nearly all family businesses welcome the contributions of qualified family members; however, having the right last name is not a sufficient condition of employment for successful family businesses. As families grow into the third and subsequent generations, family employment policies can become especially contentious. Crafting a workable family employment policy that specifies required qualifications and external work experience is often one of the first and most important tasks undertaken by a family council.2. Why does cousin Joe get such a big salary?This can be a great question, and it is quite possible that Joe is either under – or over – paid relative to his contribution as an employee. As family businesses grow, the board should carefully evaluate how compensation practices for family members compare to those for non-family members. Working in the family business should be neither indentured servanthood nor a sinecure. It is a job, and successful families treat it as such. Having one or more independent (non-family) board members can be a great way to ensure that compensation practices in the family business are fair.3. Why does cousin Sam get anything from the business?This question gets to the heart of many family business disputes we have witnessed: the belief that family members who don’t spend their lives working in the family business aren’t entitled to any distributions. Successful families are able to separate the return on labor (wages and benefits) from the return on capital (distributions). Just as the family members providing labor are entitled to market-based compensation, family shareholders are entitled to distributions if and when paid, even if they don’t work in the business. That’s simply what ownership is. It works that way for public company shareholders, and there’s really no reason to treat your family shareholders any differently.4. Why isn’t the shareholder redemption price higher?A shareholder liquidity program can be a great way to promote peace in the family. Even when a shareholder liquidity program exists, however, shareholders often don’t understand that the family business has more than one value. Which value is appropriate for a redemption program depends on the family dynamics and goals for the program.5. Why doesn’t the business pay a bigger dividend?Being wealthy is not the same thing as feeling wealthy. Many family shareholders are wealthy but don’t necessarily feel that way because dividends either aren’t paid or are only a token amount. Having a well-reasoned and easily-articulated dividend policy is an essential step in promoting family harmony and sustainability. Occasionally, founders and second-generation leaders withhold distributions simply on principle, even if the business has limited reinvestment opportunities. This rarely ends well.6. Why doesn’t the business invest more for the future?This is the flipside to the previous question. Funds that are distributed are not available to reinvest in the family business. A single dollar of earnings cannot be both distributed and reinvested – a choice is required. Making that choice wisely requires knowing what time it is for your family business. As the family grows biologically, it is natural to wonder if the family business will, or can, keep up. You have to sow before you can harvest.7. Why doesn’t the business borrow more money?Growth requires capital, and since family businesses rarely have an appetite for admitting non-family shareholders, that means debt may be the only way to fund important growth investments. Prudent amounts of leverage to help finance growth investments can actually help secure, rather than imperil, the family business’s future. But before borrowing money, directors should ask a few key questions.8. Why does the business have so much debt?Some shareholders fret about using too little leverage, while others worry about the risk of having too much debt. Over the long-run, the capital structure of your family business should reflect the risk tolerances and preferences of your family shareholders. The idea that you can financially engineer your way to a lower cost of capital (and therefore, higher value) for your family business through fine-tuning capital structure is over-rated. Capital structure determines how much risk and reward shareholders can anticipate, but does relatively little to influence the actual value of your family business.9. Why don’t we register for an IPO?There are examples of families that have taken their businesses public while retaining control over the board of directors. It’s not always a lot of fun. Despite retaining control, being public means inviting the SEC and other regulators to take a keen interest in your business. Even if your family keeps its eye on the long-run, Wall Street can take you on a wild ride based on the short run. Having publicly-traded shares may be what’s best for your family business, but it’s a big step and a really hard one to take back.10. Why don’t we sell the business?When is the right time to convert the illiquid wealth that is the family business into ready cash? A buyer might approach your family business with an offer that you weren’t expecting, or your family might decide to put the business on the market and seek offers. In either case, you only get to sell the business once, so you need to make sure you have experienced, trustworthy advisors in your corner. Selling the family business will not remove all the stresses in your family; in fact, it may add some.Of course, all of these are really great questions to be asking – the Thanksgiving dinner table is just not the right venue. This Thanksgiving, try setting business to the side for at least one day. Our advice: instead of talking about the family business, stick to a safer topic like politics. Above all, be thankful for the opportunity to be a family that works together.Happy Thanksgiving!
Differing Perspectives on the Used Vehicle Market
Feast or Famine?
With Thanksgiving around the corner next week, we hope that everyone will be able to visit with family, share a meal with loved ones, and rekindle old traditions from holidays past. All of us are not immune from the headlines that speak to disruptions in the global supply chain on a daily basis. Undoubtedly, each of us has been inconvenienced with those supply shortages with consumer products, food, and essential goods that impact our daily lives. The automobile market is no different.In a previous blog, we examined several key indicators for the entire automobile market incorporating the first six months of data. In this weeks’ blog, we offer commentary on the status of the used vehicle market and re-examine some of those metrics through third quarter data. Headlines persist describing inventory shortages, record transaction prices, record profitability and predictions for when conditions will return to normal. How do we make sense of all of it? What factors are contributing to the current conditions? Like the larger automotive industry as a whole, conditions can be described as the best of times and the worst of times, or feast or famine. Interpretation of the conditions can differ depending on the perspective of the consumer or the auto dealer. We examine some of the key used vehicle metrics and indicators and then discuss how we got here and where we are headed.PricesFeast for the Auto Dealers, Famine for the ConsumerAccording to Cox Automotive, the average transaction price for a used vehicle topped $27,000 for the month of September. This figure represents the largest average transaction price for used vehicles on record and indicates a 25% increase from the average price of used vehicles just one year ago in September 2020. Most car buyers understand the historical notion that the value of a car depreciates immediately after you drive it off of the dealership lot. In 2021, this notion simply isn’t true for the time being. There are plenty of examples in the marketplace of used vehicles that are 1-2 years old with minimal miles (25-30K) that are selling for prices higher than the original sticker price of the new vehicle!Gross Profit Per Unit Used VehicleFeast for the Auto Dealers, Famine for the ConsumerOf the department/profit centers for an auto dealership, historically, the new and used vehicle departments accounted for the largest contribution to revenue, but a substantially lower contribution to overall gross profit. According to the Average Dealership Profile from NADA, these departments typically comprised approximately 88-90% of revenues and approximately 52% of gross profits, with the remainder coming from fixed operations. Currently, these departments still comprise a similar percentage of total revenues but now comprise 60% of gross profits. This figure continues to climb as of September 2021 as reported by NADA. What is driving this increase? Rising transaction prices for used vehicles and, in turn, increased gross profit per unit (GPU). The graphic below details the current used vehicle GPU and the corresponding figures from the prior two year-ends.Average Days’ Supply Used VehiclesFamine for Auto Dealers and the ConsumerWe’ve written about average days’ supply previously in this blog, but it serves as a key indicator of the level of supply, or in this case, the shortage of used vehicles in the market. Average days’ supply is calculated as the number of used vehicles in inventory or in the market divided by the average daily number of used vehicles sold. Historically, this figure ranged between 55 and 66 for 2019 and 2020, as seen in the graphic below. The average days’ supply for used vehicles has not slumped nearly as bad as the same metric for new vehicles and has shown signs of steadying to slight improvement.Source: Cox AutomotiveThrough the early spring of 2021 and through September, this same metric cratered at 33 and has steadily maintained or slightly improved to 43.Source: Cox AutomotiveSourcing – Where do Used Vehicles Come From?To help explain the forces behind these metrics, let’s examine where used vehicles are sourced. Historically, used vehicles from an auto dealer were purchased from one of four areas: customer trade-ins, off-lease vehicles, fleet cars, and auctions.Trade-Ins – With plant shutdowns, microchip shortages, and supply chain issues, the supply of new vehicle inventory has been more adversely affected than its used vehicle counterpart. Average days’ supply for new vehicles dipped into the low 20s and dropped even lower for many local auto dealers. With fewer new vehicles to purchase, the number of customer trade-ins are also lower simply due to transaction volume and inventory availability.Off-Lease – Off-lease vehicles refer to a vehicle returned to a dealer at the end of its lease. Generally, off-lease vehicles have been gently used and tend to have lower mileage. Why are less leased cars being returned to the dealer? Most lease contracts have a clause where the consumer can purchase the vehicle at the end of the lease for a residual value. In most cases, the residual value is lower than the original value of the vehicle to reflect the depreciation of value.As discussed earlier, the value of used vehicles is at/near record highs. Many vehicles have a current value greater than the anticipated residual value stated in the original lease contract. Customers with leases face two choices: purchasing their vehicle for the residual value or returning the vehicle to the dealer at the end of the lease. Facing the inventory shortage conditions on both new and used vehicles and the prospect that the current value of their vehicle is greater than the residual value, most consumers are choosing to purchase the vehicle at the end of the lease. While others may purchase their leased vehicle and sell immediately to realize the arbitrage opportunity between the current value and residual value, most then face the prospect of locating and purchasing a more expensive vehicle. In either case, fewer off-lease vehicles are re-entering the used vehicle market.Fleet Cars – Fleet cars represent those vehicles sold to rental car companies, government agencies, or larger customer accounts. The trends affecting the current condition and the overall life cycle of these cars date back to the early days of the pandemic. In the Spring of 2020 with the advent of lockdowns and travel restrictions, rental car companies sold off much of their inventory which hit the used vehicle market at that time. Flash forward to the next 18 months that were characterized by plant shutdowns and lower sales by the OEMs in 2020, and then further inventory shortage issues caused by the lack of microchips and other factors in 2021.Historically, OEMs and the industry operated on an average days’ supply of new vehicles between 60-75. OEMs and auto dealers prioritized fleet sales with the extra inventory, as these contracts typically consisted of lower margins despite higher volumes. With the excess inventory being removed from the market, OEMs and auto dealers are now prioritizing direct consumers with the available inventory because they can achieve higher margins and offer fewer incentives. Fleet sales, and specifically rental car companies, have never been able to fully replenish their inventories. In turn, rental car companies no longer possess aging inventory that generally would get replaced and sold back into the used vehicle market. As a consequence, some rental companies are seeking to source their own used vehicles from auto auctions.The graphic below depicts total fleet sales from January through September for 2019, 2020, and 2021 as reported by Cox Automotive. While total fleet units are up slightly in 2021 from the same period in 2020, this figure is misleading when viewed in the context of more normal fleet sales in 2019. In fact, current year-to-date fleet sales are down nearly 41% over 2019 figures.Source: Cox AutomotiveAuto Auctions – Auto auctions are another source of used vehicles. The presence of auto auctions is also circular to the life cycle of the automobile. Auction cars come from various sources, including local car dealers, private sellers, police impounds, and bank repossessions. As detailed earlier in this post, the volume derived from the first two events has decreased simply due to the lack of overall transactions. Current economic conditions and forgiveness or grace periods have also led to fewer vehicles from the latter two events. If auto auctions are obtaining fewer cars, then auto dealers have fewer cars to potentially source from the auto auctions and the cycle and shortages continue.Predictions and ConclusionHow long can the good times (record profitability and margins) continue for the auto dealers and when will the bad times end for the consumer (high transaction prices and inventory shortages)? The simple answer is that they won’t continue like this forever, but no one knows when they will end. Many industry experts predict that the prevailing inventory and microchip shortages on the new vehicle side could last well into the first half or for the entire year in 2022 and beyond and will impact the used vehicle market for much of that time.For the used vehicle market, analysts at Black Book are predicting retail sales for the remainder of 2021 will equal or eclipse the levels for the same time period in 2019. Some analysts believe profit margins and transaction prices for used vehicles are already showing signs of moderating, despite some of those metrics still peaking. As a backdrop, 2019 is often considered by many as the best year ever for retail sales of used vehicles.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst all of the noise, contact a professional at Mercer Capital to perform a valuation or analysis. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry, and financial performance factors.
Built Ford “Family” Tough
Ford, Rivian, and Lessons on Family Business Diversifications
Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) start-up that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car start-up, giving it an implied stake of over $18 billion. Not bad given its sub-$1 billion of invested capital. If one were to do a "back-of-the-envelope" sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization.
We don’t highlight the current irrational exuberance to spur you into investing in an EV start-up or give you a case of ‘FOMO', but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why?
What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation.
We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article.
When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative.
However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the start-up) is yet to be seen.
Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different 'who' regarding diversification and a different 'why' to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business.
Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the 'why' for significant investment decisions.
How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision.
Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures
And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.
“If I had asked people what they wanted, they would have said faster horses.”
“Any customer can have a car painted any color that he wants so long as it is black.”
How Does Your RIA’s Client Base Affect Your Firm’s Value, and What Can You Do To Improve It?
We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others).In this post, we focus on the client demographics factor, explain how buyers view client demographics and explore steps some firms take to reach a broader client base.Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possess.Many of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply due to the fact that older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and the RIA can profitably service these accounts. However, with an older client base, the asset base usually declines as these individuals withdraw, rather than contributing additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by focusing on retaining assets to the next generation and positioning themselves to appeal to a younger client demographic.Retaining Assets To Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that prioritize engaging and developing relationships with next-generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA recent Wall Street Journal article highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also attract younger clients by hiring younger advisers.RIAs can also revaluate which marketing strategies they are using to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic can offer alternative pricing arrangements to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.
Charting the Course of the Build Back Better Bill
By this Thanksgiving, Congress hopes to pass two of the largest bills in American history, the $1 trillion infrastructure bill (which was signed into law by President Biden on November 15th) along with a $1.75 trillion Build Back Better bill. While the infrastructure bill made it through Congress with minimal tax hikes, the passing of the larger reconciliation bill may still create sweeping changes to American tax policy, specific to high-net-worth individuals.Over the past several months, numerous tax code changes have been proposed to fund the two bills, and concessions have whittled away some of the more drastic proposals that made headlines back in the Spring of 2021. In this article, we look to address what policies are still on the table, which are most likely to pass, and what the implications for their passing might be.The Unfolding of Biden’s Economic AgendaOn March 31, 2021, the Biden administration proposed The American Jobs Plan which outlined $1.7 trillion in infrastructure investment targeting a number of projects such as public drinking water, renewed electric grid, high-speed broadband, housing, educational facilities, veteran hospitals, and job training programs among various other projects.
The Made in America Tax Plan was proposed simultaneously with the American Jobs Plan as a source of funding. The plan enumerated on several proposed increases to individual and corporate tax rates as well as various other reforms. Some of which have found their way into current legislative efforts.
On April 28, 2021, President Biden proposed an additional spending plan, The American Families Plan, targeting “social infrastructural” works such as universal pre-school, universal two-year community college and postsecondary education (since dropped), childcare, paid leave (also has been dropped), nutrition, unemployment insurance, as well as various tax cuts to low-income workers. The Plan also outlined extensive tax reform directly targeting high income earners: setting capital gains and dividend taxes equal to taxes on wages and increasing tax rates on the top tax bracket from 37% to 39.6%. The sticker price of the American Families Plan was set at $1.8 trillion, with $1 trillion in direct government investment and the remainder in tax breaks.
On May 28, 2021, the Biden Administration further elaborated on his economic agenda in the unveiling of the 2022 fiscal budget plan to Congress alongside the Treasury Department “Green Book.”
On August 10, 2021, the Senate approved the $1.2 trillion infrastructure bill with bi-partisan support after months of debate. The bill includes many of the hard infrastructure objectives outlined in Biden’s American Jobs Plan. On the same day, a 100-member Congressional Progressive Caucus declared that it would refuse to vote for the bill before the larger reconciliation bill was passed in the Senate, despite overwhelming popularity of the infrastructure bill in Congress and in polling. In prioritizing Biden’s “soft infrastructure proposals” as specified in the reconciliation bill, Progressives effectively tied the fate of both the infrastructure and reconciliation bill in ongoing negotiations.
On August 24, 2021, the House Democrats approved a $3.5 trillion budget resolution which set in motion the reconciliation process by which Democrats could potentially sign the budget into law, requiring only a majority approval while circumventing an inevitable filibuster from Republicans in the Senate. The same measures were taken by the Republican Party with the passing of the American Tax Cuts and Jobs Act in 2017. Support from all 50 Democratic Senators and all but a handful of House Democrats would be needed to pass the legislation as objections from Republicans are widely expected. The budget resolution has since been negotiated down to a $1.9 trillion dollar package.
On September 12, 2021, the House and Ways Committee released a revised draft of the tax changes proposed as part of the budget reconciliation bill. Specific tax increases largely targeted trusts and estates and carried significant implications for gift and estate tax planning.
On September 27, 2021, under pressure from both moderates and progressives, Speaker of the House, Nancy Pelosi originally scheduled the House vote for the infrastructure bill for September 27th. But without the passing of the budget resolution bill, and therefore the support of Progressives, Nancy Pelosi postponed the House vote to extend negotiations. In doing so, ongoing government funding was jeopardized without a fiscal 2022 budget and government debt neared the self-imposed debt ceiling.
On September 30, 2021, the last day of the federal calendar, Congress narrowly avoided a government shut down by passing a temporary package funding the government through December 3, 2021 while the House suspended the debt ceiling through December 2022. The increase in the debt ceiling is widely expected to be rejected by Senate Republicans.
On October 21, 2021, the New York Times reported, Arizona Senator Krysten Sinema, would refuse to vote to support any increases in corporate or individual tax rates. The opposition came as a surprise to many and left the Democratic party scrambling to secure funding for the Build Back Better Bill from other avenues.
On October 28, 2021, President Biden unveiled a $1.75 trillion framework for the Build Back Better social spending bill, a draft of the legislation quickly followed. The announcement was released moments before Mr. Biden departed for Rome followed by Glasgow for the 2021 United Nations Climate Change Conference.
On November 8, 2021, the $1 trillion infrastructure bill passed in the House with bipartisan support after months of debate among members of the Democratic party looking to pass the Build Back Better bill before sending the infrastructure bill to a vote.
On November 15, 2021, the $ 1 trillion infrastructure bill was signed into law by President Biden.Proposals, Negotiations, Amendments, and More ProposalsBiden’s historically ambitious proposals made earlier in the year have since been trimmed by months of negotiations with more conservative members of the Democratic party. Most notably Joe Manchin of West Virginia and Krysten Sinema of Arizona have criticized the size of the bill, the tax hikes required for funding the bill, and the speed and process by which the party hopes to pass such landmark legislation. In efforts to gain the support of these two senators, and thereby achieve the unanimous support needed for the reconciliation, Democratic leaders have floated numerous tax proposals in recent months to fund the bill.While many of the tax change proposals outlined in the House and Ways Committee draft for the reconciliation bill were not included in the most recent framework published by the Biden Administration on October 29, 2021, many believe the policies outlined in mid-September may still be in play as negotiations continue amongst the conservative and progressive members of Congress. It is widely believed that the intent behind some of the initial funding proposals outlined by the Biden administration and later incorporated in the House and Ways Committee draft were beyond economics and were intended to combat “wealth inequality” and disparities in effective corporate tax rates.As reported in an article from CNBC, none of the three major holdouts, Joe Manchin, Krysten Sinema, or Bernie Sanders, have committed to supporting the framework as it stands. As many of the initial social spending policies have been cut, including most recently the federal paid family and medical leave proposal, uncertainty remains surrounding the scope of the bill and the funding it will require.Tax changes proposed in the House and Ways Committee draft were numerous, albeit less drastic than those considered earlier in the year. A comprehensive summary of the funding provisions can be found here. Key tax reforms specific to closely held businesses include the following:A reduction in the estate and gift tax exemption effectively reducing the exemption from $11.7 million to $6.0 million per individual.A change in the tax status of grantor trusts. Grantor trusts would be included in the grantor’s taxable estate, and transactions between grantor and a grantor trust would be subject to income tax.Discounts for lack of control and marketability would be disallowed for gifts of entities holding non-business assets such as asset holding entities.An increase in the individual income tax for the top tax bracket from 37% to 39.6%, essentially reversing tax reductions established in the 2017 Tax Cuts and Jobs Act, also passed via the reconciliation processAn increase in the maximum long term capital gains rate to 25% from the current rate of 20%. The effective date was set at September 13, 2021.Elimination of exemptions to the net investment income tax for active participants in the business, which applies a 3.8% tax to a taxpayer’s net investment income when adjusted gross income exceeds a certain threshold. Currently, income earned from active participants in the business is exempt.Limitations on the qualified business income deduction (QBID). The deduction would be subject to a cap once qualified business income exceeds $2.5 million for married couples filing jointly, $2.0 million for single filers, $1.3 million for married taxpayers filing separately, and $50.0 thousand for trusts and estates.Reimplementation of the graduated corporate income tax rate structure. In 2017, the Tax Cuts and Jobs Act established a flat rate of 21%. The proposal would restore the graduated rate structure:
< $400 thousand : 18% $400 thousand $5 million : 21% (the current rate)$5 million : 26.5%What Made it into the Biden Framework for the Build Back Better Bill?Because of recent opposition from conservative members of Congress, many of the proposed tax reforms recommended in the House and Ways Committee draft back in September were not included in Biden’s Build Back Better framework issued October 28. Funding proposals for the Build Back Better bill issued in Biden’s most recent draft included the following:A 15% minimum tax on corporations based on 15% of adjusted financial statement (book) income rather than recognized income. The tax increase was proposed as an alternative to propositions made earlier in the year to increase the corporate tax rate to 28%.A 1% surcharge on corporate stock buybacks.A separate 15% global minimum tax on corporate profits earned abroad along with a penalty rate for foreign corporations based in non-compliant countries. The proposal comes after the U.S. led negotiations earlier in the year among G20 leaders in adopting a minimum 15% corporate tax rate along with other restrictive reforms.New surtax on multi-millionaires and billionaires.Close Medicare self-employment tax loophole.Continue limitation on excess business losses.
The new surtax on multi-millionaires and billionaires is intended to replace numerous other proposals to tax high income individuals such as: a rate increase to the top tax bracket, taxing unrealized gains annually, a wealth tax, taxing unrealized capital gains at death, and ending the practice of stepped-up in basis. The surtax is set to add an additional 5% tax on income exceeding $10 million and an additional 3% tax on income exceeding $25 million. While perhaps not too different than levying additional income taxes, the surtax was agreed upon after Krysten Sinema refused to support increases to income tax rates on high earners.
While the most recent draft still targets high income individuals and corporations, most of the significant tax changes have been avoided for now. Avenues for gift and estate planning and taxes related to closely held businesses were largely spared in the recent proposal. For now, it appears that there will be no changes made to the step-up in basis, reduction in estate and gift taxes, the application of marketability and control discounts, income tax rates on the top tax bracket, capital gains tax rates, or changes in the qualified business income deductions.Forward Looking ExpectationsMuch like the Infrastructure bill, which gained bipartisan support via not drastically changing the tax code, the Build Back Better bill may make it to the final yard line without incorporating the vast majority of major tax changes proposed earlier in the year or during the negotiations in recent months. The outline and proposals set forth represent the closest framework for consensus among the Democratic party, and tax proposals put forth have been forged by nearly a year of debate among party members. However, in no way is the recent draft set forth by President Biden final.Much uncertainty still remains regarding the draft’s support from the party’s more progressive and conservative members. If the recent months have taught us anything, with a bill this large, funding measures are liable to shift upon further negotiations. Regardless, many expect the bill to be put to a vote within weeks.Mercer Capital will continue to monitor any changes to the tax code and report on how they may affect our clients. In the meantime, to discuss a valuation need in confidence, please don’t hesitate to contact us.
Themes from Q3 Earnings Calls
Part 1: E&P Operators
In Part I of our Themes from Q2 Earnings, an overarching narrative was an oil and gas industry reaching a relatively steady operational state, with efficiencies offsetting cost inflation and helping lead to growth in free cash flow despite the tumultuous past 18 to 24 months. These factors allowed most E&P operators to deleverage, and in some cases, also resume or increase their return of capital (either via dividends or share buybacks) to shareholders. In the latest earnings calls, these themes continue as the primary focus as we head towards year-end 2021. Some of the talking points in the Q3 earnings calls continue on the same trajectory as in Q2, such as maintaining capital discipline with flat or low growth in production volumes. However, there was more variance in the latest round of calls regarding E&P operators' possible approaches to fortify their value proposition to shareholders.Natural Gas ExportsAs noted in our recent blog post regarding natural gas prices and production levels, demand for U.S. LNG exports from European and Asian (primarily China) markets have resulted in elevated prices for natural gas despite the relatively high level of gas production coming from U.S. basins. This particular topic came up in several of the Q3 calls."We've talked in the past about the nearly 550,000 barrel a day increase in petchem demand in China from 2021 to 2023 and over 110,000 barrels a day of European and North American PDH growth during that same time period. What many did not anticipate was the global pressure for hydrocarbons this fall and winter that resulted in elevated LNG prices in Europe and Asia. This is driving additional demand for LPG in these markets through its use in industrial heating and power applications in lieu of today's high cost of natural gas. On a BTU equivalent basis, LPG is nearly half the price of LNG delivered in the Far East markets. The impact from this incremental demand for LPG is a widening export arb." – David Cannelongo, Vice President of Liquids Marketing & Transportation, Antero Resources"We're going to continue to look at new opportunities from an LNG standpoint and are very well-positioned. Again, it gets back to our transport, our export capacities, and just having that ability to transact, we can definitely be very nimble as we think about new opportunities." – Lance Terveen, Senior Vice President – Marketing, EOG ResourcesMany Paths to the Value PropositionPerhaps the most significant divergence in the Q3 E&P operator calls compared to the Q2 calls stemmed from how the management teams viewed their value proposition to shareholders. Global energy prices were shaken in early 2020 with the onset of the COVID-19 pandemic, with prices retreating further when the discussions regarding renewal of the OPEC+ production/price cooperation pact, a 3-year plan that was set to expire at the end of Q1 2021, fell apart as Moscow refused to support Riyadh's demand for additional production cuts. As energy prices recovered amid a background of heightened uncertainty in the global economic and financial markets, E&P operators tightened their belts and took this opportunity to enact highly disciplined capital programs in order to extract greater free cash flow from flat production levels.For some companies, the value proposition to shareholders remains focused on either increasing the intrinsic value per share via share repurchases or returns to shareholders through dividend programs."As we continue to trade at a material discount to our intrinsic per share value as we see it, we steadily increased our attention on share count reduction. And Q3 was a good example of this. Approximately 60% of free cash flow was returned to shareholders in the form of buybacks. We continue to see a significant opportunity to retire additional shares in what we believe to be currently attractive prices. And as a result, on October 25, earlier this week, the Board has increased our share repurchase authorization by $1 billion, now having a sizable share repurchase authorization at our disposal." – Nicholas Deluliis, President & CEO, CNX Resources"I don't want to get ahead of my Board, but I would say at Murphy, we're more tuned to dividend and getting our dividend back. We're a dividend payer for 60 years. And that would be best for us. And, of course, a variable dividend, I suppose, can come into that mix. And I would say at this share count, that would be the basis today." – David Looney, CFO, Murphy Oil
For other E&P operators, the name of the game moving forward is flexibility to deliver returns to shareholders through share repurchases and dividend programs."In mid-September, our Board approved a $2 billion share repurchase program. After that announcement, we repurchased over 268,000 shares at an average share price of $82 for a total cost of $22 million in the third quarter. If we do not repurchase enough shares in the quarter to equal at least 50% of free cash flow for that particular quarter, then we will make our investors whole by distributing the rest of that free cash flow via a variable dividend. This strategy gives us the ability to be flexible and opportunistic when distributing capital above and beyond our base dividend, but importantly, at least 50% of free cash flow will be returned." – Travis Stice, CEO, Diamondback Energy
Perhaps most interestingly, a handful of companies cited additional sources of future shareholder value, setting their sights on opportunities to be had out in the field, be it through acquisition activity or plans to enhance their exploration program.[Regarding the November 3rd announcement of Continental Resources's agreement to purchase Delaware basin assets from Pioneer Natural Resources] "We focus every day on maximizing both shareholder and corporate returns. The Permian Basin acquisition will be an integral contributor to these shareholder return plans. Possibly most importantly, this Permian transaction is projected to add up to 2% to our return on capital employed annually over the next five years. The acquisition of these assets strongly supports the tenants of Continental's shareholder return on investment and return of investment, dividends and share repurchases." – William Berry, CEO, Continental Resources"After weathering two downturns during which we did not cut nor suspend the dividend, the new annual rate of $3 per share reflects the significant improvement in EOG's capital efficiency since the transition to premium drilling. Going forward, we are confident in our ability to continue adding to our double-premium inventory without any need for expensive M&A by improving our existing assets and adding new plays from our deep pipeline of organic exploration prospects, developing high-return, low-cost reserves that meet our stringent double premium hurdle rate, expands our future free cash flow potential and supports EOG's commitment to sustainably growing our regular dividend." – Ezra Yacob, CEO, EOG ResourcesConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
Can You Hear Me Now? Lessons from a $20 Billion Family Business Fight
"If you cannot get rid of the family skeleton, you may as well make it dance." - George Bernard Shaw
Thankfully, the Family Business Director blog does not cover much tabloid news. However, recent turmoil engulfing the Rogers Communications (NYSE: RCI) family, who are controlling shareholders of the $20 billion Canadian wireless communications and media conglomerate, piqued our interest. Numerous outlets have covered the drama, pulling back the curtain on a bitter family battle for control of the company.
What can the public family strife affecting the Rogers family teach us (other than hug our moms a little more)? Well, quite a bit. Below we summarize the family drama and provide three strategies to keep in mind to stave off harsh family infighting that can, ultimately, bleed over into your company's ability to operate effectively.Rogers Family Dispute TimelineThe table below highlights key developments in the Rogers family saga in recent months (adapted from Reuters). The summary is far from exhaustive.Click here to enlarge the image
So what went wrong, and what can you do to avoid these mistakes? We cover that next.
Prioritize Communication and Don't Forget the RelationshipThe issue at hand is, at first blush, a leadership dispute: one group supporting the current CEO (Ms. Loretta Rogers, widow to the company's founder, along with her two daughters) and another opposed to current leadership (Mr. Edward Rogers, son to the founder and former chairman). However, as we have written about previously, family business relationships are complex. What may be banal or standard in a traditional business setting can be far from it when the parties are parents and children. So always have the family dynamic in mind.Additionally, the chain of events was kicked off with a pocket-dial, revealing the son's secret plot (with help from the CFO, no less) to oust the existing CEO. We suspect things could have been less contentious if what amounts to an attempted "corporate coup" did not take place prior to more formal leadership discussions. Were Edward Roger's concerns with the CEO known to the rest of the board? Was Loretta Roger's position understood? Was communication prioritized? Evidence points to multiple resounding "nos."Defuse the Time-Bombs in Your Governance DocumentsFollowing the revelation of Edward Roger's dissatisfaction with the existing CEO, multiple board meetings were held to discuss whether to retain the company's CEO. The independent board weighed the removal of the CEO, with an imminent acquisition of Shaw Communications (NYSE: SJR), as unwise. The board voted to withdraw the CEO's resignation and force the resignation of the CFO. Given what could be perceived as severe insubordination from the CFO (secret ousting of a superior to his benefit), this seems appropriate. The board additionally removed Edward Roger's chairman title, escalating the dispute between the two family camps.However, following board action, Edward Rogers triggered his "ace in the hole." As chairman of the Rogers Control Trust, Edward Rogers had an effective 97.5% voting interest in the company. Edward Rogers used this power in this role to negate independent board action, place a new board in power, and reinstate himself as chairman. Edward Rogers had thrown a knockout punch. As of this writing, a Canadian judge approved the action.What happened? We have written numerous times on the potential time-bombs lurking in your family business buy-sell agreements. Well, there was a "nuclear option" in Rogers Communications governance and voting structure, and Edward Rogers held the launch codes. When a single shareholder, even if it is family, can overrule the independent board and other family shareholders unilaterally, your structure is broken. A "board-in-name-only" does not represent best governance practice. One wonders how a similar board structure was not present in the Rogers Control Trust (where power resided). We recommend creating guardrails to ward off a scenario like the Rogers family is currently undergoing.Have a (Neutral) IntermediaryYou don't have to read too closely between the lines to see that the family and certain board members may have been less than independent. Thinly-veiled (and completely unveiled) barbs on social media have moved the debate into the open. The conflict between the Edward Rogers camp and the Loretta Rogers group had been brewing for a while. You don't like to see subtweets between siblings.
Like our call for communication, having someone in the middle who you and your family trust can be all the difference between passionate, constructive discussions and public feuds. The board appears to have been meant for this role, in theory. However, with members aligning themselves with rivaling family factions, neutrality and independence were lost. You and your family board should aim to go the extra mile to limit any conflict of interest or perverse incentives for board members. Additionally, if significant issues arise, bring in an outside mediator or consultant to help guide the conversation back to business and out of the family drama quagmire.
We Are FamilyThe family battle culminated in a "victory" for the eldest son, Edward Rogers, over his mother and two sisters. Justice Shelley Fitzpatrick on November 5th ruled in favor of Edward Rogers. "These family squabbles are an interesting backdrop to this dispute that would be more in keeping with a Shakespearean drama," she noted, but "at best, they are a distraction."Not to dig up the past, but we previously wrote on the Larson brothers and the contentious shareholder redemption of shares in a fossil-hunting enterprise. The result? The brothers refuse to talk to each other. Many families wisely prioritize being able to share a holiday meal when making business decisions. You and your family board are sure to learn lessons on what not to do and what steps you can take to avoid publicly damaging family brawls by studying the Rogers story. Prioritize communication and remember your familial relationships, craft conflict-reducing governance documents, and introduce truly independent intermediaries in contentious situations are three ways you can avoid the worst of the Rogers family drama.Mercer Capital has experience in thousands of valuation and financial consulting engagements for family business clients. Give one of our professionals a call if we can help guide your family through some of your family's own valuation issues.
In the Market for a Good Used RIA?
8 Tips for Being a Buyer in a Seller’s Market
Last week I got an email from the finance company that holds the lease on my car announcing that the “countdown had begun.” My lease ends in May, and the manufacturer was encouraging me to start thinking about my next vehicle – even offering to waive the $575 lease disposition fee if I terminated the lease early. Strange, I thought. Given the scarcity of new vehicles in the market, why is the manufacturer’s finance company offering me incentives to join the line of people who want but can’t get a new car?Eager to uncover the motivation for this surprising act of Teutonic generosity, I reviewed my lease agreement to see if I could solve the mystery. Knowing I had the option the buy the car at the lease’s stated residual value, I also checked some used car listings for comps with the age and mileage my roadster will have in May. This exercise suggested my car will be worth about 40% to 50% more than what I could buy it for at the end of the lease. So, my call option is in the money, and the finance company is keen to let me surrender that option to them.Alas, my good fortune isn’t all that good. If I choose to buy-and-hold my car at the end of the lease, I can’t monetize the option. If, instead, I buy-and-trade my car for something else, I may get market value, but I’ll have to find something to buy. These days that will cost me both in terms of time and money. At this point, the only thing I know for sure is that I won’t be returning my car to the finance company. Sorry fellas.In the Market for a Good Used RIA?A couple of times a week, we get calls from someone we’ve never met saying they’d like to talk with us about their RIA acquisition strategy. About half are RIAs or trustcos looking for expansion, and the other half are private equity or family offices. Very few are calling because they have a particular target in mind; fewer still have begun the process of negotiating with a potentially interested seller.If your acquisition strategy these days is starting from scratch, you’re in a tough spot. There’s nothing on the lot, and what is available looks expensive. That doesn’t mean you should give up, though. Here are some practical tips to pursue an acquisition strategy in this market environment, as well as the markets to follow.Build relationships. Sellers faced with a dozen potential suitors often exhibit a common behavior: they don’t know what they like – they like what they know. Sellers are drawn to preexisting relationships, even when the offer from those parties doesn’t quite measure up to other offers. This makes a lot of sense given that selling an RIA often means going into business with the buyer for several years. Acquisitions are a process, not an event, so get to know the people you might want to be in business with – early and often. It’ll help you win the auction – or avoid it altogether.Deliver what you promise. The most frustrating part of the transaction process is when counterparties (or their advisors) don’t meet deadlines. If indications of interest are due on Friday, don’t call on Friday to ask for more time. You might get it, but you’ll also earn a reputation for not meeting expectations, which will make sellers leery of dealing with you. Sellers are usually represented, and buyers often aren’t. If you need professional assistance in pursuing an acquisition, get them on board so that you’ll maximize your opportunity.Consider alternative structures. Not every seller needs or even wants a check. Some want a partner. Some want your stock. Some want a joint venture. Ask questions about the underlying needs of the seller to find out how you can creatively accommodate their needs and meet yours as well. Winning a deal isn’t always about being the high bid – it’s about being the best bid.Accept pricing for what it is. For lots of very rational reasons, pricing in the RIA space is high. It might not be quite as high as reported, because everyone in the deal community is motivated to dress up the multiples as much as possible (we’ve written before about reported versus pro forma numbers, pricing with and without earn-outs, the impact of rollover equity, etc.). But, like prices for new and used cars, RIAs are worth top-dollar. Neither situation is going to resolve itself anytime soon. Microchip availability may drive the supply/demand imbalance in automobiles for years. Low interest rates and a flood of PE capital may do the same for RIAs.Turn your acquisition strategy on its head. If you accept the fact that this is a seller’s market, why do you want to be a buyer? Think about selling - or merging - into a larger firm. As part of a larger buyer, you’ll have more support (talent and capital) for building through acquisitions, and you’ll have the benefit of firsthand experience as a seller.Don’t get caught up in FOMO. There is a frenzy to buy RIAs, but that doesn’t mean you have to be part of it. Discipline still matters. Some buyers are so desperate to acquire an RIA that they’re willing to look at “opportunities” that don’t make any sense. Remember that opportunity is a two-way street. The bull market of the past twelve years has redeemed a lot of bad acquisitions in the RIA space. These days, everybody on the buyside feels smart.Don’t wait for the market to become rational. If you’re sitting this “period” out because you’re waiting for valuations to come down, find another reason. Prices may drop – but it may be a long time from now. If paying full freight for acquisitions doesn’t suit you, I won’t judge you. But don’t base your expectations for the future on the hope that things will change. They may not change.You might do better on your own. For most firms, organic growth is the best growth. Competing for acquisitions is hard, and integrating them is even harder. Conventional wisdom these days is that organic growth opportunities in the RIA space are narrowing and growth is slowing. But conventional wisdom yields conventional results. If you can devise a way to generate organic growth, you’ll gain control over your future – and a standout presence as a target one day.
Shortages and tight markets are more the exception than the rule right now. I’ve heard an emerging theory in fixed income that rates will stay “lower-for-longer.” If so, yield starved investors of all stripes will be drawn to the growth and income characteristics of RIAs – which will keep multiples “higher-for-longer.” Whether or not this turns out to be the case, the shortage of acquisition opportunities in investment management firms will likely outlast the shortage of microchips that’s plaguing car manufacturing, such that even scratch-and-dent RIAs will remain pricey. As a buyer, you can’t entirely sidestep this problem, but you can pursue some basic tactics that will help – both now and in the future.
October 2021 SAAR
October 2021 SAAR was just shy of 13.0 million, as new light vehicle sales saw their first month-to-month gain since April. The October SAAR is up 6.3% from last month but remains 20.8% lower than last October. Auto dealers began the month with record low inventory levels of 972,000 units, and low inventories continue to keep car buying activity constrained. Dealers are pre-selling a significant amount of the new inventory they receive as they attempt to satisfy demand. According to Thomas King, President of Data and Analytics, nearly 54% of vehicles will be sold within 10 days of arriving at a dealership.As of now, there is no expectation that inventory on the lot will increase anytime soon. There is some optimism around the industry that inventory levels will slowly increase throughout 2022, but it is likely that these inventories will remain below pre-COVID levels for the foreseeable future. Based on our discussions with dealers and reading of the tea leaves, we think it’s reasonable OEMs will see heightened profits under the status quo and seek to structurally tweak how much inventory is kept on dealer’s lots going forward.
In October, prices have continued to rise and OEM incentive spending has continued to fall. This has been the case for several months now, and dealers have been realizing record profitability on vehicles sold for some time. If it seems like there are new profitability records being set every month, it is because there have been. Average incentive spending per unit has hit another record low of $1,628 in October. Total retailer profit per unit is on pace to reach another record high of $5,129 as well, the metric’s first time above the $5,000 mark. For perspective, this is an increase of $2,937 (more than double) from a year ago, and total aggregate retailer profits, a measure of the industry’s profitability as a whole, is up 213% from October 2019, reaching $4.8 billion. This October was the most profitable October on record for auto dealers, and it is likely that November will yield some of the same, if not better, results.
Inventory shortages and record profitability are not the only persistent conditions in which auto dealers are operating. Fleet sales continue to be outpaced by retail sales, accounting for only 142,000 units over the last month. Trucks and SUVs are on pace to account for a record high 80.9% of new vehicle retail sales in October as well. As far as new vehicle prices are concerned, transaction prices on the average new car reached another record high of $42,921. While supply and demand imbalance plays a role in these increasing prices, we note the mix of vehicles is also important. Trucks tend to be more expensive than cars, so the mix continuing to shift towards higher profit trucks leads to higher transaction prices. The moral of the story is that October proved to be more of the same for auto dealers across the country, and most dealers are still thriving in a low inventory–high price environment.
Microchip Background and UpdateMany OEMs, dealers, and research analysts following the industry have been looking ahead to try and predict when the ongoing inventory shortage might begin to improve. As we have mentioned earlier in this blog and on previous blog posts, the current estimate seems to be around the middle of 2022 at least, depending on your definition of improvement. One important determinant that many are looking at is the state of the semiconductor industry.Semiconductors, referred to by many as microchips or chips, are the brains behind electronic devices. As more electronic devices are being produced each year around the globe, the semiconductor industry has struggled to keep pace with demand for some time now. The rise of 5G technology can be blamed for increased demand, as well as increased demand from industries that have traditionally been semiconductor-free (auto makers can be included here, although chips have been common in new vehicles for years now). Another driver of increased demand is the rising number of semiconductors needed per manufactured unit across the many affected industries. For example, just one car can have anywhere from 500 to 1,500 different semiconductors. As we discussed previously, the pandemic exacerbated issues with people stuck at home reaching for electronics as a means of entertainment.The increased demand mentioned above, paired with supply chain disruptions have set up the perfect storm for a semiconductor crisis. The crisis is hitting OEMs particularly hard, as many manufacturers are announcing major slowdowns and stoppages during the fourth quarter of 2021. We have not touched on the geopolitical ramifications of the semiconductor shortage, although the sourcing of these chips going forward will be an important factor to keep an eye on.Toyota Motor recently announced that it was on pace to produce 40% fewer cars and trucks in October as a result of the chip shortage. This marks the second month in a row that Toyota slashed production estimates. GM, Ford, and Stellantis, who have all dealt with intermittent shutdowns over the last 6 months, account for 855,000 units of reduced vehicle production. Particular models from these OEMs that have been severely affected are Ford F-Series trucks, the Jeep Cherokee, the Chevy Equinox, and Chevy Malibu. Given that this crisis is becoming the single most important factor in getting vehicles on dealer lots, many executives are being asked when they think the supply chain for semiconductors will reach pre-pandemic levels.A Volkswagen executive recently released a statement, saying that “Without a doubt, this shortage is going to go well into 2022, at least the second half of '22."Likewise, Ford CFO John Lawler said that Ford is “doing everything we can to get our hands on as many chips as we can. We do see the shortage running through 2022. It could extend into 2023, although we do anticipate that the scope and severity of that to reduce.”Executives of the other major OEMs are echoing these concerns as all OEMs face similar challenges in securing chips for their vehicle production. That being said, the industry is prepping for an extended waiting game and cannot do much to produce more units in the meantime than what is allowed by current semiconductor inventories. While auto dealers are bearing the brunt of consumer frustration over the higher prices and lower availability, at least profits are up.ForecastLooking ahead to next month and the remainder of the year, we expect that the sales pace of the industry will continue to be constrained by the procurement, production, and distribution problems outlined above. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot. However, the number of incoming units is not expected to materially change in November. Essentially, dealers can expect more of the same.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.
WHITEPAPER | Selling Your Business
Practical Steps Business Owners Can Take to Ready Their Businesses for the Best Transaction OutcomeSelling your business is a daunting exercise that requires careful preparation and real-time vigilance.In this whitepaper, we define some practical steps business owners can take to ready their businesses for the best transaction outcome.These steps include identifying the right kind of buyer and transaction design, setting expectations for the timeline to consummate a transaction, hiring an advisor, understanding the various advisory fee structures that best suit each transaction scenario, as well as a few considerations every owner should contemplate before bringing their business to market.
Leftover Candy and Lazy Capital
Despite our best efforts, having four kids in the house means that we are a net candy importer over the Halloween weekend. Staring at the piles of candy in our house this morning brought to mind several recent conversations we’ve had with clients and prospects. The topic of those conversations was “lazy” capital.What Do We Mean by Lazy Capital?We were introduced to this term a few years ago, and it rather aptly describes a common situation in family businesses: capital on the balance sheet that is not generating a fair return for family shareholders.Where Does Lazy Capital Come From?Unlike leftover Halloween candy, lazy capital tends to accumulate slowly. I’ve not seen too many family businesses that have intentionally built bloated balance sheets. Perhaps ironically, the threat of lazy capital accumulating on the balance sheet is greatest for successful companies. How do successful companies wind up with excess capital?The following five broad headings capture most of the reasons.1. Reluctance to Invest in New Business LinesLike all companies, a family business has a natural lifecycle. At some point, the original business of the family will mature, with slow (or no) sales growth and more limited reinvestment needs. At this point, the family business directors should be deliberate about either (a) adopting a “harvest” mindset or (b) identifying new fields to “plant.” Families that are unwilling to take on the risk of “planting” a new crop of investments are much more likely to see lazy capital accumulate.2. Reluctance to Pay DistributionsSome family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources. Granted, there is no shortage of individual family shareholders whose stories amply validate this fear. However well-intentioned, we suspect that a reluctance to pay distributions often has serious unintended negative consequences for the family, one of which is the accumulation of lazy capital on the family business balance sheet.3. Reluctance to Divest Unproductive AssetsFamily businesses occasionally have sentimental attachment to lines of business, facilities, and other assets that have outlived their usefulness to the family business. If Division X is consistently generating a 2% return on invested capital with no real prospects for improvement, it should not be considered untouchable, even if it was the apple of Grandpa’s eye thirty years ago. Family business managers and directors are asset allocators, and a refusal to evaluate business assets and segments with a cold eye will lead to a bloated balance sheet stuffed with operating assets that either do not earn an adequate return or no longer fit the strategy of the family business.4. Reluctance to Do Things DifferentlyWithout intentional attention and monitoring, the business practices that worked well a decade ago may not be driving optimal use of capital today. Working capital can be an overlooked hiding place for lazy capital. Active management of accounts receivable, inventory, and payables is critical to ensuring that the family is earning an appropriate return on its capital.5. Reluctance to Acknowledge Available Borrowing CapacityMany family businesses are debt averse. Capital structure is a function of, among other things, family risk tolerance. Yet, there is a difference between a family business preferring to operate without debt and one maintaining a cash balance sufficient to meet every potential contingency facing the business. The prudent move for debt-averse families is to maintain and update credit facilities that will allow the business to handle sudden cash needs that may arise without carrying unwieldy cash balances which weigh down investor returns. Even families that prefer not to use debt should acknowledge their ability to issue debt in the future if needed. That borrowing capacity should not be ignored in risk management discussions. Ignoring the available borrowing capacity of the family business leads to an exaggerated sense of how much liquidity the company needs to maintain on the balance sheet.What Are Some Consequences of Lazy Capital?Unlike leftover Halloween candy, an accumulation of lazy capital is unlikely to lead to tooth decay or increased risk of diabetes. However, there are some negative consequences of which family business directors should be aware.Diminished ReturnsThis one is just math – if a significant portion of your family business capital is allocated to low-returning assets, the overall return earned by the family will be pulled down. In today’s low-rate environment, the return on cash is functionally zero. As a result, allocating 10% of invested capital to cash means taking a 10% haircut to what would otherwise be ROIC. We’ve written about ROIC in a prior post because for most family businesses it is the best comprehensive measure of performance. Whatever form it takes, lazy capital puts pressure on ROIC.Lazy ManagementWe are all more aware of how viruses spread these days, and laziness is infectious. The presence of lazy capital on the family business balance sheet can take away a healthy “edge” in how the business is managed. It is not in anyone’s best interest to fabricate some artificial sense of crisis. However, we suspect most businesses operate best with what one of our high school coaches was fond of referring to as a “sense of urgency.” An accumulation of lazy capital can blunt the productive sense of urgency and breed unintended negative consequences throughout the business.Disgruntled ShareholdersLazy capital flourishes in an environment of limited, or poor, shareholder communication. And poor communication inevitably leads to mistrust and conflict. Positive shareholder engagement is much easier to maintain when family shareholders are confident that their capital is being put to good use.How to Get Rid of Lazy Capital?It’s easy enough to foist leftover Halloween candy on unsuspecting co-workers. Disposing of lazy capital is less straightforward, but the two primary strategies are to (1) return the lazy capital to shareholders so they can put it to work themselves, or (2) find more productive uses for the lazy capital within the family business.Finding the right strategy for dealing with lazy capital in your family business is a complex process that needs to consider the attributes of the business, your industry, and your family. Give one of our professionals a call today to review your situation in confidence and see how we can help.
Sharing Growth & Spotlight
Natural Gas & Renewables Join the D-CEO Awards Stage in Dallas
Mercer Capital’s energy team sponsored and attended the D-CEO 2021 Energy Awards in Dallas last week, October 26, 2021. It was a great event and a good opportunity to connect with clients, peers, and industry leaders in the energy space. Awards ranged from honoring top executives, including Scott Sheffield of Pioneer Energy, to private equity firm innovators like Pearl Energy Investments.Oil, Natural Gas, and RenewablesThe focus of the night was the interdisciplinary threads between oil, natural gas, and renewables. “Sustainability and profitability are not mutually exclusive,” said Vikram Agrawal of EarthxCapital who participated on a panel alongside Joe Foran, CEO of Matador Resources. According to the panelists, renewables and natural gas are to be watched as the energy mix needs evolve in the U.S. and around the world. As an example, natural gas fuels about 40% of our power in the U.S. according to Agrawal.If the move goes towards more electrification, as illustrated by the news this week that Hertz has ordered 100,000 Tesla electric vehicles, there will be a need for 20% - 40% more power in the next 20 years. As we’ve discussed before, the current trajectory of renewables appears unable to meet these demand growth needs. Therefore, cleaner-burning natural gas will be a key contributor. One panelist mentioned the exception was hydrogen as a potential contributor. Interestingly, this was echoed in comments on the latest Dallas Fed Energy Survey: “The more I become educated on EVs [electric vehicles] and the charging and battery disposal problems, the more I think they will have little effect on the market in the future. My investigation turns more toward the hydrogen cell as the long-term solution.”No matter what the source, recent price growth suggests that more investments will be needed. The panel also stated that oil and gas investment will drop 26% from pre-pandemic levels to $356 billion in 2021. Various sources, including Exxon, suggest that this figure needs to increase to around $600 billion by 2040.Optimism for investment opportunities was not limited to upstream, but also infrastructure, with nearly $18 trillion in investment opportunities for energy transmission alone.Interesting Tidbits & StatisticsWithin the theme of investment opportunities, renewables, and natural gas, several interesting factoids from the evening emerged (in no particular order):1.Electric Vehicles and Charging StationsHow many electric vehicles are there for every charging station in the U.S.?
The current ratio is 17Many think this ratio needs to be closer to 10 (there are about 42,000 charging stations in the U.S. right now – many at hotels and other overnight destinations)The Biden Administration suggests we need 500,000. Agrawal thinks the real number is 1,000,000 to 1,500,0002.Electric Cars Are Not a New ThingDid you know that 120 years ago, nearly one-third of our cars were electric? Granted there were only 4,000 cars at the time. Did you also know that Thomas Edison invented the first electric-powered car?3.Investment in the Space Is Picking UpSo far this year 35 SPACs acquired businesses worth $100 billion4. What Do “Net Zero” or “Carbon Offsets” Really Mean? According to a Wall Street Journal article, only 5% of “carbon offsets” actually remove carbon.ConclusionThanks to our clients, friends, and partners that we saw at the event. It was fabulous and nostalgic to be getting out again! And thanks to D-CEO for putting on a great event. Until next time!
Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year
Hedge Funds and Private Equity Firms Capitalize on Market Volatility and Growing Investor Appetite for Alt Asset Products
Industry Overview and HistoryOver the last year, alternative asset managers have bested the market and most other categories of investment management firms by a considerable margin. Favorable market conditions, heightened volatility, strong investment returns, and growing interest from institutional investors are the primary drivers behind the sector’s recent rally. Our alt manager index actually doubled from October of 2020 to August of this year before giving back some of these gains during the market downturn last month.
Before this uptick, many alternative asset managers had struggled over the last several years. Asset outflows, the rising popularity of passive products, fee pressure, and underperformance relative to broader market returns had caused many hedge funds and PE firms to lag other investment management sectors. Industry valuations appear to have bottomed out with the market collapse during the first quarter of last year and have since rebounded. Growing investor appetite for risky assets with purported diversification benefits has fueled a fairly substantial turnaround for the sector over the last eighteen months or so. Current pricing is close to the 52-week high, and forward multiples are noticeably lower than LTM multiples, suggesting peaked valuations and expected earnings increases over the next twelve months.
While hedge funds have underperformed since the Financial Crisis (the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index since 2009), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags its underlying fund performance, so the market seems to be anticipating that higher inflows in the coming months as investors reallocate their portfolios in light of recent performance.
Alternative assets often serve to either increase diversification or enhance portfolio returns. In a near zero interest rate environment, institutional investors have sought return-generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets. It is more difficult for the average investor to gain exposure to alternative assets due to significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers.
Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets.Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios. In terms of diversification, investors have started positioning themselves for longer term volatility due to the pandemic and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history (2009-20), recent volatility has pushed investors back to the asset class.Franklin Resources’s (ticker: BEN) recently announced purchase of private equity firm Lexington Partners for $1.75 billion is illustrative of growing interest from more traditional asset managers in the alt space.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance and fee reduction, especially in the alternatives space, are the most consequential ways to attract fund flow. After a decade of lackluster performance, alternative managers have had no choice but to look to price reduction to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.SummaryDespite improving performance over the last year or so, the alt asset sector continues to face many headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with the goal of imitating private equity returns. Innovative products are being introduced to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today, despite the recent uptick in alt manager valuations.
Value Drivers in Flux
Last July I gave a presentation to the third-year students attending the Consumer Bankers Association’s Executive Banking School. The presentation, which can be found here, touched on three big valuation themes for bank investors: estimate revisions, earning power and long-term growth.Although Wall Street is overly focused on the quarterly earnings process, investors care because of what quarterly results imply about earnings (or cash flow) estimates for the next year and more generally about a company’s earning power. Earning beats that are based upon fundamentals of faster revenue growth and/or positive operating leverage usually will result in rising estimates and an increase in the share price. The opposite is true, too.For U.S. banks that have largely finished reporting third quarter results, questions about all three—especially earning power—are in flux more than usual. Industry profitability has always been cyclical, but what is normal depends. Since the early 1980s, there have been fewer recessions that have resulted in long periods of low credit costs. Monetary policy has been radical since 2008. What’s normal was also distorted in 2020 and 2021 by PPP income that padded earnings but will evaporate in 2023.Most banks beat consensus EPS estimates, largely due to negligible credit costs if not negative loan loss provisions as COVID-19 related reserve builds that occurred in 2020 proved to be too much; however, there was no new news with the earnings release as it relates to credit.Investors concluded with the release of third and fourth quarter 2020 results that credit losses would not be outsized. Overlaid was confirmation from the corporate bond market as spreads on high yield bonds, CLOs and other structured products began to narrow in the second quarter of 2020 as banks were still building reserves.As of October 28, 2020, the NASDAQ Bank Index has risen 78% over the past year and 39% year-to-date.Much of that gain occurred during November (October 2020 was a strong month, too) through May as investors initially priced-in reserve releases to come; and then NIMs that might not fall as far as feared as the yield on the 10-year UST doubled to 1.75% by late March. Bank stocks underperformed the market during the summer as the 10-year UST yield fell. Since late September banks rallied again as investors began to price rate hikes by the Fed beginning in 2022 rather than 2023.No one knows for sure; the future is always uncertain. For banks, two key variables have an outsized influence on earnings other than credit costs: loan demand and rates. In other industries the variables are called volume and price. If both rise, most banks will see a pronounced increase in earnings as revenues rise and presumably operating leverage improves. Street estimates for 2022 and 2023 will rise, and investors’ view of earning power will too.We do not know what the future will be either.Loan demand and excess liquidity have been counter cyclical forces in the banking industry since banks came into being.The question is not if but how strong loan demand will be when the cycle turns. Interest rates used to be cyclical, too, until governments became so indebted that “normal” rates apparently cannot be tolerated.Nonetheless, at Mercer Capital we have decades of experience of evaluating earnings, earning power, multiples and other value drivers. Please give us a call if we can assist your institution.
The Tricks and Treats of the Buy/Sell Process from a Selling Dealer’s Perspective
Fall District Meeting Roundup
Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell. Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions? Is this a good time to sell or a bad time to sell? As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers. Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits. Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM? Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models? Is the OEM demanding additional image requirements? How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family? Is the perceived value of the dealership equal to or greater than the offers in the marketplace? Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex. A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership. Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction. Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM? Has the dealer recently completed an image requirement or are additional requirements pending? The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads. Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process. A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations. Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members? A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts. How long will they continue or are any set to expire? Key contracts would include the Dealer Management System (DMS) among others. Selling dealers must balance opposing factors with contracts: not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues? A selling dealer should complete an environmental survey at the beginning or during this process. Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance. Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities. If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships. Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases, a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
RIA M&A Q3 Transaction Update
RIA M&A Activity Continues to Reach Record Highs
Despite the dip in the second quarter of 2021, RIA M&A activity continues to reach record highs putting the sector on track for its ninth consecutive year of record annual deal volume.
The same three demand drivers discussed last quarter persisted throughout the third quarter of 2021: (1) secular trends, (2) supportive capital markets, and (3) looming potential changes in the tax code. While fee pressure in the asset management space and a lack of succession planning by many wealth managers continues to drive consolidation, looming proposals to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current rates. Increased funding availability in the space has further propelled deal activity as acquisitions by consolidators and direct private equity investments increased significantly as a percentage of total deals during the recent quarter.
Private Equity Drives RIA M&AWe’ve written extensively on the prominence of acquisitions by private equity backed consolidators in the RIA industry. Over a decade of rapid growth and persistent profitability has established a class of RIAs with institutional scale as well as an influx of new entrants. According to a recent study by McKinsey, in 2020 there were 15 retail-oriented RIAs eclipsing $20 billion in AUM while approximately 700 new RIAs were started annually over the past five years. This dynamic of a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsors looking to leverage the number of established firms with expertise and scale available to acquire lower valuation, high growth RIA firms in the earlier stages of development.... a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsorsThree-quarters of Barron’s 2020 top 20 RIAs are owned by private equity firms or other financial institutions. Notable examples such as Focus Financial (backed by Stone Point Capital prior to IPO), HighTower Advisors (Thomas H. Lee Partners), Wealth Enhancement Group (TA Associates), and Mercer Advisors (Oak Hill Capital Partners) accounted for an outsized share of total deal volume during the third quarter of 2021, and the percentage of total acquisitions made by consolidators increased from 50% to over 70% of all transactions in the past quarter. Direct investments in the third quarter also reached an all-time high for a total of 12 transactions. Such interest from private equity backed buyers continues to support high valuation multiples.2021 RIA-to-RIA transactions as a percentage of total deal volume is expected to be at a ten-year low largely due to the increase in acquisitions made by consolidators and private equity direct investments. Increased competition for deals favors consolidators who have dedicated deal teams, capital backing, and experience to win larger transactions, and even multiple large transactions simultaneously. The trend is evidenced by increased AUM size per deal, which is on track to reach a record high for the fourth consecutive year. While this is partially a result of increased AUM due to strong market performance, Echelon Partners notes that the persistent increase is also likely due to the deep pocketed supply of capital by sophisticated buyers which has caused demand for acquisitions to outpace the supply of firms looking to sell.While systemic factors continue to be a primary driver of RIA deal activity, the surge in acquisitions made by financial buyers has led some to question the sustainability of recent M&A highs. Notably, while deal volume increased to record levels in September 2021, investor sentiment for RIA consolidators was mixed during the same period as investors have expressed concern about rising competition for deals and high leverage which may limit the ability of these firms to continue to source attractive deals in the future. Private equity buyers, and consolidators acting as private equity portfolio companies, are motivated by investment opportunity. As financial buyers flock to opportunities, they drive up valuations and simultaneously diminish IRR. Recent private equity and consolidator interest in the UK market exemplifies the saturated valuations in the U.S. market as buyers have begun to seek out cheaper entry points abroad.The RIA industry remains highly fragmented and growing.While deal volume has continued to reach new highs for nearly a decade now, there continues to be ample supply of potential acquisition targets (although not all of these firms are actively looking to sell today). The RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. Systemic trends and strong buyer demand will likely continue to bring sellers to market, and for now, there are no signs that momentum in deal activity is stalling anytime soon.What Does This Mean for Your RIA Firm?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. That said, a long-term investment horizon is the greatest hedge against valuation risks. As discussed in our recent post, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.If you are considering an internal transition, there are many financing options to consider for buy outs. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling, valuations stand at or near historic highs with ample demand from buyers. That said, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Sellers looking to leverage the scale and expertise of a strategic partner after the transaction may have many buyers to choose from.
Why Do Buy-Sell Agreements Rarely Work as Intended?
The most common valuation-related family business disputes we see in our practice relate to measuring value for buy-sell agreements. Far too often, buy-sell agreements include valuation provisions that appear designed to promote strife, incur needless expense, and increase the likelihood of intra-family litigation.The ubiquity of valuation provisions in buy-sell agreements that do not work is striking. While there are many variations on the theme, the exhibit below illustrates the broad outline of the valuation processes common to many buy-sell agreements.The buy-sell agreement presumably exists to avoid litigation, but the valuation processes in most agreements seem to increase, rather than decrease, the likelihood of litigation. It is almost as if failure is a built-in design feature of many plans.Top Five Causes of Valuation Process FailureAmbiguous (or absent) level of value. As we discussed at length in section 3 of the What Family Business Advisors Need to Know About Valuation whitepaper, family businesses have more than one value. There is no “right” level of value for a buy-sell agreement, so the agreement must specify very clearly which level of value is desired. Failing to specify the level of value, and just assuming that the eventual appraiser will know what the parties intended is a recipe for disaster. The difference between the pro rata value of the family business to a strategic control buyer and the value of a single illiquid minority share in the family business can be large. Yet too many buy-sell agreements simply say that the appraisers will determine the “value” or “fair market value” of the shares. That is not good enough.Information asymmetries. Most buy-sell agreements have no mechanisms for ensuring that the appraiser for the selling shareholder has access to the same information regarding historical financial performance, operating metrics, plans, and forecasted financial performance as the appraiser retained by the family business. The resulting asymmetries give both sides a ready-made excuse to cry foul when the valuation results do not meet their expectations. We recommend a thoroughly documented process of simultaneous information sharing, joint management interviews, and cross-review of valuation drafts to eliminate the likelihood of information asymmetries derailing the transaction.Lack of valuation standards / appraiser qualifications. It is not hard to find an investment banker, business broker, or other industry insider who probably has a well-informed idea of what the family business might be worth (particularly in the context of a sale to a strategic buyer). However, when executing the valuation provisions of a buy-sell agreement, it is crucial to specify the qualifications for the appraisers. While an opinion of value from a business broker might be suitable for some purposes, the scrutiny that is attached to a buy-sell transaction can best be withstood by an appraiser who is accountable to a recognized set of professional standards that set forth analytical procedures to be followed and reporting guidelines for communicating the results of their analysis. There are multiple reputable credentialing bodies for business appraisers that promulgate quality standards for their members. The buy-sell agreement should specify which professional credentials are required to serve as an appraiser for either the selling shareholder or the company.Unrealistic timetable / budget. Families often share a well-founded fear that the valuation process will prove interminable without specified deadlines. Deadlines are important but must be realistic. If there is ever a time for a “measure twice, cut once” mentality, it is in buy-sell transactions. Due diligence and analysis takes time, and the schedule set forth in the buy-sell agreement needs to take into account the inevitable “dead time” during which appraisers are being interviewed and retained, information is being collected, and diligence meetings are being scheduled. The same goes for budget: if you think a quality appraisal is expensive, see how costly it is to get a cheap one. Provisions that identify which parties will bear the cost of the appraisal can help incentivize the parties to reach a reasonable resolution, but can also be so punitive that they discourage shareholders from pursuing what is rightfully theirs. Each family should carefully evaluate what system will work best for their circumstances.Advocative valuation conclusions. Sadly, even when the level of value is clearly defined, information asymmetries are eliminated, valuation standards are specified, and the timetable and budget is reasonable, the two appraisers may still reach strikingly different valuation conclusions. Whether this is a result of genuine difference of (informed) opinion or bald advocacy is hard to say, but it is rare for the appraiser for the selling shareholder to conclude a lower value than that of the appraiser for the company. Valuation is a range concept, so it should ultimately not be too surprising when appraisers don’t agree. Yet that inevitable disagreement adds time and cost to many buy-sell valuation processes.Is There a Better Way?Given the challenges and pitfalls described above, is there any hope that a valuation process for a buy-sell agreement can reliably lead to reasonable resolutions? We think so. We have identified three steps that we recommend for clients to help make their buy-sell agreements work better.Make sure that the buy-sell agreement provides unambiguous guidance to all parties as to the level of value and qualifications of the appraiser.Retain an appraiser to value the company now, before a triggering event occurs. This is essential for two reasons. First, it transforms the “words on the page” into an actual document that shareholders can review and question. No matter how carefully one defines what an appraisal is supposed to do, the shareholders are likely to have different ideas about what the output will actually look like. This appraisal report should be widely circulated among the shareholders, so they have an opportunity to familiarize themselves with how the company is appraised. Second, performing the valuation before a triggering event occurs increases the likelihood that the family shareholders can build consensus around what a reasonable valuation looks like. People tend to take a more sane view of things when they don’t know if they will be the buyer or the seller.Update the valuation periodically. Simply put, static valuation formulas don’t work in a changing world. Periodic updates to the valuation help the valuation process become more efficient, and help all shareholders keep reasonable expectations about the outcome in the event of an actual triggering event. Discontent and strife are more likely to be the product of unmet expectations rather than the absolute valuation outcome. Periodic valuations help to set expectations and reduce the likelihood of friction. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers.
Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers.
This week's post is an excerpt from the whitepaper, What Family Business Advisors Need to Know About Valuation. If you would like to read the full version click here.
Natural Gas Production Levels Are High, But So Are Prices
There’s been much coverage of the run-up in oil prices since November 2020, from $37/barrel (WTI) to current prices in excess of $80/barrel. That of course ignores the April to October 2020 $28/barrel recovery from the Covid/OPEC+/Russia-induced oil price death plunge during the February to April 2020 period. Now it seems that it’s natural gas’s turn at the price run-up game.While Henry Hub (a benchmark for natural gas prices) also showed a post-Covid recovery from its March to June 2020 lows (near $1.60/MMbtu) to prices generally in the $2.60 to $3.00 range from October 2020 to May 2021, it has since been on a run that has taken it to recent highs over $5.70. So, what gives? In this week’s blog post, we address the market forces that have led to higher natural gas prices despite near record U.S. natural gas production levels.Production Is High, So Why Are Prices Rising?Per U.S. Energy Information Administration (EIA) data, 3Q2021 U.S. natural gas production neared its prior peak level, and EIA analysts expect that production will reach new record highs during 3Q2022. With such high production, basic economic theory would suggest that natural gas prices should be facing downward pressure. However, there’s the demand side of the equation to consider as well. Since the 2020 Covid-induced demand decline, the increase in natural gas demand has exceeded production recovery. Therefore, a supply versus demand imbalance has pushed prices up at an unusual rate.
Why Not Just Increase Production to Satisfy Demand? A natural question to be asked is, why wouldn’t the gas producers simply increase production to meet the heightened level of demand? That’s where an interesting set of factors come into play, with one such factor being future gas price expectations.Why wouldn’t gas producers simply increase production to meet demand? Future gas price expectations.Tsvetana Paraskova, writing for OilPrice.com, notes that producers in Appalachia, America’s largest gas-producing basin, are expecting stronger pricing signals in the future curve for gas prices a year or two from now. As such, to some extent, those producers are looking at to (i) invest now to boost production for which they’ll receive current prices, or (ii) delay that investment to boost production until later when they’re expecting to sell the same volumes at higher prices. Depending on their level of confidence in those higher future prices, they may be significantly incentivized to hold off on those volume boosting investments.
Furthermore, Peter McNally, with the consulting firm, Third Bridge, reminds us that the more recent trend among oil and gas investors in preferring more near-term return on investment (current distributions to investors), rather than more drilling (with larger distributions down the road), has pressured the producers to ease back on their drilling programs that would otherwise help maintain production levels.Where Is Demand Coming From?A natural question to be asked is, where is all the demand side pressure coming from? The answer, in large part, is exports. While the U.S. has exported natural gas via pipeline for many years, the capacity for LNG exports has ballooned in recent years and reached record levels in 2020 and 2021.
Two regions are driving demand for U.S. LNG exports. The first is Europe. After the much colder than usual winter, natural gas inventories remain well below typical seasonal levels. As a result of the lower inventories, Europeans are paying four to five times as much for natural gas relative to what is being paid in the U.S. That creates quite the incentive for U.S. produced natural gas to be exported, rather than staying within the country. The second is China. Reuters reports that China has become concerned in regard to its country-wide fuel security and is facing a winter fuel supply gap. That, in the midst of Asian gas prices that have increased more than 400% in 2021, has led to advanced talks between top Chinese energy companies and U.S. LNG exporters for the purpose of locking-in future U.S. LNG export volumes.
What Does This Mean for the U.S.?As a result of the indicated supply and demand forces at play, Reuters reports that power crunches are already hitting large economies such as China and India. While the impact in the U.S. (so far) has been relatively modest, expectations are for U.S. consumers to spend much more to heat their homes this winter. In the U.S., nearly half of homes use natural gas for heating purposes, as natural gas has traditionally been the most economical source for heating residences. The U.S. Department of Energy estimates that those homeowners will pay 30% more for natural gas this winter compared to last winter.What Are the Ripple Effects of Higher Natural Gas Prices?While home heating is a more straight-forward result of the higher natural gas prices, there are numerous ripple effects that are far less obvious. Natural gas is a key input to a number of industries where higher natural gas costs will naturally be passed through to consumers. Bozorgmehr Sharafedin, Susanna Twidale and Roslan Khasawneh, with Reuters, note several such industries including steel producers, fertilizer manufacturers, and glass makers having been forced to reduce production due to the higher natural gas prices.Industrial Energy Consumers of America, a trade group representing chemical, food and materials manufacturers has even urged the U.S. Department of Energy to limit U.S. LNG exports in order to ease their member firms’ energy-related expenses. Food producers in particular are reporting shortages of CO2 (a byproduct of fertilizer production) that is used in packaging processes, meat processing, and even for putting the “fizz” in carbonated drinks and beer. As a result, prices for those types of products are already on the rise.ConclusionAs indicated, the market forces at work in the supply and demand for U.S.-produced natural gas are many, and come from both domestic and foreign sources. The current supply/demand gap has pushed natural gas prices to recent record levels, with the impacts being both obvious in winter heating costs, and not so obvious in higher food and beverage prices. Keep reading this blog as we continue to track natural gas pricing and other energy-related industry topics.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers and Big 4 Auditors. These energy related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Middle Market Transaction Update First Half 2021
U.S. M&A activity continued to rebound in the first half of 2021 from depressed levels of activity seen in 2020 due to the COVID-19 pandemic.
How Stable Is Your Family Business Stool?
My family and I have been out at the Broadmoor in Colorado Springs for a work conference. Since we were going to a nice resort and conference center, we decided to parlay the weekend into a family business meeting.Many readers here likely undertake family meetings, whether they involve dozens of family members or just a small handful of key family stakeholders.Our agenda included company division updates, a review of the family balance sheet and estate planning, individual and family goals, and new investment opportunities. We framed many of these questions within a broader framework of defining what the family business means to us, a framework we have laid out in full in a previous post.The meaning of the family business impacts the three key legs of the family business stool: dividend policy, capital investment, and financing decisions. For our family meeting, we summarized the different meanings in the graphic below. We then extended how we define our business to the stool legs; both as it is currently and future targets.Our Business StoolMy family’s business portfolio consists of three core businesses: media, technology, and movie theatres. The holdings come in part through inheritance, in part as a diversification strategy, but mainly resulted from the passions of the primary owners: newspapers, new technologies, and the movies. How do these businesses impact the legs of our family stool: dividend policy, capital investment, and financing decisions?Dividends: Currently our technology business distributes a considerable amount of its earnings to shareholders, requiring minimal working capital and other cash needs. Our media and theatre businesses have higher up-front cash costs and have experienced margin pressure in recent years due in large part to the COVID-19 pandemic, limiting any dividends. The dividends that have been paid by the core businesses have generally been used to diversify shareholder wealth outside the core businesses into other investment areas: equities and alternative investments. Investment: While we have limited additional capital spending into the technology business, the media and theatre businesses have required additional capital to both meet operational needs and growth objectives. Similar to dividends, reinvestment capital has generally been used to diversify the family business holdings into other areas outside the core businesses.Financing: Family businesses are notorious for taking on little debt, where investor psychology and how well you sleep at night may trump return considerations. In our family, that means we are averse to taking on debt to fund investments.Do We Need To Fix the Stool?After first identifying our stool (and how stable the legs were) we asked some questions regarding what we wanted the family business to pursue in our three key decisions areas: dividends, investment, and financing.Dividends: Our technology business is successful and pays solid dividends. Should we consider reinvesting into the business (a growth sector) and pursue a more aggressive growth strategy? How would limiting these dividends impact the family business from an income perspective? Are there decisions in our media and theatre operations that we should consider to improve current income returns? What does the family need regarding current income?Investment: This discussion focused on the question of diversification, something we have touched on in detail in previous posts. What should the family be investing in? Do we need an investment committee moving forward? Different family members have different personal goals, wealth levels, and beliefs: how do we reconcile these differences?Financing: While the family business has historically avoided debt, we discussed what would lead the family to accept some debt financing. Other questions were more philosophical than return focused: why would we take on debt? How does debt play into our overall risk profile? What do different family members think about taking on debt?Final TakeawaysWhile we did not answer all the questions we had regarding our family business stool, the framework of defining business meaning and how they impact the legs of the stool did lead us to ask some important questions. These questions helped us to think about the fundamental “why” of being in business together as a family. The conversation helped us to more clearly identify our goals and desires as a family, and to better position our businesses in ways to lead the business to a sustainable long-term future.Mercer Capital works with family businesses in addressing all three legs of the family business stool. We help directors identify what the business means to the family, benchmarking key metrics to relevant peers, and improving shareholder communications. Give one of our senior professionals a call today to discuss how we can help secure a more sustainable future for your family business.BonusAs a final thought, for posterity and the “family business lore” my in-laws were insistent we bring my one and two-year-old to the board meeting. Their only comment: “More dividends!”
Asset / Wealth Management Stocks See Mixed Performance During Third Quarter
After a Strong Summer, Public Asset Managers See Stock Prices Dip as Market Pulls Back in September
RIA stocks saw mixed performance during the third quarter amidst volatile performance in the broader market. In September, the S&P 500 had its worst month since March 2020, and many publicly traded asset and wealth management stocks followed suit.Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 10% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets.The index of traditional asset and wealth managers declined 4% during the quarter, with performance reflecting the pullback in the broader market. RIA aggregators experienced a volatile quarter, but ended flat relative to the prior quarter end. The performance of RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals.
Performance for many of these public companies continued to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts.
As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, multiples pulled back moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back and AUM declined.
Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity continues to be significant, and multiples for privately held RIAs remain at or near all time highs due to buyer competition and shortage of firms on the market.Improving OutlookThe outlook for RIAs depends on several factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has remained strong despite volatility over the prior quarter. AUM remains at or near all-time highs for many firms, and it’s likely that industry-wide revenue and earnings are as well. Given this backdrop, many RIAs are well positioned for strong financial performance in the fourth quarter.
Interpreting Inflation and Interest Rates for Auto Dealers
Can Retail Vehicle Prices Continue to Soar?
Inflation and interest rates are on more people's minds lately due to supply chain disruptions across all industries. People understand how inflation and interest rates affect their daily lives when noticing the rising cost of goods/services and the cost to borrow money to buy a house, but many don't realize that inflation and interest rates are interconnected. Inflation and interest rates are frequently linked when discussing macroeconomics and they tend to have an inverse relationship. When interest rates go up, in theory, inflation goes down. However, there are many more factors other than inflation and interest rates impacting the economy in the real world.In this post, we discuss how we got to our current reality, what auto dealers might expect regarding inflation and interest rates, and how it all might impact the dealership.How Did We Get Here?Back in April, Federal Reserve Chair Jerome Powell indicated the Fed wasn’t close to raising interest rates, labeling inflation as “transitory.” At the time, he cited strengthening economic indicators, including employment and household spending and continued vaccinations which were expected to ease uncertainty and continue the economic recovery.According to Powell, “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future.” Further, the Fed indicated that clogged supply chains would not affect Fed policy as they were seen as temporary and expected to resolve themselves.While this transitory stance appeared reasonable at the time, confidence in this stance has waned and the Fed has begun signaling it would end its accommodative policies. Below we’ve included the first chart and table in the September edition of the Consumer Price Index (“CPI”) published by the Bureau of Labor Statistics last Wednesday (October 13, 2021).Source: Bureau of Labor Statistics- Consumer Price Index-September 2021Source: Bureau of Labor Statistics- Consumer Price Index-September 2021In our view, the graph of 12-month change supports the transitory view, at least in the beginning. Comparing prices in April 2021 to April 2020 is not very meaningful given the significant impediments to the economy at the time. However, as seen in the tables above, inflation has persisted on a monthly basis over the past six months. While 0.3% and 0.4% growth in the past two months is an improvement over March through July, it shows that the problem continues to linger.Are inflationary pressures still expected to be brief and transitory?On Tuesday, the day before September inflation numbers were published, Atlanta Federal Reserve President Raphael Bostic indicated inflationary pressures “will not be brief” and that he and his staff would no longer refer to inflation as transitory. Notably, Bostic is a voting member of the 2021 Federal Open Market Committee, and his public statement is the first to our knowledge challenging the transitory narrative. However, it shows how the Fed has evolved its stance over the past six months.In March, the Fed signaled it wouldn’t raise the Federal Funds rate until at least 2024. In June, the Fed stood by its transitory stance but began to indicate rate hikes would come sooner as the dot plot of expectations from FOMC members indicated two rate hikes in 2023. By September, half of Fed policymakers are expected to start raising rates in 2022, as seen below.
While the timing of rate hikes is uncertain, it appears that accommodative policy will be eased in the not so distant future. What does that mean for auto dealers?
Impact of Inflation on Auto DealershipsNotably for auto dealers, used vehicle prices surged by over 10% month-over-month in both April and June, which accounted for about a third of the total increase in the CPI for those periods. According to Cox Automotive Chief Economist Jonathan Smoke back in July, used vehicles were “the poster child illustration for transitory price hikes." While used vehicle prices, according to the CPI, have come back down to Earth in recent months, including decreases of 1.5% and 0.7% in the past two months, new vehicles have seen monthly growth of at least 1.2% since May due to supply shortages.New and used vehicle retail prices continue to climb to all-time highs. Even despite lower volumes, dealers are seeing higher revenues. Through August 2021, the average dealership was getting $3,668 in retail gross profit per new vehicle retailed. Through April of this year, that figure was $2,906 indicating a widening of profits for dealers on a per unit basis. This has played a role in the outsized profits achieved by auto dealers in 2021, who are likely wondering how long this can last.In our view, prices will continue to rise in the short-term due to supply constraints. However, consumers are becoming increasingly aware of these higher costs, and new vehicle buyers are likely delaying purchases if they are able to wait. While businesses across all industries are able to point at supply shortages and COVID as reasons for higher prices right now, at some point buyers will leave the market to wait for prices to normalize.While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position because dealerships have numerous complimentary profit centers. But how long will it last?While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position. As we’ve discussed before, auto dealerships have numerous complimentary profit centers. If a customer can’t find the new vehicle they want, a deft salesman can get them into a used vehicle. When consumers delay purchases of a vehicle, they put more mileage on their current vehicle, driving business to the higher margin service and parts operations. With fewer vehicles put on the road in 2021 due to shortages, we see a runway for more vehicle sales, even if the profit per unit declines.
In the medium term, parts and service may be the area to watch. Fewer vehicle sales means parts and service will eventually dip in the future, though this likely won’t be felt for a few years. It will also be interesting to see where consumers get their vehicles serviced after purchasing from online used vehicle retailers that don’t have these operations.
Along with the factors already mentioned, the future path of inflation for vehicles will likely also be impacted and interconnect to the path taken by interest rates.Impact of Interest Rates on Auto DealershipsAccording to an interesting Lexington Law study on how Americans are buying cars, auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide. When interest rates fall to the prevailing low levels, consumers are able to afford more expensive cars. However, the mathematical movement of lower interest rates doesn’t necessarily mean consumers will correspondingly purchase a more expensive car. Similarly, when interest rates rise, that doesn’t mean vehicle prices have to decline. Still, dealers should be aware that this is the case, at least in theory.Interest rates matter. Auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide.In practice, F&I departments can smooth out rising interest rates or rising vehicle prices by extending the length of loans. According to Lexington Law study, the amount of the monthly payment was the top priority for the average car buyer. It is natural for people to consider their monthly out-of-pocket costs and what they can afford, even if it leads to a longer loan term or higher interest rates. We should also note that APR and total interest paid are similar considerations, which when combined, amount to almost half of the decision.Source: Lexington Law | Study: How Are Americans Buying Cars?Rising interest rates will increase costs to consumers and if they’re on a fixed budget, this places downward pressure on vehicle prices. In December 2015, the Fed raised rates for the first time since the Global Financial Criss. Dealers will have to lean on their past experience on how to navigate vehicle sales in an environment of rising interest rates.
Interest rates don’t only affect top line revenues for dealerships, however. The prevailing low interest environment and inventory shortage has significantly reduced one key operating expense for auto dealerships: floor-plan interest expense. Lower interest rates mean the price of keeping inventory on the lot for test drives is lower. With lower levels of inventory, interest expense is being reduced by volume as well as price. With inventories expected to normalize and interest rates expected to creep up, auto dealers will see floor plan expenses rising. It may not get back to pre-COVID levels if OEMs structurally change the level of inventories kept on dealers’ lots, but that’s another topic for another blog post.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by the greater macroeconomic environment. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
Chesapeake Finds Vine Ripe for the Picking
In August, Chesapeake Energy Corporation announced that it would acquire Vine Energy Inc. in a stock-and-cash transaction valued at approximately $2.2 billion. We previously discussed Vine’s IPO, which was the first upstream (non-minerals, non-SPAC) initial public offering since Berry Petroleum’s debut in mid-2017. Vine’s decision to be acquired in a ~0% premium transaction less than five months after its IPO speaks to the difficulty for E&P companies to manage public market dynamics even in a much-improved commodity price environment. In this post, we dig into the transaction rationale, look at relative value measures, and analyze how this transaction seems to indicate a shift in Chesapeake’s strategy.Transaction RationaleChesapeake’s acquisition generally follows the recent upstream M&A playbook: mostly stock, low-to no-premium, and a focus on cost synergies.Cash consideration of $1.20 per share represents 8% of the $15.00 total consideration per share. It is somewhat curious that there’s a cash component to the purchase, especially for a company that recentlyemerged from bankruptcy in a transaction that doubles the company’s leverage. However, even with the cash outlay and assumption of Vine’s debt, Chesapeake management indicates that the pro forma entity will have a relatively modest net debt to 2022E EBITDAX ratio of 0.6x.Based on market data, immediately prior to announcement, the transaction consideration represents a <1% premium to Vine’s stock price. While that may not seem like a great deal for shareholders, the 92% stock consideration means that legacy Vine shareholders should benefit from any synergies achieved by the transaction. On the announcement date, market reaction was generally positive, with both Vine and Chesapeake outperforming the broader upstream universe (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP).
As for those synergies, management expects to save $20 million per year on general & administrative and lease operating expenses, with another $30 million per year in capital efficiencies, resulting in an annual savings of $50 million per year.
Valuation ConsiderationsRelative value measures for the transaction are shown in the following table:
As with any transaction with a stock component, the transaction consideration is dynamic and fluctuates with the acquirer’s stock price. The initial transaction consideration of $15 per share was only $1 higher than Vine’s IPO price. But with the run-up in natural gas prices and continued exposure via stock consideration, Vine has recently traded at all-time highs and is now within its initial IPO offer range.
Chesapeake Shifts Back to Natural Gas RootsChesapeake has historically focused on natural gas production. However, in the wake of persistently low natural gas prices from roughly 2010-2020, the company sought to diversify its production mix and become more oil focused. In pursuit of this goal, the company was particularly active on the M&A and A&D front, with actions including the sale of itsUtica assets in Ohio and acquisition of Eagle Ford producer WildHorse Development Corporation. Ultimately, the company overextended itself and entered bankruptcy in mid-2020.
After emerging from bankruptcy earlier this year, management indicated that investment activity would be focused on natural gas assets. The timing seems apt with the recent increase in natural gas prices. The acquisition of Vine will stem Chesapeake’s recent trend of production declines and materially increase its natural gas mix.
ConclusionVine’s brief stint as a public company looks to be coming to an end. With natural gas stealing the spotlight from crude oil, Chesapeake is seeking to return to its former glory as America’s natural gas champion. The combination with Vine will make Chesapeake a dominate force in the Haynesville and support the company’s pivot away from oil.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Looming Estate Plan Disruptions
Are You Prepared?
"Have you not reserved even some type of blessing for me? Has my brother really taken everything?!" cried Esau. Isaac answered, "Behold, I made him a master over you, and I gave him all his brothers as servants, and I have sustained him with corn and wine; so for you then, what shall I do, my son?” – Genesis 27 : 36-37Jacob may have caused the first recorded major disruption to a family’s long-term estate planning goals. While there is no familial deception or lentil soup traded for birthrights, numerous changes lurk in the current reconciliation bill snaking its way through Congress and it could have major ramifications to the plans you worked up just a few years ago.We applaud family businesses and their advisors setting up estate plans with more guardrails than deathbed blessings, but would we be remiss if we failed to ask: Have you pulled out those documents recently? Below we briefly touch on planning vehicles and structures as well as valuation tools currently being debated in the reconciliation bill and why they are important to many family business owners and advisors.Estate & Gift Tax ExemptionThe current law provides an estate and gift tax exemption of $11.7 million per individual or $23.4 million for a married couple. This provision is currently set to sunset December 31, 2025. Previous guidance has stated any gifts made prior to any changes to the exemption will not be clawed back.The current proposal rolls back the exemption amount to $6.02 million per individual adjusted for inflation or $12.04 million for a married couple, slashing the benefit effectively in half. The effective date of change under the current proposed bill is January 1, 2022.Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the end of the year, including gifting to descendants or a trust (more discussed below). In less eloquent terms: Use It or Lose It!Trust ChangesThe “Bull Moose” would likely beam with pride regarding the current reconciliation bill’s “Trust busting” features. In general, many of the law’s provisions are meant to curtail, if not outright eliminate, tools utilized by estate tax advisors and attorneys. Many of the changes are expected to become effective either 1) at signage of the bill or 2) January 1, 2022.The National Law Review provided a good summary regarding Grantor Trusts. In general, the current reconciliation bill largely eliminates many of the estate planning benefits of grantor trusts (trusts deemed to be owned by the creator of the trust or another person (each referred to as a “grantor”) for federal income tax purposes). The following rules would apply to trusts created on or after the date of enactment and to existing trusts to the extent transfers are made to such trusts on or after the date of enactment.Estate Tax Inclusion - Assets owned by a grantor trust would be included in the grantor's estate and subject to estate tax upon the grantor's death.Distributions as Gifts - Distributions from a grantor trust during the grantor's lifetime would generally be treated as taxable gifts.Taxation Upon Termination of Grantor Trust Status - If the trust's grantor trust status is terminated (i.e., the trust becomes a separate taxpayer from the deemed owner), the grantor would be deemed to have made a taxable gift of the trust assets.Gain Recognized Upon Transfers to Grantor Trust - Transfers between a grantor trust and its grantor would be subject to income tax regardless of when the grantor trust was created.
A key piece you and your planning team need to consider is, as it reads:
The Legislation would apply to all post-enactment transfers between a grantor and grantor trust, including grantor trusts created prior to the date of enactment.
Therefore, a sale or swap of assets after the Legislation’s effective date between a pre-enactment grantor trust and its grantor would be an income tax realization event. Likewise, a GRAT annuity payment made in kind with appreciated assets to the grantor, after the Legislation’s effective date, would be an income tax realization event. With respect to these grantor trust provisions, the House Bill includes a footnote which states, “A technical correction may be necessary to reflect this intent.”
Grantor trusts are a big deal, but many other trust structures could fall under some of the same new, restrictive rules, including the following:Grantor Retained Annuity Trusts (GRATs)Qualified Personal Residence Trusts (QPRTs)Grantor Charitable Lead Annuity Trusts (CLATs)Spousal Lifetime Access Trusts (SLATs)Irrevocable Life Insurance Trusts (ILITs)
Gassman, Crotty, & Denicolo, P.A. had a great webinar recently to cover several possible changes to these vehicles. You can check it out here.Valuation Discounts for Passive AssetsIn a business valuation setting, valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.As discussed in Mercer Capital’s Auto Dealer blog, the current version of the reconciliation bill proposes to eliminate valuation discounts for an entity’s “non-business”, or passive, assets including certain cash balances, marketable securities, equity in another entity, or real estate. Actively utilized working capital or real estate for business operations would not be considered “passive.” The effective date of enactment would be January 1, 2022.We would argue discounts for lack of marketability and control represent quantifiable economic realities facing minority owners in nonmarketable passive entities. Regardless, the law’s impact would be large. Often, combined discounts for lack of control and marketability can range from 25-45%.An option business owners should consider is triggering a valuation of minority ownership positions with a valuation date prior to the effective law date. A 25%-45% increase in reportable gifts would only be compounded by the law’s lowering gift tax exemption (discussed previously).ConclusionWe provide valuation services to families seeking to optimize their estate plans and we work with estate tax attorneys all across the country. Give one of our professionals a call to discuss how we can help you in the current environment.
“Permanent” Capital Providers Offer a Different Type of RIA Investor
Beginning With No End in Mind
Several pre-pandemic years ago, my family and I enjoyed a long vacation in England, touring the usual castles, cathedrals, and museums. At some point in the trip, my kids noticed that many of the buildings we toured and historical objects we saw were in some way tied to, owned by, or were on loan from, the royal family. Whether it was Windsor Castle, the Crown Jewels in the Tower of London, or the Bentley limousines garaged at Buckingham Palace, much of what you see as a tourist in England is recorded on Her Majesty’s balance sheet.I took the opportunity to point out to my kids that a reliable way to accumulate wealth was to invest in assets you would never want to sell, and then don’t sell them. The best assets tend to remain the best, and the avoidance of transaction costs removes a drag on returns that everyone – in my experience – underestimates.The increased prominence of “permanent” capital providers in the RIA space takes me back to the multi-generational buy-and-hold strategy of the royals, not just because of the avoidance of transaction costs but also because of the premium entry prices being paid. In 1852, Prince Albert and Queen Victoria paid £32,000 for a vacation home now known as Balmoral Castle. What was that price relative to market? I don’t know, but 170 years later, it doesn’t matter.GPs at private equity conferences once liked to boast about their success in booking “gains on purchase” – a clever way of saying they could buy at a discount to market. No one talks that way in the RIA community these days. If anything, I’m struck by how sponsor-backed acquirers are willing to state, publicly, their willingness to outbid each other. I won’t call anyone out with specific examples, but they aren’t hard to find.RIAs are probably the best coupon available in a low-to-no yield environment.It’s as if a land-grab is underway, with competing interests looking to consolidate as much market share in the investment management community as they can, as fast as possible. The trouble is that RIAs are a sort of land that is actually still being manufactured. Despite the rampant consolidation in the space, the number of RIAs is steadily on the increase. Nevertheless, there is legitimate cause for enthusiasm.As we’ve written many times in this blog, investing in the RIA space represents a singular opportunity. RIAs are probably the best coupon available in a low-to-no yield environment. They are a growth and income play like none other. They are practically the apotheosis of diversification in a way that Harry Markowitz could have only dreamed of when he started publishing his research nearly 60 years ago.Unfortunately, many reasonable ambitions, stretched far enough, eventually become wellsprings of regret.Returns and valuations are inversely related, after all. An unfettered willingness to pay more is just a race to the bottom on ROI. Financial engineering doesn’t repeal the laws of financial gravity. Taking more and greater risks leads to a greater variability of outcomes. Paying more compresses returns. To my way of thinking, this isn’t prudent – but I’m not paid to manage capital.Professional investors must work in the market they have, not the market they want. It’s all well and good to talk about “patient” capital, but LPs aren’t going to pay 200 basis points for someone to hold their cash, regardless of how advisable that might be. Given that mandate, the question of whether to make investments at these levels pivots to how best to do it. What opportunities are available in the present – and potentially lingering – environment of high entrance multiples?Financial engineering doesn’t repeal the laws of financial gravity.I’ll posit that the rise of “permanent capital” providers is both in response to and appropriate for current market conditions in the RIA space. This is in sharp contrast to the prevailing “fund” behavior in the private equity community, in which LPs commit capital for a specified length of time – ten years or so – and fund managers have to make investment decisions with an expectation of being in and out of an investment in less time than that – say five to seven – to generate the kind of ROI it takes to raise the next fund.Anyone who’s spent a few moments (or a career) with DCF models knows that there are a limited number of levers to pull to rationalize a high entry price with a five-year holding period. You can assume supernormal growth (unlikely in a mature space like investment management), high exit pricing (multiple arbitrage - aka the greater fool theory), squeezing margins (underinvestment), or low discount rates (race to the bottom on ROI).The other possible lever is, of course, leverage. Debt can enhance equity returns so long as it doesn’t wipe them out entirely. Unfortunately, it’s only in hindsight that we know what leverage ratio is (or was) optimal.Making a permanent capital investment doesn’t eliminate the depressive effects of current valuations on returns, but it mitigates them. Without the pressure to generate an exit within the foreseeable future, RIA investors can focus on the opportunities for sustainable and growing distributions. The longer distributions persist and the more they grow, the less of an impact the entry price has on total return.Further, without the financial friction of trading out of an investment in a few years and the costs and risks of reinvestment, the opportunity for superior returns – especially relative to those available at similar risk elsewhere in the current market – is greater.The question of how long “permanent capital” lasts is a good one. The investors backing many of these enterprises tend to be insurance companies with very long time horizons. The thousand-year outlook of William the Conqueror probably isn’t relevant to investing in RIAs, but the mindset of an indefinitely lengthy holding period leads permanent capital sponsors to different decision making, which may prove useful in times like this. It’s hard to think long term when the M&A headlines keep coming, but the business cycle has a lot of staying power. In this market, investors need staying power as well.
The Evolution of E&P ESG Scores
Trends from 2016-2020
As quarterly earnings calls have come and gone over the past several years, the frequency with which environmental, social, and governance topics are explicitly discussed have been ever-increasing. On the whole, ESG topics are sector and industry agnostic. While not all ESG topics come into play equally for every sector and industry, there are always some elements, issues or characteristics of any given company or industry that could be put into at least one, if not all, of those three buckets.Within the E&P space–and the oil and gas sector overall–operators have increasingly included ESG talking points in their management commentary, signaling proactive initiative rather than reactive response. One could argue this approach helps to lead the discussion by addressing what they can do, are doing, and will do, as opposed to having to answer to why they are not taking actions to mitigate some issues that were determined or assumed to be a priority by an outside party.Regardless of the impetus for ESG topics entering the zeitgeist, the result is an increase in self-reporting by E&P operators as to what they’re doing to improve, or at least address, noted ESG concerns.Naturally, however, the noble action of self-reporting does not mean the stated or signaled information is accurate or fully reflects all known or knowable information. Of course, it should not be assumed that such information is inherently or purposefully misleading either. Sometimes you take it with a grain of salt; sometimes you empty the shaker or season to taste.Given the potential for obfuscation, though, it helps to have a more objective party discern what information is verifiable and accurate, as far as that may be determinable. One such platform, S&P’s Global Market Intelligence, provides such ESG evaluation services, including the provision of ESG scores to gauge where companies stand with respect to their self-reporting.In this post, we take a brief look at several ESG criteria among E&P operators to see what trends may be present among the operators with the highest and lowest ESG scores, as provided by Global Market Intelligence.Total ESG ScoresIt is far beyond the scope of this article to explain the machinations and processes that underlie the production of the ESG scores determined by Global Market Intelligence. For simplicity, we consider the ESG scores in an ordinal and relative way. For example, if Company A and Company B have ESG scores of 10 and 20, respectively, it is not to say that the self-reporting by Company B is twice as good as Company A’s reporting, but simply that Company B reports more information which can be verified.The other side of the coin is that, in theory, a company could be a model example of ESG stewardship, but still have an ESG score of 0 if it doesn’t self-report or may not provide information that is readily verifiable. This would not be a likely scenario, but again, “in theory…”.Note that, in addition to a company’s “Total” ESG score, there are scores for the respective E, S and G groups, with more granular scores for specific criteria within each of those three buckets. We will refer to the Total ESG scores, as well as scores for three criteria that represent the environmental, social, and governance groups, respectively.We utilized the Global Market Intelligence platform to screen for U.S. E&P operators with market capitalizations over $10 million (as of October 6), with 124 resulting companies. We then pared this list down to 12 operators that consistently had annual Total ESG scores from 2016 to 2020 (the latest data available), presented as follows:Click here to expand the image aboveGenerally, the list is presented in ascending order, with the lower-scoring operators towards the top and higher-scoring operators towards the bottom.As may be gleaned from the chart above, the three lowest scoring E&P operators, on average, were Diamondback Energy, Continental Resources, and Coterra Energy.1The three highest scoring operators, on average, were Hess Corporation, ConocoPhillips, and Ovintiv (formerly Encana Corporation).We note that the ESG scores among the lowest-scoring companies all declined from 2016 to 2020, with Continental Resources’ and Coterra Energy’s scores among those with the greatest decline among the entire group of companies presented. The ESG scores for ConocoPhillips and Hess Corporation were approximately at the 3rd quartile with respect to their “growth”, while Ovintiv’s ESG scores showed a moderate decline from 2016 to 2020. Although we do not discuss Pioneer Natural Resources in depth here, we do note that it exhibited the greatest growth in its ESG score from 2016 to 2020.E, S, and GAs mentioned earlier, each of the environmental, social, and governance groups have respective subsets of criteria which are surveyed, analyzed, scored, and weighted by Global Market Intelligence. For example: criteria within the environmental group includes items such as “biodiversity,” “climate strategy,” and “water related risks”; the social group includes criteria such as “social impacts on communities,” “human capital development,” and “human rights”; and the governance group includes criteria such as “brand management,” “marketing practices,” and “supply chain management.”One environmental criterion we looked at was climate strategy, 2 with the company ESG scores as follows:Click here to expand the image aboveOnly 3 companies had ESG scores for this criterion that indicated improvement from 2016 to 2020. However, the growth between these two periods masks the development of these scores in the interceding periods. Notably, the score for Diamondback Energy dipped in 2018 and 2019, but returned to the levels seen in 2016 and 2017. Furthermore, several companies, including EOG Resources, Pioneer Natural Resources, Marathon Oil, and Ovintiv all showed significant improvement in the score from 2019 to 2020.Last, but not least, we reach the criterion selected representing the governance topics: policy influence.3Click here to expand the image aboveAs you will notice, all companies had “NA” in place of scores in 2016, indicating this criterion was not included on the Global Market Intelligence survey that year. We note that these scores objectively focus on the extent of the verifiable public disclosure related to the companies’ contributions to political campaigns, lobby groups, and trade associations which may influence the policies affecting industry operations and regulations; these scores do not indicate levels of financial contribution or subjective perspectives regarding levels of influence in promoting or interfering with any particular policy.On the HorizonMoving forward, it will be interesting to compare the objective ESG scores with the quantity and quality of the information divulged and discussed in E&P operators’ earnings calls. Presumably, the ESG scores should rise in tandem with the greater levels of discussion and disclosures in the calls. We may find out soon enough with the upcoming earnings call season, as Diamondback Energy, Continental Resources, EOG Resources, Pioneer Natural Resources, Marathon Oil, and EQT Corporation regularly make appearances in our quarterly blog post, Earnings Calls - E&P Operators.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.1 We note that the results of our company screen included E&P operators which may have had an “na” in place of a Total ESG score in one of the years from 2016 to 2020, in which case these companies were excluded from the companies listed above. There are several reasons this may occur (most likely, a lack of self-reporting for whatever reason in that particular year), but we selected the presented companies to focus on E&P operators which have made a concerted effort to self-report with consistency in the recent past.2 From Global Market Intelligence: “Most industries are likely to be impacted by climate change, albeit to a varying degree; consequently, they face a need to design strategies commensurate to the scale of the challenge for their industry. While most focus on the risks associated with a changing climate, some seek to identify and seize the business opportunities linked to this global challenge. The questions in this criterion have been developed in alignment with the CDP methodology as part of a collaboration between us and CDP https://www.cdproject.net.” We note that CDP is a not-for-profit charity that runs a global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts.3 From Global Market Intelligence: “Although companies legitimately represent themselves in legislative, political and public discourse, excessive contributions to political campaigns, lobbying expenditures and contributions to trade associations and other tax-exempt groups may damage companies’ reputations and creates risks of corruption. In this criterion, we evaluate the amount of money companies are allocating to organizations whose primary role is to create or influence public policy, legislation and regulations. We also ask for the largest contributions to such groups, and we assess the public disclosure on these two aspects.”
September 2021 SAAR
September 2021 SAAR was 12.2 million, dropping for the fifth consecutive month amidst an ongoing inventory shortage. The September SAAR was the lowest since May 2020’s 12.1 million units but has not fallen near the COVID-19 pandemic low of 8.6 million units in April of 2020.Tight inventories limited both fleet and retail sales in September, which has been the same case over the last four months. Fleet sales continue to fall as a percent of total sales, making up just 12% over the last month, as higher profit retail sales continue to be prioritized.As mentioned in last month’s SAAR blog, auto dealers started the month with industry-wide record low inventory levels of 1.06 million units. Inventory levels have not improved much since then, but the industry inventory to sales ratio has modestly ticked up from 0.68 to 0.72.
This could be explained by sales rates finally slowing down and keeping pace with production rates. High levels of demand and low supply have been coexisting for months, and there are only so many new vehicles to go around as consumers are increasingly pre-ordering vehicles before they even arrive on dealers’ lots. While high prices are keeping away certain customers that have decided to wait, wider margins are keeping dealers profitable.
However, at current production rates there are only so many vehicles being produced by OEMs that can make it to the lot, and high trade-in values and wide margins can only do so much to bridge the gap for dealers that may not have a new car to sell to a potential trade-in customer down the line.
In response to the current climate, average transaction prices have continued to rise. The average transaction price of a new vehicle is expected to top $42,800, another all-time high and the fourth straight month that prices have exceeded $40,000. Dealers have taken advantage of high prices to sustain profitability by achieving high margins on each vehicle sold for months now, and the factors involved continue to benefit dealers. For example, average incentive spending per unit is expected to reach another record low of $1,755 per vehicle, down from $1,823 a month ago, driving GPUs up even further.
Another factor that influences dealer profitability, inventory turnover, decreased again as well. The average time that a new vehicle sat in the lot during September was 23 days, down from 25 days in August and 54 days in September 2020 reducing floor plan interest expense.
What Do Tech Investments By OEMs Mean For My Dealership?In a previous blog outlining the different options that dealers have when allocating capital amidst excess liquidity, a few options were highlighted. Dealers can either 1) reinvest in the business, 2) return capital to debt and equity stakeholders or 3) seek acquisitions to drive growth. These fundamental decisions apply to OEMs as well, and over the last several months many OEMs have decided to reinvest in the core operations of the business by shifting their focus to electric vehicles.Listed below are narratives of some of the investments OEMs have made and how they might affect the value of your privately held dealership.Nissan has developed a new technique for assembling vehicles more efficiently and with less waste. This technique, called SUMO, enables Nissan to produce vehicles 10% cheaper than before, despite them manufacturing increasingly complex vehicles like hybrids and EVs.General Motors is developing a supply chain for rare-earth metals for the production of EVs, a move expected to pave the way for a more reliable stream of General Motors EVs in the future.Ford has also reinvested in EV operations, and has recently partnered with Electrify America, ChargePoint and others to bolster its charging network.Ford has also announced a state-of-the-art production facility that is set to be built in west Tennessee, creating 5,800 positions to produce electric F-150 trucks. The plant is also said to be a zero-waste-to-landfill facility.
The point is that almost every major vehicle manufacturer is investing in the future of its EV production process, a move that some analysts think will lead to higher, Tesla-like, valuations. However, it is unclear whether OEMs will start to invest in support for dealership maintenance infrastructure.
Many have already chosen to pass along the costs of investments needed for the sale and service of EV vehicles onto the dealer, creating several issues surrounding the economics of an upgrade for rural and smaller dealerships. Time will tell whether OEMs will choose to prioritize the amount of EVs on lots by further subsiding transition fees.ForecastLooking ahead to October, expectations for the full year 2021 SAAR have once again been lowered. Experts estimate that the global industry has already lost around 9 million units of production related to supply chain issues, and that number should continue to mount with no end in sight for OEMS until and likely into 2022. The demand for new and used vehicles is expected to remain feverish, but sales will have to contend with ongoing production constraints. Sales can no longer outpace production as inventory has been drawn down.At this point, we are pretty confident sales in Q4 won’t be high enough to reach our initial 2021 target. Despite a challenging year from an operational standpoint, we doubt many dealers will be complaining with the results and the profits achieved this year.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.
September Acquisitions by Sonic, Asbury, and Group 1 and What They Mean for Privately Held Auto Dealerships
Smallest Public Players Getting Larger
In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo. Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
Should Your Family Consider a Family Office?
Who Should Manage Your Family Wealth?If you are in the fortunate position to be the owner of a profitable family business you might consider hiring an expert to help manage your wealth. If so, you should be familiar with two primary business models available to assist in wealth management: traditional wealth management firms and family offices.While there is overlap in the services provided and the clientele served, there are some key differences in deciding which financial solution is best for an ultra-high net worth individual or family.Traditional Wealth ManagersTraditional wealth management offices are the most accessible avenue for financial guidance and most cost-effective solution for managing family wealth. Clients of traditional wealth managers include everyone from the mass affluent (typically considered a net worth of above $250 thousand to $1 million) to ultra-high net worth individuals (exceeding $30 million). In general, wealth management advisors manage a client’s wealth holistically, typically for a set fee based on total assets under management, a flat fee, or an hourly fee.Wealth management advisors manage a client’s wealth holistically, typically for a set fee based on total assets under management, a flat fee, or an hourly fee.The investment process often begins with financial planning, communicating a client’s financial situation, goals, and risk tolerance. Once an investment plan is in place, investors can expect annual or quarterly meetings to review and rebalance the portfolio according to the client’s current financial situation. Asset classes and investment products utilized may differ among wealth managers but for the most are usually selected based on the objective of the client.Wealth managers can either manage your assets on a discretionary or non-discretionary basis depending on what level of involvement you prefer. For those who are looking to entirely outsource their investment panning, a discretionary plan will allow an authorized broker or advisor to buy and sell securities without the client’s consent for each trade. As wealth accumulates, many families pursuing a traditional wealth management route seek management on a discretionary basis.In the wealth management community, there are two primary business types to work with: wirehouse teams and independent Registered Investment Advisors (or “RIAs”). Wirehouses include well-known brands such as Morgan Stanley, Bank of America’s Merrill Lynch, UBS, Wells Fargo among numerous others. Wirehouses are typically much larger than RIAs with branch offices and correspondents internationally sharing financial information, research, and prices. Clients can often choose to be charged on a fee basis in which advisors are paid a percentage of assets managed or by commission on transactions.In the wealth management community, there are two primary business types to work with: wirehouse teams and independent Registered Investment Advisors (or “RIAs”).RIAs are generally much smaller and more well-known RIA brands include Cambridge Associates, Mercer Global Advisors, and Fisher Asset Management among others. However, because RIAs generally consist of a single office with a handful of advisors operating on a local or regional scale, it is likely that the most readily available and appropriate RIA for you is locally owned, operated, and known (much like a local or regional bank).Hallmarks of RIAs include the fee structure of assets managed for compensation, the use of custodians, and the “Fiduciary” standard. While assets and transactions are overseen by an advisor, assets are “held away” with a custodian such as Fidelity, Schwab, Pershing, or TD Ameritrade, among others, to ensure the safety of assets and minimize holding costs. The fiduciary standard legally binds advisors to act in the best interest of the client in all circumstances. By contrast, other advisor models are held to a lower, “suitability” standard. In recent history legislation has increasingly narrowed the divide between these two standards.Other wealth management models include regional firms such as Raymond James and Ameriprise Financial, as well as boutique firms such as Credit Suisee, Deutsche Bank, and Barclays. Regional firms operate similarly to wirehouses despite having a limited geographic presence. Boutique firms are generally located in major metropolitan areas and cater to clients with a minimum of $2 million in liquid assets held. Depending on the firm, boutique managers may offer more flexible and unique investment strategies or may offer expertise in a single, niche asset class or strategy.Family OfficesThe concept of a family office dates back as far as 27 BC, however, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.Like a traditional wealth manager, a family office provides investment management services. However, a family office offers a wider variety of services providing a total outsourced solution tailored to individual family needs. A family office can assist in investment management, tax planning, charitable giving, family education, legacy planning, and in some cases, even lifestyle assistance through travel arrangements, personal security, and other household services. Because most family offices are built around an individual family’s needs, it is difficult to identify a “typical” family office.A family office offers a wider variety of services providing a total outsourced solution tailored to individual family needs.Single family offices cater a comprehensive array of services to a family, but the costs can be prohibitive due to their extensive and unique nature. Typically, a family’s assets must exceed $100 million to warrant the operation of a family office. Multi-family offices were developed as a more cost effective option, pulling a group of families’ assets (usually in excess of $25 million per family) with similar needs to share overhead. Unlike a single family office, multi-family offices must be registered with the SEC and are typically structured like RIAs or trust companies.One key differentiator is that a multi-family office is a profit driven institution whereas a single family office’s primary goal is to preserve and generate wealth for the family. Because profits are shared between families (via returns on investment) and the ownership base, multi-family offices theoretically generate lower returns on assets than single-family offices despite being more efficient due to the cost sharing across families.Which Is Right For You?At the end of the day, it comes down to your needs and, to a certain extent, preference. Family offices offer a more tailored client experience than a traditional wealth management firm and can provide a great deal more flexibility and convenience due to their ability to manage nearly all aspects of client financial life. However, traditional wealth managers can help prevent disputes arising from mixing business with family and don’t come with the prohibitive costs or necessary asset base associated with opening a family office.Most advisors recommend a balance sheet figure of approximately $100 million dollars in net worth before considering a family office and often $250 million before considering in house investment management and research. However, just because you can afford one, doesn’t mean you need one. The decision to start a family office is nuanced and relates to the complexity of a family’s portfolio, liquidity needs, lifestyle, and estate planning among numerous other factors best discussed with a personal wealth advisor.For instance, even an entrepreneur with several hundred million dollars in net worth may not need the support of a family office if his/her wealth is mostly held in one company stock. Similarly, families with net worth’s mostly tied to trading securities will not need a family office, regardless of net worth, as such a portfolio would be more efficiently served by a wealth manager. Conversely, for an investor with a highly diversified portfolio with a high degree of illiquidity and legal and accounting complexity, a family office may be justified.A complicated lifestyle and expenditure can also qualify a family or individual for a family office. If a family’s time spent budgeting, coordinating private travel, and making purchases is burdening their ability to run a successful enterprise, a family office may free up time and resources better served in the careers and businesses that created such wealth to begin with. Or perhaps, a family office can free up a family to pursue philanthropic endeavors. Families with complicated estate plans consisting of multiple family entities, foundations, and trusts may also require full time staff to execute.Family offices are not merely reserved for the passive investor. Family offices often facilitate direct investments into private equity and allow for a more “hands on” approach of investment alongside qualified professionals into alternative asset classes. The prominence of direct investments by family offices has been growing in recent years as private business owners looking for liquidity are often attracted to the longer holding periods of a family office while family offices are increasingly looking invest in specific industries or make an impact.Ultimately, the family office will be funded by a family’s sustainable discretionary income, not necessarily assets held, and the benefits of financing a family office should outweigh additional costs of simply working with a team of advisors and CPAs. For reference, a survey from Citibank estimates a small family office with two professionals and four support personnel can cost anywhere from $1.5 million to $1.8 million per year.
What Is a Reserve Report?
In this blog post we discuss the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].Why Is a Reserve Report Important?A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. Rules of 2009define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner.
In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies.” Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10.
The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.ConclusionMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)
Tax/Estate Planning Cheat Sheet for Auto Dealers
Winds of Change?
Benjamin Franklin famously said that the only things certain in this life are death and taxes. While both may be certain, taxes are always subject to change.Last fall, we wrote a blog post about the estate planning environment for auto dealers and other industries. In that post, we highlighted the prevailing conditions that existed in the marketplace that would enable auto dealers to capitalize on executing any estate planning opportunities. Those conditions included opportunities for depressed valuations caused by uncertain operational results (at the time), low interest rates, and changing political forces caused by the Presidential election.Fast forward to Fall 2021 and while some of these conditions have changed, rumors of potential tax changes have finally re-surfaced nearly three-fourths of the way through the first year of the Biden Administration.Earlier this month, President Biden and Congress introduced the Build Back Better Act (“BBB Act”). After its introduction, the House Ways and Means Committee commented and circulated a draft of many of the proposed policies. A brief synopsis of the entire BBB Act from BKD CPAs and Advisors is provided here.In this post, we focus on four particular proposals that impact estate planning and business valuations for auto dealers (and other industries): 1) Estate Tax / Lifetime Exclusion; 2) Corporate Income Tax Rates; 3) Capital Gains Rates; and 4) Valuation Discounts for Passive Assets.Estate Tax/Lifetime Exclusion AmountThe Estate Tax / Lifetime Exclusion Amount is also referred to as the Generation Skipping Transfer Tax Exemption. This concept consists of the amount of an estate that is subject to be transferred free from taxes either during the lifetime of an individual/couple or at death.Current Status: $11.7 million per individual or $23.4 million for a married couple as stated in the Tax Cuts and Jobs Act (“TCJA”) for gifts made between January 1, 2018 and December 31, 2025. Based on these figures, all estates under these amounts can be transferred during the lifetime or at death without incurring any estate taxes.Current Proposal: Revert back to $5 million per individual adjusted for inflation to arrive at a figure of approximately $6.02 million per person or $12.04 million for a married couple.Effective Date of Change: January 1, 2022Valuation Impact: If enacted, the current proposal would now lower the lifetime annual exemption to $12.04 million for married couples, nearly cutting the exclusion in half. Estates with a value over $12.04 million would now be subject to tax on the amount exceeding $12.04 million.Who Should Consider: Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the BBB Act is passed. Current estates with values exceeding $23.4 million or those estates that have not utilized the full prior lifetime annual exclusion amount, should also consider executing estate planning strategies before that heightened amount is reduced. The reduced exclusion amount also increases the number of affected people. Someone owning a business worth $15 million could now benefit from tax planning strategies that previously may have been less concerned when they fell below the threshold established by the TCJA.Corporate Income Tax RatesCorporate income tax rates are the amount of taxes paid on profits earned by a corporation.Current Status: Flat rate of 21%, reduced by the TCJALatest Proposal: Graduated rates with a top rate of 26.5%Effective Date: January 1, 2022Valuation Impact: Business valuations of auto dealerships are generally impacted by three broad overall assumptions: expected annual cash flows, growth of said cash flows, and risks to achieve those cash flows. A proposed increase in the corporate income taxes would reduce the annual cash flows of an auto dealership simply by the fact that income tax rates are higher. We saw the reverse of this trend when income tax rates were lowered by the TCJA. While many auto dealerships are organized in entities that consist of S Corporations, Limited Liability Companies, and Partnerships, the corporate income tax assumption still impacts the business valuation. We won’t belabor the mechanics of a business valuation in this post, but effectively the hypothetical earnings of a business are tax affected to a C Corporation equivalent basis since the assumptions for the discount and capitalization rates (the risks associated with achieving expected cash flows) are derived from public C Corporations.Who Should Consider: As briefly discussed above, income tax rates comprise one of the assumptions in a business valuation. On its surface, the proposed increase in corporate income taxes will certainly reduce expected the after-tax earnings of an auto dealership, all other things being equal. However, other prevailing industry conditions, such as heightened profitability due to operational efficiencies, might mitigate the overall impact caused by increased tax rates. The opposite was true in 2017.Capital Gains Tax RateThe capital gains rate is the tax rate paid on the disposition of an asset. Rates can differ based on the holding period of the asset prior to disposition and are often bifurcated into short-term (one year or less) or long-term (longer than one year) rates.Current Status: Rates of 15% to 20% + 3.8% surtax on net investment incomeLatest Proposal: Top rate of 25% + 3.8% surtax on net investment income for tax year 2022Effective Date: Transactions occurring after September 13, 2021, would be subject to new rates. Transactions occurring prior to September 13, 2021 would be subject to current rates.Valuation Impact: Most business valuations do not calculate or consider the net amount received after a sale or disposition of the company or asset because the premise of these valuations is a going concern. However, we know business owners are definitely interested in the proceeds that ultimately hit their bank account.Who Should Consider: Auto dealers that are contemplating whether to sell their dealership or continue to hold and operate should consider this potential rate increase. Dealers are currently experiencing record profits but also face challenges with the inventory shortages caused by suspended manufacturing from the pandemic and the microchip shortage. While it can be hard to let go when profits are rolling in, there are long term concerns surrounding the increasing capital costs of developing and maintaining digital platforms to compete with the public auto groups and larger private groups. Many dealers are choosing to sell, as evidenced by the current white hot auto dealer M&A market. If the BBB Act passes, auto dealers that sell in 2022 can expect fewer after-tax dollars from a sale or disposition due to higher capital gains tax rates, all other things being equal.Valuation Discounts for Passive AssetsBusiness valuations of auto dealerships, real estate holding companies, and related businesses typically consist of determining the value of the entire business, as well as the value of a particular interest in the business. Often the subject interest comprises less than 100% of the total business and exhibits elements of lack of control and marketability. As such, discounts for lack of control, lack of marketability, and lack of voting rights are often applicable and determined to reduce the fair market value of the overall pro rata value of the subject interest.Current Status: Valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.Latest Proposal: The current version of the BBB Act proposes to eliminate valuation discounts for an entity’s “non-business,” or passive, assets. The BBB Act defines “non-business” or passive assets as cash, marketable securities, equity in another entity, real estate, etc. Further, passive assets are those assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. Passive assets which are held as part of the reasonably required working capital of a trade or business are also excluded. Real property is excluded from this rule if real property assets are used in the active conduct of real property trade or business in which the transferor actively and materially participates. Examples include real property used for rental, operation, and management, among others.Effective Date: January 1, 2022Valuation Impact: In a world where combined discounts for lack of control and marketability can range from 25-45%, this is a material impact. Passage of this piece of the legislation in its current form may not have a dramatic impact on the business valuation of dealership operations, which would still be subject to discounts. However, many auto dealerships carry excess cash or working capital in order to smoothly run operations or provide cushions in down periods. If the BBB Act were to interpret that all cash or working capital exceeds the “guide” figure on the dealer financial statement, this could inflate both the total value of the business as well as the portion attributable to passive assets, which would not be subject to discounts. Many auto dealers currently hold heightened levels of cash and marketable securities as a result of increased profitability and retainage of any PPP funds and loan forgiveness. Many of our auto dealer clients also own the operating real estate for the dealership in a separate asset holding company. These proposed rules could also jeopardize the applicable discounts for lack of control and marketability in those entities for any marketable securities or “non-business” or passive assets.Who Should Consider: If these discounts are eliminated for “non-business” or passive assets, auto dealers owning both types of entities, operating dealerships and real estate holding companies, should consider implementing and executing estate planning strategies. If all the discounts (not likely) or the discounts on “non-business” or passive assets are eliminated, the resulting business valuation of a subject interest in either of these types of entities will be dramatically higher. In turn, the overall values of the estates of auto dealers or the net value of transfers could be greatly increased for transfer tax purposes.ConclusionsJust as death and taxes are the only certain things in life, another relevant adage is that change is inevitable. As the BBB Act and proposals from the House Ways and Means Committee start to evolve, there are numerous tax and estate planning implications.While the final version of the Act will look almost certainly different than the current proposals for each provision, changes to existing rates and policies are anticipated. Fall 2021 is shaping up to be a busy estate planning season.Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equal. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.
Fairness Opinions - Evaluating a Buyer’s Shares from the Seller’s Perspective
Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.Click here to expand the image aboveThe rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Tangible BVPS Earn-Back - As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Capital and the Parent Capital Stack - Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.Loan Portfolio Concentrations - Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.Ability to Raise Cash to Close -What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.
Three Considerations Before You Sell Your Business
After spending years, if not decades, building your business through hard work, determination, and a little luck, what happens when you are ready to monetize your efforts by selling part or all of your business? Exiting the business you built from the ground up is often a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. However, long before your eventual exit, you should begin planning for the day you will leave the business you built.We suggest you consider these three things.1. Have a Reasonable Expectation of ValueMany business owners have difficulty taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods to develop a reasonable purchase price. An acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on an assessment of the underlying risk and growth factors of the subject company.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process should enhance a buyer’s understanding of the cash flows and corresponding returns that result from purchasing or investing in a firm. For sellers or prospective sellers, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Consider the Tax Implications When analyzing the net proceeds from a transaction, you must consider the potential tax implications. From simple concepts such as ordinary income vs. capital gains and asset sales vs. stock sales, to more nuanced concepts such as depreciation recapture and purchase price allocation, there are almost unlimited issues that can come up related to the taxation of transaction proceeds. The structure of your own corporate entity (C Corporation vs. tax-pass through entity) may have a material impact on the level of taxes owed from a potential transaction.We recommend consulting with your outside accountant (or hiring a tax attorney) early in the process of investigating a transaction. Only a tax specialist can provide the detailed advice that is needed regarding the tax implications of different transaction structures. There could be strategies that can be implemented well in advance of a transaction to better position your business or business interest for an eventual transaction.3. Have a Real Reason to Sell Your BusinessStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your Company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.The process of selling a business is typically one of the most important, and potentially complex, events in an individual’s life. Important decisions such as this are best made after a thorough consideration of the entire situation. Early planning can often be the difference between an efficient, controlled sales process and a rushed, chaotic process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have assisted hundreds of companies with planning and executing potential transactions since Mercer Capital was founded in 1982. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our dedicated and responsive team is available to advise you through a transaction process, from initial planning and investigation through eventual execution. To discuss your situation in confidence, give us a call.
Bakken Recovery Falters
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 4% year-over-year through September. Production in the Permian and Appalachia increased 10% and 3% year-over-year, respectively, while the Eagle Ford’s production declined 2%. While production in the Bakken rebounded sharply once wells were brought back online aftercurtailments in mid-2020, it has generally trended lower during 2021. Production in the Eagle Ford and Permian was meaningfully impacted in February 2021, driven by Winter Storm Uri that disrupted power supplies throughout Texas.
As of September 17th, there were 23 rigs in the Bakken up 156% from September 11, 2020. Eagle Ford, Permian, and Appalachia rig counts were up 300%, 109%, and 34%, respectively, over the same period.
One may wonder why Bakken production has been on the decline given substantial rig count growth, while Permian production has continued to increase despite a more moderate increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration, the Bakken needs roughly 19 rigs running to offset existing production declines. That number for the Permian is approximately 200 rigs. The Bakken’s rig count only recently broke above that maintenance level of drilling, whereas the Permian has had over 200 active drilling rigs since February 2021. Current activity in the Bakken should stem the recent production declines, but growth will likely be modest without additional rigs.
Oil Stabilizes while Natural Gas SoarsAfter a significant run-up in the first two quarters of the year, oil prices were largely range-bound during the third quarter of 2021, with front-month futures prices for West Texas Intermediate (WTI) generally oscillating between $65/bbl and $75/bbl. Rising COVID-19 cases in the U.S. caused the Delta variant to put a damper on travel activity and associated fuel consumption. However, producers seem to be maintaining their capital discipline even in light of higher prices, which is limiting production growth. Henry Hub natural gas front-month futures prices began the quarter at approximately $3.63/mmbtu but broke above $5.00/mmbtu in September. The current run-up in natural gas prices has some concerned about what the winter may hold, when prices generally increase due to heating demand. In Europe, declining coal capacity and less-than-expected wind generation from North Sea wind turbines have contributed to surging natural gas prices, and the situation is beginning to impact industrial production.
However, the current commodity price environment may be short-lived. Commodity futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated in their September 2021 Short-term Energy Outlookthat “growth in production from OPEC+, U.S. tight oil, and other non-OPEC countries will outpace slowing growth in global oil consumption” and would likely lead to lower oil prices.
Financial PerformanceThe Bakken public comp group saw strong stock price performance over the past year (through September 20th), with all constituents outperforming the broader E&P sector (as proxied by XOP). Continental and Whiting prices increased 175% and 151% year-over-year, compared to the XOP’s increase of 78%. Oasis, which emerged from bankruptcy in November 2020, is up 191% from its initial closing price post-bankruptcy. However, this impressive stock price performance is probably more reflective of the dire straits of these companies last year. Both Whiting and Oasis declared bankruptcy in 2020 and appear to have benefited from a cleaned-up capital structure.Keystone XL Finally CancelledThe Keystone XL pipeline, originally proposed in 2008, was finally cancelled by its developer, Canadian midstream company TC Energy. President Biden revoked a key permit needed for the project on his first day in office.The proposed pipeline caused significant controversy during its planning stages as it provided takeaway capacity for production from Alberta oil sands (which is more energy intensive, and thus less sustainable, than other forms of hydrocarbon extraction) and its path through Nebraska’s environmentally sensitive Sandhills region and Ogallala Aquifer. Keystone XL also would have provided additional pipeline capacity out of the Bakken, which could become very needed if the also-controversial Dakota Access Pipeline gets shutdown.ConclusionWhile the Bakken saw strong production increases in the wake of mid-2020’s commodity price rout, that recovery appears to have faltered in 2021. Production has generally been on the decline this year, though the recent increase in rigs operating in the basin should stem this decrease and provide for modest production growth going forward. However, companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Tax Changes Remain Murky: A(nother) Tax Update
Estragon: Let's go! Vladimir: We can't. Estragon: Why not? Vladimir: We're waiting for Godot. Estragon: (despairingly) Ah!Waiting for Godot, Act I- Samuel BeckettYes, “Ah!”. Tax watchers seem to have been unsuspectingly cast in Samuel Beckett’s famous existential and absurdist play, leaving many waiting and waiting. We have waited alongside many tax professionals and family business advisors, writing about the prospect of tax changes here, here, and here among other places throughout the year.However, in what could only be described as excitement similar to Christmas morning, many rushed to tear open the U.S. House Ways and Means markup of the $3.5 trillion reconciliation bill. There were definitely surprises both big and small, and below we summarize some of the major pieces that you and your family board need to keep an especially close eye on as Godot finally approaches.Summary ChangesBKDprovides a good summary of the House’s Tax bill changes for both corporations and individuals. While the write-up goes into more details, the changes we are watching most closely include:Increases the top rate C Corp tax rate to 26.5% from 21% for corporations with incomes of $5 million while reducing the rate to 18% for corporations with incomes less than $400,000 (corporations with income from $400,000 to $5 million would remain at 21%).Increases the top capital gains rate to 31.8% (25% statutory rate + 3.8% NIIT + 3% percent surtax). This proposal is lower than the 43.4% top capital gains rate proposed by the president for those with adjusted gross incomes exceeding $1 million ($500,000 married filing separately). The proposed effective date for a 25% capital gain rate is September 13, 2021.Cuts the estate and gift tax lifetime exemption from the current inflation adjusted $10 million per person ($11.7 million in 2021) to an inflation adjusted $5 million. The proposed change would apply to estates of decedents dying and gifts made after December 31, 2021.
Numerous other changes, including limitations on Roth IRA rollovers, creating a 3% surtax on individuals at certain income thresholds, and a host of other changes exist in the reconciliation bill and are being hashed out in Congress currently.Estate and Gift TaxesThe National Law Reviewdiscussed specifics of the reduction in the gift and estate tax exemption available to family businesses. In addition to the reduction of the exemption by 50% beginning January 1, 2022, current legislation is also targeting other estate planning tools. WealthManagement.com highlights a bevy of changes to current trust treatments as well as valuation discounts on gifts of specific entities.Some Dodged BulletsRandall Forsyth at Barron’s summarized some areas where the current iterations of the tax plan diverged from the original White House proposals. The top capital gains rate is expected to be well below the top individual rate as discussed previously. Additionally, the proposed elimination of the step-up in cost basis for estates, an area of concern for many multi-generation family businesses, did not make the House’s language. The $10,000 ceiling on state and local tax deductions was unchanged, which ruffled the feathers of Congressmen from high-tax states.Something Is Rotten in the State of DenmarkSimilar to Shakespeare’s Hamlet, something is in fact “rotten” in the Democrat’s respective Senate and House caucuses. Some obvious defections are highlighted below:Senator Joe Manchin (D-WV), the nation’s most watched Senator, penned an op-ed highlighting his concerns with the current $3.5 trillion reconciliation bill. Senator Manchin has called for a more modest proposal and highlighted hesitation to numerous new taxes.Senator Krysten Sinema (D-AZ), as well as moderate House Democrats, are sharing their own reservations as well as a desire to vote on the bi-partisan infrastructure bill first.The Hill highlighted opening issues on the more progressive side as well, with Senator Bernie Sanders (I-VT) and Rep. Pramila Jayapal (D-WA) arguing the bill must stand at $3.5 trillion, which they view as a compromise from their initial $6 trillion goal.
We mention these political developments only to highlight one thing: the final bill is going to look different.ConclusionDissimilar to Godot, the budget bill will, in fact, arrive in the next few weeks. Family business directors can prepare themselves and their businesses by checking in with their estate attorneys and financial advisors regarding their estate plans.We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.
Valuations for Gift & Estate Tax Planning
Managing Complicated Multi-Tiered Entity Valuation EngagementsWhen equity markets fell in early 2020 due to the onset of the COVID-19 global pandemic, many business owners and tax planners contemplated whether it was an opportune time to engage in significant ownership transfers.Although equity markets have recovered to all-time highs, a confluence of three factors may make 2021 an ideal time for estate planning transactions for owners of private companies:Depressed Valuations. Valuations for many privately held businesses remain somewhat depressed due to significant supply chain challenges and hiring difficulties.Low Interest Rates.Applicable federal rates (AFRs) are at historically low levels, allowing business owners to make leveraged estate planning strategies more efficient.Political Risk.The Biden administration’s proposal to lower the gift and estate tax exemption andincrease the capital gains tax rate may prompt some individuals and businesses to take advantage of currently favorable tax conditions before any adverse changes are made.Mercer Capital has been performing valuations for complicated tax engagements since its inception in 1982.For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance.In this article, we describe the processes that lead to credible and timely valuation reports.These processes contribute to smoother engagements and better outcomes for clients.Defining the EngagementDefining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved, it becomes critical.It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure.The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued.This allows the appraiser to plan the underlying due diligence and analytical framework to design the deliverable work product.For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure?Or, can certain entities or underlying assets be valued using a consolidated analytical framework?Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.Collecting the Necessary InformationDuring the initial discussion of the engagement, the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations, and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion.Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.Information Needed for Complex Multi-Tiered Entity ValuationRequested information for complex multi-tiered entity valuations typically falls into three
broad categories:Legal documentation. The legal structure and inter-relationships in complex assignments are essential to deriving reliable valuation conclusions.In addition to the operating agreements, it is important to have current shareholder/member lists.A graphical organization chart is often a very helpful supplement to the legal documents and helps ensure that everyone really is “on the same page” regarding the objectives of the valuation assignment.Financial statements. A careful review of the historical financial statements for each entity in the overall structure provides essential context for the cash flow projections, growth outlook, and risk assessment that are the basic building blocks for any valuation assignment. Depending on ownership characteristics and business attributes, it may be appropriate to combine financial statements for multiple entities to promote efficiency in project execution.Supplementary information.For operating businesses, supplementary information may include financial projections, detailed revenue and margin data (by customer, product, region or some other basis), personnel information, and/or information pertaining to the competitive environment.For asset-holding entities, supplementary data may include current appraisals of real estate or other illiquid underlying assets, brokerage statements, and the like.The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.In short, providing high quality information in response to the appraiser’s request list promotes a more predicable outcome with the IRS and with other stakeholders.The Importance of Reviewing the Draft AppraisalUpon completing research, due diligence interviews with appropriate parties, and the valuation analysis, the appraiser should provide a draft appraisal report for review.The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report.The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy.Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require complex valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.Click here to expand the checklist above
Four "To Dos" Before You Sell Your Investment Management Firm
Considerations for Every RIA Owner
Selling the business you built from the ground up is a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. While this delay may only prove mildly detrimental to deal proceeds in other industries, in the investment management space, there are very few buyers who will be interested in YOUR business without YOU (at least for a little while).Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four:1. Have a Reasonable Expectation of ValueTaking an objective view of the value of your company is difficult. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many investment managers have spent most of their adult lives nurturing client relationships, growing their client base, and developing talent at their firm. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers use various methods of developing a reasonable purchase price. Most commonly, an acquirer will utilize historical performance data, along with expectations for future cash flow to generate a reasonable estimate of run-rate EBITDA, and an appropriate multiple that considers the underlying risk and growth factors of the subject company.With the recent run-up in RIA multiples observed, and the even faster run-up in headline multiples, setting reasonable pricing expectations given your firm’s specific risks and opportunities is an increasingly important step in preparing for a transaction.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process can enhance a seller’s understanding of how a buyer will perceive the cash flows and corresponding returns that result from purchasing or investing in a firm. Additionally, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Have a Real Reason To Sell Your BusinessStrategy is often discussed as something that belongs exclusively to buyers in a transaction, but this isn’t always the case.Without a strategy, sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization to reduce the day-to-day headache of running a business, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future cash flow for a check today. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.3. Get Your Books in Order Today To Maximize Proceeds TomorrowAs Zach Milam, mentioned last week, in his post on bridging valuation gaps between RIA buyers and sellers, the best time to address a potential buyer’s concerns about your firm is before you start the process.In advance of transactions, sellers should consider an outsider’s perspective on their firm and take action to address the perceived risk factors that lower value. For example, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.4. Consider the Tax ImplicationsWhen considering the potential proceeds from a transaction, you should contemplate the tax implications. A large number of RIAs are S-corporations and C-corporations, which is no longer the preferred structure as they constrain a company’s ability to easily grow and transfer equity. We recommend consulting with a tax attorney prior to a transaction on the tax implication of different transaction structures. Before selling your business, you should also be aware of the pros and cons of a stock versus an asset sale as well as an all cash transaction versus a combination of cash and stock consideration.How Can We Help?At Mercer Capital, we routinely perform valuations and financial analysis for buy-sell agreements and internal transactions as well as offer fairness opinions for proposed transactions. We can help you better understand the potential risks to your business model and the opportunities for growth, as well as help you establish reasonable pricing expectations so that when you are ready to sell, the process is more seamless.
Public Auto Dealer Profiles: Sonic Automotive
As we discussed in the first installment of this blog series, there are six primary publicly traded companies that own approximately 923 new vehicle franchised dealerships as of Q2 2021, or 5.6% of the total number of dealerships in the U.S. (16,623 at year-end 2020 per NADA). This demonstrates how fragmented the industry continues to be, despite recent consolidation.The total number of dealerships has remained largely the same, though the number of dealers is dwindling as big shifts towards e-commerce accelerated by the pandemic require heavier investment for smaller operations to compete.This issue of consolidation is not limited to just mom and pop stores.According to the Wall Street Journal, Suburban Collection of Michigan sold to Lithia this year in part due to the need for outside capital. David Fischer Jr. and his father sought a strategic partner to update their business to the new digital retailing environment despite having 56 franchises across 34 stores. In 2020, Suburban Collection was the 21st ranked auto group in terms of size, retailing just under 30 thousand new vehicle units.Given current blue sky values, the size of the deal and Lithia’s aggressive acquisition strategy, we realize premium pricing may have ultimately won the day in the Fischers’ decision to divest. Still, for an auto group of that size to be seeking a minority partner, prior to eventually being acquired, is noteworthy. We’ve also heard concerns from our clients that the potential for rising taxes and tweaks to the supply chain (with OEMs considering a model that reduces the autonomy of dealers) could lead to further consolidation.Our goal with these posts is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit in benchmarking to public auto dealers. Smaller or single point franchises may find better peers in the average information reported in NADA’s dealership financial profiles or more regional 20 Group reports. Public auto dealers also give dealers insight to how the market prices their earnings, the environment for M&A, and trends in the industry.Sonic Automotive Locations and BrandsBased in Charlotte, North Carolina, Sonic has 84 franchised dealerships, the lowest of any publicly traded company that operates principally as a new vehicle dealer. As seen below, the company earned over 50% of its revenue in Texas and California, with another 30% of 2020 revenue coming from Colorado, Tennessee, Florida, and Alabama. By year-end 2021, the company projects 25% population coverage.
While the company is smaller and relatively concentrated in terms of its footprint compared to its public peers, Sonic is targeting 90% population coverage by 2025 (see projection below in recent investor materials). This growth will largely come from its EchoPark segment comprised of physical locations selling pre-owned “nearly new” vehicles with many having remaining OEM warranty.
According to the Automotive News Top 150, Sonic sold the seventh most new retail units in 2020, at just over 93 thousand, trailing the other public dealers and Hendrick Automotive Group, the largest private auto group, also based in Charlotte.
As seen in the table below, 55% of Sonic’s 2020 revenues came from Luxury brands, particularly BMW and Mercedes. This is more than double the company’s combined sales from domestic (10%) and EchoPark (15%), which are assumed to target a lower price point. Assuming continued growth in EchoPark, Sonic appears to be targeting consumers at various income levels which should provide balance in any market environment.
Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. Sonic’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume based incentive fees, operating income can be negative for dealers before accounting for these profits.Due to differences in reporting, Sonic captures other income along with F&I as a revenue item with no corresponding cost of sales line item. The minimal amount of reported other income/expense not included as revenue if added to gross profit, would not change its reported gross margin of 14.85% by one basis point.Interestingly, its gross margin through the first half of 2021 was down immaterially from 14.89% in 2020. This comes despite industry-wide improvement in gross margins and a pickup in margin for new vehicles, whole vehicles, and parts, service and collision operations. That means Sonic has been negatively impacted by its declining margins on used vehicles (2.8% compared to 3.6%) and/or the contribution of gross profit (relatively less high margin fixed operations and/or more used vehicles).While EchoPark likely explains this, it is interesting to contrast to the average dealership as reported by NADA which saw gross margin improve from 11.8% to 13.4% in the first half of 2021. While this appears lower than the figures reported by Sonic, we note the difference between operating profit and pre-tax profits (largely aforementioned back-end profits) was 2.3% of revenues, which added to gross margin, would be 15.7%.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on Sonic Automotive. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Sonic’s Blue Sky value per share is approximately $35.19.Given recent outperformance, Haig Partners prescribes a 3-year average be taken in determining ongoing pre-tax income (2018, 2019, and LTM June 30, 2021). Using this methodology and applying the 25% tax rate implied by Sonic’s financials, its ongoing pre-tax earnings per share would be $4.97 or just over 7.0x Blue Sky.
While this is lower than all of its public counterparts besides Group 1 Automotive, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential as well as its tilt towards luxury brands.
ConclusionAt first glance, Sonic may appear to be a close comparable for private auto groups. Unlike other public auto dealers, it does not have other business lines (Penske) or international operations (Group 1). It’s not rapidly acquiring other dealerships (Lithia) and its franchised dealership count is about a third of AutoNation. However, like Asbury, it is tilted towards luxury with very little domestic sales, and still has significantly more dealerships than most groups.Sonic also has meaningful used-only operations in EchoPark, which is where the company is allocating much of its capital. Geographic diversification and access to capital markets can also materially impact comparisons, particularly for smaller dealerships. Still, management commentary on the macro environment in the auto dealer space is valuable and appropriate benchmarking comparisons are still possible if you know what you’re looking for.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers, gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
Bakken M&A
Transaction Volume and Deal Size Rebound in 2021
Over the last year, deal activity in the Bakken has been steadily increasing after a challenging 2020. Eight of the nine deals referenced below occurred in the last eight months as the price environment has turned more favorable. As the industry seems optimistic that the worst of COVID-19 is behind us, deal activity may continue to increase into next year, but there is always hesitation, especially with the Delta variant on the rise.Recent Transactions in the BakkenA table detailing E&P transaction activity in the Bakken over the last twelve months is shown below. Relative to 2019-2020, deal count was unchanged, but median deal size increased by roughly $480 million, which was lead by the $5.6 billion Devon-WPX transaction.Click here to expand the chart aboveOasis Adds Strategic Acreage in Core AreaOn May 3, 2021, Oasis Petroleum announced that it entered a definitive agreement to acquire select Williston Basin assets from Diamondback Energy in a cash transaction valued at approximately $745 million. The effective date of the acquisition will be April 1, 2021, and the deal has yet to officially close. The purchase consideration is expected to be financed by cash, revolver borrowings, and a bridge loan. Transaction highlights include:Production (2021 Q1) – 27 Mboe/dAcreage – 95,000 net acres in Dunn, McLean, McKenzie counties, ND200 drilling locationsProved Reserves - 80.2 mmboe
A pro forma table of the transaction is shown below:
Diamondback has built a reputation of being focused on the Permian Basin, but in late 2020, the company acquired QEP Resources which gave them exposure to Williston acreage. It took them roughly six months to sell their Bakken acreage package to Oasis, returning them to their pure-play Permian status.
Equinor Lets Go of Its Bakken PositionOn February 10, 2021, Equinor announced that it was selling its Bakken asset portfolio to Grayson Mill Energy for $900 million. Grayson Mill Energy is a Houston-based exploration and production company backed by Encap Investments, a private equity firm that has raised over $38 billion of capital. An exit from the Bakken, which Equinor entered in 2011 by acquiring Brigham Exploration Company for $4.7 billion, follows the sale of its operated assets in the Eagle Ford for $325 million to Repsol in November 2019. The deal closed on April 27, 2021 and included the following:242,000 net acres, and associated midstream assets48,000 Boep/d as of Q4 2020
In parallel with the transaction, Equinor Marketing and Trading entered into a term purchase agreement for crude offtake with Grayson Mill Energy. Al Cook, Equinor’s executive vice president of Development & Production, referenced that the company is focused on improving the profitability of its international portfolio.ConclusionM&A transaction activity in the Bakken was steady through year-to-date 2021 and consisted of notable strategic acquisitions and exits in the basin. Deal activity in the Bakken will be important to monitor as companies shift their focus to other basins and are forced to prioritize other initiatives.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Selling Your RIA? Four Ways to Bridge the Valuation Gap
Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.1. EarnoutEarnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.2. Staged TransactionIf an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.3. Deal FinancingBeyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.4. Mitigate Risk Factors Before You SellSellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.
How Are Business Valuations Prepared?
For family businesses that have never had an external valuation, there is likely to be some confusion as to what the process involves. In this post, we give a brief walk-through of the valuation process, from engagement through to issuance of the final report.EngagementThe first step in the valuation process is preparing and executing an engagement letter. The engagement letter should clearly define several key components of the valuation, including:The subject interest to be valued (i.e., XX shares of XYZ Corporation, Inc.) - There needs to be absolute clarity on what will be valued. It is not uncommon for enterprising families to develop a rather elaborate structure of holding companies and operating businesses, and the engagement letter should clearly state what is being valued.The "as of" date for the appraisal - Any valuation conclusion pertains to a specific subject interest as of a specific date. Markets change, and the value of a family business is not static across time. For most engagements, the valuation report is issued after the "as of" date. In other words, there is nearly always some lag between the effective date for the conclusion and when that conclusion is rendered.The level of value for the conclusion - As we discuss at greater length in the following section of this whitepaper, family businesses have more than one value at any particular date, so the engagement letter should specify which level(s) of value are relevant for the valuation.The standard of value and purpose of the engagement - The engagement letter should indicate how the valuation is expected to be used and what the corresponding standard of value is.Fees - Most valuation engagements can be performed for a fixed fee. Occasionally, the scope of an engagement is sufficiently open-ended that the parties agree to calculate fees on an hourly basis. In either case, the engagement letter should spell out how fees will be calculated and when billings will occur.
Prospective clients naturally want to know how much a valuation will cost. Unfortunately, the answer to that question is that it depends on the complexity of the assignment. Most valuation professionals will ask to review a family business’s financial statements to help in preparing a fee quote. This allows the valuation professional to gauge the complexity of the analysis that will be required.
Valuation fees are ultimately a product of the estimated time required to complete the engagement and a targeted effective billing rate. Effective billing rate is a function of project complexity and the ability of the firm to leverage staff resources effectively to complete the valuation engagement efficiently. When comparing fee quotes, family businesses should keep this in mind. When presented with widely diverging fee quotes, one should ask if there are underlying differences in scope expectations or perceived complexity that need to be clarified.Data CollectionValuation is a data-intensive process. Concurrent with the engagement letter, most valuation firms will provide a preliminary information request. While potentially voluminous, the requested items are often ready to hand for family businesses, and include historical financial statements, financial projections, data on the assembled workforce, customer relationships, market segments, and product lines. In addition, clients often have access to industry-wide performance measures that are not readily available to those outside the industry. In short, the valuation professional will seek to collect the same sorts of data on the subject company that a potential investor would.DiligenceUpon receipt of the requested information, the valuation firm will perform diligence procedures, including relevant economic and industry research and analysis of the subject company’s historical and projected financial performance. The diligence phase of the engagement culminates in an interview with senior management of the family business. The purpose of the management interview is to help the valuation professionals identify and articulate the underlying narrative of the company: what makes this family business tick, and why is it valuable?AnalysisThe heart of the process is the application of valuation methods under the asset-based, income, and market approaches. Each approach seeks to answer the valuation question from a unique perspective.What are the current market values of the business’s assets and liabilities? This is the key question underlying the asset-based approach. It may involve assessing whether there are assets or liabilities that do not appear on the company’s balance sheet and evaluating whether there are assets having current market value different from that recorded on the balance sheet (such as real estate that has been owned for decades).What are the expected future cash flows of the family business, and how risky are those cash flows? This is the income approach to valuation, and it involves a careful analysis of the historical earnings of the family business, as adjusted for unusual or nonrecurring items, and the outlook for the economy, relevant industry, and the family business itself.What can be inferred about the value of the family business from transactions in reasonably similar businesses? This is the essence of the market approach, and it involves searching for and analyzing comparable public companies and/or transactions involving comparable private companies.
In applying these methods, the valuation professional seeks to develop reasonable inputs and consider prevailing market conditions at the “as of” date for the valuation.Draft Report ReviewConcurrent with performing the analysis, the valuation firm will prepare a draft valuation report which describes the company, relevant industry and economic trends, valuation methods applied, and inputs used. The client should have an opportunity to read this document in draft form. This draft review is a critical step in the valuation process, helping to ensure there have not been any misunderstandings or miscommunications that would undermine the credibility of the conclusions in the valuation report.Clients should read the draft report carefully to assess whether the valuation firm developed a balanced and informed view of the industry and the company. Clients should be able to recognize their company in the valuation report. If they don’t, the draft review process should allow them to discuss those concerns with the valuation analyst.Issuance of Final ReportOnce the draft review process is concluded, the valuation firm will issue a final report. The final report should include the attributes of the engagement from the engagement letter and a clear description of who is entitled to use the report and for what purpose.BillingBilling practices vary and should be detailed in the engagement letter. Many valuation firms request a retainer at the beginning of the engagement and invoice for the remainder of the professional fee at the end of the engagement, either upon completion of the draft report or issuance of the final report.TimelineIn the normal course, family business leaders should anticipate that the valuation process described in this section should take six to eight weeks to complete. Most valuation firms are able to adjust as needed to accommodate reasonable deadline requests so long as they are communicated to the valuation firm during the engagement process. Prompt responses to information requests and follow-up questions help to keep the valuation process on track. Regular communication between the client and the valuation firm is the most important factor in meeting deadlines for project completion.ConclusionMercer Capital has worked with hundreds of family businesses over the last 40 years. If you think your family business needs a valuation but don’t know where to start, give one of our professionals a call, we’d be happy to help discuss your needs today.This week's post is an excerpt from section 2 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.
Cash-Out Transactions and SEC Amended Rule 15c2-11
It may seem an odd time for some publicly traded companies to consider cash-out merger transactions because broad equity market indices are at or near record levels. Nonetheless, the changing market structure means some boards may want to consider it.Among a small subset of public companies that may are those that are traded on OTC Markets Group’s Pink Open Market (“Pink”), the lowest of three tiers behind OTCQB Venture Market and OTCQX Best Market. Pink is the successor to the “pink sheets” which was published by a quotation firm that was purchased by investors who rechristened the firm OTC Markets Group.Today, OTC Markets Group is an important operator in U.S. capital markets because it facilitates capital flows for 11,000 US and global securities that range from micro-cap and small-cap issuers across all major industries to ADRs of foreign large cap conglomerates. Many issuers are SEC registrants, too.The issue that may cause some boards of companies traded on Pink to contemplate a cash-out merger or other transaction to reduce the number of shareholders is an amendment by the SEC to Rule 15c2-11, which governs the publication of OTC quotes and was last amended in 1991. Since then, markets and the public participation in markets have increased significantly as trading costs have declined and information has become more widely disseminated. The amendment applies only to Pink listed companies because those traded on OTCQB and OTCQX already meet the new requirements.Because of a quirk in how the rule was written in conjunction with a “piggyback exception” for dealers, financial information for some Pink issuers is not publicly available. The amended rule, which goes into effect September 28, 2021, prohibits dealers from publishing quotes for companies that do not provide current information including balance sheets, income statements and retained earnings statements. OTC Markets Group requires companies to comply with the rule through posting information to the issuer’s publicly available landing page that it maintains.While the disclosure requirement presumably is not burdensome, not all companies want to disclose such information, especially to competitors. Companies that choose not to comply with amended Rule 15c2-11 will no longer be eligible for quotation. Because shareholders of these companies historically have had the option to obtain liquidity, boards may want to evaluate an offer to repurchase shares or a cash-out merger transaction that reduces the number of shareholders.1Also, some micro-cap and small-cap companies whether traded on an OTC market or a national exchange may not obtain as many advantages compared to a decade or so ago.Given the rise of passive investing in which upwards of 50% of US equities are now held in a passively managed fund, companies that are not included in a major index such as the S&P 500, Russell 1000, NASDAQ or Russell 2000 are at a disadvantage given the amount of capital that now flows into passive funds. In some instances, it may make sense for these companies to go private, too.Cash-out transactions can be particularly attractive for companies that have a high number of shareholders in which a small number of shareholders have substantial ownership. Cash-out merger transactions require significant planning with help from appropriate financial and legal advisors. The link here provides an overview of valuation and fairness issues to consider in going private and cash-out transactions for companies whether privately or publicly held.Mercer Capital is a national valuation and financial advisory firm that works with companies, financial institutions, private equity and credit sponsors, high net worth individuals, benefit plan trustees, and government agencies to value illiquid securities and to provide financial advisory services related to M&A, divestitures, capital raises, buy-backs and other significant corporate transactions.1 Cash-out merger transactions are also referred to as freeze-out mergers or squeeze-out mergers in shareholders owning fewer than a set number of shares receive cash for their shares while those holding more than the threshold amount will be continuing shareholders.
Fairness Considerations in Going Private and Other Squeeze-Out Transactions
Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.Pros and Cons of Going PrivateStructuring a TransactionValuation AnalysisFairness Considerations
Not Every RIA Buyer Is a Control Freak
Despite Conventional Wisdom, Some Investors Prefer Minority Positions
Ideally, our work with investment management firms at Mercer Capital distills both conventional valuation principles and real-world industry experience. These two influences typically align; valuation theory develops to represent the thinking of actual transacting parties, and – in turn – transaction behavior validates theory.Sometimes, though, we witness rational actors engaging in transactions that challenge certain norms of professional thinking. At such times, we ask ourselves whether valuation theory, as we know it, is doctrine or dogma.The pricing of minority transactions in the RIA space leaves some people scratching their head. Traditional valuation theory holds that investors pay less for minority interests than controlling interests. Reality suggests otherwise. Some established institutional buyers of minority interests in RIAs invest at similar, or even higher, multiples to what other consolidators will pay for controlling interests. Some institutional buyers even prefer taking minority stakes in investment management firms – not a circumstance we see much from the private equity community. Even insider transactions don’t always follow valuation maxims, as valuations for succession are colored by considerations far beyond the sterile realm of hypothetical buyers and sellers. It seems to some that the RIA community has turned valuation theory on its head, but the truth is more nuanced.Valuation Vacuum WonkeryConventional wisdom holds that minority interests in closely held companies are worth less than their pro rata stake in the enterprise. A 15% interest in a business that would sell for $10 million is widely believed by valuation practitioners to be worth something less than the $1.5 million that its pro rata stake in the enterprise would otherwise command. The difference between value inherent in controlling interests and minority interests can be illustrated by way of a diagram known as a levels of value chart.
The value of an enterprise can be described as the present value of distributable cash flow – and this parameter is useful for thinking about the different perspectives of control and minority investors.
A control level investor effectively has direct access to enterprise level cash flows, with unilateral influence over operations, the ability to buy, sell or merge the enterprise, pay distributions, and set compensation policy. Absent special considerations, a control investor can achieve the greatest benefit, and therefore pay (or expect to be paid) the highest price for an enterprise.
Most reported transactions in the RIA channel are made on this basis, and M&A multiples reported publicly, or whispered privately, reflect change of control valuations.
Minority investors lack two important prerogatives of control: influence and liquidity.Minority investors lack two important prerogatives of control: influence and liquidity. Discounts for lack of control – also known as minority interest discounts – reflect the inability of minority interest holders to direct the enterprise for their own benefit. The marketable, minority interest level of value is analogous to an interest in a publicly traded company, wherein investors can access the present value of distributable cash flow by way of an open market transaction but have no particular sway over a company’s strategy or operations.Discounts for lack of marketability (a.k.a. marketability discounts) capture the lack of access to enterprise cash flows via distributions or a ready and organized market to sell the interest. The nonmarketable, minority interest level of value is what most valuation practitioners think of when they think of minority interests in closely held enterprises: a value which is materially distinct from a pro rata controlling interest.Internal Transactions Challenge Valuation TheoryReal world economics of minority transactions in RIAs can look very different than our professional discipline would suggest, reflecting issues unique both to the industry and to the universe of typical investors in the industry.Much of the reason that RIA transactions don’t always conform to traditional valuation pedagogy is the nature of the investment management model itself. The theory behind the levels of value is intended to represent the perspective of hypothetical disinterested investors. In a world of financial buyers who can choose freely between alternative instruments, this idea holds.But most RIA investors are insiders, practitioners who work at the investment management firms. The lines between returns to labor and returns to capital are often blurred (although we strongly advise structuring your model otherwise). Insiders have different motivations to show loyalty to their employer, and in turn firms often bestow ownership on staff on favorable terms because of the labor-intensive, relationship-based nature of investment management.Insider ownership is often managed by buy-sell agreements, which at the same time restrict owners from certain actions but also provide them with access to liquidity (under specified circumstances) and a claim on returns. Buy-sell agreements often establish particular parameters for valuation as a way to side-step valuation theory to benefit the ownership and the business model of the particular RIA. Valuation theory operates in a ceteris paribus (all else equal) universe, whereas buy-sell agreements do not operate in this vacuum.Valuation theory operates in an all else equal universe, whereas buy-sell agreements do not.Finally, the issue of discounts for lack of marketability – that minority investors suffer from lack of ready access to enterprise level cash flows – is a byproduct of focus on old economy, heavy industry businesses structured as C-corporations in which dividend policy can be parsimonious. Most RIAs are structured as tax pass-through enterprises (LLCs or S-corporations) and don’t rely on heavy amounts of capital reinvestment. High payout ratios (often nearing 100%) mean minority investors do, in fact, typically enjoy regular returns from enterprise cash flows. Consequently, discounts for lack of marketability are usually smaller for investment management firms than for minority investments in many other industries.Institutional Investors Make Minority Investments With Majority ConditionsOne would expect institutional investors, as financially driven actors who are free to invest across a broad spectrum of opportunities, to behave in a manner more consistent with the hypothetical investors described by valuation theory. The institutional community has, however, developed practices to protect itself from many of the vagaries of minority investing. Achieving rights and returns similar to control investors has led to transaction pricing on par with control transactions, a phenomenon which isn’t inconsistent with conventional wisdom.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections. No two firms handle this the same way, but board representation, performance reporting, rights to change senior management, compensation agreements, bonus plans, restrictions on non-cash benefits, assurance of timing and performance for distributions, and even revenue sharing arrangements can go a long way to putting a minority investor on terms comparable to a majority owner. Without the risks that accompany lack of control and lack of marketability, minority participants can focus on the value of the enterprise.As an added benefit, if management still holds most of a firm’s equity, then outside investors have more assurance that insiders will pay attention to their jobs. This avoids the issue of RIA leadership “calling in rich” following a lucrative recapitalization and mitigates the monitoring costs that accompany most private equity investing. Sitting alongside management on an economic basis, but knowing management is sufficiently motivated, many institutional investors have effectively created the best of both worlds in minority investing: comparable returns without comparable responsibility.Valuation Theory Is the Real WorldUltimately, valuation models are descriptive, not prescriptive. The economic principles underlying valuation models are the real secret sauce.The behavior of insiders and professional investors is often seen in conflict with the notion that minority interests carry a lower value than pro rata control. In fact, these minority investors are not typical, coupling their money with conditions of ownership that mitigate or eliminate the distinctions between value on an enterprise basis and value on a fractional basis. In our view, the behavior of professional minority investors substantiates the presence of valuation discounts for investors who lack similar protections and privileges.About the car: In the late 1950s, while Detroit focused on building huge, heavy, powerful, front engine sedans and wagons, Italian automaker Fiat designed a petite coupe with a canvas roof and a two-cylinder rear-mounted engine. The Fiat 500 was as contradictory to conventional wisdom at the time as it was easy to park and cheap to own. Detroit boomed, but the Cinquecento sold almost four million units over 18 years. Different markets have different needs.
When Does Valuation Matter to Family Businesses?
Why should family business leaders care about the value of their business? If the family is not contemplating a sale of the business, why does valuation matter?Clearly, valuation matters a lot when it is time to sell. But valuation matters at other times as well. In this post, we describe four common valuation applications in family business.Ownership Succession and Tax ComplianceEnterprising families prioritizing sustainability of the family business over decades need a strategy for ownership succession from generation to generation. Ownership transfers within a family unit can occur either during the present owner’s lifetime or upon death. In either case, compliance with tax laws require that the shareholders determine the fair market value of the shares being transferred.Family shareholders occasionally confuse fair market value with what they believe the shares to be worth to them. Fair market value is the statutory standard of value that emphasizes the actions of "hypothetical willing" buyers and sellers of shares in the family business. Revenue Ruling 59-60, which provides guidance for valuation of closely held companies, presents a working definition of fair market value:2.2 Section 20.2031-1(b) of the Estate Tax Regulations … define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.In other words, fair market value is not defined by what a particular family shareholder feels like the shares are worth to them or “what they would be willing to pay,” but is rather defined by a more rigorous process that considers the behavior of rational, willing, and well-informed parties to a hypothetical transaction involving the subject block of shares.Shareholder RedemptionsNot all family shareholders need the same things from the family business. A share redemption program can help provide interim liquidity for shareholders and provide a release valve in the event relationships among the shareholders deteriorate to the point that it becomes advantageous for some shareholders to be bought out completely.In contrast to tax compliance valuations that must conform to fair market value, there is more flexibility in pricing shareholder redemptions. In other words, enterprising families can seek to execute shareholder redemptions at a price considered to be “fair” or that otherwise advances the goals of the share redemption program.Regardless of the underlying goals or valuation philosophy selected, it is important for the transaction price to be the product of a disciplined valuation process. Doing so helps to ensure that the share redemptions do not detract from broader family goals or undermine other estate planning objectives of family shareholders.Performance Measurement, Evaluation, and CompensationWhether family members or outside “professionals,” the managers of the family business are stewards of family resources. Family shareholders should be entitled to periodic reporting on the effectiveness of that stewardship. While there are a variety of “internal” measures of corporate performance that are helpful in this regard (return on invested capital, etc.), periodic “external” measures that reflect the change in the value of the family business over time are also essential.Most observers acknowledge the benefit of aligning the economic interests of managers and family shareholders. The most common strategy for doing so involves using some form of equity-based compensation, and the most common equity-based compensation programs require periodic valuations for administration. Many family businesses have installed employee stock ownership plans, or ESOPs, to provide a broad-based ownership platform for employees, and ESOP administration requires an annual independent valuation of the ESOP shares.Corporate Finance DecisionsFinally, valuation is an essential component of the most important long-term corporate finance decisions made by family business directors and managers.The graph below depicts the inter-relationships between the capital structure, dividend policy, and capital budgeting decisions facing family businesses.The capital structure and capital budgeting decisions are linked by the cost of capital. There is a mutually reinforcing relationship between the value of the family business and the cost of capital, as each one influences, and is in turn influenced by, the other. The cost of capital depends on both the financing mix of the company and the riskiness of capital projects undertaken. The cost of capital also serves as the hurdle rate when evaluating potential capital projects.The availability of attractive capital projects is also reflected in the value of the family business and is the point of intersection between capital budgeting and dividend policy. If attractive capital projects are abundant, family business leaders will be more inclined to retain than distribute earnings.Finally, the cost and availability of marginal financing is also affected by the value of the family business. The resulting cost of capital influences both the value of the family business and the decision to distribute or retain earnings or to borrow or repay debt.In short, the value of the family business is inextricably bound up with these critical corporate finance decisions and is an important consideration in making those decisions.This week's post is an excerpt from section 1 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.
Oilfield Water Management
Clean Future Act Regulatory Concerns
In the midst of the COVID pandemic, the rise of the Delta-variant, and general summer distractions, not a lot of attention has been given to the 117th Congress’ H.R. 1512 – aka the “Climate Leadership and Environmental Action for our Nation’s Future Act” or the “CLEAN Future Act.” The Act was first presented as a draft for discussion purposes in January 2020. After more than a year of hearings and stakeholder input, it was introduced as H.R. 1512 in March 2021. The Act’s stated purpose is:“To build a clean and prosperous future by addressing the climate crisis, protecting the health and welfare of all Americans, and putting the Nation on the path to a net-zero greenhouse gas economy by 2050, and for other purposes.”As broad as that stated purpose is, it’s not surprising just how far-reaching the implications of the nearly one-thousand-page-long Act are for many sectors of the U.S. economy. While Congress is a long way away from any bipartisan climate legislation being enacted, the Act provides some insight regarding the plans of the House Democrat Leadership for a clean energy future. It also potentially serves as a “red flag” to many industry participants that will be materially impacted by those plans.Of particular interest to the Oilfield Water Management sector, is Section 625 of the Act. In that section, the Environmental Protection Agency would be ordered to determine whether certain oil and gas production byproducts, including produced water, meet the criteria to be identified as hazardous waste. The legislation in fact, mandates that the EPA must make its determination within a year after the Act becomes law.Per the EPA’s April 2019 study publication, Management of Exploration, Development and Production Wastes: Factors Informing a Decision on the Need for Regulatory Action, produced water is defined as “the water (brine) brought up from the hydrocarbon bearing strata during the extraction of oil and gas. It can include formation water, injection water, and any chemicals added downhole or during the oil/water separation process.” Since 1988, EPA has held that oilfield-produced water should be regulated as non-hazardous waste. As such, produced water has been subject to the Resource Conservation and Recovery Act’s (RCRA) much less restrictive Section D provisions regarding non-hazardous waste, instead of RCRA Section C’s much more restrictive provisions regarding hazardous waste.Per a June 2021 report by Rice University’s Baker Institute for Public Policy, if the EPA’s Act-directed review of the 1988 produced water’s non-hazardous classification is revised to a hazardous classification, an enormous disruption in oilfield water management would result. The report specifies that severe disposal capacity constraints would be brought into play.At the current time, oilfield produced water disposal is available at an estimated 180,000 Class II disposal wells located throughout the U.S. If the Act were to lead the EPA to reclassify produced water as hazardous waste, all produced water would have to be disposed of in Class I wells, of which there are far fewer. The EPA’s data on Class I wells indicates that approximately 800 such wells are in existence; however, the wells are located in only 10 states due to geological requirements. The majority of those Class I wells are located in Texas and Louisiana. The EPA also indicates that only 17% of the Class I wells are available for hazardous waste disposal. Adding to the limited Class I well availability matter, the University of Wisconsin Eau Claire reports that those hazardous waste disposal wells are located at a mere 51 facilities. Source: EPA The cost of transporting Eagle Ford and Permian Basin produced water (in excess of 10 million barrels per day), for example, hundreds for miles to Class I facilities on the Texas and Louisiana Gulf Coast would be prohibitive to many producers. As a result, a substantial reduction in U.S. oil and gas production would be a natural and expected consequence, with the economic and industry ripple effect of such reduced production being enormous. Gabriel Collins, the Baker Botts Fellow in Energy and Environmental Regulatory Affairs at the Baker Institute, notes that any such re-classification would very likely lead to multi-system disruptions severe enough to make achieving the Act’s climate, energy, environmental, and social objectives impossible.While the Act is awaiting action by the U.S. House of Representatives, it’s well worth Oilfield Water Management industry participants keeping a close eye on it. Although Congress’ attention has been focused on COVID relief and is now focused on infrastructure matters, the CLEAN Future Act will eventually come to the forefront, with potentially far-reaching impacts if unchanged from its current form.ConclusionMercer Capital closely monitors the Oilfield Water Management and other areas of the Oilfield Services industry. We’re always happy to answer your OFS-related, or more general valuation-related questions. Please contact a Mercer Capital professional to discuss your needs in confidence.
Growing Pains
Is the RIA Industry in Growth Mode or Shake-Out?
While the wealth management industry is not new, the amount of change, churn, and growth that has occurred in the industry over the past ten years make it easy to forget how far the RIA industry has come since the heyday of broker-dealers.Following a financial crisis brought on by scandal and exacerbated by leverage, the fiduciary model has become the solution to restore trust in the industry among both clients and regulators. Since this transition, AUM has grown dramatically, as has the number of RIA firms. After a ten-year bull run, which was only momentarily stalled by the country’s shortest economic recession, strong performance from passively managed funds has enabled fee compression throughout the industry.Contextualizing the challenges facing the wealth management industry leaves one to wonder if many of these trends are no more than growing pains in the sector’s life cycle. And if so, what might such analysis suggest about the prospects for the fiduciary model?The lifecycle of an industry is often characterized by the following phases: start-up, growth, shakeout, maturity, and decline.Start-Up. During an industry’s infancy, customer demand is at first limited due to unfamiliarity with the new product and its performance. From the aftermath of WWII until the advent of ERISA in the 1970s, the broker dealer model flourished. During the 1970s, bad market conditions kept the lid on RIA growth, but by the 1980s registered reps were leaving wire-house firms and young trust officers were leaving banks to set up registered investment advisors, usually offering a very wide variety of services priced under what was then the new fee-based concept, instead of commissions.Growth. Just as customer demand is limited at first, so is competition which can lead to impressive growth and profits until more players enter the space. However, the inevitability of competitors chasing profits, is an elementary principal of economics. Over the past couple of decades, the count of RIAs, the number of professionals who work for
RIAs, and the dollar volume of assets managed by RIAs, has exploded. But, competition has led to the need for differentiation, and that need has led to specialization.Shakeout. Periods of high profits, low market concentration, and pressure for consolidation is often described as the shakeout period because many firms aren’t positioned to survive. As market participants vie for a limited supply of market share, all the while cutting costs to remain competitive, consolidation is inevitable. In theory, ‘economic profit’ in an industry is only temporary.
If the recent history of the wealth management industry can be grafted to a typical industry life cycle framework, the wealth management industry may be in a shakeout period. Consider the following trends that have dominated the independent advisor narrative in recent years:The wealth management industry may be in a shakeout period.Product Innovation: Product innovation is the catalyst for every industry lifecycle. That initial great idea, product, or service is adopted by many market players as the industry grows. These adopters often bring their own ideas to the table, or spawn other industries in response. In short, innovation, and the industry life cycle for that matter, is an iterative process bound by serendipity—or disaster as was the case for the fiduciary model after the Financial Crisis.
While fiduciary money management has been around for quite some time, its rapid adoption resembles something like a genesis. The growth in the RIA space over the years has been charged by innovation, be it money managers finding new business models that allow their teams more independence or clients demanding new services or increasing levels of specialization. As seen in the 2021 Charles Schwab RIA Benchmarking Study, firms of all sizes are continuing to increase their offerings (across all service types: tax planning, charitable planning, estate planning, family education, bank deposits, and lifestyle management) as firms look to distinguish their value proposition.CLICK HERE TO ENLARGE THE IMAGE ABOVENumber of firms: A shakeout period is often defined by both low market concentration and rapid consolidation as firms use acquisitions to maintain economic profit rather than seek growth organically. As we recently noted, the number of RIA firms continues to grow to record numbers despite intense deal activity that would otherwise be considered a hallmark of consolidation. Meanwhile, wire-houses have consistently lost market share over the past ten years as the myth of corporate brand continues to be undermined by AUM flow. This conflict between the increasing number of firms and the pressure for consolidation is in large part being driven by the same profit dynamics that categorize the beginnings of a shakeout period.
Growth & Profitability: While assets managed by independent advisors nearly tripled during the ten years between 2009 and 2019 profitability has begun to lag as clients have become increasingly fee sensitive. Much of the fee compression in the RIA space is being driven by competition with passively managed funds, which until recently have had the longest bull run in history to go unchallenged. But, as evidenced by the record number of independent advisors, competition among firms is just as easily responsible. Regardless, profitability explains the high deal volume in a wealth management space that benefits from economies of scale. Because revenues are tied to AUM and certain overhead costs are more or less fixed, operating leverage can have a positive impact on margins even with modest fee pressure. But it’s not just fees that are feeling pinched. RIAs are increasingly competing for talented money managers who have become more aware than ever of the value of their book of business.Economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space.For this reason, economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space. In an industry as labor intensive as wealth management, advisors are just as much clients as they are the product, and advisors are leaving wire-houses in favor of independence, often for reasons not always tied to pure economics.Ultimately, as the industry tries to accommodate both the price preference of clients and the lifestyle preferences of its most valuable assets, market concentration will remain low and deal values high. As such, and despite ballooning valuations, acquisitions remain at all-time highs while so too does the number of RIA firms. A shakeout period explains the conflict between the need for scale and the pressure to retain talent as economic utility is being carved out.CLICK HERE TO ENLARGE THE IMAGE ABOVEOr, is the RIA Industry still in Growth Mode?For now, we see no end in sight for the RIA acquisition frenzy. And, despite the large number of RIA transactions, most firms are not looking to sell. In a yield starved environment, RIAs continually are perceived as the ultimate growth and income investment. AUM growth, and ultimately earnings growth, show no signs of slowing. An upward trending market is a further catalyst. So, while there may be a growing quantity of RIA firms, the appetite for acquisitions appears to be greater with many owners holding on.What does this mean for your independent wealth management firm? While the industry lifecycle may be a helpful tool for understanding current industry headwinds, the timeline of industry phases is impossible to predict. Innovations can arise that can propel an industry back into a growth phase or just as likely syphon profitability towards rival industries. Additionally, firms can always achieve high growth through product innovation or superior capital budgeting no matter what industry they operate in. At most, the industry lifecycle helps make sense of the challenges facing the industry today and perhaps where to look for solutions, be that through additional services, reduced fees, or acquisitions.That said, the wealth management industry is competitive and will continue to be so. Fee compression will continue to be a headwind, and as a result staying cost competitive is as important as ever. Higher fees should be justifiable by premium services, value adds or ancillary services. But perhaps equally as important, retaining talent will continue to be crucial as advisors have more market power than perhaps ever before. And while the days of charging 1% of AUM might be waning, the combination of high cash flow and high growth continue to be attractive as evidence by elevated deal volume and multiples.
M&A, Reinvesting in Core Operations, or Paying Dividends
How Public and Private Dealerships Should Think About Allocating Capital Amidst Excess Liquidity
Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business
Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital
Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely.
OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements.
Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
How Long Will It Take to Sell My Family Business?
That Depends on the Type of Transaction …
In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss expectations around the timeline for your business transition or sale and summarize key points to keep in mind when driving towards an internal or external sale.
Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions and expectations you can share with your family board members.Internal TransitionsIn this section, we discuss the importance of a buy-sell agreement in a sale to the next generation. Then we take a brief look at employee stock ownership plans as another potential avenue to an internal transition.Sale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Family-owned companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a family business with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the family and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangementsMost modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website.The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany families cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that family business directors and managers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.In most external transactions, there is a significant imbalance of deal experience ... accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists the family (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of August 24, 2021
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation MultiplesDownload Study
Q2 2021 Earnings Calls
Public Auto Dealers Weigh Record Profits, Days’ Supply, and Capital Allocation
Second quarter earnings calls across the group of public auto dealers began with similar themes: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit.Executives revisited the reductions in personnel expense and their sustainability as GPUs are expected to decline at some point in the future. In a previousblog post, we discussed the prevailing industry conditions in inventory as reflected in the average days’ supply of new and used vehicles. The table below displays SG&A expense as a percentage of gross profit and the average days’ supply for the public auto companies for the second quarter:Click here to expand the image aboveThe trends reported by the public franchised dealers mirror those of the industry as a whole: continued tightening on the new vehicle side, but improvements on used vehicles. Executives offered their predictions for how the OEMs and the industry might evolve to supplying new vehicles once plant production and the microchip crisis normalize. Executives also discussed the ability to leverage their dealership platforms to source used vehicles from several sources including trade-ins, lease returns and campaigns such as “We’ll Buy Your Car” by AutoNation. As a result, the public franchised dealers are less reliant on auctions for used vehicle sourcing and are seeing some improvement in their used vehicle counts.Last week’s blogexamined the investment thesis and results of used-only public retailers such as CarMax, Carvana, Shift and Vroom. With record profits and a red hot M&A market, public executives discussed the opportunities for capital allocation and how they are evaluating and prioritizing the best fit for their companies. Three of the public companies in particular, AutoNation, Sonic and Penske, have chosen to invest in their used vehicle supercenter locations branded as AutoNation USA, EchoPark, and CarShop, respectively.Sonic provided some insight into the overall strategy of its used-only retail locations in its second quarter investor presentation. While front-end GPUs are expected to be lower (and sometimes negative) at the EchoPark locations, executives expect superior returns to be driven by the increased F&I GPU and overall volume of transactions at these platforms, compared to their franchised dealerships. These investments and strategies combined with other omnichannel investments by all of the public companies are in an attempt to capture the overall trend of an online retail experience.A deeper dive into some of the themes listed above is provided below, including remarks from management, related to expectations moving forward.Theme 1: The public companies continue to post improvements in SG&A as a percentage of Gross Profits driven by both sides of the equation: decreased expenses and record gross profits. While gross margins are universally expected to decline at some point, the jury is out on sustainability of cost reductions?“Our strong performance continues to be driven by strict cost discipline, leverage of our digital capabilities and robust vehicle margins. […] overhead decreased by 760 basis points, compensation decreased by 380 basis points, and advertising decreased by 30 basis points on a year-over-year basis […] I think for this year we will be in around the 60% range […] over 90% [of the increase in SG&A] is coming through variable cost. We are doing a very good job of keeping the fixed costs fixed, with strong discipline and leveraging the digital tools that we have”
– Joe Lower, CFO, AutoNation“Same store SG&A to gross profit was 56.4% in the quarter, an improvement of 1,440 basis points over 2019. While we expect SG&A to gross profit to normalize [as] new vehicle supply and gross margins bounce back to historical levels […] we continue to benefit from the permanent headcount reductions of almost 20% or almost 300 basis points of SG&A and other efficiency measures implemented last year.”
- Christopher Holzshu, COO of Lithia Motors“Obviously if growth comes down, that impacts SG&A…we’ve taken 11.5% of our workforce out […] we’re finding out we’ve got better productivity. Our mechanics are all over 120%. We see sales now per unit for a sales associate going from 9% to maybe 12% or 13%.”
– Roger Penske, CEO Penske Automotive Group“If you look at our productivity on our sales associates […] we used to sell 12 units per month […] now we’re running 18,19. […] the other one [cost saving] is centralization of advertising […] we’re spending a lot less on advertising, and it’s even more effective.”
- Heath Byrd Chief Financial Officer, Sonic AutomotiveTheme 2: Public executives boast of continued improvements in their omnichannel/digital platforms displaying that customer behaviors justify the infrastructure costs from these platforms. Advancements are illustrated in unique number of visitors, online transactions, and increased use of DocuSign and other electronic forms of signature software. Digital channels also allow the public companies to expand their footprint.“Our customers continue to vote yes on Acceleride […] we continued our upward trajectory in the second quarter by selling a record 5,600 vehicles through Acceleride, more than double the prior year. […] when incorporating all steps of the sales process, nearly 30% of our customers are using Acceleride. […] there’s opportunity to leverage Acceleride to expand our used vehicle business through our existing footprint […] in this quarter, we acquired almost 4,000 units through Acceleride […] and that was in a lot of markets that we’re not in today.”
- Darryl Kenningham, President of US and Brazilian Operations, Group 1 Automotive“Driveway generated over 350,000 monthly unique visitors in June. Driveway eclipsed the 500-unit milestone with 550 transactions in June […] 98% of our Driveway customers during our second quarter were incremental and have never done business with Lithia or Driveway before […] we can now market and deliver our 57,000 vehicle inventory to the entire country under a single brand name and negotiation free experience […] 97.5% of customers in Driveway are entirely new to Lithia and Driveway […] we are delivering cars at a lot further radius […] last quarter we were at 740 miles or so […] we’re at 930 miles [because of] scarcity in vehicles."
- Bryan DeBoer, CEO and President, Lithia MotorsTheme 3: A frenzied M&A market and heightened valuations have forced public executives to be more disciplined in their capital allocation approaches. Some of the publics (AutoNation, Group 1 and Penske) have prioritized share repurchases, others (AutoNation, Sonic) have prioritized reinvestment into their existing used vehicle platforms, while all must constantly evaluate acquisition opportunities against their individual growth, geographic and rate of return requirements.“A lot of different sellers that would like to work multiples off of Covid earnings. […] in the last six months [we] have walked away from $3 billion or $4 billion in business because we didn’t feel like it was priced appropriately.”
– David Hult, President and CEO, Asbury Automotive Group“We’re investing in our existing stores […] keeping them top-notch […] but when we see that AutoNation is an attractive price, we have not hesitated to buy aggressively […] we view purchasing our own company relative to the pricing we see as other choices as the best use of that capital after having taken care of investing in our existing stores and building out [AutoNation] USA. […] I bought 9% of AutoNation rather than doing a lot of acquisitions that I thought were overpriced.”
– Mike Jackson, CEO, AutoNation“During the second quarter, we repurchased 125,000 shares […] while the first priority for capital allocation remains M&A, we continue to be open to returning cash to our shareholders in the form of both share repurchases and an increase in our quarterly dividend. […] But the acquisition market is probably as frothy as it’s ever been […] it’s best if our acquisitions are accretive […] so we’re going to keep that as our top priority for capital allocation […] I would say it’s clear that share buybacks have been our second priority when we’re not able to find acquisitions to meet our financial hurdle.”
– Daniel McHenry, Senior VP and CFO, and Earl Hesterberg, President and CEO, Group 1 Automotive“Despite a slightly more competitive environment, we continue to successfully target after tax returns of 15% plus, investments of 15% to 30% of revenues, and three to seven times EBITDA […] potential acquisitions that we believe are priced to meet our return thresholds […] we are expecting acquisition cadence for the remainder of 2021 to be strong.”
- Bryan DeBoer, CEO and President, Lithia MotorsTheme 4: While average days’ supply on used vehicles is beginning to improve, the supply of new vehicles still remains near record lows due to production challenges from plant shutdowns, microchip shortages and increased consumer demand. Public and private franchised dealers have navigated these conditions to record profits. Will the current levels of production and inventory supply prove transitory, or will the OEMs adapt to the current conditions that one executive compared to the aphorism “rising tides raise all boats”.“I’m hopeful that when things normalize, we don’t quite settle back at the 70-80 day supply, we’ve run a good 20 days below that. […] OEMs are building the inventory the consumer wants.”
- David Hult, President and CEO, and Dan Clara, SVP of Operations, Asbury Automotive Group, Inc.“The manufacturers […] are using the chips that they do have to produce vehicles that consumers want [to] buy. […] I really don’t know if we will ever see a crossover point back to the old push system […] maybe the best path is somewhere in between. […] it’s not 14 days […] but maybe its 30-40 days […] somewhere like we run pre-owned […] I was expressing more of a hope of where the industry would see as a new goal and not going back to the 70,75,80, 90 days’ worth of inventory. […] I have never been a strong proponent or advocate of the build-to-order model […] People are getting 95%, 98% of what they really want in a relatively short period of time of 30 days to 45 days.”
- Mike Jackson, CEO, AutoNation“With our geography, we’re very big truck retailers […] You traditionally carry a pretty high day supply of those domestic brands because of the proliferation of models on full-size pickup trucks […] so if we could run a leaner distribution system, it would really reduce our inventory carrying costs and our land requirements.”
– Earl Hesterberg, President and CEO, Group 1 Automotive“I think there’s a big wave between 60-70 days supply and a zero-day supply […] even at a 23-day supply, customers are able to get immediate gratification […] this idea that you’re going to have 100 cars to choose from that are all quite similar, that Americans seem to like […] I think consumers will ultimately determine that by not buying cars on the lot that are run of the mill and rather get that additional individuality that maybe they’re looking for.”
- Bryan DeBoer, CEO, Lithia Motors“The big question there is can we keep the discipline at the OEM level from the standpoint of days’ supply in the 30 to 40 days […] and see what it does for them from a profitability standpoint. And obviously it’s been key for us at the dealer level.[….][OEMs] understand that their costs are down on supporting inventories […] if they start building units to fill these plants that aren’t the ones that customers want we’re then going to see an inventory pickup of vehicles that are not ones that people want to buy and then it’s going to start bouncing back in the same direction we were before.”
- Roger Penske, CEO, Penske AutomotiveTheme 5: With the proliferation of Electronic Vehicles (EVs), private franchised dealers are left wondering what their involvement will be from the retail and service side. Most of the public executives envision the continued use of the dealer franchise system for EVs as opposed to a direct to consumer model.“The best model of supply [EVs] to the consumer is through the dealer franchise system. These cars are very complex, people need to be able to communicate locally [….] the highest dollar spent [in the service department] on electric vehicles […] its first generation technology, there’s a lot of software glitches […] we’re already working them into our collision center […] over time […] they still need brakes, batteries….[…] we’ve made a lot of investments already and we’ll continue to make more investments both in physical training and equipment.”
- David Hult, President and CEO, Asbury Automotive Group“The complexity of the automobile is going exponentially. And that when there are issues […] the number of entities that actually can care for it and fix it are fewer and fewer. And that we look at only the electric vehicles, the investments we are having to make in specialty equipment and technical training. Expertise is unbelievable in the connected [EV] car.”
- Mike Jackson, CEO, AutoNation“We’re supporting our OEMs with EV. EV is going to be driven by political [forces] […] from a dealership standpoint, until we get a significant market of EVs, I don’t see a big issue from the standpoint of parts and service growth. It’s going to take a different technician…because of the technology. […] the warranty [work] will have to be done by us and we’ll also obviously have to deal with the complexity.”
– Roger Penske, CEO, Penske AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
WHITEPAPER | What Family Business Owners and Advisors Need to Know About Valuation
Family business advisors help companies and leaders navigate a wide range of business and family challenges, ranging from corporate governance to succession planning to family relationship dynamics and all points in between. Over the past several years, many of the family business advisors we have met have expressed a desire to better understand the intersection between business valuation and the family business advisory services they provide. We have written this whitepaper to help fill in that gap. The whitepaper is organized in four sections, each of which seek to answer a specific question about valuation.
Don’t Read This Book
Don’t read this book if you run a family business that is flush with cash, growing like a weed, regularly enjoys drama free family dinners, has their succession plan for your grandchildren in order, and do not foresee any disruption to your business over the next few generations.Assuming the above does not describe you perfectly, the Harvard Business Review | Family Business Handbook by Josh Baron and Rob Lachenauer is a comprehensive and useful tool for anyone involved with or working in their family business. Messrs. Baron and Lachenauer are cofounders and partners at BanyanGlobal, a global family business advisor group, and have decades of experience in family business consulting. BanyanGlobal is a thought leader in the family business advisory space, and when this group talks, we like to listen.When we think about the important stakeholder groups in our lives, often the top of the list includes our places of work and our families. There are bookstores full of family cohesion books and best business practice guides: this handbook provides a comprehensive guide on the intersection and intertwining of these two stakeholders.If you have read other Harvard Business Review books or "10 Must Reads," you will be familiar with the format. Each chapter introduces a key concept, provides a roadmap and tools to address the concept, and summarizes the key takeaways for you to apply – all in 15-20 pages. Enjoy it with a cup of coffee, or if you are like me with two kids under three, in the recess of night when everyone is sound asleep.The book is divided into three parts:Cracking the Code of Your Family Business: Understand the influence of individuals, relationships, and ownership on your family business across generations.The Five Rights of Family Owners: Determine your business type, governance strategies, transition planning, and communication strategies to develop the core of your business.Challenges You Will Face: How to handle and address family disruptions, conflict among family members, family employment policies, how to live with your wealth, and the pros and cons of a family office.
The authors remind us that, "Family and business are two of the most powerful forces in the world." At its foundation, the Family Business Handbook provides an in-depth education for family businesses, not just businesses run by families. The challenges and opportunities that face family businesses are unique and advice often runs opposed to standard business advice. Add leverage to maximize ROE? Not if you are concerned with family control and are opposed to your family values. Triple revenue growth? Not if you care about work-life balance and have a different family mandate that’s not dependent on growth.
We’d recommend following the authors prompts and roughly analyzing your own company throughout the chapters. Who can own my company? Do we have a family employment policy? Is an outside CEO necessary? How do we bridge family branch gaps despite divergence? What’s our shareholder communication strategy? How do we arrive at a healthy level of conflict within the family that drives us forward? Why are we in business together?
I took more from some chapters than others, but a continual theme is the counter-intuitive opposition of "financial theory" against “family practicality and values." One example highlighted this well for me. We excerpt the section below:Because family companies face so little scrutiny from the outside world, it might be all too easy to take "just this once" baby steps down a path that can eventually destroy the values they hold dear. Radio Flyer’s Pasin recalls one such moment with his father, years ago, when he questioned his father’s decision not to use cheaper materials for one of the company’s trademark red wagons. "I remember my Dad making the decision whether to use a cheaper steel and a cheaper tire on one of our wagons years ago," Pasin recalls. "And I said to my Dad ‘Does it really matter? Will consumers know?’ And my Dad said I’m not sure. But when in doubt, I like to overbuild stuff because I can sleep at night. There will be a lot of things you will lose sleep over running this business, but this won’t be one of them.’ I think about that every day. It’s one of the most important lessons my Dad ever taught me."My father-in-law, David, runs the family business my wife works in currently. He often reminisces about his father who founded the business and ran the company for 40 years. David, who ran the company with his dad as CEO, would ask why they don’t make a change to improve earnings and cut costs: "No one will really miss it and we will improve earnings." My wife’s grandfather would simply retort, "Yes, but I will know."Family businesses have multiple objectives that both include, and extend beyond, dollars and cents. The Family Business Handbook is a timely reminder that none of these objectives can be pursued in isolation at the expense of the others. We endorse this book whole-heartedly for any family business and recommend it as a resource to keep on your shelf or to share at your next family business meeting with your shareholders.
Why Is No One Selling in a Seller’s Market?
Even in One of Hottest M&A Markets in Recent History, Most RIA Principals Still Do Not Plan to Sell Their Business in the Next Three Years.
According to a recent Franklin Templeton Survey, only 14% of RIA principals expect to transact their ownership-interest in their investment management firm over the next year while 36% expect to sell between one and three years from now.Source: Franklin Templeton InvestmentsThese statistics are perplexing for an aging industry where less than half of advisors over the age of 65 have a formal succession plan and acquisition multiples continue to climb higher.Source:Franklin Templeton InvestmentsThere are some explanations to this disconnect. From an economic perspective, many RIA principals are hesitant to forego their high dividend coupon in a yield-starved environment. Additionally, when an RIA principal exits the business, they forfeit their salary and bonus payments, so the sale price would have to justify this substantial loss of annual income. Many principals also prefer to keep their firm employee owned, but it’s often difficult to sell the business to younger staff members who may be unwilling or unable to purchase the firm at its current market value. Additionally, the sale of smaller advisory practices (under $100 million in AUM) may not be practical since the primary principal often manages most of the client relationships, which may not transfer after he or she exits the business.These realities don’t excuse the industry’s ownership from failing to plan for an eventual sale or exit from the business. Most investment management firms have value beyond their founding principals. Not only can planning for that eventuality maximize your sale proceeds, but it can also ensure your key employees and clients will stick around long after your departure.How To Ensure a Successful SuccessionA logical starting point for accomplishing a successful transaction is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value (FMV). This process ensures that selling shareholders (who hope to sell at a maximum value) are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they remain committed after the initial buy-in.Simply put, a successful succession requires the alignment of buyer and seller interests. Gradually transitioning ownership to the next generation of management at a reasonable price is one way to align your interests with the next generation of management.A successful succession plan also requires decoupling your day-to-day responsibilities from ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she assumes more of your management responsibilities and not just your share count. Your work hours should decrease over this transition period.When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.
Understanding Transaction Advisory Fees
Real Expertise Is an Investment, and the Benefits in Return Should Well Exceed the Costs
In the previous article, we highlighted the various benefits of hiring a financial advisor when investigating the potential sale of a business.
In a transaction with an outside party, the buyer will almost always be far more experienced in “deal-making” relative to the seller, who often will be undertaking the process for the first (and likely only) time. With such an imbalance, it is important for sellers to level the playing field by securing competent legal, tax and financial expertise.
A qualified sell-side advisor will help ensure an efficient process while also pushing to optimize the terms and proceeds of the transaction for the sellers.
As with anything in this world, favorable transaction processes and outcomes require an investment. Fee structures for transaction advisory services can vary widely based on the type and/or size of the business, the specific transaction situation, and the varying roles and responsibilities of the advisor in the transaction process.
Even with this variance, most fee structures fall within a common general framework and include two primary components: 1) Project Fees and 2) Success Fees.
Project Fees
Project fees are paid to advisors throughout an engagement for the various activities performed on the project. Such activities include the initial valuation assessment, development of the Confidential Information Memorandum, development of the potential buyer list, and other activities. These fees generally include an upfront “retainer” fee paid at the beginning of the engagement.
Retainer fees serve to ensure that a seller is serious about considering the sale of their business. For lower middle market transactions, the upfront retainer fee is typically in the $10,000 to $20,000 range.
Often times, a fixed monthly project fee will be charged throughout the term of the engagement. These fees are meant to cover some, but not all, of an advisor’s costs associated with the project.
For lower middle market transactions, monthly fees are typically $5,000 to $10,000. In certain situations, the engagement will include hourly fees paid throughout the engagement for the hourly time billed by the advisor. Such hourly fees are billed in place of a fixed monthly project fee.
Hourly fees are typically appropriate when the project is more advisory-oriented versus being focused on turn-key transaction execution. Hourly fees serve to emphasize the objective needs of the client by counter-balancing the incentive for an advisor to “push a deal through” that may not be in the best long-term interests of the client.
An hourly fee structure typically front loads the fees paid throughout the transaction process and is paired with a reduced success fee structure at closing which brings total fees back in line with market norms.
Mercer Capital has had favorable outcomes with numerous clients when fee structures are well-tailored to the facts and circumstances of the seller and the seller’s options in the marketplace.
Success Fee
A success fee is paid to a transaction advisor upon the successful closing of a transaction. Typically, success fees are paid as part of the disbursement of funds on the day of closing. As with project fees, success fees can be structured in a number of different ways.
A simple approach is to apply a flat percentage to the aggregate purchase price to calculate the success fee. The use of a flat percentage fee seems to have increased in recent years, and makes a fair bit of sense as it allows the client to clearly understand what the fees will look like on the back-end of a transaction.
Traditionally, the most used success fee structure employs a waterfall of rates and deal valuation referred to as the Lehman Formula. This formula calculates the success fee based on declining fee percentages applied to set increments (“tranches”) of the total transaction purchase price.
For lower middle market transactions, the simplest Lehman approach is a 5-4-3-2-1 structure: 5% on the first million dollars, 4% on the next million, and so on down to 1% on any amount above $4 million. The Lehman Formula, which can be applied using different percentages and varying tranche amounts, pays lower percentages in fee as the purchase price gets higher. Smaller deals may include a modified rate structure (for example 6-5-4-3-2) or may alter the tranche increments from $1 million to $2 million.
The Lehman Formula, in its varying forms, has been utilized to calculate transaction advisory fees for decades. While the formula may add some unnecessary complexities to the calculation (versus say a flat percentage), it has proven over time to provide reasonable fee levels from the perspective of both sell-side advisors and their clients.
A success fee can also be structured on a tiered basis, with a higher percentage being paid on transaction consideration above a certain benchmark. If base-level pricing expectations on a transaction are $15 million, the success fee might be set at 2.5% of the consideration up to $15 million and 5% of the transaction consideration above this level. If the business were sold for $18 million, the fee would be 2.5% of $15 million plus 5% of $3 million. The blended fee in this case would total $525,000, a little under 3% of the total consideration.
Escalating success fees are often favored by clients because they provide an incentive for advisors to push for maximized deal pricing rather than settling for an easier deal at a lower price.
Typical Total Fees
Transaction advisory fees, on a percentage basis, tend to be higher for smaller transactions and decline as the dollars of transaction consideration increases. Various surveys of transaction advisors are available online that suggest typical fee ranges.
Consensus figures from these sources are outlined below. Based on our experience, these “typical” ranges (or at least the upper end of each range) appear to be somewhat inflated relative to what most business owners should expect in an actual transaction advisory engagement.
Mercer Capital’s View on Fees
At Mercer Capital, we tailor fees in every transaction engagement to fit both the transaction situation at hand and our client’s objectives and alternatives.
In situations where a client has an identified buyer, we understand that our role will likely be focused on valuation and negotiation. Many sellers are unaware that price is only one aspect of the deal, and terms are another. Altering the terms of a definitive agreement can move the needle by 5%-10% and can potentially accelerate end-game liquidity by 6 to 12 months.
Accordingly, we design each fee structure to recognize what we are bringing to the process, typically utilizing some combination of hourly billings and a tiered success fee structure on the portions of the deal where our services are making a difference in the total outcome.
If we are assisting a client through a full auction process, it may be appropriate to utilize a more traditional Lehman Formula or a flat percentage calculation. A primary focus of our initial conversations with a potential client is to understand the situation in detail so that we can develop a fee structure that ensures that the client receives a favorable return from their investment in our services.
Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982.
Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate critical transactions, providing timely, accurate, and reliable results. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.
Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients. We recommend to clients to accept the right deal or no deal at all.
Our dedicated and responsive team is available to manage your transaction process. To discuss your situation in confidence, give us a call.
Themes from Q2 Earnings Calls
Part 2: Mineral Aggregators
Last week, we reviewed the second quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry.
In this post, we focus on the key takeaways from mineral aggregator second quarter 2021 earnings calls.Operators Maintaining Drill Bit DisciplineAggregators keep a close eye on E&P companies as they often reap the benefits of the drill bit, but also fall victim to capital discipline initiatives. In the second quarter, many aggregators made note of operators’ disciplined approach as prices and rig counts continued to rise.“Our portfolio has benefited as bigger and better capitalized operators have taken over operatorship of our minerals to enable more consistent and disciplined development. Our focus on the highest rate of return undeveloped locations throughout our history ensures that our mineral position migrates to the top of any operator's drilling inventory.”
– Ben Brigham, Executive Chairman & Director, Brigham Minerals“Despite the increase in rig count through the second quarter, we do anticipate that trend to flatten through the remainder of the year, as operators maintain their capital discipline.”
– Jeff Wood, President & CFO, Black Stone Minerals“Operators in the U.S. continue to practice discipline with their drilling activity even in the face of significantly higher commodity prices.”
– Bob Ravnaas, Chairman & CEO, Kimbell Royalty PartnersCapitalizing on Favorable Price EnvironmentIndustry participants remain optimistic as prices have increased significantly over the last year. Some aggregators were heavily hedged, and others, like Brigham Minerals, are reaping the benefits of their unhedged position.“In fact, this is the best macro setup I've seen in my career, and I've lived through numerous cycles. Benefiting from our diversified portfolio of high-quality mineral assets, our shareholders are positioned to benefit from what I believe is very likely a long ramp of elevated pricing for oil, NGL and natural gas prices. This is particularly true given that unlike some of our peers, we are unhedged.”
– Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Oil prices are now well above pre-COVID levels, but the U.S. land rig count is 39% below year end 2019 levels. Furthermore, natural gas prices are trading at multiyear highs, driven primarily by increased power demand in the U.S. and surging exports of LNG to Europe and Asia. Given that a significant portion of our daily production is natural gas, we expect this improved pricing to benefit our cash available for distribution in Q3 2021 and into the winter months based on the current strip pricing.”
– Bob Ravnaas, Chairman & CEO, Kimbell Royalty Partners“The increase in royalty volumes was mainly due to the Midland and Delaware properties but we also saw nice increases outside of our major shale plays as well, but seen a remarkable rebound in commodity prices since the middle of last year and are currently well above pre-pandemic price levels.”
– Tom Carter, Chairman & CEO, Black Stone MineralsDistributions Ramping UpAggregators have built a reputation of acting as a yield vehicle with the ability to reinvest, unlike traditional royalty trusts. Their popularity increased as they maintained healthy distributions over the years, however the challenging environment in 2020 put most payouts in jeopardy. With the uptick in prices and a more optimistic outlook, aggregators seem confident to return to historical payout levels.“The $0.31 per common unit distribution this quarter reflects a 75% payout of cash available for distribution. We will use the retained amount, 25%, to pay down a portion of the outstanding borrowings under Kimbell’s credit facility.”
– Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“This allowed us to maintain a 100% distribution in the second quarter of 2020 and importantly enter 2021 unhedged with our investors fully exposed to the run-up in commodity prices as the economic reopening took hold toward the end of last year and more fully during the first quarter of this year associated with the vaccine rollout.”
– Robert Roosa, CEO & Director, Brigham Minerals“We generated $72.1 million of distributable cash flow for the second quarter or $0.35 per unit. That gave us a lot of flexibility to increase our distribution while still holding some cash and reserve for further debt repayment.”
– Jeff Wood, President & CFO, Black Stone Minerals Conclusion
Aggregators seemed optimistic across the board in the second quarter of 2021. Prices have rebounded, and distribution policies are returning to normal, which in their minds creates good shareholder sentiment. However, the continued capital discipline of E&P operators may affect aggregators in the short to intermediate term.Conclusion Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.
Used Vehicle Margins in 2021
How Large Used-Only Auto Retailers Are Measuring Up
As our dealer clients know, automotive retailing competition has intensified with large, well-capitalized online-only retailers getting plenty of attention. Due to imbalances between supply and demand, gross margins on both new and used vehicles have increased in 2021.In this post, we survey gross margins for the publicly traded dealerships, in light of the current operating environment and reconsider the investment thesis put forth by the new entrants.Investment Thesis of Online Used-Only RetailersInvestors in used-only retailers likely have numerous reasons for believing in these companies. We’ll highlight some of the reasons below, then delve deeper into a few of them.Lack of franchise agreements in used vehicle space enable significant growth/market reachCOVID-19 anticipated to accelerate auto retailing towards e-commerce seen in other retail sectorsCustomer dissatisfaction with traditional retail experienceGross margins tend to be higher on used vehicles than new vehiclesAsset-light business modelLack of Franchise AgreementsFor the publicly traded traditional auto retailers, franchise agreements can inhibit growth. Executives have discussed on earnings calls the obstacles that can occur when they accumulate numerous stores in the same brand. For used-only retailers, there are no similar restrictions as the sale of used vehicles are not subject to franchise agreements. While this may be a positive for growth and geographic diversification, this limits the market available to these companies.Vroom’s 2020 investor deck highlighted used auto as one of the largest markets at $840B trailed by grocery ($683B) and new auto ($636B). Using these figures (which are pre-pandemic), used-only players are limited to ~57% of the market.While growing to become the premier used vehicle operator would have obvious benefits, if any of these players can meaningfully consolidate the highly fragmented market, there is a downside to only interacting with consumers when they want a used vehicle. This is also why executives of franchised auto dealers have started harping on the number of "touch-points" they have with consumers which includes new and used sales as well as service appointments. source: Vroom, Inc.COVID-19 and the Shift to EcommerceA core strength of pre-pandemic automotive retail was the lack of penetration from ecommerce. As seen above, ecommerce penetration prior to the pandemic was less than 1% as determined by Vroom. The space has been Amazon-proof to a degree, though auto dealers and consumers were thrust into a digital world last March and April. Over a year later, it seems clear that the number of transactions and the percentage of transactions completed online will increase.Online retailers tout that they are the future, and the pandemic has only accelerated trends in consumer preference towards online. Only time will tell how truly transformed the environment is. Does the lack of ecommerce penetration represent a massive opportunity for new entrants in the market, or does it just paint a picture of how difficult it will be for these companies to attract profitable market share?Gross Margins and Profitability at LargeAnother long-term key consideration will be profitability. As with Amazon and Facebook, tech companies can command huge valuations prior to turning profitable. Many Silicon Valley startups claim to be the next unicorn that will achieve scale, ramp down expenses relative to revenue growth, and watch red ink turn to black.Because Carvana, Shift, and Vroom are still relatively young companies, their lack of profitability has not yet detracted from their value. However, gross margins can still be compared because companies spending significant amounts on advertising will have a hard time turning the corner if the unit level economics aren’t there.Let’s revisit what was mentioned at the outset. Used vehicle margins have been stronger than new vehicle margins. That remains to be true. Gross profit margin for the average dealership through the first half of 2021 was 13.4%, up from 11.8% through 1H20. For the new vehicle department, gross as a percentage of selling price increased to 8.3% YTD 2021, up significantly from 5.5% in the prior year period. The same is true for used vehicles: 14.0% YTD 2021 versus 11.4% in 2020. New and used margins are up in 2021, and used margins continue to outpace new.Parts and service departments have higher margins than vehicle sales departments, and these departments account for a significant portion of gross profit for auto dealers. According to NADA, through the first half of 2021, gross profit contribution from parts and service was considerably lower than historical levels (37.4% of total gross profit), but it still outpaced that of both new and used vehicle departments despite making up a much lower percentage of revenue. Below, we have calculated gross margins in 2021 for the public auto dealers.Click here to expand the image aboveUsed vehicle gross margins exceed new vehicle gross margins for Asbury, AutoNation, Group 1, and Lithia. Notably, however, that is not the case for Penske, LMP, or Sonic. Sonic’s 2.8% used vehicle gross margin stands out as an outlier, but we do see here that used vehicle gross margins are not exclusively higher than new. This could be due to the difficulty of sourcing vehicles in this environment.LMP and Penske also have the highest new vehicle margins, which could be at the detriment of used vehicles margins if they extract higher ASPs on new vehicles by offering higher trade in values.For total gross margin, however, the impact of fixed operations is clear. Blended total gross margin for traditional franchised auto dealers is approximately 15-18%. For used-only retailers, used and total gross margins are much lower as seen below.Click here to expand the image abovePerhaps these retailers are underpricing their vehicles to gain market share, and it is true that lost incremental vehicle sales from these retailers has a compounding effect. In addition to a lost vehicle sale, consumers are also less likely to go to a dealership for parts and service if they didn’t originally purchase the vehicle from that dealership. While this could have a long-term negative impact on total gross profit for dealerships, it remains to be seen if there will be mass adoption to buying vehicles from these platforms. Unless there is a material change in franchise laws, these companies won’t be able to sell new vehicles.ConclusionUsed-only online retailers may be the future. Customer dissatisfaction with "the old way" may push more people to try something new. The Carvana's of the world may improve their gross margins with data-driven technologies lowering costs and tactfully raising prices without losing their new customers.The asset-light model may help attract enough investors to lower the cost of capital for larger players enabling a virtuous cycle of greater scale and efficiencies. These players may eventually also look to get into the service and parts business to improve gross margins, though this would be hard to square with an asset-light approach.For now, though, franchised auto dealers will continue to operate with the strong foothold afforded to new vehicle dealers that can cater to customers throughout the life cycle of their vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
Treasures in the Attic
The Value of Future Fiduciary Appointments
Independent trust companies are frequently named in wills to serve as the trustee of an estate or living trust. These appointments may create a revenue opportunity for an independent trust company next year or fifty years from now. A trust company is sometimes notified of their assignment but isn’t always. Future fiduciary appointments certainly have some value; but how much and how do you measure it?Valuation MethodologyFuture fiduciary appointments are one element that factors into a trust company’s overall valuation. As such, the value of these relationships isn’t generally considered separately from the rest of the business, and the guidance on how these appointments contribute to the overall value of the business is limited. There are, however, many situations where analogous assets may be valued on a stand-alone basis for accounting or other purposes. These similar concepts from other disciplines or industries can provide direction and perspective on the value of future fiduciary appointments.Future fiduciary appointments are one element that factors into a trust company’s overall valuation.Contract ValuationsWhen a business combination such as a merger or acquisition occurs, accounting standards generally require that an exercise known as a purchase price allocation (PPA) be performed. The purpose of a PPA is to allocate the consideration paid for a business to the acquired tangible and intangible assets, which can include acquired technology, customer relationships, contracts (customer and supplier), noncompete agreements, tradenames, etc. Future fiduciary appointments for trust companies bear some similarity to a customer contract; although, a trust company does not have to agree to a fiduciary appointment, the executor of an estate is contractually obligated to hire the trust company unless it does not accept.There are many different commonly accepted approaches to contract valuation, but the most relevant as it relates to future fiduciary appointments is the income approach. In a purchase price allocation, the value of a contract can be determined using the income approach by projecting out the future cash flows that result from the contract and applying an appropriate discount rate. But in purchase price allocations, the existence of the contracts and terms of the contracts are known, whereas independent trust companies are not always notified of their appointment in a will, and even if notified, the size of the estate and potential revenue is often unknown.Oil & Gas Reserve ValuationsAt first glance, it’s hard to imagine two industries more different than independent trust administration and oil and gas. But the future fiduciary appointments held by trust companies do have a notable similarity to oil and gas reserves. Oil and gas reserves represent a real asset to the landowner, but the size and profitability of these reserves is often unknown. Likewise, future fiduciary appointments are a real asset for trust companies, but the size and profitability of these relationships is generally not known in advance. Oil and gas reserves are categorized as Proven Developed Producing (PDP), Proven Undeveloped (PUDs), Possible (P2), or Probable (P3). PDP reserves currently generate revenue and can be valued using a discounted cash flow analysis. But PUD reserves, which are proven to exist but not currently developed or revenue generating, and probably and possible reserves, which are less likely to be recovered, are not as easily valued.Can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves?So, can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves? Are known appointments comparable to PUDS and unknown appointments comparable to P2 and P3 reserves?Valuation practitioners sometimes rely on option pricing to capture the value of PUDs, probable, and possible reserves. As the price of oil increases, PUDs, probable, and possible reserves become more economical to develop. The PUD and unproved valuation model are typically seen as an adaptation of the Black Scholes option model. Applying this same principle to value fiduciary appointments would require significant assumptions about the possible number of appointments, the size of the estates, and the average number of deaths per year. Additionally, a future fiduciary appointment is not necessarily option-like, as there is no set exercise price. And for most independent trust companies who are likely to generate significant cash flows in the near term, the impact of these future cash flows may be too small to matter (once present value math has been applied).The Right Way To Value Fiduciary Appointments May Be More SubjectiveFiduciary appointments do have value, but separating this value from the enterprise as a whole may not be the best way to think about it. Rather than valuing these separately, we typically adjust our projection and discount rate assumptions and our guideline company analysis.Discounted Cash Flow Method. As we discussed above, discretely projecting cash flows from future fiduciary appointments is not always possible. But an analyst can factor in the potential upside of these assignments when selecting the appropriate discount rate and terminal growth rate. Should the discount rate be lower since there are additional future revenue opportunities that weren’t built into the projections? Or maybe the terminal growth rate should be higher, as these appointments will allow the company to sustain higher levels of ongoing cash flow growth.Guideline Public Company Method. Although there are no publicly traded pure-play trust companies, publicly traded investment managers do have a similar structure to independent trust companies. Both earn fees on assets under management / administration and have operating leverage such that when AUM / AUA increase, fixed costs do not increase at the same rate. Therefore, we often use the pricing of publicly traded investment managers to gauge investor sentiment and establish a reasonable range for pricing expectations for businesses that manage or administer assets on behalf of clients.We may apply an adjustment to the implied valuation multiples of the public companies to account for the differences between an independent trust company and the selected group of publicly trade investment managers. While many independent trust companies are smaller in size, have less access to capital markets, and have lower margins (trust administration is labor intensive), some of this risk may be offset by the growth opportunity presented by future fiduciary appointments. How much of that risk is offset is a matter of the facts and circumstances of the particular independent trust company.Who Should Value Your Independent Trust Company?Choosing someone to perform a valuation of your independent trust company can be daunting in and of itself. There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. And there are a number of industry experts who are long-time observers and analysts focused on the industry, who understand industry trends, and have experience providing advisory services to independent trust companies.At Mercer Capital, we think it is most beneficial to be both industry specialists and valuation specialists.
Sanderson Farms Case Study
Cargill is one of the largest family businesses in the world. Earlier this year, we analyzed the Family Capital list of the world’s 750 largest family businesses; Cargill checked in at number 15 on that list, with annual revenue reported to be in excess of $110 billion. Cargill made headlines earlier last week for its acquisition (together with another family business, Continental Grain) of Sanderson Farms, a publicly traded poultry business (ticker: SAFM).It is not every day that family businesses acquire publicly traded companies, so the transaction is worth exploring a bit further. For family business directors contemplating M&A activity of their own, or thinking about whether now is the right time for the family to sell, the Sanderson Farms acquisition rather perfectly illustrates why family businesses have more than one value.The Value of Sanderson Farms on a Standalone BasisSince its shares are traded in the public markets, we know what Sanderson Farms was worth on a standalone basis. Prior to rumors of a potential transaction influencing trading, SAFM shares closed at $155.74 per share on June 18, 2021 (corresponding to 7.9x trailing EBITDA).Business values always reflects consensus expectations regarding future cash flows, risk profile, and growth prospects. We will spare you the math, but the public market expectations for each of these factors is summarized in Table 1.
As is the case with many agribusiness companies, earnings for Sanderson Farms are cyclical, depending in large measure on various commodity markets. Table 2 relates the estimate of "ongoing" EBITDA noted above, to recent earnings (the green dotted line).
So, what does the public market price of $155.74 "mean"? If investors paid that price, and the company continued to operate on a standalone basis while growing at 2.9%, those investors would earn an annualized return of 6.5% on their investment, which is consistent – on a risk-adjusted basis – with alternative investments available to them.
The Value of Sanderson Farms to Cargill/ContinentalIn contrast to public market investors, the Cargill/Continental consortium agreed to pay $203 per share for Sanderson Farms, or 10.4x trailing EBITDA. This represents a 30% premium to the public market price. Why where these buyers willing to pay more to for the company? As described in last week’s post, Cargill and Continental are strategic buyers. In other words, they anticipate integrating Sanderson Farms into their existing poultry operations. By doing so, their expectations for the three factors determining value are different, in some respect, than the expectations of public market investors for the company on a standalone basis.Table 3 summarizes several different scenarios that correspond to the $203 per share transaction price.
Why might Cargill and Continental have different expectations than public market investors?
Cash Flow. As strategic acquirers, the Cargill/Continental consortium might reasonably expect to be able to extract higher earnings from Sanderson Farms by combining with existing operations. Common cost savings in mergers come from consolidating facilities and eliminating redundant overhead costs. As shown in Table 3, the purchase price implies approximately $50 million of annual cost savings. In recent years, total selling, general and administrative expenses for Sanderson Farms have been on the order of $200 million annually. Could the buyers anticipate eliminating 25% of the existing corporate overhead? Perhaps, but one shouldn’t rule out other expense saving opportunities within cost of goods sold as the combined entity will likely enjoy greater negotiating leverage with suppliers than Sanderson Farms did on a standalone basis.Growth Prospects. Moving one column to the right in Table 3, we see that the higher acquisition price could also be explained by more aggressive growth expectations. It is likely that the newly combined entity will also enjoy enhanced negotiating leverage with customers as well as suppliers. Perhaps the greater market share of the combined entity will unlock opportunities for faster growth than would be available to Sanderson Farms on a standalone basis.Risk. Return follows risk. If the acquiring consortium enjoys a lower cost of capital than SAFM does, it may be willing to accept a lower prospective return on the acquisition. By way of perspective, published data on the returns for shares of companies stratified by size suggests that the returns for mid-cap firms like Sanderson Farms is on the order of 125bps higher than the return for large cap companies the size of Cargill.
The acquiring consortium is more likely to anticipate incremental value from each of the three potential sources, as illustrated in the rightmost column of Table 3.
It is important to note that transaction prices do not necessarily represent the maximum price that a strategic buyer could pay for the acquired company. In other words, it is possible that Sanderson Farms is really worth $220 per share to Cargill/Continental, but the seller was only able to extract $203 per share due to the relative negotiating leverage of the two parties. The value of the seller on a standalone basis (in this case, $156 per share) sets the floor for the transaction, while the (unobservable) value of SAFM to the acquiring consortium represents the ceiling. The ultimate transaction price of $203 is the point within that range at which the negotiating leverage of the two parties was balanced.Takeaways for Family Business DirectorsMost of our family business clients are not likely to acquire a public company. Even so, family business directors should bring the same discipline to bear when evaluating a potential transaction.When considering an acquisition opportunity, it is important to carefully analyze not just what the target company could be worth to you, but also what it is worth to the existing owners. Developing a bid for the target within that range should consider both the actions of other potential bidders for the target and how unique the target is.When contemplating a sale, the same considerations are appropriate. What is the family business worth to your family? What can you reasonably expect the family business to be worth to potential buyers? What strategies can you put in place today to help tip the negotiating leverage in your favor so you can extract more of the incremental value to the buyer?
These are tough deliberations and the consequences of your final decision may affect your family for decades to come. Don’t make these decisions without a seasoned financial advisor in your corner. Give one of our professionals a call today to discuss your situation in confidence.
Consolidation in the RIA Industry
RIAs Are Being Acquired at a Record Pace, But Does That Really Mean the Industry Is Consolidating?
Consolidation is a theme that has a lot of traction in the RIA industry: that a growing multitude of buyers are scrambling to outbid each other for a limited and shrinking number of firms.Circumstances, such as, aging founders or a lack of internal succession planning are bringing firms to market, where firms are quickly bought up and rolled into any one of a number of acquisition models that have emerged (and continue to emerge) in the industry. Aggregators are bolting RIAs onto their platforms, branded acquirers are assembling RIAs with national scale through a series of acquisitions, and larger RIAs are growing through strategic acquisitions of smaller firms. Competition amongst these buyers for the limited number of firms coming on the market has driven acquisition activity and multiples to all-time highs.With the rapid pace of deal activity in the RIA industry, you might expect to see the number of firms decline, as that is typically the norm for consolidating industries. The banking industry, for example, has been consolidating for three decades and, as a consequence, the number of banks in the U.S. has steadily declined from about 18,000 in 1990 to about 6,000 today. But that’s not been the case in the RIA industry, at least yet.Despite consolidation pressures and record levels of acquisition activity, the reality is that the number of RIAs continues to increase, with formations outpacing consolidation. In 2019, there were approximately 13,000 individual SEC registered investment advisory firms, up from about 10,900 in 2014.Several factors have contributed to the increase in the number of RIA firms. For one, the RIA industry has experienced secular tailwinds from the shift from the broker dealer / commission model to the fee-based, fiduciary model. As the chart demonstrates, the number of FINRA registered broker dealers has gradually declined in recent years—the mirror image of the growth seen in the RIA industry. In many cases, broker dealers have shifted to fee-based models, and firms with dual registrations have gradually shifted to the RIA side of the business.This overarching shift from the broker dealer model to the RIA model is multi-faceted. For one, it’s clear that clients (in general) prefer the advisory relationship offered by RIAs over that offered by their broker dealer counterparts. And a model that’s in demand by clients is also in demand by advisors. Additionally, we’ve found that building significant enterprise value (value attributable to the business, not the individual) is generally easier for firm owners to achieve under the RIA revenue model than the broker dealer model. This prospect of building a business with enduring value that can be sold to an external buyer at the end of the founder’s career or transitioned to next generation management is a key motivation behind many advisors’ decisions to start their own RIA. It also doesn’t hurt that, compared to the broker-dealer model, the amount of capital required to start an RIA is relatively minimal.When looking at the increase in the number of RIA firms, though, there are a couple of nuances to keep in mind. Some acquisition models in the industry result in the acquired firm maintaining its SEC registration, so consolidation doesn’t necessarily mean a decline in the number of registered firms. Another caveat is that the data captures only SEC-registered investment advisors and not state registered investment advisors (generally, advisory firms with over $100 million in AUM are required to register with the SEC, whereas firms below that threshold are regulated by the state in which they do business). These wrinkles aside, the data is unambiguous that there are more SEC registered advisory firms today than ever before—and that’s hardly indicative of an industry in the throes of consolidation.Another way to track consolidation is to look at how assets under management are distributed across firms of different sizes, rather than at the number of firms. The industry hasn’t seen significant consolidation by this metric either. Consider the chart below, which shows the distribution of industry assets across different sized firms in 2011 and 2021. After a decade of significant M&A activity and strong market growth, the distribution of assets across different size firms looks about the same as it did ten years ago. Then, as now, firms under $100B AUM controlled approximately one-third of industry assets, while firms over $100B control approximately two-thirds of industry assets. What we haven’t seen is an erosion of market share for smaller firms; in fact, they’ve maintained market share in a growing market.What does all this mean for the industry? As it stands today, rising supply of RIAs has done little to dampen the pricing for RIAs; instead, it’s seemingly added fuel to the M&A fire. Notwithstanding an increase in the number of firms, attractive firms whose founders are open to selling today remain scarce, and the ratio of buyers to sellers remains high. As a consequence, multiples for RIAs are at or near all-time highs today. Whatever downward pressure there’s been from the supply side of the equation, strong buyer demand has more than offset it.While the consolidation pressure in the industry is real, we are still in early stages. Many successful advisory practices prefer to go at it alone and transition internally, unless circumstances such as age of the principals or lack of next-generation management arise to force an external transaction. Consolidation pressures may ultimately lead to an increase in the number of firms that are on the market and a shift in the supply/demand equilibrium, but as it stands today, sellers are scarce, and building a new firm from scratch is difficult. Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry, but at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.
2021 Transportation Industry Update | COVID in Review
COVID-19 has had a lasting impression on many industries throughout the world, but the U.S. trucking and transportation industry was among the first industries to feel the impact of the pandemic.Lockdowns in China (initiated in December 2019) began affecting the U.S. trucking industry in very early 2020 as Chinese imports account for nearly 40% of all shipments entering the U.S. By the beginning of March, the U.S. had already begun to see massive declines in incoming freight with an escalation of shipping cancellations. The ports of Seattle and Long Beach experienced 50-60 container shipment cancellations reflecting declines of 9% relative to the prior year.When discussing the decline of imports in the port of Seattle, Sheri Call of the Washington Trucking Association said, “That’s the kind of decline we’d normally see over the course of an entire year.” Disruption of international trade led to transportation companies reducing capacity as early as the beginning of March. Outbound rail and trucking shipments from LA dropped 25% and 20% respectively, in March 2020.Due to social distancing requirements throughout the United States, many roadside eateries and rest areas were closed in the first several months of the pandemic, which reduced truck drivers’ access to food and other necessities for long days on the road. Trucking companies were forced to alter their transportation network, frequently carrying empty loads as a result of uneven and declining demand. According to Reuters, “trucks hauling food and consumer products north to the United State are returning empty to Mexico where mass job losses have hit demand, leaving cash-strapped truckers to log hundreds of costly, empty miles.” Empty loads increased nearly 40% worldwide in the immediate aftermath of the lockdown.An indication of the health of U.S. trucking industry can be seen through the ratio of full north bound trips to full southbound trips at the Mexico-US border. The ratio is typically one full southbound trip to every three full northbound trips, but the ratio began to lean closer to a one to seven ratio during the pandemic with the remainder being empty or partially full. Additionally, new freight contracts have fallen 60% to 90% since the rise of COVID-19 in 2020.Increased online shopping from consumers has led to a spike in demand for last-mile delivery services. Amazon reported $75.5 billion in 2020 first-quarter sales which was a 26% increase from the first quarter of 2019. Many last-mile delivery companies like FedEx and Amazon continued to hire workers with Amazon seeing an increase in company employment of nearly 175,000 workers from March to April of 2020. Last-mile delivery carriers also eliminated signature requirements so that they can now achieve a “contactless” delivery process.The level of domestic industrial production is correlated to the demand for services within the transportation industry. The Industrial Production Index is an economic measure of all real output from manufacturing, mining, electric, and gas utilities.Lockdowns that began in March of 2020, as a result of the pandemic, led to a sharp decline in the Industrial Production Index. The index began a rapid recovery during the summer months of 2020. At the end of the first quarter of 2020, the Industrial Production Index saw a quarter-over-quarter decrease of 16.7% while also being down 17.7% on a year-over-year basis. The index rebounded in the second quarter of 2020 with a quarter-over-quarter increase of 12.7%. The index continually increased over the last three quarters of 2020, but it had not reached pre-pandemic levels as of April 2021.
The outlook for the trucking industry at the beginning of 2020 was promising with economists predicting that freight rates would grow 2% over the course of the year. Strong economic growth in the first two months of 2020 was halted by the outbreak of the unforeseen pandemic. The impact was dramatic – though not entirely negative for all carriers. Carriers of essential goods like groceries, cleaning supplies, and medical supplies experienced skyrocketing demand for their services while industrial, manufacturing, and other non-essential carriers are still undergoing lasting effects from the pandemic.
One non-essential industry that experienced a downward turn at the onset of the pandemic was the vehicle shipping services industry. A strong economy with high disposable income and consumer confidence ramped up consumer spending for the American automobile industry in the periods leading up to the pandemic.
The industry’s growth prospects were halted during 2020 due to a high unemployment rate and a drop-off in disposable income. The success of the vehicle shipping services industry is closely intertwined with new car sales and consumer confidence. The graph below shows the relationship between revenue of the vehicle shipping services industry and new car sales and consumer confidence. Overall, decreased consumer confidence in 2020 led to many Americans electing to defer vehicle upgrades, which created a major economic downturn for the vehicle shipping services industry.With many businesses closed, overall Cass Freight trucking shipments plummeted, seeing a decrease of 15.1% and 22.7% from April 2019 to April 2020. Truck tonnage also dropped 9.3% on a from March 2020 to April 2020 while declining 8.90% from April 2019 through April 2020.The fall of the number of shipments along with overall truck tonnage caused transportation companies to lower contract and spot rates. Flatbed and reefer rates hit a five-year low in April of 2020, though they rapidly recovered and had surpassed pre-pandemic rates by the fourth quarter of 2020. Truck tonnage has not recovered at the same rate as spot and contract pricing and had not reached pre-pandemic levels by March 2021. These trends are reflected in the Cass Freight and Shipment Indices. While the Shipments index has increased relative to its April 2020 level and has surpassed pre-pandemic levels, the Expenditures index increased over 27% from March 2020 through April 2020.Even though contract rates did not have as sharp of a decline in March of 2020 as spot rates, both experienced a drop-off at the onset of the pandemic. Spot rates dropped below numbers that had been seen in recent years. After the sharp decline of spot rates in March, rates for all categories began to steadily increase. Rates hit a seasonal decline at the end of December due to decreased consumer spending after the holiday season. Rates resumed their climb during the first months of 2021. Overall, the rising price of contract and spot rates spins a positive image for overall outlook of the trucking industry, while also encouraging new competition to enter the market.At the beginning of 2020, there were strong predictions for revenue in both the long distance and local trucking industries. Once the COVID-19 pandemic hit, revenues for both parts of the trucking industry dropped along with future revenue predictions. After a few months of lockdowns, the trucking industry began a rapid rebound as a result of businesses reopening and increased online retail. Future revenue predictions from March and April of 2021 from both the long distance and local sectors exceed predictions made in October 2020.Industrial production and consumer spending, spurred on by the substantial stimulus programs enacted by federal government, have recovered more rapidly than initially expected. This rapid recovery has seemingly reduced the expected long-term impacts of COVID-19 on the long-distance and local trucking industries.The effects of rising trucking rates and revenues coupled with optimistic outlooks for both categories can be seen in the number of long-distance and local trucking establishments. Lured in by appealing spot and contract rates, March 2021 predictions for the number of establishments in the trucking industry look to be on the rise. Naturally, there was a drop-off in the number of establishments in 2020, but the industry seems to have recovered with numerous new entries into the market in 2021. The long-distance trucking industry is projected to have more than one hundred thousand more establishments than originally forecasted in January of 2020.
The Potential Buyers of Your Family Business
An Overview of the Different Types of Buyers for Closely Held, Family Businesses
In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss internal and external exit options for you and your family business and summarize the possible buyers for your family enterprise.
We regularly encounter family business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many families believe now is a sensible time to exit.
Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful preparation and real-time market awareness from your family business board of directors. Families often fail to realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective representation.
Under ideal circumstances, your family will begin planning for ownership transition well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual exit is to understand who the potential buyers might be and the different characteristics of these buyers. In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionPotential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof). When done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. These transactions generally occur two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP). While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to the current generation of family owners regarding their legacy and the continuing prospects of the business as an independent going concern.Sale or Transfer to Next GenerationFor many family businesses, transitioning ownership and leadership to the next generation of family members is the primary exit consideration. For other families, a sale to the non-family management team makes more sense. In either event, the value of the shares being transferred is critical.Whether transferring ownership to the next generation of family members or to the non-family management team, the value of the shares being transferred is criticalFor sale transactions, the question of how the transaction will be financed is equally important. Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures. Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert themselves into active leadership. Many may view seller financing as desirable in order to control the terms and costs of the arrangements and to benefit from the interest and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. The following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership Plan“ESOPs” are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership. Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure best practices are implemented and compliance awareness governs the transaction. To that end, family businesses contemplating an ESOP need to be keenly aware of the importance of following a well designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA, ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.Establishing an ESOP includes creating an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation. Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement. During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the Plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different waysThere are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should consider an alternative liquidity strategy.External SaleIn general, the ability to sell your family business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers, the pros and cons of which are listed in the following sections.Strategic BuyersA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets. These buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from expanded market area and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your family business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the family’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple nearly 100% cash deals as well as deals that include various forms of contingent consideration and employment/non-compete agreements.There is a good chance that a potential strategic buyer for your family business is someone or some group you already knowMany family owners in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control. Further, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vis-a-versa. Family business owners must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries, strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financials sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true ups that may apply are areas in which family business owners should seek proper professional advisory guidance outside their family boards and advisors.Financial BuyersFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front end and back end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criterion on behalf of their underlying fund investors, who have signed on for a targeted duration of investment that by nature requires the financial investor to achieve a secondary exit of the business within three to seven years after acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial Investors,Permanent Capital Providers, andSingle/Multi-Family Offices
Despite their financial expertise, financial buyers usually do not typically have the capacity or knowledge to assume the management of the day-to-day operations of all of their investments. As such, the family’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.A sale to a financial investor can be a viable solution in situations where one owner wants to cash out and completely exit the business while other owners remain involved with the businessWith respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process of making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic and financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach your family business with an offer that you were not expecting, you and your family might decide to put the business on the market and seek offers, or your family might opt to sell to the next generation of the family in an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you and your family manage the transaction process.
July 2021 SAAR
The July 2021 SAAR was 14.8 million units, roughly flat compared to July 2020, but down 12% from July 2019. SAAR was expected to fall for the third straight month, but this figure is lower than many experts predicted in June. As far as contributing factors to this slip, automotive manufacturers continue to struggle producing enough vehicles to meet insatiable demand that is emptying car lots around the country. Inventories continue to be drawn down and consumers are beginning to abandon their preferred color and trim selections as well as their preferred model and production year in favor of similar vehicles simply because they are actually available for purchase.As we detailed in last week’s blog, retail sales have crowded out fleet sales with an estimated 90% of total sales volumes in July, and this trend is also expected to continue as dealers no longer need to sell larger blocks of inventory at discounted prices. Dealers are doing everything they can to get new cars in the hands of consumers, as elevated prices continue to boost profits on a per unit basis.The average new-vehicle retail transaction price in July is expected to reach a record $41,044. The previous high for any month, $39,942, was set last month in June. Dealers are also capturing a greater share of these transactions prices as average incentive spending per unit, a measure of financial inducement used by manufacturers to motivate sales of specific vehicles, is expected to fall to $2,065, down from $4,235 in July 2020 and $4,069 in July of 2019. However, this doesn’t necessarily translate to skyrocketing costs for consumers as high trade-in values and low interest rates mean average new vehicle monthly payments of $622in July are only up 6.4% while transaction prices have increased 17%.Despite lower volumes, dealers are seeing record revenue levels as supply/demand imbalances have led to these surging prices. It also illustrates the relatively inelastic demand for consumers. Record vehicle prices have been noted across mainstream media outlets, yet customers continue to buy what little inventory dealers have. Consumers who can wait to buy a vehicle may be starting to hold off. But for those returning to the office in the wake of a public health crisis, there may not be many functional alternatives to personal vehicles. As noted above, monthly vehicle payments also haven’t surged as much as sticker prices.The trends outlined above tell the story of what auto dealers have been experiencing for months now. Tight supply unable to keep up with demand are leading to a red hot market, and it looks like price and turnover metrics may continue to reach new heights until supply issues are alleviated.Pickup Truck Market Share StumblesOne effect that these current market conditions have had on the automotive industry involves sales of pickup trucks. According to Wards Intelligence, large-pickup truck market share was 13% of total sales in July 2021, down from 15.2% in July 2020. This was the lowest market share figure for the vehicle class since July 2016. In April of this year, Ford decided to prolong its production shutdown for the F-150 pickup truck, citing parts shortages as the primary cause. During this period of shutdown for Ford, General Motors pressed forward with its production of the GMC Sierra, mentioning the importance of its pickup truck sales to the firm’s bottom line. Ford was able to restart truckproduction in June, but the decision by General Motors to sink available resources into its truck models eventually resulted in its own forced production shutdown in late July.Stories like these have dominated automotive news cycles over the last several months and it is not hard to believe that, despite the importance of pickups to the profitability of these firms, trucks are equally as hard to produce during this period of input shortages as other vehicle classes, particularly for the larger trucks as compared to other trucks and crossovers. Manufacturers are having to make decisions regarding which models to prioritize, and it seems like start-stop production has already become normal for most manufacturing plants around the country. Manufacturers are expected to continue to intermittently shut down truck production until automotive supply chains recover, while production of other best sellers are prioritized for weeks at a time.With a more complete understanding of the lumpy nature of model-specific production during the last several months, it can be expected to see large swings in market share for under-produced vehicle classes. Shutdowns in April and May related to the F-150 and shutdowns in July and August for the GMC Sierra have resulted in fewer trucks hitting lots, and therefore less market share in the sale of all vehicles for an underrepresented truck class. For the ones that are sold, many may not even see lots as pre-selling has become increasingly important. Once the dust settles and the necessary inputs for vehicle production become more readily available, the market share for pickups is expected to normalize at historical levels or even expand in response to pent-up demand. Until then, expect volatility in metrics like market share going forward.What To Expect? ForecastOver the last three months, many experts have tried to predict vehicle production rates to no avail. Mercer Capital’s own December 2020 Forecastfor the 2021 SAAR was in the range of 16 million units, quite bullish at the time. Looking forward to the end of supply shortages and heightened demand has proven a difficult task, and many previously bullish analysts are rolling back their expectations for a third quarter rebound. For example, the LMC Automotive forecast was reduced by 200,000 units on its last iteration. With more frequent announcements on manufacturing stoppages hitting the presses each week, the industry should not expect inventory levels to change much over the next month. With this in mind, total light vehicle sales are still expected to be around 16.5 million unitsin 2021.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.
Benefits of Hiring an Advisor When Selling Your Business
While many business owners have a general sense of what their business may be worth and a threshold selling price in mind, going at it alone in a transaction process involves more than a notion on pricing – it involves procedural awareness, attention to detail, as well as a good measure of patience despite the desire for an immediate outcome.
In most external transactions (i.e., a business owner selling to a third party rather than to family or employees) there is an acute imbalance of savvy and experience between buyers and sellers. For certain sellers who owe their business successes to personal effort, brute force, and honed skills, it’s a difficult decision and an act of faith to turn the business asset over to an advisory team.
Buyers, both financial or strategic in nature, have completed many transactions while most sellers have never bought or sold a business. Given this near universal lop-sidedness in experience and resources, sellers need to assemble a team of experienced advisors to assist in navigating unfamiliar terrain. The time intensity and distractions of the process can cause the business to suffer if ownership sacrifices on operational oversight and foregoes the attention to detail that made the business an attractive acquisition target in the first place.
We strongly recommend hiring a full transaction team composed of, at a bare minimum, three primary players:
Transaction attorneyTax accountantFinancial (sell-side) advisor
By securing a turnkey transaction team, business owners benefit from the multi-perspective expertise and overlapping skillsets of the team. The diversity and breadth of the team often facilitates proactivity and response capability for a wide variety of developments that can derail or compromise the timing, process and financial outcome of the final deal.Benefits of Hiring a Financial AdvisorThe following are a few of the many benefits of hiring a qualified sell-side advisor to assist in the transaction process.Maximize Net ProceedsThe core components and key terms of a transaction are often complicated and sometimes deceptively obscured in the legal rhetoric of an LOI, APA or SPA. Hiring a sell-side advisor with the right experience and expertise can help business owners maximize the net proceeds from the transaction. Financial intricacies and other points of negotiation, such as working capital true-ups or contingent consideration arrangements, often require careful analysis and modeling in order to foster clear decision making regarding competing and differently structured deals.A good sell-side advisor encourages objective comparative assessment of competing offers, negotiates key points, and helps acclimate sellers to certain realities of getting a deal done.Negotiate Best Possible TermsSell-side advisors have years of experience reviewing purchase agreements and will work with ownership’s legal counsel to ensure the transaction documents accurately reflect the agreed upon value and terms. These documents can often be cumbersome and need to be reviewed and crafted with the utmost attention to detail. Experienced advisors can help streamline the fine-tuning of these documents to assist the business owner(s) in negotiating favorable (or acceptable) terms of sale.At some point in most deals, a seller has to pick the fights worth fighting and concede on those terms that aren’t likely to change or have no real benefit. A good advisor should be frank and forthright with sellers, even when the recommendations or choices are not entirely satisfying. Sellers must be aware that a buyer needs a few wins and concessions to justify their investment. An informed seller, using the advice of a good seller representative, can better identify and prioritize the issues that impact the deal.Drive Transaction to ClosureSeasoned sell-side advisors have often worked on hundreds of transaction engagements. This range of experience can be of great help if and when unexpected issues arise, and unexpected issues almost always arise. Sell-side advisors will work with the rest of the transaction team to manage these issues and provide the information necessary to make critical decisions regarding proposed solutions with the end-goal of driving a transaction to closure.Confidentiality and Ownership BurdenRevealing a contemplated transaction to your employees and stakeholders can often lead to undue stress, which compounds the strain already present on ownership and management during a transaction process. With the help of a sell-side advisor, ownership and management can maintain their focus on running the business and generating profits while knowing that the transaction process is progressing in the background.Ownership can also gain peace of mind in knowing that the transaction will become “public information” at the appropriate time, which allows the business to function normally throughout the entire process. Many of the delays and sensitivities involved in the selling process, represent the potential for unexpected breaches of information to employees and other stakeholders. Owners can avoid many water cooler dilemmas by using an outside representative who collects, organizes, and disseminates information and manages exchanges between the parties.ConclusionAdmittedly, we are valuation and transaction advisory providers – go figure, that our advice is to retain us, if you desire strong representation that we believe will pay for itself. If you have a good business asset to sell, it’s likely you have been highly concentrated in your capital investments and your personal efforts to create that wealth. Selling such an asset is not only the opportunity to diversify your wealth but to outsource much of the pain and worry that accompanies the process of selling.Mercer Capital offers a seasoned bench of professionals with a diversity of experience unmatched by most pure-play brokers and M&A representatives. We combine top-shelf valuation competency with a vast array of litigation, transaction advisory and consulting experience to facilitate the best available strategic outcomes for our clients. To discuss your situation in confidence, give us a call.
DUC Clock Ticks On Cheap Production: Low-Cost Cash Flow Won’t Last
As we await second quarter earnings for publicly traded upstream producers, there are several markers and trends that suggest cash flows and profits will swell. Investment austerity and the recently resulting profits will almost certainly be bandied about on management calls. However, what might not be touted as loudly will be how much longer this can last? Existing U.S. production, much of it horizontal shale, is declining fast, operational costs and inflationary pressure are rising again, and the only way to augment production is through some combination of drilling and fracking.Cash Flow Crowned KingAccording to the latest Dallas Fed Energy Survey, business conditions remain about as optimistic as they were in the first quarter whilst oil and gas production has jumped. In the meantime, U.S. shale companies are on the precipice of delivering superior profits in 2021: in the neighborhood of $60 billion according to Rystad. How are they doing that? A combination of revenue boosts and near static investment levels. Analysts are pleased and management teams are crowing about cash. The industry should be able to keep it up, but only for a finite period. How long is that? Nobody knows for sure, but a good proxy may be the shrinking drilled but uncompleted (DUC) count of wells in the U.S.
Overall DUC counts peaked in June of 2020 at 8,965, with the Permian leading the way. June 2021 statistics show DUCs at 6,252 or a 2,713 (30%) drop in one year. Just last month 269 DUCs disappeared with nearly half of those coming out of the Permian. This matters because DUC wells are much cheaper to bring online than fully undeveloped locations. Around half the drilling costs are already sunk and therefore it is incrementally cheap to complete (frack) and then produce from a DUC well. It’s low hanging fruit and producers with high DUC counts can profitably take advantage of recent price surges. However, these easily accessed volumes can’t be tapped forever. Last month’s DUC drawdown pace leaves less than a two-year backlog of DUC’s remaining, and it’s worth remembering that companies like to keep some level of inventory on their books, so the more realistic timing may be before 2022 ends.
Inventory On The DeclineAll this is in conjunction with permit counts way below even 2019 levels (although rising – particularly among private companies). There’s likely going to be supply shortages in the future, as most producers in the Dallas Fed Survey suggest - but who will pick up that slack? OPEC may not be the only answer here. Granted, not every OPEC country has the spigot capability Saudi Arabia does and some other OPEC+ members have not been above cheating on their production limits in the past.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short term energy outlook expects production to catch up due to OPEC+ recent production boost announcements, but nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts.
There’s no certainty the U.S. shale industry will be able to pick up the demand slack either. They are preparing to live on what they have already drilled. Producers are under immense pressure to keep capital expenditure budgets under wraps and focus on investor returns. As such not much external capital is chasing the sector right now. A good example is this respondent to the Dallas Fed’s Survey:
“We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.”
Pretty said. As a result industry analysts at Wood Mackenzie say U.S. crude production will grow very modestly during 2021 and likely 2022. OPEC+ is adding production, but not a lot – only 400,000 barrels per day being added back compared to the nearly 10 million per day cut in 2020. That leads to price pressure and the market has been catching on.
Valuations on the AscentThese industry forces have contributed to the E&P sector having an outstanding year from a stock price and valuation perspective. Returns have outpaced most other sectors, and Permian operators have performed at the top of the sector. However, it is important to note that much of this gain is recovery from years of prior losses.An interesting observation (and consistent theme of mine) is that proven undeveloped reserves (PUDs) are the biggest beneficiary of this value boost. As production from existing wells declines, the value from tomorrow’s wells is getting a big bump. Mergers and acquisitions in the past year at what now appear to be attractive valuations, often paid very little if anything for PUDs, but buyers got them anyway. They are gaining valuation steam now. What were out of the money options are now moving into the money. Acreage values are intrinsically going up in West Texas (both Delaware and Midland basins), South Texas (Eagle Ford) and recovering in other areas such as the Anadarko basin in Oklahoma.Companies like Diamondback Energy have acquired acreage recently (QEP and Guidon deals) that surround or is contiguous with legacy acreage positions. This will come in handy when new wells come into view of capex budgets, and as I mentioned – there is a visible path whereby they could come into view in the next couple of years with oil above $70 per barrel.Investors appear to be cautious in view of OPEC+ perceived sword of Damocles hanging overhead, which is logical. However, the fundamentals remain lopsided towards high prices for some time, barring another catastrophic event, which of course could always be lurking around the corner.Originally appeared on Forbes.com.
The Fundamental Value of RIAs? Scarcity.
If the Choice Is Buy vs. Build, "Build" Doesn’t Even Come Close
Are RIA transaction multiples getting out of hand? Contrary to the usual laws of supply and demand, each week it seems like we hear about another blockbuster deal rumored to have happened at an astronomical price, and correspondingly, we meet a new capital source we hadn’t known previously who is looking for a way to implement an acquisition strategy in the RIA space. Is this FOMO on a grand scale, or just part of a grander moment in market dynamics?
If you weren’t hiding under a rock last week, you probably read plenty about the Robinhood ($HOOD) IPO. Robinhood is a noteworthy counterpoint to the RIA space because it is practically the anti-RIA. RIAs target high net worth investors who want returns and capital preservation; $HOOD targets young speculators with money to burn. RIAs develop recurring revenue streams from investment management; $HOOD builds transaction volume by hyping "opportunities." RIAs follow a fiduciary standard; $HOOD monetizes clients with margin accounts and payment for order flow. If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.Yet, $HOOD’s initial few days of trading bear out a revenue multiple that is mind-numbing, even compared to the high-watermark transactions in the RIA space. I can’t explain it, and I’m tempted to dismiss it as a sideshow altogether. But, a glance at Robinhood, digital assets, or 10 year treasuries for that matter, suggests that the wall of money that has moved an array of asset valuations higher over the past 15 months has yet to abate.Valuation practitioners are wired to respect intrinsic value. We can’t help but view assets like Bitcoin and Meme-stockbrokers with a curmudgeonly air. And it’s hard to get excited about bond yields measured in basis points instead of percentage points, regardless of your inflation outlook. RIA valuations, on the other hand, we can defend.RIAs remain the ultimate growth AND income play.RIAs remain the ultimate growth AND income play. What other business model produces a coupon in the upper single to low double digits, and then increases the dollar amount of that return with market and organic growth? Even at EBITDA multiples that would have made people blanche a few years ago, the return profile on RIAs is hard to match. Low yielding treasuries don’t come close, even on a risk adjusted basis.This isn’t to say that investing in RIAs is without risk. Investment management is labor intensive so much that we’ve been told by one very experienced buyer that he feels one can "rent" an interest in an RIA, but never really "own" one. Many RIAs struggle with genuine organic growth, and the most recent Schwab industry study shows AUM growth outstripping revenue growth, suggesting that realized fees are eroding – even in wealth management. Nevertheless, looking back over the past 18 months, it’s hard to find a business that was more adaptable and resilient than investment management – what looked like bottomless downside turned into banner performance.Our perspective isn’t unique. The problem is that for all the interest in acquiring RIAs, there aren’t that many to be had. While the total count of RIAs is debatable (about 15,000 to 40,000 – depending on who’s counting), what is easier to see is that the portion of substantial RIAs, especially those in the wealth management space (where much of the acquisition interest is these days) is small. There are maybe 500 wealth management firms with AUM in excess of $1.0 billion, and a good portion of those see themselves as acquirers rather than sellers. You can always consolidate smaller firms, of course, but it’s hard to build a $100 billion shop with $300 million add-ons.Acquisition activity is hot, multiples are strong, and there’s no end in sight.Bitcoin aficionados can talk about verifiable scarcity all day, but most people aren’t qualified to audit the bitcoin algo that limits the number of coins. We know what it takes to build multi-billion dollar AUM firms – time – a lot more time than it takes for server farms to mine digital coins. The best growth for RIAs is still organic, but life is short, and most grandiose investment strategies in investment management don’t budget the decades it takes to do it from scratch. Ergo, acquisition activity is hot, multiples are strong, and there’s no end in sight.The Aston Martin DB4 GT pictured above looks very similar to the ones produced in the early 1960s, but it was actually built in 2019. The GT version (more power, less weight) of the DB4 was supposed to total 100 cars, compared to the 1200 or so regular models. The DB4 GT production run ended early, though, as Aston Martin introduced the DB5 (the model ultimately mythologized in James Bond movies) after building only 75. As a consequence, auction prices of the GT version usually had an extra digit compared to those of comparable non-GT series cars.Five years ago, Aston Martin decided to do a special production run of the final 25 cars. Each car took an estimated 4,500 man-hours to build, and all were presold at £1.5 million. Interestingly, the 33% increase in supply didn’t dent auction prices for original DB4 GTs, and I suspect a similar increase in larger RIAs would just add to buyer enthusiasm.I wonder if crypto-investors would have a similar experience.
First Half 2021 Review of the Auto Dealer Industry
What Are Key Statistics Saying?
As we enter into the second half of 2021, first half statistics are being released and second quarter earnings calls are on the horizon for the public auto companies. We’ve all read the headlines of the auto dealer industry in 2021: heightened profitability, historic gross profits per unit and soaring retail sales prices for new and used vehicles, and inventory shortages and challenges caused by plant shutdowns and the microchip shortage. What are some of the key statistics saying about the current and future health of the auto dealer industry? Have they peaked, are they continuing to increase or beginning to decline, and/or how long will the current conditions hold?Back in December, we analyzed the state of the auto dealer industry through the use of various statistics/metrics: Retail Gross Profit Per Unit – New Vehicles, Retail Gross Profit Per Unit – Used Vehicles, and Used to New Vehicle Sales Unit Ratio. In this post, we revisit and examine those statistics through the first half of 2021 and discuss other key statistics including Average Days’ Supply, Fleet Sales, and Vehicle Miles Traveled.According to Dealership Profiles reported by NADA, average dealerships have posted pre-tax earnings at 5.1% of revenues as of May 2021 (most recently published data at the timing of this post). This figure has climbed through the start of 2021 and is higher than any reported annual figure since 2010, (when the NADA began publishing the data). How long can this continue and what are the key drivers of the historic profitability?New VehiclesThe sale of new vehicles continue to be impacted by imbalances between supply and demand. While auto dealers are selling fewer new vehicles, the average selling price and the retail gross profit per unit ("GPU") are at all-time highs.Let’s revisit retail gross profit per new vehicle: the numerator is gross profit achieved on the retail sale of new vehicles (as measured by the retail selling price less the cost paid to the manufacturer to acquire the vehicle) and the denominator is the total number of new vehicles retailed (fleet sales are excluded).As seen in the graphic below, the new vehicle GPU rose throughout late 2020 and has continued that rise through May 2021, to a total of $3,139 per unit.
New vehicle GPU has risen every month in 2021, but will/can it continue? To answer that question, let’s start with the average days’ supply of the new vehicle equation.
Average days’ supply is a metric used to measure the amount/supply of new vehicles that either an auto dealership or the auto dealer industry as a whole holds in relation to the average daily demand. The ratio is calculated by first determining the average monthly daily units of new vehicles by taking the prior month’s or average month’s unit sales divided by 30 days to arrive at average daily units. Finally, the number of new units in inventory at any given point in time is divided by the average daily units to determine the average days’ supply. This ratio is tracked on both new vehicles and used vehicles.
Historically, the auto industry operated at an average days’ supply for new vehicles around 60 days. Average days’ supply on new inventory continues to plummet in 2021, reaching a low of 25 days’ supply as of June 2021. At the two state auto conventions that we attended last month, every auto dealer that we spoke with reiterated these conditions. It was very common to hear dealers state inventory unit numbers in the single digits for most of their franchise’s best models.
Industry experts are predicting that July numbers will continue to follow these trends. July sales are expected to decline due to a lack of inventory, putting downward pressure on both the numerator and denominator.
If the average days’ supply for new vehicles continues to fall, that means supply is falling faster than demand. Some early highlights from the Q2 earnings calls from the public auto companies indicate that they are experiencing average days’ supply less than 20 days and in some extreme cases, less than 10 days.
New vehicle production and inventories are not anticipated to stabilize until the latter part of 2021 or perhaps not until 2022.
In the next few months, the lack of supply will eventually cut into the heightened profitability that auto dealers have experienced for the first half of 2021.
Even if GPUs are high, eventually such a decline in volume will necessitate a decline in overall gross profit levels, even if margins remain solid.
It will be interesting to see how the OEMs respond to new vehicle production and average days’ supply when plants and conditions return to normal. The industry has proven it can operate more efficiently at leaner levels of inventory, but will the OEMs return production to the historical levels of 60 average days’ supply? While profits are higher, consumers are unlikely to be as understanding to the lack of inventory after the difficulty of reopening post-pandemic is solved.
Used VehiclesLike new vehicles, used vehicles have also been impacted by supply and demand. Demand for used vehicles has increased rapidly due to shortages of new vehicle inventory and also changing consumer preference for those impacted financially by the pandemic.According to Cox Automotive, the average retail price of a used vehicle climbed to an all-time high above $25,000 for June 2021. As a result, auto dealers are experiencing record highs for retail gross profit per used vehicle.GPU for used vehicles is calculated the same as new vehicles discussed earlier, just for used vehicles. As seen in the graphic below, the used vehicle GPU rose in late 2020 and continued to rise through May 2021, to a total of $3,275 per unit.
Used vehicle GPU has also risen every month in 2021, but will/can it continue? To answer, we again turn to average days’ supply.
According to data published by Cox Automotive, the average days’ supply of used vehicles ranged between 55-66 as seen by actual data from November 2019 (pre-pandemic) and December 2020 (during the pandemic). Average days’ supply on used inventory has shown signs of improvement from a low of 33 units in March 2021. June 2021 levels have risen to 41 days supply as seen below.
The bigger impact for auto dealers continues to revolve around sourcing for used vehicle units.
Historically, auto dealers have sourced used vehicles from trade-ins, purchasing wholesale units at auction, buying back rental car fleets, and purchasing off-lease vehicles.
With fewer new vehicle sales, there are fewer trade-ins. Sourcing vehicles at auction can be tricky for auto dealers in a market where used vehicle prices are at all-time highs and will likely revert back to normal at some point. Dealers must be cautious not to purchase large amounts of used vehicles at these elevated prices for the fear that they won’t be able to sell all of those units before prices return to more normal levels.
As we will discuss later, the number of used vehicles available from rental car fleets has been drastically reduced from historical levels. Finally, there are fewer off-lease vehicles available for repurchase as customers are choosing to purchase those vehicles outright once the lease term ends.
As discussed in our December post, the ratio of used vehicles to new vehicles sold approached 1:1 as dealers experienced heightened GPUs on both sides. That ratio continued to climb in the early part of 2021 topping out at 98.2% in January but has declined slightly to 87.5% in May 2021.
Historically, the gap between GPU earned on used vehicles to new vehicles was wider than it has been in recent months. Now auto dealers are seeing margins nearly as high on new vehicles. This ratio continues to be impacted by shortages in inventory supply, increased retail prices, and uncertainty of financial constraints caused by the pandemic.
We can think of two potential demand-related reasons GPUs earned by dealers on new vehicles are catching up to used vehicles. Surging auto prices have made it into the headlines; consumers continuing to shop likely have some level of inelastic demand and if they have to pay heightened prices, they may as well pay a little more to get a new vehicle. Also, with the “K-shaped recovery” we’ve seen during the pandemic, it’s possible those with more disposable income, who may be more likely to buy a new vehicle than a used vehicle, are composing a greater percentage of buyers, tilting demand and thus profits, towards new.
Fleet SalesFleet sales consist of sales to large rental car companies, commercial users and government agencies.Historically, fleet sales allowed auto dealers to sell surplus inventory and to sell larger blocks of units at one time. While fleet sales typically occurred at reduced margins compared to retail sales, they allowed auto dealers to put more vehicles in service to hopefully benefit the fixed operations of an auto dealer as those vehicles will eventually require service maintenance and parts. Auto dealers anticipate that buyers of new vehicles will continue to return to the same dealership for those services during the lifetime of the warranty period and hopefully beyond.During the height of the pandemic, fleet sales declined significantly. Rental car companies weren’t just canceling orders, they actively sold off their existing fleet to build up cash as cities endured temporary shutdowns and much of domestic travel was halted or significantly curbed. While travel has returned in the second quarter of 2021, overall fleet sales remain depressed.As discussed earlier, auto dealers no longer have excess inventory, and so OEMs are prioritizing all the vehicles they can produce to be sold at heightened retail prices and gross profit margins to individuals.Fleet sales for the first half of the year totaled 969,751 units according to Cox Automotive. This figure represents an increase of nearly 5% compared to the same period in 2020 as demand has increased. However, comparisons to 2020 are not as meaningful due to the interruptions in the auto dealer industry caused by the pandemic. For a truer comparison, 2021 fleet sales represent a decline of over 40% from the same six month period in 2019 as seen below.
So far, auto dealers have not been fazed by the lack of fleet sales. Perhaps the biggest impact of fleet sales has been felt by consumers.
If anyone has traveled recently and tried to obtain a rental car, you likely have experienced an overall lack of supply and a dramatic increase in rental car prices.
The impact felt by the fleet market on auto dealers has been on the used vehicle side of operations. While rental car companies sold off large portions of their fleets in 2020 with the lack of travel, they have not been able to replace that inventory as travel demands have increased. In turn, rental car companies are currently no longer a source of used vehicle units for auto dealers since those purchases were pulled forward in 2020.
It will be interesting to see how these conditions evolve over the latter half of 2021 and 2o22 as manufacturing begins to return to normal from the OEMs.
Vehicle Miles TraveledAnother key indicator that portrays the health of the automotive industry is the number of miles driven or vehicle miles traveled ("VMT"). As with the number of vehicles in service, the number of miles driven contributes to the fixed operations of an auto dealer as vehicles require more parts and service as they are driven more frequently or for longer distances. Increased miles will also lead to the eventual purchase of a new vehicle either from new or used vehicle inventory.VMT has been tracked since 1971, and a graphical view of the rolling 12-month average can be seen below.Over time, VMT has generally increased as the population has grown and more vehicles have been put in service. Since 1971, there have only been a few occasions where the rolling-12 month average has declined, which as noted above, tend to correlate with recessions: 1974, brief periods in the late 1970s and the early 1980s, the Great Recession in 2008 and 2009, and the pandemic in 2020.During the height of the pandemic, the rolling-12 month VMT average dropped below 3 trillion miles for the first time since mid-2014 and even below 2.8 trillion for the first time since the early 2000s. The rolling-12 month average bottomed out in February 2021 at approximately 2.77 trillion miles and has steadily climbed back up to 2.97 trillion miles as of May 2021.During the pandemic, a report from KPMG highlighted some of the factors impacting the VMT and also hinted at longer-term trends that could eventually push that figure back up to historical levels. Obvious factors from COVID-19 included temporary stay-at-home orders and restricted travel. As the pandemic continued, work and commute habits also changed as more individuals either worked from home initially, or others have continued to work from home in some capacity. These behaviors drastically contributed to fewer and shorter work commutes. An additional factor impacting VMT was fewer shopping trips. Digital platforms and e-commerce continue to grab market share from traditional shopping trips to the store. This phenomenon was already occurring prior to the pandemic but continues to persist as some consumer behaviors may have been permanently altered due to long-term health and safety concerns.Is it all bad news as far as VMT is concerned? As mentioned above, the rolling-12 month average has been steadily climbing since January 2021. Shutdowns and stay-at-home orders have all mostly expired and there is pent-up demand in domestic travel.As a result of the pandemic, more people could eventually decide to move out of larger metropolis areas into smaller suburbs. Moving out of the city could create longer commute times and miles driven. Additionally, people may continue to avoid public transportation and rideshare services due to the health impact scares of the pandemic. Both of these trends could lead to more individuals purchasing vehicles, which would eventually contribute to more miles driven.Conclusions The first half of 2021 has been a memorable one for auto dealers highlighted by all-time profitability, heightened gross margins on new and used vehicles, and shortages of new and used inventory. How long will these trends continue and have some trends already shown reversion back to normal levels?As we’ve discussed, certain metrics such as gross margins per unit continue to rise, while others such as average days’ supply of used vehicles, overall auto sales, and vehicle miles traveled appear to be trending toward historical levels. Industry experts are mixed on predicting when inventory conditions stabilize; some indicate later this year, while others indicate it could be 2022 before inventory/supply issues return to normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst the noise, contact a professional at Mercer Capital to perform a valuation or analysis.
Estate Planning Changes Update
It’s been over six months since we last took inventory of where we stood in the face of tax changes (increases) affecting estate planning. We are happy to report that in that time we have gained a firm understanding of the changes that are set to occur. Estate planners should have clarity on how to work through the changes with their clients in a timely manner and at a leisurely pace before the end of the year. Hey look, flying pigs!As Paul wrote to the Corinthians, "For now we see through a glass, darkly." While we may have some ideas on what is coming with the current tax policy, the full picture remains murky. Here’s what we are reading and listening to regarding tax changes and other factors affecting family businesses and estate plans.What Are the Exact Changes as Proposed?Fiduciary Trust International highlighted the key tax issues currently at hand regarding estate planning. These included:The top individual federal income tax rate could increase from 37% to 39.6%.Long-term capital gains tax rate could increase from 23.8% to as high as 43.4% when including the net investment income tax of 3.8%.Cost basis ‘step-up’ could be removed for gains of over $1 million on inherited assets.The federal estate tax rate could increase on a progressively sliding scale for assets transferred over $3.5 million.
A reduction in the gift and estate tax exemption has not been explicitly included in the current round of changes. Given that the current limits are set to expire in 2025, one may wonder if conserving political capital was not part of the equation in leaving the current $11.7 million exemption ($23.4 million for a married couple) in place. One piece of advice the article gives: consider using your full estate and gift tax exemption before the exemption amount is set to decrease.Tax Update: How Proposed Tax Changes Could Impact Family-Owned BusinessesFamily Business Magazine sponsored a webinar featuring two members from BMO Family Office discussing tax planning and tax changes that could affect family businesses – including tax considerations for buying and selling, the tax impact for C corporations vs. S corporations, and 1031 exchanges. The webinar is free for replay when you sign up. Overall, the speakers are 'bullish' (read: not convinced) at the likelihood of the full tax changes coming to fruition. One of the speakers highlighted that the step-up in basis at death has been repealed multiple times legislatively, all to be reversed shortly thereafter. He cited the administrative nightmare of determining basis in family businesses/assets that have been held by families for decades.Bipartisan Infrastructure Deal Still Faces a Long, Uncertain RoadMarketWatch highlighted the recent U.S. Senate movement on the stand-alone infrastructure bill coming in at a cool $1 trillion in new infrastructure spending. However, the Biden Administration’s proposed tax increases would be included in the larger $3.5 trillion budget reconciliation process and are not currently part of the bipartisan traditional infrastructure bill. Benjamin Salisbury, director of research at Height Capital Markets, relayed the following in an investment note:"We maintain our estimate of a roughly 35%-45% probability of passing a joint bipartisan infrastructure bill and slimmed down reconciliation bill, although the situation is highly fluid.""A lesser probability (20%-30%) is that either the infrastructure bill or reconciliation bill pass on their own.""Lastly there is an ever present risk (25%-45%) that the entire effort will collapse under its own weight. We continue to regard the inflation narrative as the largest risk to passage."Moderate Democrats Remain SkepticalElected moderate Democrats remain the most watched politicians in the U.S. today, with multiple congressmen giving pause to the full slate of tax increases and new spending. Senator Kyrsten Sinema (D-AZ) said to the Arizona Republic, "I have also made clear that while I will support beginning this process, I do not support a bill that costs $3.5 trillion." Senator Joe Manchin (D-WV) indicated months ago that he does not support raising the corporate tax rate to 28%. House Agriculture Committee Chairman David Scott (D-GA) has criticized Biden’s plan to get rid of the so-called step-up basis, worrying about its impact on family farms and small businesses. Senator John Tester (D-MT) shared a similar sentiment regarding the basis step-up.Further ReadingNational Law Review – President Biden's Tax Plan Impacts Estate Planning, Capital GainsNorthwestern Mutual – With Gift Taxes and Estate Taxes in Congress’ Sights, Consider Revisiting Your Estate PlanningBarnes & Thornburg LLP - Unprecedented Changes Proposed to Gift and Estate Tax LawsKiplinger – Biden Hopes to Eliminate Stepped-Up Basis for MillionairesFinal ThoughtsOne of my favorite books in 2020 was Radical Uncertainty: Decision-Making Beyond the Numbers. The authors make the distinction between risk (quantifiable: think roulette tables) and uncertainty. Most of life is uncertain, and we are naïve to place numbers and probabilities on all aspects of our lives. The authors note, "Radical uncertainty cannot be described in the probabilistic terms applicable to a game of chance. It is not just that we do not know what will happen. We often do not even know the kinds of things that might happen." Tax changes are quantifiable risks, political machinations in Washington represent uncertainty. Our actions need to represent this distinction.Thus, we leave you with the same advice we provided six months ago: take care of your family and make sure your current estate plan makes sense today. We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.
How to Value an Oilfield Services Company
As the volatility continues with oil field service companies (the OSX has nearly doubled since November 2020), valuation and techniques associated therewith are important to consider right now. Therefore, this week we are reposting our blog post and whitepaper as it pertains to how to understand and value oil field service companies.
When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries)Source: Energy Education
Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value.
Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As previously shared in May of 2019, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns.
While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed. Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers. A widely diversified customer base is typically worth more than a concentrated one. Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied. The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry.ConclusionWe have assisted many clients with various valuation needs in the oil and gas space for both conventional and unconventional plays around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.Originally posted on Mercer Capital's Energy Valuation Insights Blog June 3, 2019
Strong Quarter Propels Alt Managers to New Highs
The second quarter was especially kind to the alt manager sector, which benefited from favorable market conditions and growing interest from institutional investors. Heightened volatility creates more opportunities for hedge funds to generate alpha (when their positions aren’t concentrated in meme stocks), and market peaks often spur interest in alternative asset classes, like private equity and real estate. These trends initially took root last fall before gaining considerable momentum in the second quarter. Much of this momentum is attributable to the VC space as investors turn to private equity and start-up tech firms for higher returns than more traditional asset classes. According to CB Insights, a record 249 firms achieved the $1 billion “unicorn” valuation status in the first half of 2021, almost doubling the total tally from last year.Growing interest in the sector also stems from the fact that alt managers are often better positioned during a prospective downturn than their traditional asset management counterparts. Alt assets aren’t directly correlated to market conditions and are often held in illiquid investment vehicles, which means their investors are locked up for years at a time with no withdrawal rights.While sticky assets can provide a cushion for alt managers in a downturn, the longer-term performance of many of these managers depends on their ability to raise new funds and put that money to work. Raising institutional capital is often a long and involved process in the best of circumstances. For many managers, the economic interruption of last year’s global shutdown presented challenges to their fundraising process that often involves extensive in-person due diligence. And if new funds are raised, there is the question of how fast managers can put that money to work without sacrificing proper due diligence.M&A declined significantly in the second and third quarter of last year, leaving deal teams at many PE firms on the sidelines before rebounding sharply over the last nine months or so.It’s also important to keep in mind that these alt managers and their assets are still vulnerable to bear markets. Public alt managers were particularly affected during the selloff last March, reflecting the decline in portfolio asset values and reduced expectations for realizing performance fees. From February 19, 2020 (the prior market peak), our index of alt managers declined nearly 45% in just over a month. Since then, an outsized recovery has pushed the index back to all-time highs.Such a sharp gain in alt manager stock prices means the market is increasingly optimistic about the sector’s prospects. Performance fees and carried interest payments are likely to increase with rising asset prices. Strong investment performance also tends to entice inflows from institutional investors, which will buoy AUM balances and management fees for most of these firms. The market is therefore anticipating higher revenues for the industry, which should be accompanied by even greater gains in profitability given the sector’s relatively high level of operating leverage (fixed costs).Many alt manager funds also have high levels of financial leverage (debt) that can augment returns when things go well. The trouble is that both forms of leverage can exacerbate earnings when revenue dips or investments underperform. These attributes are what make the alt management industry so volatile and are part of the reason why the sector lost nearly half its value last March before doubling over the next year.On balance, we believe the recent run-up is justified, but it’s important to remember what can happen when alt asset prices go the other way. Expect volatility to remain as investors weigh the impact of a recovering economy and rising inflation on alt asset returns.
5 Trends Facing Family Businesses Today
Back in the spring of this year, we discussed five broad economic indicators family businesses needed to keep their eye on. In this week’s post, we wanted to revisit those trends and see where we have come over the last four months, as well as what we are hearing from our clients on the ground.COVID-19 Cases and VaccinationsSince March, over 120 million people have received at least one dose of the various COVID-19 vaccines, pushing the COVID vaccination rate for U.S. adults to nearly 70%. Daily cases troughed in mid-June and have begun rising once again. However, daily death counts remain 90% below their mid-January peak, and a confluence of vaccinations and estimated infections has pushed a level of ‘herd immunity’ to over 70%, according to J.P. Morgan’s reading of the data. While there is some trepidation regarding the recent increase in infections, the majority of our family business clients are operating at the most "business as usual" we have seen since the genesis of the pandemic.Interest RatesIn March, a consensus was beginning to form that interest rates would continue their ascent unabated. However, as rates took a dive my colleague, Jeff Davis, posed whether or not the “reflation trade” could be coming to an end, with fears of economic growth stalling out and (thankfully) inflation fears perhaps overblown (more on that below).Current rate movements present a double-edged sword for family businesses. If broad rates continue their decline it could portend less-than-stellar economic growth. However, low interest rates still represent an opportunity for financing capital projects and are favorable to gift and estate strategies. Our advice given the backdrop is similar from the gifting side as it was last year: gift now.Labor MarketsBroadly speaking, the labor market has improved dramatically since the height of the pandemic, with most major indicators pointing toward a stronger labor market. This trend is exacerbating one of the main issues facing our family business clients: labor shortages. From electrical supply distributors to medical suppliers, general contractors, and HVAC companies, finding and maintaining talent remains a sticking point for many of our clients. Our clients are quick to point out these are not minimum-wage jobs, with industries most affected looking for labor in pay ranging between $20 to $30 an hour.An article in the Wall Street Journal highlighted Americans are leaving unemployment rolls more quickly in states that were set to end expanded benefits early and reentering the job market. According to NFIB’s monthly jobs report, “46% of small business owners reported job openings they could not fill in the current period, down two points from May but still above the 48-year historical average of 22%.” Expanded benefits are set to expire nationwide in early September, which should create an influx of workers if the states ending benefits early, serve as a guide.Inflation"The Gipper" once said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” While perhaps it’s not really quite as bad as those things, readers who lived through the early Reagan years likely recall the economic pain brought about by inflation rates topping 10% annually. Tighter labor markets, supply chain constraints and disruptions, and a red-hot economy boosted inflation fears during the second quarter.Many of our clients who operate in the energy, hard goods, distribution, and construction fields have seen input costs rise sharply. Inflation rose in June at its fastest rate since the U.S. housing market crash in 2008. The fed continues to monitor inflation levels, but still views the current increase as "transitory". We will have to wait and see: while lumber prices have fallen precipitously and steel stabilized below recent peaks, absolute levels for many inputs goods (soybeans, copper, resin,) and services (container shipping rates) remain high (or as the Reddit-ors would say “To the Moon”). Family businesses would be wise to keep an eye on the ball and revisit pricing assumptions on forecasts more than a few months out.Sentiment IndicatorsWhen we last took a look at sentiment indicators, the concerns of CEOs of larger businesses, could not have been more optimistic, whereas small businesses saw numerous challenges ahead. While the difference in outlook still exists, overall confidence has risen across the board. Consumer confidence (related to consumer spending, which represents nearly 70% of annual U.S. GDP) is expected to continue driving a strong economic expansion. This mirrors many of the conversations we are having with our clients, and family businesses are beginning to shift from "cash preservation" mode, back to smart growth and expansion.SummaryWhile we don’t pretend to play economists, Mercer Capital maintains a sharp watch on national and global economic trends to better advise you and your family businesses. Give us a call to discuss how economic trends are likely to affect your family business.
Formula Clauses for Auto Dealerships
Pros and Cons of Using Formula Clauses in Buy-Sell Agreements
In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents. Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information. For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods. Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric. These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business. This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets. No long division required.This can also lead to less contentious transfers if everything goes smoothly. If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly. However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven.
Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million.
Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%.
Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%.
These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn.
ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
Formula Clauses for Auto Dealerships
Pros and Cons of Using Formula Clauses in Buy-Sell Agreements
In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents. Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information. For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods. Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric. These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business. This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets. No long division required.This can also lead to less contentious transfers if everything goes smoothly. If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly. However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven.
Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million.
Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%.
Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%.
These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn.
ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.
How Long Will It Take to Sell My Business?
That Depends on the Type of Transaction…Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions.Internal TransitionsSale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the owners of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a Company with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the Company and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website. The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany entrepreneurs cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, sellers need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that sellers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists ownership (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.
The Potential Buyers of Your Business
An Overview of the Different Types of Buyers for Closely Held, Mid-Market CompaniesWe regularly encounter business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many prospective sellers believe now is a sensible time to exit.Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful seller preparation and real-time market awareness.Little do most sellers realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective M&A representation.Under ideal circumstances, the planning process for an exit will begin well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual sale is to understand who the potential buyers might be and the different characteristics of these buyers.In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionWhen done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. Potential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof).These transactions generally occur one of two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP).While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to exiting owners regarding their legacy and the continuing prospects of the business as an independent going concern.
Sale to Next GenerationA key consideration in selling to family members or to employees is price. Equally important is the question of how the transaction is financed.Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures.Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert into active leadership. Many may view seller financing as acceptable, if not necessary or desirable, in order to control the terms and costs of the arrangements and to benefit from the interest payments and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well-situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. Following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership PlanESOPs are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership.Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure that best practices are implemented and that compliance awareness governs the transaction. To that end, owners contemplating an ESOP need to be keenly aware of the importance of following a well-designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA (Employee Retirement Income Security Act), ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.In function, the establishment of an ESOP includes the creation of an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all of the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation.Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement.During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should likely consider an alternative liquidity strategy.External SaleIn general, the ability to sell your business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers.The Strategic BuyerA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets.Strategic buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from an expanded market area (cost and operational leverage in our terminology) and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the seller’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple, nearly 100% cash deals, as well as deals that include various forms of contingent consideration and employment/non-compete agreements.Most sellers in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases, strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control.Additionally and/or alternatively, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vice versa. Sellers must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financial sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true-ups that may apply are areas in which sellers should seek skilled professional advisory guidance.The Financial BuyerFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front-end and back-end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criteria of their underlying fund investors, who have signed on for a targeted duration of investment that, by nature, requires the financial investor to achieve a secondary exit of the business within three to seven years after the original acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial InvestorsPermanent Capital ProvidersSingle/Multi-Family Offices
Despite their financial expertise, financial buyers usually do not have the capacity or knowledge to assume the management of the day-to-day operations of all of their business investments. As such, the seller’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.
With respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process by making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.
The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic or financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.
Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach you with an offer that you were not expecting, you and your partners might decide to put the business on the market and seek offers, or you and your partners might opt for an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you manage the transaction process.
Pioneer Natural Resources Pay to Play
A Tale of Two Transactions
As noted in our June 2021 blog post covering Permian M&A activity, M&A transactions picked up in the twelve months ended mid-June relative to the twelve-month period preceding it. Perhaps more importantly, there seemed to be an inflection point in transaction multiples that hinged around the U.S. elections in November 2020.Among all the transactions that occurred over this period, one pair jumped out involving a common buyer and for which valuation metrics were available. These related to Pioneer’s acquisition of Parsley Energy in October 2020 and DoublePoint Energy in April 2021, with implied transaction metrics well above the average and median values in the the respective sub-periods of the reviewed period. Statistics of the valuation metrics for the transactions occurring between mid-June 2020 to mid-June 2021 and the bifurcated sub-periods, both including and excluding Pioneer transaction data, are as follows:Click Here to Enlarge the ImageWe note that, as compared to the transactions table in the aforementioned Permian M&A activity blog post, the transaction counts and statistics presented exclude four transactions for which acquired assets were working interests, as opposed to a property or corporate acquisition. We also note that only one of the four excluded transactions involving the acquisition of a working interest had any useful transaction data available, and the metrics for this one transaction tended to be outliers (on the high side) in the context of the full set of transactions.Tech talk aside, the main point here is Pioneer consistently paid top dollar for its acquisitions from the perspective of the transactions’ valuation metrics. Why?Easy Answer: Pioneer Is a Large Strategic BuyerIn Pioneer’s October 2020 press release covering its acquisition of Parsley Energyand April press release for its acquisition of DoublePoint Energy, the strategic nature of the acquisitions was cited. Prominent in both releases was mention of significant synergies and “unmatched scale” with respect to Pioneer’s footprint in the Permian play.Regarding the Parsley acquisition, Pioneer’s President and CEO, Scott D. Sheffield, stated, “This combination is expected to drive annual synergies of $325 million and to be accretive to cash flow per share, free cash flow per share, earnings per share and corporate returns beginning in the first year.…” It was further noted that, “The combined company will be the leading Permian independent exploration and production company with a premium asset base of approximately 930,000 net acres [representing an approximately 37% increase over its pre-transaction net acreage] with no federal acreage and a production base of 328thousand barrels oil equivalent per day (“MBoepd”) and 558 MBoepd as of the second quarter of 2020. Additionally, based on year-end 2019 proved reserves, this transaction will increase Pioneer’s proved reserves by approximately 65%.”Similarly, synergies were noted in the DoublePoint acquisition, including expectations annual cost savings over the next 10 years of $175 million, stemming from increased operational efficiencies and reduced G&A and interest expenses, with a total present value of savings of approximately $1 billion. This transaction also expanded Pioneer’s Permian footprint by an additional 97,000 net acres to over 1 million total net acres in its core Permian position. This addition implies an increase of 10% over its 930,000 total net acreage holdings following the Parsley Energy acquisition, and further fortifies the company’s position as a premier Permian E&P operator.While the strategic argument makes sense fundamentally, arguably any transaction involving an existing E&P company entering or expanding their presence in the Permian could be deemed a “strategic” acquisition. Let’s dive a little deeper into the numbers behind Pioneer’s acquisitions to see if there may be another differentiating factor.Deeper Answer: Production DensityIn our analysis of Permian M&A activity over the past twelve months, we presented deal values and valuation metrics such as deal value per acre and per production (Boepd). As might be gleaned from those metrics, our data set included the net acreage and production values associated with the acquisitions, though these specific data points were not presented outright.Utilizing the full set of data to examine the transactions, we developed and reviewed certain indicators beyond the presented valuation metrics. In particular, we calculated the implied annual production (total implied Boe) per acquired acre for each transaction. We’ll refer to this as “production density.” The following table presents the full data set which will be referenced:Click Here to Enlarge the ImagePioneer’s acquisition of Parsley Energy indicated a production density factor of 267 Boe/acre. Among the six transactions that occurred from July to October 2020, this was the second highest value, being only 7 Boe/acre lower than the highest indicated value implied by the Devon Energy-WPX Energy transaction. Conversely, this production density factor of 267 Boe/acre was 26% greater than the next highest factor of 212 Boe/acre implied in the ConocoPhillips acquisition of Concho Resources, which was announced the day prior to the Parsley acquisition announcement.Among the transactions announced from November 2020 through mid-June of this year, the production density factor of the Pioneer-DoublePoint Energy acquisition was 376 Boe/acre, which was just over 13% higher than the production density of the next highest value of 332 Boe/acre implied by the Vencer Energy-Hunt Oil acquisition, and was the highest value among all the acquisitions in the Permian listed over the full 12-month period ended mid-June.ConclusionIn our prior analysis of Permian M&A activity from mid-June 2020 to mid-June 2021, several points came to light:Transaction multiples appeared to have an inflection point, with significantly lower multiples indicated from the transactions announced after October 2020 relative to the indicated multiples for transactions announced prior to November 2020.Given the publicly available information, Pioneer was the only buyer in both sub-periods noted (for which useful transaction data was available).The transaction multiples stemming from the Pioneer acquisitions were among the highest, if not the highest, in the respective sub-periods, making them among the highest multiples for the entire 12-month period reviewed.
While commodity prices could have been a factor, we note that WTI futures as of April 2021 were, on average, 30% higher than WTI futures as of October 2020 when looking at a 12-month span consecutively for nine annual periods that followed the respective measurement dates. On one hand, this could be interpreted to mean that valuations should have been greater in the latter sub-period (with higher futures prices). On the other hand, the higher prices in the future might have been indicative of uncertainty regarding the Biden Administration’s rhetoric and possible actions that would more than likely prove to be headwinds to the oil and gas industry overall. Commodity prices notwithstanding, the data available and subsequent information gleaned from it suggest Pioneer was able to act on two prime opportunities that would further enhance the quality of its acreage and production portfolio.
We have assisted many clients with various valuation needs in the full stream of the oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
RIA M&A Q2 Market Update
Whispered Numbers Shout
RIA MIA activity slowed somewhat in the second quarter of Q2, but RIA markets are still on track to record the highest annual deal volume on record.In the latest RIA M&A Deal Report, Echelon Partners attributes the pace of RIA M&A to (1) secular trends, (2) supportive capital markets, and (3) potential changes in tax code in the future.
As we discussed last quarter, fee pressure in the asset management space and a lack of succession planning by many wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. Further, the Biden administration’s proposal to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current tax rates.
But could some of this activity be attributable to the RIA rumor mill and the hype of double-digit multiples in the space?
He Says, She Says … "They sold their firm for 12x"Although there are over 13,000 RIAs in the U.S., during times like these, the investment management world feels pretty small. Word travels far and fast, and often with minimal detail.Clients have been asking us about double-digit deal multiplesOver the last few months, more of our clients are asking us about double-digit deal multiples and many owners of small firms are understandably confused when they see our comparably lower indications of value.So how does all this transaction activity affect valuations?Guideline Transaction MethodAs independent valuation analysts, we are tasked with finding market transactions of privately held companies in the same or similar business that may provide a reasonable basis for valuation of the company we are valuing. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company and the comparable companies. Activity and earnings multiples developed using the market transactions method are used to capitalize appropriate estimates of AUM, revenue, and earning power for the subject company.In most of our valuations of investment management firms, we seek perspective on the M&A market’s pricing of closely held investment management firms by evaluating transactions involving acquired U.S.-based investment management firms with between $1 billion and $25 billion of AUM. However, given the lack of publicly available information for transactions in the industry, the data from guideline transactions has limited significance for making inferences.Even when deal multiples are “known,” they can be misleadingEvery transaction has different motivators that affect the buyer’s willingness to accept a certain price and the seller’s willingness to pay up. Most RIA transactions include some form of earnout, which can skew the implied deal multiples. And more frequently, deals include some form of an earn-more consideration that may or may not be reasonable to include when calculating implied deal multiples.Even when deal multiples are “known,” they can be misleading. A transaction priced at, say, nine times pro forma earnings – with normalized compensation, back-office synergies, anticipated changes in fee schedules, and other adjustments – might also be viewed as fifteen times earnings, as reported. So, is the deal multiple nine or fifteen?RIA buyers are, for the most part, very sophisticated, and not disconnected from realityUnfortunately, there is a perverse incentive to talk about the higher multiple. Sellers want to brag about how much they got. Buyers want to be seen as the most generous to attract other sellers into the process (reality can wait until after the LOI is signed). And in a market with surplus of buyers, intermediaries (the investment bankers), naturally, want to encourage sellers however they can.Don’t get us wrong, the RIA market is very strong, and multiples are very high. But RIA buyers are, for the most part, very sophisticated, and not disconnected from reality.Much of the confusion we see in expectations is being fueled by dozens and dozens of deal announcements with undisclosed terms. In the absence of real information, imagination fills the void. Although we have knowledge of the pricing of many undisclosed deals, we can’t directly rely on this information in a business Appraisal (with a capital “A”) – as it doesn’t constitute known or knowable information to hypothetical buyers and sellers. But all this transaction activity and the increase in observed deal multiples has, nonetheless, impacts investment management valuations. This conflict between publicly available pricing information and rumored deal multiples makes it even more important to hire a valuation firm experienced in this space.There is no argument that multiples across the investment management space have increasedBecause reliable guideline transaction information is scarce, it is essential to build the factors driving the volume of transaction activity and heightened pricing into projections and the cost of capital. Improved equity markets have been driving AUM growth. The inherent operating leverage in the business along with the realization over the last year that RIAs can operate just as efficiently with less or cheaper office space, is driving margin expansion. While it is harder to model increased demand for these businesses into a discounted cash flow model, it can serve to minimize risk and reduce discount rates. Overall, these changes to valuations are generally more subjective.But there is no argument that multiples across the investment management space have increased. As our president, Matt Crow, has said before about RIA transaction multiples, “an option has value, even if you don’t exercise it.”
June 2021 SAAR
The June 2021 SAAR totaled 15.4 million units, which is up 12.4% compared to June 2020 (the lowest June figure in recent memory due to the COVID-19 pandemic) but down 9.9% from May 2021. New light vehicles sales fell for the second straight month in June, highlighting the ongoing supply and demand imbalances in the market for new cars and trucks.After a strong start to the year, driven by feverish demand from retail and fleet consumers, a shortage of new car and truck inventory has started to weigh on sales. The Inventory to Sales Ratio, published along with SAAR, continues to fall, as seen in the graph below. This ratio captures what many auto dealers already know: demand has been strong and supply chain issues have not gotten any better.
With such strong demand intersecting low supply, many vehicles are selling at or above MSRP. According to J.D. Power, in mid-June, 75% of vehicles sold for MSRP or above, up from 67% in May 2021 and up even more from the pre-COVID-19 pandemic average of 36%.
SAAR ran hot from 17.0 million to 18.6 million from March to May this year, making supply even shorter. Inventories have plummeted as dealers are not able to replenish their lots. While this has led to lower floor-plan costs and higher GPUs, the decline in SAAR in June shows dealers may finally be experiencing what people were concerned about. Business owners can draw down inventories to maintain sales levels, but eventually, those inventories will run out. Lower inventory levels are expected to continue to limit the sales pace of dealers around the country.
Microchip Issues PersistAccording to the NADA, the inventory crunch is likely to get worse before it gets better. Average inventories are expected to remain flat in June compared to May at around 1.5 million units, before dropping again to around 1.3 million units by the end of July. Microchip shortages continue to plague the industry and are a predominant factor in the slowdown, though dealers have noted other parts and areas of vehicles are in short supply as well. With little to mitigate the situation on the horizon, it has become clear that this shortage will impact the manufacturing of new vehicles for months to come. This chip shortage is not unique to the United States or to the Automotive industry, as Automotive News Europe recently reported that the “exponential increase in demand for microchips will need a long term solution.”We note the “end” to the microchip shortage continues to be kicked down the roadMany sovereign governments are considering taking steps to increase production, as the number of industries that require microchips continues to grow. Economic agents are considering economy-wide solutions to this sweeping problem, but relief is not expected until sometime in early 2022. Until then, dealers will most likely have to continue to operate at lower-than-normal inventory levels or focus on vehicles that utilize less chips. We note the “end” to this shortage continues to be kicked down the road, so even the expectation this situation will be alleviated in early 2022 may not comfort dealers that have seen expectations continue to get pushed out.Several U.S. automotive manufacturing plants have had to suspend operations in response to the chip shortage. For example, the Ford plant in Chicago that produces the Ford Explorer will be shut down from the week of July 5th to the week of July 26th. Additionally, the Ford plant in Kansas City that produces the best-selling F-150 pickup truck announced it will be shuttering the production line for a few weeks in July as well. Ford’s Michigan assembly plant that recently started shipping the Ford Bronco will also be down for two weeks in July due to parts shortages. These shutdowns are not specific to Ford, as most auto manufacturers have been trying to find ways to react to the ongoing situation.It’s Not Just Microchips Many automotive plants have temporarily shut down due to the microchip shortage, but microchips are not the only input that has been scarce. Seating foam, plastics, and other petroleum-based products have been harder to acquire over the last several months due to longer lead times on orders, historically high prices, and very tight supplies.According to Industrial Specialties Manufacturing, the market is currently unable to supply the U.S. demand for plastics. Experts say that the complete restoration of the plastics industry could come in late 2021 or early 2022, but certain factors must be in play for this recovery to occur, like repairing oil and gas infrastructure, returning to normal volumes of chemical feedstock for plastics production, and repairing plastics compounding and extruding machinery in plants that have yet to ramp up to full production capacity.Used Vehicles In High DemandWhile the story surrounding new cars and trucks has been characterized by supply constraints over the last two months, used cars have stepped into a more prominent role at most car lots to fill this gap. Pent up demand for new cars is pushing car buyers into the used-car market, driving up prices of used cars in the process. Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last year, the highest price jump on record for the auto research firm. This has had ripple effects throughout the economy.Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last yearThe Consumer Price Index jumped 5.4% in June, stoking concerns about runaway inflation. However, the Federal Reserve has maintained its view that inflation is transitory, which appears to be supported by the significant year-over-year increases in used vehicles, gas, and airfare, which have played a large role in the jump in CPI. Excluding these, month-over-month core CPI would have only risen by 0.18% in June according to Bank of America.Used vehicle prices have climbed at a steep pace due to similar supply and demand-related pressures as the new car market, with scarcity issues coming in the form of hotly contested wholesale markets where dealers typically acquire most of their used inventory. Dealers are being forced to spend more to fill their lots with used vehicles, making it harder for buyers to negotiate on used car prices than in the past. Jonathan Banks, Vice President of Valuation Services at J.D Power had this to say about the used market:"After increasing for 24 consecutive weeks, wholesale auction prices peaked in June, attaining their highest level on record, and have now begun to gradually decline. Despite the recent cooling, the used market remains incredibly strong and, at the end this year, prices are expected to be up by approximately 29% on a year-over-year basis. The used market’s continued strength is driven primarily by the expectation that used supply will remain a challenge and that new-vehicle market challenges will remain in place for the foreseeable future."What Forecast to ExpectAfter an unusually hot start followed by a tightened market environment, this year has been unpredictable for dealers and manufacturers in the automotive industry. As far as demand is concerned, it is unlikely that the desire for new and used vehicles will cool off any time soon, as many consumers return to work and may be in search of a new or used vehicle to get them there. However, new light vehicle sales for the remainder of the year will likely continue to be supply-constrained. If production can recover and exceed expectations, we could see sales close to 17 million units by the end of the year. However, given the more likely outcome, total light vehicle sales are expected to be somewhere between 16.3 and 16.5 million units in 2021.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.
A (Not So) Bold Prediction
The Rise of Non-Family Equity Capital in Family Businesses
The rise of the family office has been one of the most significant themes in family enterprise over the last decade. Looking forward, we believe that the number of family businesses raising non-family equity capital will grow dramatically in coming years.We don’t think we are going too far out on a limb with this prediction. In this post, we take a quick look at the growing supply of capital seeking minority investments in family businesses, the sources of growing demand from family businesses for such investment capital, and how directors can best position their family businesses to thrive.Growing SupplyWith an abundance of dry powder to invest, private equity firms are increasingly willing to acquire non-controlling stakes in family businesses. Governance and exit mechanisms vary, but more and more PE investors are willing to ride in the passenger’s seat rather than the driver’s seat.Family offices also represent a growing source of capital for family businesses. Following the old investment adage of “Invest in what you know,” some enterprising families seek to diversify their portfolios by acquiring minority stakes in other family businesses.Finally, in last week’s post, we commented on Amazon’s strategy in acquiring equity warrants for minority investments in suppliers. While we focused on the issue of customer concentration in that post, it is also an example of strategically motivated capital available to family businesses.Growing Demand?But will there be demand for the supply of non-family equity capital? For decades, many families have perceived a stigma to using non-family equity capital. What factors could cause that stigma to fade?We sense an increasing willingness to consider using non-family equity capital in our discussions with clients. This inclination seems to be especially pronounced among shareholders in the third and subsequent generations. Among those members of the family, we find more of a tendency to evaluate risk and return from the family business in the context of other investment alternatives. In other words, many shareholders want to treat the family business as an important part of their personal portfolios but are not enthused about having all their investment eggs in the family business basket.These family shareholders tend not to be enamored by either of the traditional family business capital management strategies: (1) constrain growth to that which is supportable by retained earnings, or (2) rely on periodic "bet the farm" debt levels to fund more aggressive growth plans. Using non-family equity capital opens a third path along which businesses can grow without starving family shareholders of current income or using uncomfortable levels of debt financing.Finally, given the challenges of managing family dynamics, the need to prune the family tree of unaligned shareholders will probably never go away. Exchanging Uncle Joe for a non-family equity investor can ease family tensions without adding to the financing constraints facing the managers of the family business.Questions for Family Business Directors to ConsiderWhat questions should family business directors begin asking themselves about this trend? Let us suggest five:Where is your family business going? What is your strategy for meeting the challenges and opportunities that are likely to arise in your industry? If long-term sustainability and family control is your goal, what should your family business look like in ten years?What is the return profile of your family business? Investment returns come in two – and only two – forms: current income from dividends and capital appreciation. What mix of these return components are you providing to your family (or prospective) shareholders? How do those return components compare to other investment alternatives available to your shareholders?Who should own your family business? Your current shareholder list is likely of function of time and chance more than intention. If you could start from scratch today, who would your family shareholders be, and why? Are some of your existing family shareholders a better fit for the return profile of your family business than others?How will investors value your family business? What are the expected cash flows, risk factors, and growth prospects that are relevant to your existing shareholders? To a potential equity investor? Remember that your family business has more than one value.When will your family business need outside capital? For many years, our colleague, Chris Mercer, has been asking, “Is your business ready for sale?". Opportunities often arise unexpectedly, and Chris’ point to business owners is that there are significant benefits to being ready to sell even when you don’t intend to do so. The same idea applies to family businesses that may need outside capital: the time to prepare for that day is now.
We don’t make a lot of predictions here at Family Business Director, but the growing use of non-family equity capital in family businesses is one that we are confident making. Family business directors would do well to begin thinking about how to leverage this trend to their benefit. Look for more on this trend in future posts.
Does Vine Debut Portend Ripe Market for More E&P IPOs?
It’s been tough out there for equity capital markets bankers covering the upstream sector. Since 2016, there have only been five U.S. exploration & production company IPOs. [1] The dearth of activity is driven by a number of factors, including poor historical returns from the space, special purpose acquisition companies (SPACs) supplanting the traditional IPO process, and environmental, social, and governance (ESG) pressures resulting in less capital availability.
Three U.S. E&P IPOs took place in late 2016 and early 2017. Berry Petroleum, a California producer focused on conventional production methods, went public in mid-2018. Nearly three years would pass until the next IPO: Vine Energy.
Vine IPOVine Energy, a pure-play Haynesville gas producer, broke this nearly three-year dry spell with their IPO in March of this year. However, Vine had a rough start as a public company. The IPO priced at $14 per share, below the anticipated offering price of $16 to $19 per share indicated in Vine’s S-1. Once trading began, there was no typical IPO pop, as the stock opened at $13.75. The stock continued to trade down over the next several weeks, closing below $11 in mid-April.
However, Vine’s stock price performance since the nadir has been relatively strong. The stock price rose to almost $16 in late June, up more than 44% from its low. Overall, the stock is up 8% from its IPO price, outperforming the broader E&P sector (as proxied by XOP, the SPDR S&P Oil & Gas Exploration & Production ETF), though still lagging the S&P 500.
Are More E&P IPOs Coming?While we don’t have a crystal ball, there several are factors that could lead to additional E&P IPOs over the next several years.Restraint Leading to Returns: E&P companies were maligned for a “drill, baby, drill” mentality which led to huge amounts of capital being deployed to generate suboptimal returns. However, they seemed to have learned their lesson and are now showing capital discipline, even in light of a much-improved commodity price environment. The result is that shale drillers are actually delivering free cash flow. That appears to be impacting stock prices, as the year-to-date performance (through 7/13/2021) of XOP has trounced the S&P 500 (shown in the following chart). If this performance holds, investors who previously shunned the industry may begin dipping their toes back in with increased allocations to the sector.Need for Private Equity to Exit: Between 2015 and 2019, private equity funds raised approximately $86 billion of capital to deploy on U.S. oil & gas assets. However, that capital raising has slowed, and traditional oil & gas PE sponsors (including Riverstone, EnCap, and NGP) have begun focusing on energy transition investments. With less private equity capital in the ecosystem, and public E&Ps showing restraint with respect to capital spending, public markets may be the best exit opportunity for certain larger PE-backed companies.
It Might Be Another Long Dry Spell Before We See Another E&P IPOLack of Public S-1 Filings: The IPO process is an involved and lengthy affair. One of the first steps required to go public is filing an S-1, which is the initial registration form for new securities required by the SEC. The S-1, which is usually filed well in advance of an actual public offering, describes the company’s operations and includes financial information. According to data from Capital IQ, there do not appear to be any U.S. E&P companies with active registration statements for material sized (>$50 million) offerings. The most recent S-1 filings for uncompleted offerings are from Tapstone Energy and EnVen Energy Corporation. However, both of those registration statements have been withdrawn. With no E&P companies currently teed up to go public, it will likely be a while before one makes it through the process.Less Need for Growth Capital: As previously discussed, with many shale drillers generating free cash flow, there is less need for growth capital to support operating activities. As such, private operators may eschew the scrutiny and pressure of public markets and remain private.Continued ESG Pressures: With increasing emphasis on ESG issues, it could be challenging to generate the typical level of investor appetite necessary to successfully execute an IPO, especially among large institutional investors who typically anchor many IPO processes.SPAC Alternative: SPACs have emerged as a viable alternative to the traditional IPO process. Several E&P companies were early adopters of SPACs as a means to go public, including Centennial, Alta Mesa, and Magnolia. While many energy-focused SPACs indicate that they are seeking opportunities in the energy transition space, there are a handful that may be seeking to acquire E&P companies.ConclusionVine’s public market debut brought an end to a long-running drought of E&P IPOs, though it may be more of an anomaly than a harbinger of things to come. With no public S-1 filings among upstream energy companies and continued investor focus on ESG issues, we don’t expect to see any new public E&P companies any time soon.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] We note that there have been other upstream companies that have gone public via a SPAC (e.g., Centennial, Alta Mesa, and Magnolia) as well as mineral-focused companies that have had traditional IPOs (e.g., Brigham Minerals and Kimbell Royalty Partners). However, this post is focused on traditional IPOs of exploration & production companies.
Asset / Wealth Management Stocks See Another Quarter of Strong Market Performance
Publicly Traded Asset / Wealth Managers See Continued Momentum Through Second Quarter as Market Backdrop Improves
RIA stocks continued to have strong performance during the second quarter, with most individual stocks in our indices hovering near 52-week highs today. Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 26% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets. The index of traditional asset and wealth managers rose 15% during the quarter, with performance driven by rising AUM balances and favorable market conditions. The stock price performance of RIA aggregators trailed other categories, with the aggregator index increasing only 6% during the quarter. Weak relative performance for the RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model.While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals.
The upward trend in publicly traded asset and wealth manager share prices over the last quarter is promising for the industry, but it should be evaluated in the proper context. Many of these public companies continue to face headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance during the second quarter was generally better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts.
As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first and second quarters last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances.
Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. With markets near all time highs, most RIAs are well positioned for strong financial performance in the back half of the year.
The Electric Vehicle Race
Tesla vs. Everyone
Is Tesla’s Grip On the EV Market as Iron Clad as It Once Seemed?Electric vehicles have continued to gain momentum, forecasted to reach 3.55% of the U.S. market share of total vehicles by the end of this year. While this is still a relatively small portion of total auto sales, manufacturers continue to invest in their electric technology to prepare for a future in which electric vehicles may be the norm.
When you think “electric vehicles,” there has been one brand that has established itself as a clear leader: Tesla.
Elon Musk, Tesla CEO, when he’s not tweeting about Dogecoin or other memes, is solidifying the company as the go-to manufacturer for electric vehicles. According to data from Experian, Tesla accounted for 79%of U.S. EV registrations in 2020, with 200,561 of its electric battery operated vehicles registered. This is an increase of 16% from 2019 when owners registered 172,438 Teslas. Tesla has dominated the industry, with the three highest selling EV models since 2018 as seen in the graph below.
Tesla’s Model 3 alone has more sales than all the other electric vehicles combined and when you consider the Model S and the Model X, there have been three times more Tesla vehicles sold than the trailing top 5 competitors. While Tesla’s dominance in the U.S. is clear, the graph below helps illustrate that Tesla’s lead may not be as iron clad as it once was when looking at market share on a year-to-year basis.
Tesla’s Model 3 has been losing market share since 2019, largely attributable to the influx of new EV options in the marketplace. In 2021, Model 3 market share is anticipated to drop even further, with expected new EV options diluting the market. With more auto groups intent on gaining a slice of the pie, competition is expected to continue to steepen going forward.
CompetitorsWho is challenging Tesla in the EV space? We have laid out the top competitors:VolkswagenAfter half a million diesel Volkswagen models were cited for violations in the 2014 emissions scandal, the company is clearly trying to clean up its image. One way they are doing this is in electric vehicle initiatives. In 2020, the brand delivered nearly three times as many pure-electric vehicles as they did the year before, up to 134,000 electric vehicles and 212,000 electrified cars in total worldwide. By 2030, the company hopes that their fully-electric vehicles will account for more than 70% of the brand’s European sales and a market share of over 50% in U.S. and China.Deutsche Bank analysts have bullish predictions for Volkswagen. As a team of analysts led by Tim Rokossa noted that with a new target for electric vehicles of 1 million this year, the majority of which will be electric battery vehicles, the German automobile maker should come “very close to Tesla’s battery electric vehicle sales.” Volkswagen is already taking a lead in European markets, as they accounted for more than 22%of the market shares after 10,193 vehicles were registered. This compares to Tesla’s market share in 2020 of only 13% across the pond. Looking forward, Volkswagen’s ability to convert customers in the U.S. market will be crucial in gaining market share.StellantisLike Volkswagen, Stellantis presents a substantial threat to Tesla’s electric vehicle dominance in the United States after it has performed impressively in Europe. The world’s fourth largest car maker’s electric vehicle share accounts for nearly 17% of the market share in Europe, trailing only Volkswagen. The company announced last Thursday that it would invest more than $36 billion through 2025 as a plan to accelerate in the EV race. The company had already announced in April that they set out targets to offer an electrified version of nearly 100% of its models by 2025. With this investment initiative is the bold plan of targeting 70% of European sales and 40% of U.S. sales coming from low emission vehicles by 2030. The company has significant ground to make up in the U.S. markets in order to achieve this goal, and like Volkswagen, will need to focus efforts on conversion in this market.FordFord’s sales of EVs expanded 117% in June, reaching a new first half sales record of 56,570 vehicles. Behind these figures were the success of Ford’s fully electric Mustang Mach-E and F-150 PowerBoost Hybrid. More importantly than just the recent increase is the fact that 70% of customers who bought the battery electric SUVs are new to Ford, meaning the additions may be helping them to capture market share.Ford’s ability to produce an electric pick-up, the F-150 Lightning Electric truck, makes them dangerous in a U.S. auto market driven by light truck sales (light trucks accounted for 75.9%share of U.S. auto sales in 2020). With Ford having thesecond largest total vehicle market share in the U.S., trailing only GM, their ability to convert current users of their traditional vehicles to electric will be just as important as gaining new customers in expanding their EV market share reach.General MotorsThe largest auto manufacturer of traditional vehicles in the U.S. is hoping to have success in the EV space as well. The Chevy Bolt has the highest number of sales in the U.S. of non-Tesla brand vehicles. Additionally the company has committed to becoming an all-electric vehicle company by 2035, meaning there is significant investment in this business line that is occurring. The company is also hoping to cut costs through making their own battery cells through a joint venture with LG Chem in Ohio. A facility is under construction and expected to be completed by 2022. Like Ford, a key component in gaining electric vehicle market share will be converting some of their current users of traditional vehicles.Batteries Are KeyDespite the encroachment of other traditional OEMs on Tesla in the EV space, the hurdle that they will have to overcome to catch up lies in one specific part of the vehicle: the battery. It is currently a race to the bottom, with the battery costs in an electric vehicle being a primary reason that electric vehicles continue to be pricier more costly than traditional vehicles. However, this price has been dropping, with Tesla leading the way. Tesla has managed to drop their cylindrical cell battery pack down to around $150 per kWh last year, nearly an 87% decline from 2010 as seen in the graph below:
Tesla is the only automaker to use this type of cylindrical battery cells in its battery pack. Its competitors, like those discussed above, use battery packs containing pouch or prismatic battery cells. According to Cairn, these cost on average more than $200per kWh in 2019. Automakers are aware that even though they are throwing billions of dollars at batteries and EV production, Tesla’s lead on the technology of these vehicles is undeniable. Colin Rusch, auto analyst for Oppenheimer notes, “At core there is really incredible battery technology within the organization and that is material science that they have been working on for well over a decade. We think they have some substantial advantages on that.” Tesla competitors eager to get the edge on the EV giant will have to continue to invest in their battery technology in order to drive down prices.
The Real WinnersThough uncertainty remains surrounding whether or not Tesla will be dethroned in the U.S. EV space, there is one clear winner among all of this investment and competition: the consumer. More investment into EV technology and competition between brands means that electric vehicles likely will become more readily available to car buyers at more affordable prices. While Tesla is the largest player in the U.S. market, their image of luxury vehicles prevents many people interested in electric from joining the market. Larger offerings of mass market vehicles will help to show the true demand that is there for these types of cars and trucks.Additionally, auto dealerships also stand to benefit from this push. With two thirds of car consumers interested in electric vehicles, they may present a unique opportunity for dealerships particular those whose OEM is able to produce the most attractive models. However, there are some concerns about how EV’s will affect the bottom line on the service portions of the business. A 2019 reportfrom AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell. If electric vehicles ultimately gain the market share that they are anticipated to, dealerships may need to become more savvy in mitigating these service and parts revenue declines. Like NADA, we remain bullish on the role of auto dealerships in the EV sales process despite concerns regarding direct-to-consumer sales channels from the OEMs. Additionally, dealership owners have expressed some concern over how OEMs will handle the EV units from their traditional dealership models. If OEMs continue to allocate units to each dealership, this presents an opportunity. However, if they instead follow Tesla’s lead and adopt a more direct to market approach to selling new units, this may pose a problem for dealerships.If you would like to know more about the electric vehicle industry and what this all may mean for your auto dealership, feel free to reach out to anyone on Mercer Capital’s Auto Team.
Customer Concentrations and the Value of Your Family Business
With a new CEO ascending to power and an old CEO ascending to space, there has been no shortage of Amazon-related headlines this week. But amid the leadership transition news, a less-prominent Amazon story is equally relevant to family business directors. AWall Street Journal article revealed how Amazon uses its dominant negotiating position to extract warrants to purchase equity in suppliers.For years, our clients have told us how purchasing groups at Wal-Mart pushed aggressively for price cuts. Our clients were grateful for the business but knew that holding on to that business and earning a profit on it required them to identify and root out inefficiencies in their own operations. Several clients reported that the discipline of supplying Wal-Mart had spillover benefits on other areas of their business. Now Amazon has added a page to Wal-Mart’s playbook, seeking to capture a portion of the upside accruing to shareholders by acquiring warrants in those suppliers.A warrant gives the holder the right – but not the obligation – to purchase shares in a company at a fixed price at some future date. Because the price is established today, but doesn’t have to be paid until the future, the warrant holder shares in the benefit of upside with the shareholders but does not bear the burden of the downside. For example, if the warrant has a fixed price of $100 per share and the company performs well, pushing the stock price to $200 per share, the warrant holder will exercise her purchase right and realize a gain from the increase in value. On the other hand, if the company performs poorly and the share price falls to $50, the warrant holder will simply decline to exercise the purchase right and thereby avoid the loss borne by the shareholders.Since warrants have such an attractive investment profile, why are suppliers willing to give them to Amazon? Obviously, they think the opportunity to do business with Amazon is worth the dilution to future returns. Amazon’s negotiating leverage is an example of the perils of customer concentration.When we value family businesses, we focus on three things: expected cash flow, risk & growth prospects. Large customer concentrations can boost expected cash flows, but also increase the risk of those cash flows. All else equal, higher risk translates into a lower valuation multiple. For many clients, this is a “high class” problem: would you rather have a business with $100 of EBITDA and a 6x multiple, or $200 of EBITDA and a 5x multiple? The challenge for family business directors is to identify strategies for mitigating the risks of customer concentration while retaining the business of the large customer.We have observed two strategies that have worked well for our clients seeking to mitigate customer concentration risk.The first, and probably most obvious, is to leverage what you learn from dealing with the large customer into new business with other customers. Just as the most demanding teacher is probably the one that you learned the most from, the most demanding customer is probably the one to teach you the most about your own business. As we mentioned at the beginning of this post, several clients have confessed to us that, while selling to Wal-Mart was not exactly enjoyable, the challenge of doing so forced them to improve their processes and cost structure. As a result, they were in a better position to secure profitable business from other customers.Continuing our example, suppose the company leverages its experience with the large customer to capture additional profitable business from other customers and EBITDA grows from $200 to $300 (a 50% increase). As the customer concentration risk recedes in the wake of a more diversified customer base, the valuation multiple is restored to 6x, resulting in an 80% increase in value ($1,000 to $1,800).The second, and more difficult strategy, is to rebalance the negotiating leverage in the supplier/customer relationship. Does your customer have leverage because they can “push” your product through to the end user? This is how most large customer concentrations start. But some of our clients have been able to take back some of that leverage by investing effectively in their brand so that the end user “pulls” the product through the customer’s channel. Successful brands are less susceptible to the power of large customers because those customers need the brand as much (or more) than the brand needs them. Strengthening the family business brand to this point is likely the work of decades, not years, but can pay significant dividends in both higher cash flows and higher valuation multiples.
Does your family business have a significant customer concentration that is reducing the valuation multiple? If so, what steps are you and your fellow directors taking to mitigate this risk? Give one of our valuation professionals a call today to discuss how customer concentrations are affecting the value of your family business.
Summer 2021 Reading
Family Business Director is off enjoying 4th of July festivities this week. For our readers that are looking for some beach reading, we thought we would direct your attention to some of our more popular posts in case you missed them the first time around.Valuation Principles Family Business Directors Should Know in 2021Family business directors will make plenty of difficult decisions in the remainder of 2021, and many of those decisions will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target. What should you and your fellow directors know about valuation? In our experience, there are six basic valuation principles that can guide directors as they make tough valuation-related decisions in the coming year.Click Here to ReadNavigating Tough Family Business ConversationsHow should your family business have discussions around sensitive topics? Perhaps it is a patriarch who has run one too many strategic board meetings, the cousin who refuses to take their Vice President role seriously, or the aunt who is rather loose in defining what a “business meal” is. “No Aunt Millie, this is not a case of defining what ‘is‘ is”.Click Here to ReadThe Three-Legged Stool of Family BusinessOur family business advisory practice is focused on three strategic financial questions that weigh on family business directors and can keep them awake at night. Clients often solicit our advice because they are struggling with one of these questions. But, in our experience, the questions can’t really be tackled in isolation. Each question comprises one leg of the three-legged stool of the family business. As an engineering-minded client recently pointed out to us, while it is impossible for a three-legged stool to wobble, it can be crooked. If the three legs are not designed to work together, the stool won’t be level, and won’t hold anything valuable for long.Click Here to ReadAll EBITDA Is Not Created EqualIn the world of family-owned and other private businesses, EBITDA is the most commonly cited performance measure. Every company has EBITDA, but some EBITDA is better than others. Why is that?Click Here to ReadThe Economics of Family Shareholder RedemptionsRegardless of the reason, significant shareholder redemptions are among the least understood corporate transactions. In this post, we consider the economics of family shareholder redemptions from three perspectives: the selling shareholder, the family business, and the remaining shareholders.Click Here to ReadWe hope you have a relaxing and enjoyable summer break. If you know a family business director or advisor that might benefit from our content, forward this note or email us and we will be sure to add them as a subscriber. Happy reading!
Industry Trends From the Road
Key Takeaways from State Automotive Annual Conventions
We recently attended the annual conventions of two state automotive groups – Kentucky and the Tri-State Convention consisting of Tennessee, Alabama, and Mississippi. It was refreshing to attend live events again after the virtual world we have all grown accustomed to over the last fifteen months. Live events like these serve as a great venue for shared information about industry trends and cultivating business relationships.In this post, we summarize certain sessions that our readers might find of interest. If the topics were similar, we present those topics together. We also layer in highlights from our conversations with dealers and other industry participants.Cybersecurity for Auto Dealerships and Fraud and the Distracted EmployeeCybersecurity IssuesOver the last year, there have been several high-profile instances of cybercrimes and fraud, including the ransomware hacks on Colonial Pipeline and JBS. These topics that typically lurk in the shadows have been brought into the national discourse, and there were two sessions devoted to best practices to protect against cybercriminals and how to detect fraud from within an organization.While we typically think of these sorts of things as something that happens to other people, speakers showed just how much they can impact the auto dealer industry and how the economic fallout of the COVID-19 pandemic has increased the motivation and prevalence of fraud.Auto dealers experience nearly six times the amount of cyber criminal activity than other industriesIdentity Theft crimes account for $50 billion in damages and recovery expense annuallyOne of the most common methods for committing a cybercrime in auto dealers is through the use of business emailOne of the most common methods for committing a cybercrime in auto dealers is through the use of business email. Key management and particular controllers, payroll managers, and accounts payable clerks should pay special attention to the spelling of names in emails received and also the domain name portion of the address. The strongest defenses against compromises in cyber crimes attempted through business emails are the following:Strong Password – have unique and lengthy passwords for all of your various accountsTwo-Factor AuthenticationTelephone confirmation for fund transfers before wiringBeware of unexpected urgency – Phishing emails prey on the urgency of the situation they create by saying that funds must be wired within a short amount of time to guilt the recipient into immediate actionCyber Security Training – Create a culture of training and accountability for your staff. Create a message from the top that permeates throughout your dealershipHow to Understand and Protect Your Dealership from FraudUnfortunately, these threats are not exclusively external threats. Too often internal and trusted employees can be the culprits. Auto dealers should consider the following statistics.Over 50% of companies have been victims of embezzlement by their own employeesTypical organizations lose 5% of their top line revenue to fraudOver 50% of employees committing fraud have been with the company over five yearsMedian length of time to detect fraud is 18 months58% of fraud cases have no recovery at allAnonymous tip lines are one of the greatest ways to detect fraud because someone within the organization is probably aware of what is going on
If fraud is occurring in your dealership and it is most likely being committed by longer tenured employees. What behaviors should you be observing as possible red flags?Employees living above their means, or the opposite, experiencing financial difficultiesEmployees that are unwilling to share their duties with other members of the organization and/or rarely take time offEmployees who have recently divorced or are experiencing other family problemsEmployees that have an unusually close relationship with a particular vendorKey TakeawaysAuto dealers should communicate to their employees the potential damage to the business from a ransomware attack or other similar threats. This includes training employees on what these schemes look like and creating a culture to protect against external and internal threats. Auto dealers must confront conflicting agendas to protect their dealerships: while you want to empower your employees to do their jobs well and trust them without micromanaging, it’s also important to not be too detached and “inspect what you expect” might be potential fraud. Finding that balance is critical. A three-pronged approach to internal fraud is key: deter, detect and prevent.How can auto dealers put this approach into practice? Set up internal controls so that one employee isn’t responsible for all elements of transactions. Segregate duties among various employees. Rotate functions so that the same person doesn’t handle the same aspect of the business at all times. Besides being good practice against fraud, this also reduces systemic risk of the dealership that we in the valuation world discuss as a “key person risk.” Businesses whose operations are not specifically reliant on one person tend to be less risky and therefore more valuable. While typically this is thought of as the dealer principal or upper level management, it’s important to have these considerations throughout your organization.The Dealership of Tomorrow and Regulatory Items in the Biden EraFuture Trends and Their Possible ImpactThe pandemic had an acute economic impact on many Americans, and it accelerated many trends from before 2020. One of our speakers took a long view at these trends and offered his view of the future of traditional auto dealers.Then, we look at recent trends in the industry from a more regulatory point of view. When the White House administration changes, particularly to a different party, there is likely to be change to regulations at the federal level, particularly considering Biden was a part of the administration that preceded his predecessor. How will these changes impact dealerships?Despite the ebbs and flows of trends that come and go, dealerships have utilized all of their profit centers to their advantage, so when one area of the business is declining, another is likely benefiting. Even through challenges such as electric vehicles, autonomous vehicles, rideshare, and connected cars, the industry has proven it can adapt and remain viable.No country in the world exclusively utilizes a direct sales model for retail automotive salesWhen it comes to electric vehicles, speakers at our conferences offered some rebuttals to some prevailing arguments, particularly those proffered by proponents of direct to consumer sales. No country in the world exclusively utilizes a direct sales model for retail automotive sales. While some upstarts like Tesla have adopted that model, all countries still maintain and utilize some OEM/dealership model. While direct sales proponents insinuate that franchise laws are the only thing preventing a shift in the market, countries without these laws do business very similarly. If EVs are going to be successful, it will likely be dealers who have made the investment in personal relationships in their community who can help consumers understand the benefits and challenges of the new technology.There has been plenty of talk around the topic of consolidation in the industry, but the total number of automobile dealerships or stores has only declined approximately 1.9% from 1970 through 2019. There are approximately 18,000 stores in the U.S., and it looks like this number may stay relatively consistent.In the past decade, the number of owners has declined from 10,000 to 7,500. Despite the challenges related to the pandemic, the auto dealer industry only lost 31 dealers in 2020, or ~0.2%. While some dealers may capitalize on heightened valuations and exit with more Blue Sky value, there’s a sense that the total number of rooftops nationwide won’t similarly decline. Despite the recent uptick in investment by the public auto dealers, their share of the entire automotive market is less than 10% by location. If Lithia and others continue to acquire and Blue Sky values stay high, this could change. However, years of evidence does not seem to clearly indicate that public dealers necessarily can operate more efficiently than their privately held counterparts.Will OEMs exercise restraint with their facilities and imaging requirements? The buying experience for consumers and their preferences shifted during the pandemic. Shutdowns and health fears led to more investment in the digital/online channels for vehicle retail sales. With dealers seeing less foot traffic at their dealership locations, will they want to downsize their facilities, or will the OEMs continue to require continuous upgrades and imaging requirements? Trends surrounding facilities that could evolve after the pandemic include unbundling facilities (i.e., sales and service operations not being conjoined on the same property), placing greater importance on convenience and flexibility.From a regulatory standpoint, there appear to be more threats than opportunitiesPossible RegulationFrom a regulatory standpoint, there appear to be more threats than opportunities:Trade can be an area of opportunity now with the removal of 25% tariffs, but dealers should be aware of how the USMCA, which replaced NAFTA, may impact themLabor constraints have made operations more difficult across all industries, but the speaker pointed to the classification between W-2 employees and independent contractors as a regulatory issue to watchFuel economy standards have changed depending on the current administration, which can make it hard for OEMs and dealers to make long-term plans when the goals for 2035 and beyond continue to be a moving target. Hopefully for dealers, these requirements will be tied to economic viability50-60% of dealers report on LIFO, which is beneficial when inventory levels and/or values are increasing. When volumes dropped during the pandemic (which have been extended by the chip shortages), LIFO dealers are stuck recognizing income, which is unlikely to be changed despite NADA lobbying effortsF&I has increasingly become a profit source, with dealers recognizing more and more of overall profit from F&I rather than the sale of the actual vehicle itself. Will that lead to concerns from the Consumer Financial Protection Bureau that dealers are in effect selling products with interest rates too high, or is this just semantics of how profit is allocated?Key TakeawaysWhile the external alternatives to traditional automobiles continue to arise and the imaging requirements may change in the future, traditional auto dealerships appear to be stable and on solid footing for years to come. Auto dealers should become active and stay in communication with their state associations and politicians to ensure their best interests are being protected during periods of regulatory changes.Succession PlanningGeneral succession planning forces individuals to confront uncomfortable topics including their personal financial circumstances and needs, circumstances and feelings of other family members, and circumstances of the business, age, and quality of key managers/employees. Auto dealers face additional decisions contemplating the OEM requirements for their children or other family members to become a dealer and what will be required for them to become a successful dealer. The approval of a second generation or other family member as a dealer principal is not guaranteed by the OEM. We have encountered this situation at the untimely death of a dealer principal.A critical element of succession planning is determining the value of the business to implement the particular action stepsOne of our speakers demonstrated the difference between “having a plan” and succession planning. Having a plan is more like the noun, or the passive part of the process. Succession planning is the verb, or the active part of the process.A plan can consist of a Buy-Sell Agreement. The success of the process is to live by the terms of the Buy-Sell Agreement or plan and make it a living document rather than have it become a static document that resides in a file cabinet. A Buy-Sell Agreement may appear stronger if it includes a mechanism for the pricing of a dealership that accounts for its Blue Sky value. However, if the document simply indicates a static multiple (say 5.0x, for example) from when the document is drafted, it may not capture how the dealership and the market for dealerships change over time.Key Takeaway: At the risk of appearing self-serving, we offer this truth: a critical element of succession planning is determining the value of the business to implement the particular action steps. Mercer Capital assists auto dealers around the country by performing business valuations to assist with succession planning and wealth transfers. Do you have a plan or have you engaged in succession planning with a financial advisor?ConclusionWe’re glad to be back attending in-person conferences and talking with dealers in person. This leads to a better exchange of ideas on current trends and best practices. If you would like to discuss any of information in this post and how your dealership might be impacted, please contact any of the members of the Mercer Capital auto team.Sources“Cybersecurity for Auto Dealerships,” John Iannerelli, former FBI Special Agent – KADA Convention“Fraud and the Distracted Employee,” Lori Harvey, CISA, CISM, PCI QSA, DHG – Tri-State Conference“Dealership of Tomorrow,” Glenn Mercer, Glenn Mercer Automotive – KADA Convention“Regulatory Items in the Biden Era,” Paul D. Metrey, NADA – Tri-State Conference“Plan Now or You Could Lose Everything,” Loyd H. Rawls, Rawls Group – KADA Conference
What Is Your Firm’s “Brand” Worth?
Building the Value of an RIA Involves Making it More Than a Group of Professionals
This week we look back at a post from November 2018. Don't let the dates fool you, the topic is still very relevant today. The announcement from Merrill Lynch last week that it was cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product With an Ambiguous BrandA couple of weeks ago I was driving around Memphis and spotted a unicorn, or, more specifically, a Bricklin SV-1, an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.If the Bricklin were a metaphor for a cohort of RIA practice, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor Versus Returns to CapitalWhen the C suite at Merrill Lynch decided to cut advisor payouts a few years ago, they were shifting cash flow returns from labor to capital. Advisors probably felt like they were being devalued, and arithmetically they were. But Merrill was also testing its brand value. Could they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill’s opting to remain in the broker protocol can be seen as confidence in its brand to attract, grow, and retain an advisor network.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit from about the same time suggested the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers alleged that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit indicated that even association with a tarnished brand can impair a career. It was an interesting lawsuit, because in blaming the firm for advisor performance, it suggested that the advisor/client relationship was more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit was basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach, with uniform and templated marketing programs and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied. Focus Financial, on the other hand, has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less than name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity.In the End, Brand Value Is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than “what’s in a name?”, the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.
Estate of Michael J. Jackson v. Commissioner - Key Takeaways
It is imperative for estate planners to engage valuation analysts that perform the proper procedures and follow best practices when performing valuations for gift and estate planning purposes. It is necessary to have a well-supported valuation because these reports are scrutinized by the IRS and may end up going to court. The recent decision by the U.S. Tax Court in Estate of Michael J. Jackson v. Commissioner provides several lessons and reminders for valuation analysts, and those that engage valuation analysts, to keep in mind when performing valuations for gift and estate planning purposes.
Michael Jackson, the “King of Pop,” passed away on June 25, 2009. His Estate (the “Estate”) filed its 2009 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, listing the value of Jackson’s assets. After auditing the Estate’s tax return, the Commissioner of the Internal Revenue Service (the “Commissioner”) issued a notice of deficiency that concluded that the Estate had underpaid Jackson’s estate tax by a little more than $500 million. Because the valuation of some assets were considered to be so far off, the Commissioner also levied penalties totaling nearly $200 million on the Estate. The IRS and the Estate settled the values of several assets outside of court. The case involved three contested assets of Michael Jackson’s estate: Jackson’s Image and LikenessJackson’s interest in New Horizon Trust II (“NHT II”) which held Jackson’s interest in Sony/ATV Music Publishing, LLC, a music-publishing companyJackson’s interest in New Horizon Trust III (“NHT III”) which contained Majic Music, a music-publishing catalog
We discuss the key topics that the Tax Court ruled on and addressed that inform valuation analysts in the preparation of quality valuation reports.Known or KnowableIt is important that valuation analysts only rely on information that was known or knowable at the valuation date.In the decision, the Tax Court rejects the analysis of experts on several occasions for using information that was “unforeseeable at the time of Jackson’s death.”The Tax Court goes on to state that “foreseeability can’t be subject to hindsight.”It can be difficult to distinguish and depend on only the information known or knowable at the valuation date especially when a significant amount of time has passed between the current date and the valuation date.Therefore, a careful examination of all sources of information is necessary to be sure that it can be relied upon in the analysis.As can be seen from the Tax Court’s opinion, valuation analysts and experts can undermine their credibility by relying on information that was not known or knowable at the valuation date.Tax Affecting S CorporationsThe Tax Court, in this specific case, did not accept the tax affecting of S Corporations: “The Estate’s own experts used inconsistent tax rates.They failed to explain persuasively the assumption that a C corporation would be the buyer of the assets at issue.They failed to persuasively explain why many of the new pass-through entities that have arisen recently wouldn’t be suitable purchasers.And they were met with expert testimony from the Commissioner’s side that was, at least on this very particular point, persuasive in light of our precedent.This all leads us to find that tax affecting is inappropriate on the specific facts of this case.”The Tax Court did, however, leave room for the possibility of tax affecting being appropriate by stating, “we do not hold that tax affecting is never called for.”At Mercer Capital, we tax affect the earnings of S corporations and other pass-through entities.Given that this issue continues to be a point of contention, it is imperative that valuation analysts provide a thorough analysis and clear explanation for why tax affecting is appropriate for S corporations and other tax pass-through entities.Developing Projected Cash FlowsIn the valuation of NHT II, the Court found it more reasonable to use the projections of Sony/ATV in the development of a forecast used in the income approach rather than relying on historical financial performance to inform the projection.The Tax Court based its decision on the fact that “the music-publishing industry was (and has remained) in a state of considerable uncertainty created by a long series of seismic technological changes. We think that projections of future cashflow, if made by businessmen with an incentive to get it right, are more likely to reflect reasonable estimates of the short-to-medium-term effects of these wild changes in the industry that even experts, much less judges, are unlikely to intuit correctly.”This decision makes it clear that valuation analysts need to fully understand the industry in which the company operates and develop a forecast that is most reasonable given the information available as of the valuation date.In cases where analysts have access to a projection developed by management, valuation analysts should have a clear, well-reasoned rationale for not relying on the forecast should they decide not to use it in the analysis.However, valuation analysts should not blindly accept management’s forecasts as truth but should perform proper due diligence to assess the reasonability of the forecast and clearly articulate any deviations from management’s forecast.Other Topics AddressedA few other topics of note are addressed throughout the decision that can help valuation analysts provide reliable valuation analyses.On more than one occasion, the Tax Court sided with the expert that provided a compelling explanation for the use of a certain assumption rather than arbitrarily using an assumption without explanation.The Tax Court also sided with one expert simply because they provided a clear citation for their source when another expert did not.The Tax Court also called out the inconsistency of an expert in their report and testimony.These topics addressed by the Tax Court demonstrate that consistently explaining and citing the sources of assumptions and key elements of the valuation analysis help to produce a supportable valuation analysis.Finally, the expert for the Commissioner seriously damaged their credibility in the eyes of the Tax Court when the expert was caught in a couple lies during the trial.The Tax Court found that the expert “did undermine his own credibility in being so parsimonious with the truth about these things he didn’t even benefit from being untruthful about, as well as not answering questions directly throughout his testimony.This affects our fact finding throughout.”Takeaways & ConclusionThe table below presents the valuation conclusions of the Estate, Commissioner, and the Tax Court at trial. This decision has shown that it is critical for valuation analysts to present quality valuation reports that are clear, supported, and follow accepted best practices.At Mercer Capital, estate planners can be confident that we follow the proper procedures, standards, and best practices when performing our valuations for gift and estate planning.Mercer Capital has substantial experience providing valuations for gift and estate planning as well as expert witness testimony in support of our reports.Please do not hesitate to contact one of our professionals to discuss how Mercer Capital may be able to help your estate planning needs.
What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses?
Recently, the Biden Administration announced elements of its tax agenda in the American Families Plan. The Biden Administration aims to make some significant changes to current tax law.These changes are highlighted by the following:Increasing the top capital gains tax rate to 39.6%Increasing the top federal income tax rate to 39.6%Increasing the corporate tax rate to 28%
Another substantial proposal includes the elimination of the step-up in basis. The potential elimination of the step-up in basis presents an estate planning opportunity to high-networth individuals and family business owners or should at least spur them to contemplate revisiting their estate plans.What Is the Step-Up In Basis?The step-up in basis refers to the current tax environment that allows individuals to transfer appreciated assets at death to their heirs at the current market value without heirs having to pay capital gains taxes on the unrealized capital appreciation of those assets that occurred during the individual’s life. In other words, heirs currently benefit from a “step-up” in tax basis of inherited assets to the market value on the day of death, and no taxes are paid on unrealized capital appreciation of the assets.Biden Administration ProposalThe Biden Administration is proposing to eliminate this step-up in basis. This means that the heir would be responsible for the taxes on the unrealized capital appreciation of the assets being transferred as if the assets had been sold. This would result in a large tax burden on the heir especially when considering that the Biden Administration is also aiming to increase the top capital gains tax rate to 39.6%. Specifically, the proposal would end the step-up in basis for capital gains What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses? in excess of $1 million (or $2.5 million for couples when combined with existing real estate exemptions). So, the first $1 million of unrealized capital gains would be exempt from taxes and only the excess would be taxed. However, the proposal does state that “the reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.” These protections and exemptions seem to provide some relief for family businesses, but the details of the protections have yet to be specified.TakeawaysThese proposals are certainly not set in stone and may change as the proposals are debated and legislature eventually makes its way through Congress. However, the Biden Administration’s current tax proposals could have a significant impact on the estate planning environment.The potential elimination of the step-up in basis is yet another reason for high-net-worth individuals and family business owners to make estate plans or revisit their current estate planning techniques. When considered alongside other Biden Administration proposals such as an increase in the capital gains tax and the fact that the increased lifetime gift and estate tax exclusion limits are set to sunset in 2025, now is a great time to have a conversation about planning. Contact a professional at Mercer Capital to discuss your specific situation in confidence.
Permian Production Pushes Higher
The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production increased approximately 8% year-over-year through June, though current production remains below the peak observed in March 2020. Production in Appalachia increased 5% year-over-year, while the Eagle Ford’s production was essentially flat. The largest production gain was observed in the Bakken (up 26%), as the Bakken saw a high level of shut-in wells(in response to low commodity prices) which have subsequently been brought back online. Permian production has generally been increasing over the past year, but there was a meaningful decline in February driven by Winter Storm Uri that disrupted power supplies throughout Texas.
The Permian’s production increase is the result of more drilling activity in the basin. There were 237 rigs in the Permian as of June 18th, up 73% from June 12, 2020. Bakken and Eagle Ford rig counts were up 55% and 146%, respectively, while the Appalachia rig count was down 3%.
Permian production should continue to increase modestly over the next several months based on the current rig count, legacy production declines, and new-well production per rig.
Commodity Prices Grind HigherThe second quarter of 2021 saw rising commodity prices, driven largely by accelerating travel and economic activity amid the vaccine rollout and fewer COVID cases in many parts of the world. Front-month WTI futures began the quarter at ~$60/bbl and broke above $70/bbl before the end of the quarter. The rise in prices was generally slow and steady, with the exception of a dip in mid-May, though that was likely driven by short-term dislocations caused by the shutdown of the Colonial Pipelinein response to a ransomware attack. Henry Hub natural gas front-month futures prices began the quarter at approximately $2.60/mmbtu and have been above $3/mmbtu for all of June thus far.
However, the current commodity price environment may be short-lived. WTI futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated that “continuing growth in production from OPEC+ and accelerating growth in U.S. tight oil production—along with other supply growth—will outpace decelerating growth in global oil consumption and contribute to declining oil prices” in their June 2021 Short-term Energy Outlook.Financial PerformanceIn a nice change of pace for energy investors, the Permian public comp group saw strong stock price performance over the past year (through June 22nd). All of the Permian companies except Pioneer outperformed the broader E&P sector, as proxied by XOP (which was up 73% during the past twelve months). That stock price performance is probably more reflective of the dire straits of some companies last year in the aftermath of the Saudi/Russian price war and COVID-19 lockdowns, as small, leveraged companies like Centennial and Laredo have had the biggest gains. However, stock prices for all of the Permian comp group companies remain below all-time highs.Federal Lands Drilling Ban Could Shift Production Within the BasinPart of President Biden’s environmental platform was banning new oil and gas permitting on public lands. An initial action under this platform was a 60-day moratorium on permitting activity, though that was recently blocked by a federal judge. While many think a ban would haverelatively modest impacts at a macro level, the impacts could be more severe for companies and areas with a high level of exposure to federal lands.The Federal Reserve Bank of Dallas performed an analysis to look at the potential impact to the Permian Basin. Under a restrictive policy scenario, production growth would slow (relative to no change in policy), though overall production from the basin is still expected to increase.[1]
However, approximately half of New Mexico’s Oil & Gas production comes from federal acreage. As such, the impacts to New Mexico are much more acute under a restrictive policy scenario. The consequence is a shifting of drilling activity (and associated employment and spending) from New Mexico to Texas.
ConclusionThe Permian was not immune to the impacts of historically low oil prices observed in 2020, though it has proven to be resilient. Production, while still below peak levels, is growing, and growth is generally expected to continue. Activity levels are improving, though companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] The Dallas Fed describes the policy scenarios as follows:Reference Case: This serves as the benchmark and assumes little-changed leasing, permitting and drilling from first-quarter 2021 levels.Hybrid Case: It assumes no new federal leasing, but existing leaseholders continue receiving drilling permits. Permit reviews are more rigorous, leading to slower approvals and a costlier operating environment beginning in 2022. Based on companies’ public statements, firms that hold acreage across the basin gradually relocate drilling rigs and completion crews to their nonfederal locations.Restrictive Case: No new federal permits or extensions are granted starting in 2023. This is when the most-recently issued permits will expire. The existing permitting freeze adversely affects production in the near-term due to a lack of approvals of permit modifications and pipeline rights-of-way. As in the Hybrid Case, companies shift their focus to nonfederal acreage.
Whitepaper: Understand the Value of Your Auto Dealership
If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.Editor's Note: This whitepaper was originally published in August 2020. WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper
Family Business Purpose and Transactions
In this post, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out.
NYU Professor Aswath Damodaran has highlighted the mixed bag on value creation through acquisitions. However, McKinsey & Company suggests that family businesses are more prudent in their M&A activity, and don’t necessarily seek the home run deals, but instead seek value creation.
My family’s business did its best to be prudent when engaging in M&A transactions. We developed objectives for selling and buying within the framework of our business’s meaning and family goals.
During my stint in the family-business, the company was going through radical changes. We divested significant operating assets and acquired new businesses in a span of four months. Over the same period, the shareholder base was reduced from 30+ individuals to a select handful.
But why? Framing the question in terms of the following four meanings of family business can help answer it.Give Me One ReasonAs we have previously written, the meaning of a family business is a function of both family and business characteristics. Most family businesses hold one of four “meanings” for their family shareholders, which we have summarized below:Economic Growth Engine - Create economic growth for future generations. Less emphasis on distributable income for the current shareholders; focus on growth opportunities for business to grow along with the family.Store of Value - Preserve the family’s capital. Serve as a stabilizing component of the family’s overall balance sheet.Source of Wealth Accumulation – Focus on significant current distributions that family shareholders are expected to allocate to unrelated investments.Source of Lifestyle – Priority on stability of dividend payments and the business is managed to protect the company’s dividend capacity to help facilitate travel, philanthropy, education, or other family objectives.
With the above framework in mind, where did my family’s business fit in?The Times - They Are A-Changin’The family business was going through big changes when I arrived. A major part of the business was being sold to another family and the shareholder base was in the process of consolidation. From the mid-70s through mid-2010s, the business had been the economic growth engine for the family: minimal distributions and earnings plowed back in to achieve growth. But with the passing of the patriarch (first generation), the new shareholders (majority control in second-generation) experienced a shift in their objectives for the business.After nearly 40 years of growth, many of the new controlling shareholders were ready to "de-risk" their personal balance sheets. The family business could help provide that, but the most immediate way to do that was to sell part of the operating assets.Thinking in terms of the “Four Meanings” framework, this transaction represented a radical wealth accumulation transition. If the family were to develop more diversified personal balance sheets, either distributions from the legacy family business would have to increase in a hurry, or a sale of at least a portion of the business would be required (at the right price). It just so happened the right price came along.Turn The PageAs we were spinning off a large part of the business, I was preparing to move to Florida to jump into the family business with my wife. We knew we were joining a company that was different than the one my wife had known her whole life.But what company would we be joining? For one, it would have a consolidated shareholder base, with our CEO, my father-in-law, the primary shareholder. Second, it would be considerably smaller. The assets we were selling to generate cash flow for the other major shareholders represented the lion’s share of the company’s revenues. Our objectives for the future, while not “to-the-moon,” were more ambitious than maintaining a “lifestyle” family business. We wanted the remaining company to scale to a level that could support the remaining shareholders’ goals and objectives.Following the divesture, we completed a smaller acquisition relative to the business units sold to achieve an expected cash flow level suitable for the new, smaller shareholder base. Our impetus was to grow to ensure the longevity and stability of the overall family enterprise for the remaining family shareholders and allow our family to pursue other strategic investments outside the business. Getting there will require a growth mindset for the next several years. I’ll report back on our progress.Here Comes the Sun: What Will Family Business Directors Do?We have noticed that our wisest clients demonstrate patience and know where they are and what they are trying to accomplish through transactions. These clients have focused on what the family business means to them: growth engine, store of value, wealth accumulation, or lifestyle. This framework helps them make the right deals at the right times for the right reasons. Otherwise, a “deal” can become a four-letter word for your family.ConclusionMercer Capital has a long history of working with companies on both the buy and sell-side of transactions. Let us know if we can help you and your fellow directors evaluate the transaction opportunities and challenges facing your family business.
Permian M&A Update: A Buyer's Market
Pocketbooks Open for More Deals and Larger Positions
Transaction activity in the Permian Basin picked up in earnest this past year, indicating greater optimism in extracting value from the West Texas and Southeast New Mexico basin.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2019-2020, deal count increased by five transactions, representing an increase of 23% over the 22 transactions in the prior period. Furthermore, median deal size nearly tripled from $138 million to $405 million, period-over-period. The median acreage among these transactions increased 2.5x from 14,500 acres to 36,250 acres (not shown below). Given the concurrent increase in transaction values and greater acreages acquired, the median price per net acre was down a slight 4% period-over-period.The big story though, was production. The median production among transactions from June 2018 to June 2019 was 2,167 barrel-oil-equivalent per day (“Boepd”); while over the past twelve months, the median production value was 8,950 Boepd (not shown). As buyers “purchased in bulk” this period relative to the prior twelve-month period, the median transaction value per production unit declined nearly 41% from $53,584 per Boepd to $31,886 per Boepd. Transactions came in waves. There was one transaction announced regarding Permian properties between June and August 2020. September saw three deal announcements, and 10 transactions were announced during Q4 2020. Activity fell silent in Q1 2021 as the industry waited for the Biden Administration to settle in Washington. Deal announcements then resumed in earnest in Q2 as WTI crude oil and Henry Hub natural gas prices showed signs of fairly stable upward trajectories, with the exception of a temporary spike in gas prices due to the mid-February freeze.Click here to expand the imageLooking a bit closer at the data, it appears there may have been an inflection point in deal valuations over the past twelve months. First and foremost, there was a notable concentration of larger-than-average deals, in terms of transaction values, from July to October 2020. Except for the Pioneer Natural Resources DoublePoint Energy transaction in early April, all deal values after October 2020 pale in comparison to those in the early period. As presented in the comparative statistical tables below, bifurcating the presented metrics further between the periods of July to October 2020 and November 2020 to the present reveals the potential pivot in valuations.The post-October median transaction value declined 95% to just $294 million from the pre-November median value of $5.6 billion. However, more tellingly, the cost per acre nearly halved with the median metric value declining from $20,449/acre in the July-October 2020 transactions to $10,482/acre in the post-October transactions. If you remove the outlier value of the Northern Oil and Gas transaction ($180,303/acre), the nearly 50% decline is slightly reduced to an indicated decline of 45% in the price per acre. I am not a gambler, but without soliciting direct commentary from the respective management of the buyers listed above, I would wager that the inbound Biden Administration and the uncertainty surrounding potential regulatory changes were a significant factor in this valuation decline.Click here to expand the imageOne noteworthy pair of transactions, which may receive further Mercer Capital analysis sooner than later, relates to acquisitions made by Pioneer Natural Resources, including the October 2020 announcement of a definitive agreement to acquire Parsley Energy and its April 2021 announcement of a definitive agreement to purchase the leasehold interests and related assets of DoublePoint Energy. Pioneer was the only buyer to appear more than once on our list of transactions with a major transaction before November and one after (for which deal metrics were available), with indications of significant increases in the cost-per-net-acre and cost-per-Boepd valuation metrics.Northern Oil and Gas Enters the Delaware BasinIn September 2020, Northern Oil and Gas announced its entrance into the Permian with its acquisition of non-operated working interests in Lea County, New Mexico from an undisclosed seller. The deal consisted of 66 net acres, with an initial 1.1 net wells proposed to be spud in late-2020 to early-2021 and production expected to start in Q2 2021. The total acquisition costs (including well development costs) were expected to be $11.9 million. At first blush, these metrics indicate a cost per net acre of approximately $180,300, which suggests a notable premium.The next highest cost per net acre value among the transactions listed was $67,000 forthe Pioneer Natural Resources-DoublePoint Energy dealannounced in April. A premium was paid as far as net acreage acquired is concerned. However, at the expected peak production rate of 1,400 Boepd, the cost per production unit was $8,500 per Boepd, the second-lowest metric after Contango Oil & Gas’s acquisition in late November, and one-third of the minimum $-per-Boepd metric among the transactions listed in the June 2019-2020 season. Despite recent volatility in the industry due to energy prices and domestic regulatory changes–whether real or proposed–the economics of the Permian have remained attractive enough to induce Northern Oil and Gas, a stalwart Bakken E&P company, to try its hand in Southeast New Mexico.Vencer Energy Acquires Hunt Oil Company’s Midland Basin AssetsIn late April, Vencer Energy, the U.S. upstream Oil & Gas subsidiary of the Dutch energy and commodity trading giant, Vitol, announced its first investment in the Midland Basin. While the total transaction value was not disclosed, the acquisition included approximately 44,000 net acres with a total estimated production of 40,000 Boepd. This represents an estimated total annualized production of approximately 332 Boe per net acre. This “production density” value (annualized production per net acre) is the second-highest value among the listed transactions, only behind the comparable metric of 376 Boe per net acre indicated from the Pioneer-Double Point deal (with acquired/estimated production of 100,000 Boepd across 97,000 net acres).Ben Marshall, Head of Americas – Vitol, commented on the transaction: “This is an important day for Vencer as it establishes itself as a significant shale producer in the U.S. Lower 48. We expect U.S. oil to be an important part of global energy balances for years to come, and we believe this is an opportune time for investment into an entry platform in the Americas. This acquisition represents an initial step to building a larger, durable platform in the U.S. Lower 48.”ConclusionM&A transaction activity in the Permian was a bit of a roller coaster over the past year in terms of deal timing, but the overall story is one of resurgence over the past twelve months relative to the twelve months before it. Still, despite a renewed interest in acquiring greater acreage and production positions, even greater changes could be on the horizon. This past week, it came to light that Shell was reviewing its Permian holdings for potential sale, according to certain people familiar with the matter. However, it is pure speculation at this juncture as to what option(s) Shell may pursue regarding the partial or full sale of the company’s estimated more-than-$10 billion of Permian holdings. Assuming any dispositions, though, this news could portend even more opportunities for continued buy-in into the Permian by existing regional E&P companies and potential new entrants.
Five Questions with Paul Hood
L. Paul Hood, Jr., JD, LL.M, CFRE, FCEP is a long time friend of the firm and an experienced and thoughtful estate planner. He has considerable experience working with family business continuity planning. A native of Louisiana (and a double LSU Tiger), after obtaining his law degrees in 1986 and 1988, Paul settled down to practice tax and estate planning law in the New Orleans area. Paul has spent over 30 years specializing in taxes and estate planning. He has taught at the University of New Orleans, Northeastern University, The University of Toledo College of Law and Ohio Northern University Pettit College of Law. The proud father of two Eagle Scouts and LSU Tigers, Paul has authored or co-authored seven books and over 500 professional articles on estate and tax planning and business valuation. We hope you enjoy this brief Q&A with Paul.Welcome, Paul. Tell us a little bit about yourself and your practice.Paul Hood: I like to describe myself in two ways. First, I’m a recovering tax lawyer. Second, I’m a purposeful estate planner. I believe in focusing much more attention on the human side of estate planning because it’s the most challenging part of estate planning, much more so than the tax planning and property disposition aspects of estate planning. But very few estate planners want to delve sufficiently deeply into the human side because it involves dealing with real human emotions, including our own.Along the course of my life, I’ve been a father, husband, lawyer, trustee, director, president, partner, trust protector, director of planned giving, expert witness, agent, professor, judge, juror and a defendant, and I use this life experience in these myriad roles to guide others. I help people pursue a "good estate planning result" in every case, whatever that looks like in each unique situation.You’ve written extensively about the "psychology of estate planning." In your experience, what is the single biggest psychological hurdle for family business shareholders to begin estate planning?Paul Hood: Perhaps the greatest hurdle to estate planning is most people lack sufficient self-awareness. By self-awareness, I mean that almost no one realizes the power that each of us has with respect to our estate planning decisions. One of my most important beliefs and philosophies about estate planning is that a person’s estate plan will have effects on the relationships of those who survive them, whether they want them to or not.One of the reasons why I preach the gospel of intergenerational communication from every pulpit that’ll have me is because the best estate plans I’ve ever witnessed all involved honest two-way communication between givers and receivers. Perhaps the biggest reason for post-death estate or trust litigation is the parties didn’t communicate about the estate plan.After the testator’s death, if an heir is unhappy about the estate plan, they too often entertain what I call the parade of horribles because what happened didn’t meet their expectations, and they immediately too often blame someone still alive and come out suing.A simple explanation of why the testator arranged their estate plan the way they did can eliminate a lot of post-death litigation and hurt feelings and ended relationships. A simple conversation could cut off heartbreak and family cutoff, yet most estate planners don’t implore their clients to have these essential conversations.Estate planning tends to focus primarily on minimizing transfer taxes. While that is a laudable goal, what other objectives should family business shareholders think about when it comes to estate planning?Paul Hood: A "good estate planning result" is one in which property is properly transmitted as desired, and family relations among the survivors aren’t harmed during the estate-planning and administration process.Notice that conspicuously absent from this definition is any mention of taxes. Taxes have always been the easiest piece of the estate-planning puzzle, yet the overwhelming majority of estate planners still focus their attention almost solely on the tax piece, probably because it’s easiest to solve and easiest to demonstrate quantifiable, tangible results. This misfocus has contributed to several problems for planners and clients alike.The sad fact is that perfectly confected and properly drafted estate plans render families asunder every single day in this country because the estate planners failed to address the human side of estate planning. Sadly, many of these problems are easily predictable. Frankly, I don’t know how some estate planners sleep at night.In one of your articles, you describe a "Path of Most Resistance" to achieving a good estate-planning results. Once a family business shareholder decides to engage in estate planning, what are the pitfalls that they need to watch out for?Paul Hood: The Path of Most Resistance is a model that I developed to illustrate graphically what has to happen in order to achieve the "good estate planning result" that I defined earlier.
As the Path model illustrates, there are psychological machinations at work in every participant in the estate planning play, which includes the estate planners. As I have already discussed, intergenerational communication is essential in my opinion, particularly in a family business.
Where there’s a family business involved, I view a frank and honest keep-or-sell discussion involving the entire family as perhaps the most important conversation that too few families in business ever have. Why is that? I view such a discussion as a means of gauging the family members’ individual and collective interests in continuing to be in business together. However, it’s a loaded question that can open up some family wounds, so caution is in order.
Done correctly, the discussion can reinvigorate a business family’s overt commitment to the business in its current form. Unfortunately, lots can go wrong and can hasten or cause loss of the family business and family relationships because the keep or sell discussion can get very emotional and bring out hidden or suppressed feelings that have been harbored in silence and allowed to simmer past the boiling point upon their invitation to the surface.
An estate plan should provide a system of checks and balances on power and authority, particularly in a family business. Estate planning necessarily involves a passing of the torch of leadership and control. As Lord Acton observed long ago, power tends to corrupt, and absolute power corrupts absolutely.
Power shifts can expose people and leave them vulnerable to oppression, even to being terminated in employment or as a beneficiary through, for example, a spiteful exercise of a power of appointment (POA). The purposeful estate planner will build in a series of checks and balances that simultaneously allow exercise of authority and provide protection to those who are subject to that authority, which can be in the form of veto powers, powers to remove and replace trustees, co-sale or tag along rights, accounting rights or similar types of protections.
Who are the different parties involved in the estate planning process? Do you have any tips for ensuring that all these parties work together for a successful outcome?Paul Hood: As the Path model illustrates, there are several "players" in the estate-planning play. I realize that most clients have more than two estate-planning professionals or advisors assisting them, but the larger point is that having more than one advisor itself creates potential obstacles in the path toward a good estate-planning result.In addition to the interested parties (the giver and one or more receivers), achieving a good estate planning outcome often involves one or more attorneys, an accountant, a valuation professional. Depending on the structure of the plan and the clients' needs, life insurance or other professionals may be involved in the process as well.The client should have as many advisors as he feels is necessary or appropriate. I’m a big believer in referrals and collaboration simply because it was my experience that clients get better service and a better estate plan. However, having more advisors creates a situation that must be watched and managed. I’ve seen estate-planning engagements fall apart because the advisors were incapable of cooperating and collaborating, which is a bad result for the client and can add to the negative experiences that the client will take to the next advisor, if any.Each of the estate-planning sub- specialties have their own ethical rules and conventions. These ethics rules impact subspecialties differently. The legal ethics rules insert some additional complexities in the estate-planning process, particularly in the areas of confidentiality and conflicts of interest. It’s imperative that the planner’s engagement letter permits complete and total access to all of a client’s advisors.Moreover, different advisors in the same subspecialty may have vastly different philosophies about estate planning. It’s critical that advisors check their egos and biases at the door before getting down to work with an open mind and collaboratively on a client’s situation. With collaboration comes diversity of professional backgrounds, educational and experiential pedigrees; different manners of training; and significant knowledge about a certain aspect of the client’s estate plan. This diverse strength of the group exceeds the strength of the sum of its individual members. This excess is called synergy.Estate planning is one of the most important tasks a business owner will face. Assembling the right team, and making sure they can work together, can increase the odds that you achieve a good estate planning result.
May 2021 SAAR
After three straight months of impressive gains, the SAAR fell 9.6% in May from 18.8 million units to 17.0 million units. The summer is typically a strong season for auto sales, but several supply-side factors have limited the availability of vehicles over the last month.May 2020 SAAR (12.1 million units) is a poor comparison to this year’s rate, as the pandemic’s impact was still sending shock waves through the industry at that time. In comparison to May 2019, SAAR is down roughly 2%.The dip in SAAR from April highs should not be viewed in a totally negative light, as many industry experts have spoken to the adaptability and resilience of the industry during a period of record high demand and increasingly less inventory. As seen in the graph below, the inventory to sales ratio has hit record lows as dealers cannot keep inventory on the lots.
As noted in JD Power’s Automotive Forecast for May, the average number of days a new vehicle sits on a dealer lot before being sold is on pace to fall to 47 days, down from 95 a year ago. Dealers are also selling a larger portion of vehicles as soon as they arrive in inventory, with 33.4% of vehicles being sold within 10 days of arrival, which is up from 18.2% in May of 2019. Rising vehicle prices continue to reflect this supply and demand imbalance and benefit retailer profits. As reported by JD Power, total aggregate retailer profits from new vehicle sales will be $4.5 billion, the highest ever for the month of May, and up 162% from May 2019.
Fleet customers are continuing to suffer as OEMs prioritize deliveries to retail customers over fleet customers. NADA reported that fleet deliveries accounted for just 10% of new-vehicle sales in May, after averaging 16% the first four months of the year. Notably, this was already depressed in 2021 as pre-pandemic levels were closer to 20% of monthly sales. As we noted in our April SAAR, rental cars will continue to be hard to come by. These high prices on rental cars and limited selection will most likely continue until the chip shortage has been straightened out and supply has stabilized.
Consumer ReactionsConsumers are having to get creative in order to secure a vehicle. As we mentioned on our April SAAR blog post, manufacturers are hoping that consumers will be flexible and purchase models with less features to save on chips.Consumers seem to be going the extra mile however, with Cars.com finding that nearly 1 in 3 recent buyers drove 100 miles or more to secure the car they want. Kelsey Mays, Cars.com assistance managing editor, noted “With the current auto inventory challenges, recent car buyers are going to great lengths to find the car they want…I don’t anticipate this trend slowing down, either. Of consumers currently in the market and shopping for a car, 65% said they would consider purchasing in another state.”While the extra mileage to find car options presents a clear inconvenience for consumers, they may reap some benefits as well. Over half (53%) of those looking for a new car also plan to trade in their current vehicle to the dealerships. As the inventory shortage has limited the availability of cars on lots, the dealerships are often willing to pay a premium for new inventory. The extent to which consumers are willing to travel to find a car sheds further light on the current supply and demand incongruencies.Government ReactionsThe chip shortage has reached such an extent that the U.S. government is trying to assist. According to Automotive News, the Senate has passed an expansive bill to invest nearly $250 billion in bolstering U.S. manufacturing and technology to meet the economic and strategic challenge from China. More specifically for auto dealers, the bill includes $52 billion in emergency outlays to help domestic manufacturers of semiconductors expand production, which was a bipartisan addition sought by Republican Senators John Cornyn (Texas) and Tom Cotton (Arkansas) and Democrats Mark Kelly (Arizona) and Mark Warner (Virginia). The addition of the semiconductor expansion was cheered by those in the industry who have been struggling to meet demand for months. Though the bill would be welcomed with open arms by the auto dealer industry, its fate is still uncertain as support in the House of Representatives is somewhat unknown. However, Senate Majority Leader Schumer has indicated that he believes the House will be able to get something passed through to President Joe Biden’s desk.When It Will End?With 93%of respondents to a survey conducted by Automotive News about the global chip shortage finding that they believe the chip shortage will have a severe impact on the auto industry, the question on everyone’s mind is when is the end date.While 72% of respondents believe that it will last the rest of the year, Goldman Sachs chief Asia economist Andrew Tilton believes the worst may be over. He has noted that there has been “noticeable tightening” of supply chains and shipment delays in North Asia, which will ultimately have an impact on downstream sectors such as auto production. He and his team believe the chip shortage could improve in the second half of 2021. However, this is a continuously evolving situation as multiple aspects of the supply chain are being disrupted, most recently in Taiwan. Chip manufacturing plants use large amounts of water, and Taiwan, home of the world’s largest contract chipmaker, is facing its worst water shortage in 56 years. This, as well as the continuing COVID-19 pandemic, will need to be monitored closely as the auto dealer industry hopes to move out of this ongoing chip shortage.ForecastWith the chip shortage still in full effect, inventory constraints are going to continue to be an issue through the remainder of the summer. Thomas King, president of the data and analytics division at J.D. Power notes:“Looking forward to June, with sales continuing to outpace production in aggregate, falling inventory levels may start to put pressure on the current sales pace. However, based on what we have seen so far, retailers may continue to adapt by turning inventory more quickly to maintain sales velocity. However, regardless of inventory position, manufacturers and retailers will continue to benefit from strong consumer demand and a higher profit per unit sold.”Through June and the rest of the year, ability to turnover what inventory auto dealers are able to get their hands on will be critical to maintaining profitability levels. Consumer’s willingness to go the extra mile (literally) in order to secure a new car is a positive tailwind, and a continuation of this trend will be beneficial for dealerships. However, the chip shortage continues to need to be monitored closely, though expectations of it easing and government assistance are providing some optimism to the situation.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.
To the Moon or Back to Earth?
RIA Valuations Have Increased Substantially Over the Last Year, but That Doesn’t Necessarily Mean These Stocks Are Overpriced
To the Moon?A few weeks ago we blogged about how RIA stock prices have increased over 70% on average over the last year. This rapid ascent begs the question if valuations have gotten too rich with the market run-up during this time. To answer this question, we have to analyze the source of this increase.Click here to expand the table aboveMoving from left to right on the table above, we see that financial performance actually deteriorated over this time – revenue declined and margins compressed, leading to a 20% drop in EBITDA on average for this group of publicly traded RIAs with less than $100 billion in AUM. The increase in the EBITDA multiple more than compensated for the decline in profitability and is the primary driver of the overall increase in value from March 31, 2020 to March 31, 2021. At first glance, a 70% increase in value (when year-over-year earnings have actually declined) suggests that current pricing may be overstretched.Back to Earth?When we observe historical levels of RIA valuations, however, we get a much different perspective. Even after the recent run-up, EBITDA multiples are still at the lower end of their historical range. The multiple expansion follows an all-time low for the industry last March when these businesses were trading at 4x EBITDA during the bear market.
There’s also a logical explanation for the multiple doubling over this period. These multiples are directly related to the outlook for future revenue and profitability, which tend to fluctuate with AUM since management fees are typically charged as a percentage of client assets. AUM balances have risen with the stock market over the last year, so the outlook for future revenue and earnings has rebounded accordingly.
Trailing twelve-month (TTM) earnings in March of last year were also suppressed by the bear market’s impact on profitability during the first two quarters of 2020, so a higher TTM multiple is justified when historical earnings lag ongoing levels of profitability. This trend marks a complete reversal of what happened last March when AUM and run-rate performance declined with the market but trailing twelve-month earnings had not yet been impacted. As earnings figures lagged the abrupt price declines, multiples hit all-time lows. Because of this phenomenon, RIA multiples can be especially erratic during volatile market conditions.
ConclusionWhile the significant gains in RIA valuations over the last year is fairly alarming, the fundamentals warrant such an increase. The market’s significant rise over the last year buoyed AUM and ongoing profitability, so investors are rationally anticipating higher earnings relative to recent history. Another correction or bear market would certainly reverse this trend, but at the moment, all industry metrics are pointing to the moon.
How to Value Oil Companies in the Biden Era
Like a small boat navigating a big sea, oil & gas valuations are impacted by a plethora of factors that can change almost instantly. Some factors help in arriving at a shareholder’s destination, others do not. Some factors the crew can control, others not so much (and some factors are more predictable than others). As this vessel heads for the destination shores of high returns, it must navigate through natural economic influencers such as production risk, commodity prices, supply logistics and demand changes. In addition, it also must face regulatory shifts that the Biden Administration is and could generate in the future such as tax changes, policy shifts and more. Most likely, these policies will create some volatility and headlines, but in the aggregate will not change valuations much. Let us examine a few of these regulatory items and how they might change the course of an oil and gas company’s valuation going forward.HeadwindsThere are several recent policy actions, and some that are being debated that are affecting the industry, primarily by disincentivizing new U.S. production. Actionsalready taken include a moratorium on federal oil & gas drilling permits and a construction stoppage of the Keystone XL pipeline. While it can grab a headline, from a valuation perspective it should not be a direction changing headwind. Most drilling is not done on federal lands, and a lot of companies with existing permits that will allow multiple years of drilling. Even if this becomes an enduring policy, the impact would likely be a revision too, rather than a material reduction of planned drilling activity.There are also some long-standing tax incentives that may be ended as well: the intangible drilling cost deduction and the percentage depletion allowance. Theintangible drilling cost deduction (which expenses as opposed to capitalizes certain drilling costs) has been around for over 100 years, and thepercentage depletion allowance (15% reduction in gross income of a productive well) has also been around nearly that long. The rationale behind both is to encourage investment by allowing tax breaks for development activity by delaying or decreasing cash taxes in any given year. This is an enjoyed benefit for investors and has allowed cash flows to either be higher or come faster than if the tax breaks were nonexistent. This is considered a headwind for the industry However, since many upstream companies are not cash taxpayers these days, and capital expenditure budgets have already been slashed in the past year, this issue (if it comes to pass) may end up being not much more consequential than a slight breeze.Another matter on U.S. producers’ radar is the expectation that Iranian oil sanctions will be lifted. Iran’s president Hassan Rouhani has said that a broad outline to end sanctions has been reached. Since November 2020 Iran’s crude and condensate exports have already gone up and the global market must contend with another 500 thousand barrels a day of exports. The good news is that the market may have already priced this in and WTI is still over $68 per barrel with Brent Crude over $70.TailwindsNot everything coming out of Washington is detrimental to upstream producers. In fact, some of it may end up being materially beneficial over the course of time. One example is the budget proposal to utilize federal funds for plugging old wells. Biden’s $2 trillion infrastructure proposal includes $16 billion for cleaning up disused wells and mines. Long a balance sheet issue for producers, this can has been kicked down the road for decades. The opportunity to be addressed from a subsidized standpoint would be a welcome development for producers. Even if it is executed inefficiently (North Dakota plugged 280 wells for $66 million: approximately $236k per well) as many government actions can be, it could help producers clean up over 50,000 “orphan” wells that can be over 100 years old in some cases. Considering the beating that oilfield service companies have taken in recent years, this initiative could be a shot in the arm for them as well.The other major tailwind is less about a direct policy, but more an indirect derivative of it. As the Biden Administration restricts drilling on federal lands, the supply of oil is (at least somewhat) constrained. Coupled with the multi-trillion dollar federal budget being proposed, these bring about inflationary pressures that are positive for commodities such as oil. As Sir Isaac Newton once said: “For every action there is an equal and opposite reaction.” Oil and gas companies have been consistently sailing towards capital discipline for several years now, as growth is out of favor in comparison to free cash flow. This strategy is expected to start showing fruit as cash flow and dividends become more prevalent in the industry, something that investors have been awaiting.Tempests on The Horizon?One area where headwinds and tailwinds could clash into a storm system is how inflationary pressures could impact production costs. As commodity prices rise, labor and material costs will impact production (particularly new drilling costs). There are varying opinions as to how much and how long the impact of inflation will be, but most analysts I have read agree that it is either coming or already here. One thing to consider is that while oil prices are global, development costs will be more constrained to the U.S.. Another disturbance will also be the costs of mineral rights payments as the shift of production moves to private lands and away from federal lands. Those items could counterbalance some of the expected commodity price gains and are something that should be on management teams’ radars.Mythical KrakensThere are two things that have been mentioned that could have seismic effects on the industry: banning fracking and limiting LNG exports. However, at this point the odds are low enough to place them in the fabled category. There have been state level fracking policies for years already (New York for example), but nothing about banning fracking has ever gone very far federally. Still, some voices who echo this idea are now close to the Biden Administration. Even with the 50/50 Senate split, most think Senator Manchin (D-WV) would never let it happen.The other idea is to choke the nascent Gulf Coast LNG export industry for ESG or other related priorities. However, that is also highly unlikely. A few months ago Energy Secretary Jennifer Granholm said:“[U.S. LNG is often headed to] countries that would otherwise be using very carbon-intensive fuels, it does have the impact of reducing internationally carbon emissions. However, I will say there is an opportunity here, as well, to really start to deploy some technologies with respect to natural gas in the Gulf and other places that we are siting these facilities for that we are obligated to do under the law.”While an argument can be made that there may be some environmental reasons for shutting this down, pragmatically there is little to no way it will happen anytime soon. If it did somehow, the natural gas business in the US would take yet another ship sinking blow.Heading For Home: High ReturnsWhile upsetting a few, the Government’s action is mostly having the effect of accelerating a lot of things investors have pressed for some time now. Capital discipline is positive for prices. Prices have crept up for months, but announcements for more aggressive drilling plans have been sparse. Matador added a rig in February, but the stock price quickly dropped 5%. Most US producers are more wary of OPEC and Russia than they are of the Biden Administration. Besides, many producers have multiple years of drilling inventory already permitted so federal permit moratoriums do not stop drilling in any substantive sense. Capital has already fled the industry, some for economic reasons, some for more ideological reasons. However, if the prices keep going up and cash flow returns become the norm in an inflationary economy, this vessel could make itself a popular destination for high returns in the future.Originally appeared on Forbes.com.
Crypto, Meme Stocks, NFTs and Your Family Business
Italian artist Salvatore Garau made headlines last week with the reported sale of his invisible sculpture at an auction. It is probably not our place to wade into heady debates surrounding the ontology of art, but the reported winning bid of $18,000 is admittedly hard to evaluate relative to something which, in at least a material sense, does not exist. Nonetheless, the sculpture did come with instructions for its proper display.Mr. Garau’s innovation is in some ways the perfect embodiment of several valuation-related stories over the past year or so.Cryptocurrencies have been garnering headlines for several years, but the rise to prominence of Dogecoin during 2021 has been noteworthy, with spectacular daily price volatility and a year-to-day (as of June 7, 2021) return of over 7,500%. While other cryptocurrencies stress limited supply as support for value, Dogecoin eschews supply limitations and is described as "intentionally abundant" with a reported 10,000 new coins mined every minute.Interest in so-called meme stocks has ballooned in 2021, with retail investors buying shares in companies with less-than-inspiring fundamental stories in an effort to squeeze short sellers. While buyers of GameStop (up approximately 1,500% year-to-date) and AMC (capital appreciation of over 2,500% year-to-date) have certainly made shorting those stocks unprofitable, it remains to be seen whether the shares can hold onto current valuations over the long-term.NFT’s or non-fungible tokens blur the line between cryptocurrencies and real assets. NFTs are digital assets that represent ownership rights to digital artwork, highlight clips, music or the like. Unlike units of a cryptocurrency, NFTs are unique (hence the "non-fungible" element of the name). At the extreme end of the market, digital artist Beeple sold an NFT through Christie’s for $69.3 million. Despite not owning the NFT, you can view it here.
What does the well-publicized market activity for cryptocurrencies, meme stocks, and NFTs suggest for the value of your family business?
Valuation specialists like to distinguish between "price" and "intrinsic value." Prices can be observed in transactions; intrinsic values cannot. For some asset classes, there is no meaningful difference between the two notions. For example, individual investors in the U.S. treasury market are essentially price takers, so attempting to distinguish between price and intrinsic value doesn’t make much sense. Intrinsic value generally relies on a belief that there is a "fair" rate of return on an asset and it hard to argue that the "fair" rate of return on treasuries is anything other than the prevailing yield in the market.
When we move to the market for publicly traded shares, there are two dominant schools of thought. The first argues that public stock markets are efficient enough that any differences between price and intrinsic value do not persist long enough for investors to reliably profit from them. The logical conclusion from this belief is that one should invest in passively managed vehicles (index funds and the like). Active managers, in contrast, believe that they can successfully identify instances in which price and intrinsic value diverge.
We suspect that as one moves into more esoteric asset classes like crypto, meme stocks, and NFTs, the wild observed price volatility reflects the higher degree of difficulty associated with estimating intrinsic value. Investor returns come from cash flow yield and capital appreciation. When cash flow yield is negligible or not expected, value depends on expected future exit prices. Is GameStop a good investment at $280 per share? It is if you can sell it for $300 per share next week. If you can’t find that next buyer, it may prove to be a bad entry price for a long-term hold.
Where do family businesses fit in to this picture? The sort of "momentum" investing that powers market moves in crypto and meme stocks depends on liquidity: an investor can buy today and sell tomorrow if his mood changes. This same liquidity does not exist for family businesses, much less for minority shares in them. As a result, when you are thinking about the value of your family business, it’s probably best to turn off CNBC and think about three fundamental factors:Cash flow. How much cash flow does your family business generate after necessary reinvestments to sustain operations?Risk. How does the risk of your family business compare to that of other investments? By other investments, we don’t mean crypto or NFTs, we mean alternative investments of broadly comparable risk. The market for those assets determines the return required by potential investors: the higher the risk, the lower the value.Growth. What opportunities are available to sustainably grow the cash flows generated by your family business over time? Higher expected growth rates result in higher values.
The sale of Mr. Garau’s sculpture is a "man bites dog" sort of story and therefore generates a lot of headlines. For better or worse, the value of your family business is much more of a "dog bites man" story. Our advice is to ignore the headlines and keep focusing on the fundamentals: cash flow, risk, and growth.
Fairness Opinions
Evaluating a Buyer’s Shares From the Seller’s PerspectiveM&A activity in North America (and globally) is rebounding in 2021 after falling to less than $2.0 trillion of deal value in 2020 for just the second time since 2015 according to PitchBook; however, deal activity has accelerated in 2021 and is expected to easily top 2020 assuming no major market disruption due to a confluence of multiple factors.Most acquirers whose shares are publicly traded have seen significant multiple expansion since September 2020;Debt financing is plentiful at record low yields;Private equity is active; and,Hundreds of SPACs have raised capital and are actively seeking acquisitions.
The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares.
As of June 3, 2021, the S&P 500’s P/E based upon trailing earnings (as reported) was 44.9x compared to the long-term average since 1871 of 16x. Obviously trailing earnings were depressed by the impact of COVID-19 on 2020 earnings, but forward multiples are elevated, too. Based upon consensus estimates for 12 months ended March 31, 2022, the S&P 500 is trading for 21x earnings.
High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”
A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, operating earnings (usually EBITDA or EBITDA less capital expenditures) in addition to EPS. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on revenues, EBITDA, margins, EPS and capital structure. The per share accretion and dilution analysis of such metrics as earnings, EBITDA and dividends should consider both the buyer’s and seller’s perspectives.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. If the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed? Worse would be if the market expected a dividend cut. These same questions should also be asked in the context of the prospects for further increases.Capital Structure - Does the acquirer operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Will the proposed acquisition result in an over-leveraged company, which in turn may lead to pressure on the buyer’s shares and/or a rating downgrade if the buyer has rated debt?Balance Sheet Flexibility - Related to the capital structure should be a detailed review of the buyer’s balance sheet that examines such areas as liquidity, access to bank credit, and the carrying value of assets such as deferred tax assets.Ability to Raise Cash to Close - What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.
Tax Planning for Auto Dealerships
Why Auto Dealers Might Not Pay “Market” Rent
In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent.
While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets. It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income. As discussed below, there are also other tax planning benefits from this structure.
Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent. As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations. If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.
Succession Planning for Independent RIAs
The Best Time To Plan Is Now
Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: over 60% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet, when RIA principals are asked to rank their firm’s top priorities, developing a succession plan is often ranked last.What Is a Succession Plan?Despite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor. Internal transitions allow RIAs to maintain independence over the long-term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. Further, a gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.When managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. While this is one piece of a succession plan, we would suggest, instead, that the starting point is strategic planning for the business.One of the keys to understanding succession planning is understanding what it is not.A Succession Plan Is Not…A succession plan is not a continuity plan. A continuity plan ensures that your clients will have uninterrupted services in the event of a disaster. Your eventual retirement should not be treated in the same manner as a sudden death or earthquake.A succession plan is not an exit plan. An exit plan is a business owner’s strategic plan to sell their ownership to realize a profit or limit losses. This line can be fuzzy, but strategic transactions rarely obviate the need for succession planning. Leadership transition issues can loom large even in strategic transactions.The Time To Plan Is NowIf you’re a founding partner or selling principal, you have several options, and it’s never too soon to start thinking about succession planning. Proper succession planning needs to be tailored, and a variety of options should be considered. See our recent whitepaper for more information on succession planning.ConclusionSince our founding in 1982, Mercer Capital has provided expert valuation opinions to over 15,000 clients throughout the U.S. and six continents. We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.
Book Review: When Anything Is Possible
Over 80% of trust beneficiaries believe their trust has a negative impact on their lives. Really? That is one of the numerous counterintuitive findings presented by David C. Wells, Jr. in his new book When Anything Is Possible: Wealth and the Art of Strategic Living. Wells does something that not many financial books aim to do.Most financial literature focuses on one of three areas:Help, I have a problem! Think Dave Ramsey.How do I get more money? This includes The Millionaire Next Door and other DIY investing books.How do I learn more? Consisting of deep dives into REITS, stock selection, or portfolio construction. Your practitioners.
Wells aims to tackle a new frontier: how to live a full life strategically with wealth in hand."All I ask is for the chance to prove that money can't make me happy."The affluent do not naturally inspire pity, but Wells highlights the unique challenges associated with accumulated wealth. Wells poses a compelling question that family business advisors and business owners should consider: how does wealth allow one to live well on a personal and fundamental level as human beings?Wells provides numerous examples of wealthy people living rather poorly. Divorce, depression, anxiety, and other issues seem to plague those who are free from the financial constraints most people face. This is the gap Wells hopes to fill with When Anything Is Possible – how can we have our wealth serve those who have it, and not the other way around."The unexamined life is not worth living."When Anything Is Possible is structured in three sections: Wealth Structure, Wealth Identity, and Wealth Strategy. Wealth Structure, found in Part I, focuses on defining wealth and the common psychological issues that befall those with considerable wealth, leaning on Nobel laureate Daniel Kahneman, the Bible, and other resources. One highlight of the book for me was the 25 or so recommendations provided at the conclusion of each section. On the strength of these recommendations, I encouraged others to read the book before I had even finished reading it myself.
Wealth Identity is dissected in Part II. Wells highlights the "Self-and-Money Framework" he developed and currently uses in his family business consulting practice to help families and wealthy individuals define themselves. Wells advocates for a personal family wealth "mission statement" – akin to the guiding principles spelled out at companies like Nike or Coca-Cola – as well as "vision statements." These are meant to define the "why" and the "where we are going" questions that define the wealth journey for enterprising families.
Family businesses would be well served to give serious thought to mission and vision. Avoiding the dreaded "shirtsleeves to shirtsleeves" cycle can only be accomplished by giving heed to both next quarter's P&L and the vision of the family members in the company."Money brings some happiness, but at a certain point it just brings more money."Part III covers Wealth Strategy and how wealthy individuals spend, invest, gift (to family), and give (charity). Wells highlights several great anecdotes, books, and data points to drive home a singular point: consumption and wealth without a "why" brings happiness only to a point.A single image that shows the living patterns of individuals in homes drove this point home to me perfectly. Families spend most of their time in two rooms: the kitchen, and the family/living room. Based on square footage and usage, formal dining rooms might cost $1,500 per use. How about a private room at the Capital Grille instead? As Wells points out: no dishes.Wells provides great tools in the final chapters for thinking about our consumption, estate planning, investing, and giving decisions. The book does a good job continually re-centering decisions back to a key question: Why?ConclusionWells sells himself short by claiming the book is not for everyone. While not a member of the two or three-comma club, I found his study of psychology, purpose, and faith as it applies to wealth both enriching and a cause for self-reflection. In our family business advisory practice at Mercer Capital, we help our clients navigate the intersection of family issues and business realities. Built around the framework of wealth structure, identity, and strategy, When Anything Is Possible is a timely guide for business owners thinking about the role of wealth in their families.
Purchase Price Allocations for Asset and Wealth Manager Transactions
There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill.Transactions structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions.
Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.
Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2016 and 2020, Focus completed 106 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 53% was allocated to customer relationships and 3% was allocated to other assets, with the remaining 44% comprising goodwill.Expand ChartTradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of an assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.
Not All MOEs Are Created Equal
In the December 2020 BankWatch, we provided our M&A outlook for 2021 and touched on themes that we believed would drive deal activity for the year.Our view was that the need to reduce costs in the face of revenue pressure would create urgency for banks to engage in M&A and lead to increased deal activity, given that credit quality remained stable and the economy avoided a double-dip recession. Specifically, we noted that these drivers may cause mergers of equals (“MOEs”) to see more interest.Indeed, four of the largest bank deals in 2020 were structured as MOEs or quasi-MOEs (low premium transactions), and we believed the trend would only gain more traction as economic clarity emerged. Thus far in 2021, against the backdrop of economic reopening, stable asset quality, and favorable bank stock performance, deal activity in the industry has picked up, and MOEs remain a hot topic.S&P Global Market Intelligence reported 53 U.S. bank deals year-to date through April 30, compared to 43 during the same period in 2020.The pace increased notably in April as 19 deals were announced in the month, including two large MOEs.BancorpSouth (BXS) announced a merger with Cadence (CADE) on April 12, and Webster (WBS) announced a deal with Sterling Bancorp (STL) one week later on April 19.U.S. Bank MOEs by Year
# of Announced DealBank MOEs are not a new concept, but they have occurred more frequently over the past several years, with the most notable being the BB&T – SunTrust combination to form Truist Financial (TFC).The BB&T-SunTrust combination has been reasonably well received, while it is perhaps early to judge some of the more recent deals.These types of transactions certainly have their merits and can appear strategically and financially compelling.However, MOEs involve a number of risks that should not be overlooked.For management teams considering an MOE, it is important to assess both the benefits and potential risks of such a deal.CLICK HERE TO ENLARGE THE CHART ABOVEBENEFITSReduce CostsPerhaps the most apparent benefit is the opportunity to reduce costs and improve operational efficiency.This is especially valuable in the current environment as revenue growth opportunities are limited.Reported estimates for cost savings in recent MOEs have been on the order of 10% to 15% of the combined expense base.These savings are often achieved by consolidating back office and administrative functions and/or right-sizing the branch network.With the increased adoption of digital banking, branch networks have become less central to banks’ business models and can be a drag on efficiency.MOEs provide management teams an opportunity to re-evaluate their banks’ physical distribution systems and reap the benefits of optimizing the branch network.CLICK HERE TO ENLARGE THE CHART ABOVEInvest in TechnologyThe savings from efficiencies and branch consolidation can be invested in upgrading the bank’s technological capabilities.Almost all recent merger press releases include some type of statement indicating management’s intent to invest in the pro forma bank’s digital capabilities.While the specifics of such investments are often not disclosed, it is clear that management teams view the ability to invest in technology as a key piece of the rationale for merging.By gaining scale, banks can dedicate the necessary resources to develop sophisticated financial technology solutions. Expand FootprintWith a challenging loan growth outlook, many banks are considering entering new markets with favorable demographic characteristics.Unlike a de novo strategy or a series of small acquisitions, an MOE provides an opportunity to quickly establish a sizeable presence in a desired market.In merging with Cadence, BancorpSouth will in a single transaction more than double its deposit base in Texas where it previously had been acquiring smaller banks, with three sub-$500 million asset bank acquisitions since 2018.As banks look to position themselves for growth, MOEs are a potentially attractive option to gain meaningful exposure to new markets. Diversify Revenue StreamA merger offers opportunities to diversify the revenue stream by either gaining new lending expertise or entering a new fee income line of business.The more retail-focused First Citizens Bancshares will significantly diversify its lending profile when it completes its combination with the commercial-oriented CIT Group, announced in October of last year.Similarly, IberiaBank diversified its revenue stream by combining with First Horizon which has a sizeable fixed income operation.As revenue growth remains challenging, management teams should consider if a transaction might better position their bank for the current environment. RISKSWhile an MOE can offer benefits on a larger scale, it also presents risks on a larger scale.The risks detailed below largely apply to all mergers and are amplified in the case of an MOE. CultureCulture is often the arbiter between success and failure for an MOE.Each of the subsequent risks detailed in this section could be considered a derivative of culture.If two banks with conflicting management philosophies combine, the result is predictable.The 1994 (admittedly before my time) combination of Society Corporation and KeyCorp was considered a struggle for several years as Society was a centralized, commercial-lending powerhouse while KeyCorp was a decentralized, retail-focused operation.Potential merger partners need to honestly assess cultural similarities and differences and evaluate the proposed post-merger management structure before moving forward. It is also important that merging banks be on the same page regarding post-merger ambitions.If one views the merger as “fattening itself up” for a future acquirer while the other desires to remain independent, they will likely diverge in their approach to other strategic decisions.When executives or board members frequently clash, the pro forma entity will struggle. Staff RetentionThere is usually some level of employee fallout with an acquisition, but if enough key employees leave or are poached by competitors, the bank’s post-merger performance will suffer.This is an especially important consideration when acquiring a bank in a new market or with a unique lending niche.If employees with strong ties to the communities in a new market leave for a competitor, it will be difficult to gain traction in that market.Likewise, a new lending specialty or business line can fail if those with the knowledge and experience to run it do not stick around for long. Execution/IntegrationAcquiring a bank of the same or similar size requires a tremendous amount of effort.Loan and deposit systems must be consolidated, customers from the acquired bank must be onboarded to the new bank’s platforms, and branding must be updated across the franchise.If the acquirer’s management team has little experience with acquisitions, successfully integrating with a large partner may prove difficult.When considering an MOE, the acquiring bank must assess what tasks will be necessary to combine the operations of the two organizations and achieve the projected cost savings.Management teams must consider whether their organization has the expertise to do that or, if not, what external resources would be needed. CreditCredit quality issues from an acquired loan portfolio can come back to bite a bank years after the acquisition.Merger partners need to be sure they have performed thorough due diligence on each bank’s loan portfolio and are comfortable with the risk profile.While recent credit quality concerns in the industry have not materialized and greater economic clarity has emerged, would-be acquirers need not be lulled to sleep by the current credit backdrop.The past year has shown that the future is unpredictable, and that forecasts are not always correct. CLICK HERE TO ENLARGE THE CHART ABOVEAdverse Market ReactionIn recent MOEs and low premium transactions, acquirers’ shares have faced an adverse reaction from investors with declines of 5% to 7% in the days following announcement.First Citizens is an exception as its shares were up 34% five days after announcing its acquisition of CIT, which largely reflects the favorable price paid (44% of tangible book value).While it is not uncommon for buyers’ shares to decline following the announcement of an acquisition, these drops could reflect the market’s concerns around the heightened execution and integration risk of an MOE.It is early to judge whether the deals will create value in the long run or if the market’s initial reaction was justified. CONCLUSIONWe believe M&A will continue at a strong pace in the coming months as the economy continues to reopen and banks dust off previously shelved pre-Covid deals.We also expect MOEs will continue to garner more interest due to the aforementioned benefits.Management teams may be more willing to negotiate now than before on price, management roles, board composition, branding, etc.A balanced consideration of the benefits and risks of an MOE is imperative for making the optimal decision.Mercer Capital has significant experience in advising banks as buyers and sellers in transactions, including MOEs.
Mineral Aggregator Valuation Multiples Study Released
With Market Data as of May 26, 2021
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation MultiplesDownload Study
Post-Pandemic Tax Planning for RIAs
Is It Time To Consider a Change in Your Corporate Structure, or Your Address?
Most of our colleagues at Mercer Capital live in Texas or Tennessee – two states with very low tax burdens. This is not by design so much as by circumstance: our firm grew up where we already lived. Until recently, the relatively low cost of living, short commutes, and moderate climate came with a tradeoff: most of our clients are on the coasts, so regular travel away from home was a necessity.Now that the pandemic has made geographic proximity for many meetings a non-issue, we’re beginning to wonder how many of our clients are ultimately going to join us. Dynasty’s move from New York to Florida and UBS’s relocation to Tennessee got plenty of attention. And we’re starting to hear of smaller RIAs contemplating similar moves. This isn’t a crowded trade yet though; most investment management firms still call high-cost, high-tax states home.Texas and Florida have been climbing the rankings of states with the most RIAs, but two states still dominate this survey – New York and California. New York’s position is even stronger if you include adjacent communities of investment management firms in Connecticut, New Jersey, and Pennsylvania.California is in an enviable position as the fifth largest economy on the globe, not to mention mostly-beautiful weather. That hasn’t been enough for Schwab, which has been migrating staff to Texas, Colorado, and Arizona for years. Now we’re starting to hear from California clients with staff members who moved out of state during the worst of the pandemic and would like to continue working remotely. When will their employers follow?Manhattan is another story altogether, with city tax burdens layered on top of state taxes. With all due respect to Manhattan’s theme song, in the post-pandemic, remote-work world, if you can make it anywhere, why make it there? We have another wealth management client who just relocated from New York to Tennessee – cost structure and concern over the quality of life in Manhattan for the foreseeable future were key factors.What the table above doesn’t show is the value of the talent pools already established in financial hubs like San Francisco and New York. But the relative cost of living may be enough to convince some of that talent to relocate. If that becomes a trend, all bets are off.The wrong corporate structure can exacerbate the state tax differential. Imagine the extreme scenario of a Manhattan based C Corporation that considers moving to Florida and converting to an LLC.After-tax dividends/distributions to the Florida LLC member are about 30% higher than for a shareholder in a New York City C Corporation with the same EBIT (earnings before interest and taxes). But this differential is far greater if you consider the cost of living in Florida versus New York – a difference that will widen further if President Biden successfully rolls back some or all of the reduction in corporate taxes enacted in 2017.As for proximity to clients, there are reasons to expect ultra-high net worth families in California and New York to relocate. Florida still has no estate tax, while New York just raised theirs. Tennessee and Texas (two states with no personal income tax) also have no estate tax, and Tennessee has strong and well-developed trust laws considered on-par with South Dakota.Anecdotal experience supports this trend. Friends on the west coast and in the northeast have told me they have a recurring conversation with their neighbors that revolves around the question: “how much longer are you going to stay here?” The implication of this question is that, as soon as they could, they would decamp for a lower-tax, lower-cost of living part of the U.S. Just as the pandemic accelerated many trends, we expect to see a migration of wealthy clients to more cost-effective jurisdictions, as well as the firms that serve them.
Making Sense of 2020: Part 4
History, Valuation & the Future
It makes sense that stock prices reflect financial performance, and over the long run they do. So how to explain 2020, which saw corporate earnings devastated by the pandemic and stock indexes soaring to all-time highs? We’ve covered the pandemic’s affect on the operating, investing, and financing decisions made by public companies in our last three posts. This week, we conclude by examining shareholder returns.Chart 20 summarizes the performance of the Russell 2000 index (small cap shares) during 2019 and 2020.
At the onset of the pandemic, the index fell precipitously. This is pretty easy to understand: investors don’t like risk, and risk was everywhere in the spring of 2020. During the second and third quarters, investors began to feel that they had a handle on the pandemic. In other words, investors grew increasingly comfortable that the long-term economic impact of the pandemic could be reasonably estimated. By the end of 3Q20, the index value had returned to pre-pandemic levels.
When thinking about valuation, it is important to recall that the emphasis is always on the future. When the end of 3Q20 rolled around, it was clear that earnings for 2020 would be impaired because of the pandemic – so how could share prices be at the same level? Because the lower earnings for 2020 no longer mattered; the market was focused on earnings expectations
for 2021 and beyond.
Chart 21 shows that, while the market as whole had recovered by the end of 3Q20, not all companies did. Different industries fared differently. For example, healthcare shares increased sharply while energy shares were devastated.
The storyline changes when we turn our attention to market performance in the fourth quarter of 2020. As shown on Chart 20, the index value surpassed pre-COVID levels by almost 20%. Chart 22 summarizes average share price changes by industry for the fourth quarter of 2020.
In contrast to the share price performance during the first three quarters, the uplift in market prices during the fourth quarter was broad, with all sectors posting substantial average share price gains.
Share prices change when earnings change and/or earnings multiples change. As shown in Chart 23, increasing earnings multiples played a significant role in the share price gains during the fourth quarter of 2020.
Earnings multiples are defined by investor expectations for growth and returns.
Growth. From the existing base, how fast are earnings expected to grow in the future? The faster the expected growth, the higher the earnings multiple. As visibility into vaccine pipeline increased during the quarter, investors may have been willing to credit companies with higher growth prospects.Returns. What return are investors demanding? Returns are the sum of the yield on risk-free assets plus a premium to compensate investors for taking risk. All else equal, investor returns are inversely related to earnings multiples. The increase in multiples during 4Q20 suggests that required returns decreased. Since risk-free returns increased during the period, the return premium received for taking risk likely fell more dramatically.Takeaways for Family Business DirectorsWhat does all of this mean for family business directors? The effect of the pandemic on business operations has been well-documented. However, for most family businesses it is time to move on from the survival mindset required during 2020.How will your family business grow in a post-pandemic world?One message from the stock market run-up during 4Q20 is that public market investors are expecting growth. Even if you think your family shareholders are different, public market sentiment likely shapes the behavior of your competitors and will influence what happens in your industry whether you want it to or not. In the wake of changes to supply chains and distribution channels, what new strategies will your family business need to adopt to compete and grow in the post-COVID world?How will you adapt to a lower cost of capital?The cost of capital is the price of money, and family businesses are ultimately price takers in the capital markets. While family shareholders may be protected from short-term public market volatility, public capital market trends do affect family businesses in the long-term. Regardless of whether you assign the cause to central bank actions or shifting investor sentiment, the overall cost of capital was probably lower at the end of 2020 than at the beginning of the year. This has significant implications for how family businesses evaluate and make distribution, investment, and capital structure decisions.These questions rarely have simple answers. Give one of our family business professionals a call to discuss what adjustments may be appropriate to help your family business thrive in the post-COVID world.
Valuation and M&A Trends in the Auto Dealer Industry
Full Speed Ahead or Partly Cloudy?
A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the release of their Fourth Quarter 2020 Haig Report. Specifically, I wanted to focus on the unique conditions impacting the industry, and also the changing methodology that buyers are utilizing to assess dealership values. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for various auto manufacturers based on their observations and data from participating in transactions in this industry.The Haig Report mentions many buyers are utilizing a three-year average of earnings to calculate the expected performance of the dealership. Why has this new trend occurred and how has a buyer’s pricing methodology shifted in 2020/2021?KN: Prior to the pandemic, the auto retail market had effectively plateaued with sales declining slightly and dealership profitability fairly stable. The roller coaster of 2020 - a lockdown, then a big upswing as pent up demand and stimulus money flowed through the system in the summer, followed by continued retail demand and tight inventories, created a lot of “noise” in dealer financial statements. Even with exclusion of PPP fund impact, overall dealership profitability was incredibly strong with many stores achieving all-time record profits.
This created a challenge for buyers as they attempted to identify the correct income to base their buying decisions. When you apply a multiple against expected earnings to determine value, one needs to have confidence the earnings will materialize. Given the volatility in performance, buyers have been reluctant to price a deal solely on 2020 results, making the argument the performance was artificially inflated. Sellers counter by illustrating the strong results were not a summer phenomenon but have continued into 2021 and no end is in sight. Going forward inventory availability remains an issue creating nice margins, interest rates will remain low for the foreseeable future, and expense controls have taken some of the bloat out of the business.
As a result, many buyers are using a three-year average (2018-2020) as their earnings baseline. This gives the seller credit for the strong 2020 numbers but reflects expectations that future results will likely settle back to pre-pandemic numbers. Notably, some markets that were harder hit by the pandemic did not generate record numbers, and some buyers are utilizing 2019 as their baseline so as not to punish a seller for a down year in 2020. Regardless, it takes more massaging of past performance to establish a baseline for future results.
SW: The methodology described by Kevin compares to our longer-term view of a dealership’s earnings and profitability. A valuation considers the expected ongoing earnings or cash flow of the dealership, and as such, several factors should be considered including historical, current, and expected operations in the future. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year, if neither are sustainable. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Will buyers revert to Trailing 12 Months (TTM) as their baseline or will the three-year average method remain for some time?KN: Adjusted TTM earnings became the primary baseline for applying a multiple because the industry performance had been fairly stable for some time. Yes, there were specific dealerships that had better or worse results, and those were valued with appropriate modifications to forecasted earnings. Given the aforementioned volatility in 2020, the expectations of a strong 2021 and a potential gradual return to pre-pandemic levels, using a three-year average of earnings has become a more accepted strategy. Until we see stability in the automotive retail sector for some time, it’s unlikely TTM will return as the primary earnings metric. Of course, there are always exceptions including unique market dynamics, identified changes to the business or a highly competitive market for a dealership that may require buyers to give more credit for 2020 and 2021 results.Has there been a prior time when a three-year average was the preferred method for calculating earnings and, if so, what were the underlying conditions at the time?KN: Using a three-year average was a fairly standard method until recently but as dealership performance became stable and predictable, both buyers and sellers gradually settled on TTM as an effective proxy to base their valuation. Simplicity and the lack of variance in performance made it an easy calculation and removed some of the tension during negotiations. Of course, there has and will continue to be discussion and debate on add-backs and proforma earnings when strategic shifts at the dealership might yield better results.
In general, the more consistent the performance, the more likely the buyer can get comfortable using the most recent financial period to calculate a value.
SW: As we discuss on a monthly basis, the auto SAAR (number of lightweight automobiles and trucks sold on an annual basis) is one of the general indicators of the conditions in the industry. To view Kevin’s rationale behind the stability in the industry through the lens of SAAR, SAAR was fairly stable and roughly averaged between 16 and 18 million units from mid-2014 through the first few months of 2020 prior to the pandemic. SAAR collapsed to 11.361 million units in March 2020, before bottoming out at 8.721 million units in April 2020.What other changes or areas of focus are buyers concentrating on given the unique 2020 environment?KN: As buyers look to 2021 and beyond and evaluate how a target might perform going forward, there are certainly some areas of the business that are receiving attention:New vehicle margins – Given industry constraints on production, new inventory levels on dealer lots are quite low, allowing dealers to increase transaction prices and realize stronger margins. This is expected for most of 2021 and possibly into 2022. There is also dialogue that given improved profitability at OEMs, suppliers, and dealers, a more balanced production vs. demand market may continue, maintaining improved margins.Used vehicle margins – The used vehicle market dropped initially during the pandemic lockdown, spiked again, and has remained fairly strong since the fall. Now with new vehicle shortages, we are hearing dealers are driving up acquisition prices on used vehicles. The lack of new availability could drive consumers to used and keep margins strong or the frenzy to buy inventory could lower margins if consumers balk at the higher costs of the vehicle.Fixed operations – Most dealers saw a drop in 2020 fixed operations as the lockdown cost them weeks and months of customers. Given most dealership service bays are at or near capacity, you can’t make the business up. However, the 4Q of 2020 saw fixed revenue return to pre-pandemic levels. Thus, we expect 2021 to show nice growth in fixed operations over a lower 2020 and the past trend of annualized revenue increases should continue in 2022 and beyond.SG&A expenses – Key expense categories including floor plan interest, advertising and personnel saw nice declines in 2020. It is likely interest rates will remain close to zero, possibly into 2023. Many dealers see lower advertising as a continued theme for the foreseeable future given demand is exceeding supply. Finally, as dealers refine their sales and delivery channels and more transactions move online, we hear a number of dealer principals indicate their staffing levels will be permanently lower.SW: Gross profit per unit numbers for new and used vehicles continues to be very strong, with average reported figures for March at $2,764 and $2,859 per unit respectively, according to the average dealership statistics published by NADA Dealership Profiles. As daily reports of inventory shortages and challenges due to the microchip crisis continue, it will be interesting to see if/when these constraints catch up to the industry and halt the record profitability. Perhaps, we will begin to see some of these hiccups finally materialize in the financial performance either in the April or May figures when they are published.With rumors of tax rates rising, what impact could this have on Blue Sky multiples?KN: The Biden administration platform includes a material increase in capital gains taxes which directly impacts sellers of dealerships. As a result, some sellers who have been considering a sale are accelerating their plans and pursuing a sale in 2021 before a likely tax change in 2022. There are a number of attractive opportunities for buyers and dealers looking to expand so its expected values will remain robust. If/when tax rates rise, several situations might occur:Fewer sellers come to market, reducing dealership inventory and putting upward pressure on valuations.Less after tax proceeds to the seller pressures them to require higher valuations to sell their store.Higher taxes reduce consumer spending, lower sales, reduce dealer profits and bring valuations down.
As a result, it’s difficult to predict the future but there’s no doubt higher taxes will have a ripple effect throughout the dealer buy/sell market.
SW: My colleague David Harkins previously authored a post highlighting the proposed tax changes and their impact on valuation by comparing expected earnings under several tax bracket structures.Looking back, how did the Tax Cuts and Jobs Act (TCJA) affect multiples and values?KN: Lower taxes certainly provided a boost to consumers and helped ensure stability in vehicle sales in an environment where we were beginning to see declining sales. Corporate tax rate changes did little to help dealers as most are not C-corporations, and some dealers saw personal taxes go up due to the changes in deductibility of certain items. Overall, the rates kept the momentum rolling, nice profits for dealerships, and stable valuations for stores. Buyers were also able to forecast higher after-tax proceeds from their stores to justify paying more.
We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. While the last year has been a turbulent one for the industry, auto dealers have been resilient in navigating the changing conditions. The first four to five months of 2021 have continued the momentum of the last half of 2020 in terms of dealership profitability and transaction volume. It will be interesting to see how long these trends will continue, or if auto dealers will experience any hiccups as market constraints threaten current profitability. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.
Themes from Q1 2021 Earnings Calls
Part 2: Mineral Aggregators
Last week, we reviewed the first quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregator first quarter 2021 earnings calls.Favorable M&A OutlookTransaction volume was largely muted throughout 2020 as the depressed pricing environment drove bid-ask spreads wider. Buyers were offering what they believed was supportable based on current market conditions, and sellers were convinced that their assets were being undervalued. This led to sellers holding onto assets for dear life unless they were forced to liquidate. As mineral aggregators have the reputation to reinvest capital, participants on the earnings calls were intrigued to learn about their strategy in what many believe may be a price recovery environment.“We had a stock price where we didn't really feel like the equity was a usable acquisition currency, and I think sellers still had higher expectations than the environment warranted. And so with prices and equity recovering, and frankly where sellers were sitting on those assets for another 12 to 18 months, we think the environment is just getting much more constructive.”
–Jeffrey Wood, President & CFO, Black Stone Minerals“Since the third quarter of last year, we've continued deploying capital to mineral acquisitions and believe the assets we've acquired over the past three quarters will generate differentiated performance over the next several years. We will continue to employ our disciplined underwriting of deals to enhance shareholder value and at the same time see more of our acquisitions internally funded via retained cash.” –Bud Brigham, Founder & Executive Chairman, Brigham MineralsHedgingHedging strategies differed among the aggregators. Some companies, like Black Stone and Viper, executed hedges that mitigated risk in 2020, but have been a detriment to recent financial performance. On the contrary, Brigham Minerals stated that their hedging portfolio was minimal which allowed them to participate in the positive pricing environment seen in the first quarter.“As most of you are aware, we have always been active hedgers of our commodity risk. Those hedges benefited us greatly last year when prices cratered, but also tempered the impact of the dramatic rise in prices for us during the first quarter.” –Jeffrey Wood, President & CFO, Black Stone Minerals“First, we did not need to panic at any point during the rollercoaster year of 2020 and execute hedges, which today are currently serving as strong headwinds to numerous companies in the energy space. Here at Brigham, we are managers of a premier mineral portfolio, non-commodity traders and we prefer to give our investors full exposure to the commodity.”
–Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Also, we believe our hedging strategy is a prudent methodology for managing the company’s future price risks on oil and natural gas. Having substantial hedges in place on a rolling two-year basis before the price shocks that occurred in 2020 proves to be a very effective risk mitigation strategy.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“We had a lot of ‘21 hedges put on this year that are unfortunately, underwater because of the recovery. But I think as you think about 2022 and beyond, putting some sort of floor under the low end of distributable cash flow is something we’re thinking about.” –Kaes Van’t Hof, President, Viper Energy PartnersDebt SituationAggregators continued to pay down debt and improve liquidity, which was a major priority heading into the new year. Relationships with lenders was a concern during 2020, but Jeffrey Wood, President and CFO of Black Stone Minerals, stated that the company was able to execute a favorable extension to their existing debt facility. This is a positive sign for the industry moving forward. Aggregators will continue to allocate free cash flow between debt paydown and shareholder return as the year progresses.“After the end of the quarter, we finalized an extension of our existing revolving credit facility last week. We added 2 years to the maturity date of that facility, which is now November of 2024. It's been a very difficult bank market over the past year, so we're really happy to get this extension done with relatively minor modifications to the terms of the facility and we appreciate the continued support from our long-term lending relationships.”–Jeffrey Wood, President & CFO, Black Stone Minerals“As we have done in previous quarters, the company utilized 25% of its Q4 2020 cash available for distribution to pay down a portion of the credit facility in Q1 2020. Since May 2020, the company has paid down approximately $25 million in debt by allocating a portion of its cash flow to debt paid down. We expect to continue to allocate 25% of our cash available for distribution for debt pay down in the future.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“As a result, Viper generated almost $55 million in net cash from operating activities, which enabled us to reduce debt by $27 million during the quarter. We have now reduced total debt by over $136 million, or roughly 20%, over the past 12 months.” –Travis Stice, CEO, Viper Energy PartnersConclusionIt is safe to say that sentiment among the participants was positive in the first quarter earnings calls, especially relative to last year. Aggregators seemed to grind through 2020 and flip the script for a new year. Although a price recovery may be in sight, challenges remain, specifically with the Biden Administration taking office. The calls largely glossed over political implications of the new administration but those issues may come into focus as the year unfolds.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.
Q1 2021 Earnings Calls
Improved Profitability, Online Tools and Market Share, and High Valuations
The earnings calls in Q1 began with a focus on many of the same trends as prior quarters: increasing or record EPS despite inventory struggles as gross margin improvement drove operating leverage. The chip shortage has taken center stage, with cloudy expectations of when inventory levels might normalize. Contrast to factory shutdowns last year, dealers are faring much better as strong demand has improved vehicle pricing, benefiting both dealers and manufacturers. OEMs have tried to mitigate the impact of the chip shortage by removing certain features requiring chips, while others have prioritized more in-demand models to maximize profits.A couple of other trends require the proper framing of the subject to truly understand what’s happening. First, many execs talked about “pent-up demand” for parts and service work. If “pent-up demand” means parts and service revenue is expected to increase in the coming months, then that appears likely as vaccination rates increase and mandates are relaxed. However, on previous calls, many discussed the notion of consumers deferring maintenance on their vehicles since they could get by because they were driving less. Deferred maintenance has not been discussed as much, suggesting deferred maintenance activity has not meaningfully presented itself. In many instances such as the winter storms, execs noted that unit sales may have been delayed but service revenue losses would not be recovered.We also need to appropriately frame the degree to which online sales are truly “incremental,” or not cannibalizing traditional in-person sales. Execs highlighted online sales to customers who had not previously bought from them before as evidence that online tools were incremental. Given the long life cycle of vehicles, we are less convinced this necessarily says a consumer only purchased from their company because of the online feature. While Lithia noted nearly 98% of its online sales were to first time Lithia purchasers, we believe the 43% sold to customers outside of their retail market presence is a better representation of incremental sales, which is to say the company is improving its market share. While there were technical difficulties throughout the Sonic call reducing our ability to pull meaningful quotes, their investor deck similarly noted 30% of customers of its EchoPark segment (its stand-alone Pre-Owned operations) traveled more than 30 minutes to shop their inventory.On the other hand, Penske casts doubt on the notion that these sales were truly additional in the sense that consumers aren’t buying cars they didn’t otherwise need solely because the option to buy online now exists. While we tend to agree, it is meaningful if larger players are able to poach customers with the scale provided by their online platforms. Over the longer term, this could negatively impact unit volumes for smaller dealerships who choose to not take advantage of online options or are not able to meaningfully compete. Simply having a website may not be enough for the local Honda dealership to compete if comes up 5th on a Google search.The franchised auto dealer space is fragmented by nature. As such, the few publics are frequently asked about consolidation in the industry, as they have both the experience to operate at scale and a liquid market for their equity which allows acquired dealers to achieve liquidity without necessarily losing the upside of their dealership in a transaction (either receiving stock or investing cash from the deal into that stock). However, despite plenty of transactions in the industry, public auto dealers have not typically provided much financial information on their targets aside from revenues. In a recent investor deck, Lithia took things a step further, quantifying its intangible investment as a percentage of revenues as shown below:
Many noted increasing valuations, and an analyst on the AutoNation call mentioned his M&A modeling at about 15% to 30% of sales. CFOs for multiple companies noted their focus on EBITDA multiples when doing deals, which are highlighted in theme #4. For perspective, the market ascribes about a 7.7x EV/EBITDA multiple for AutoNation with floor-plan interest treated as an operating expense as calculated below:
Theme I: Microchip shortages have extended longer than initially anticipated, but strong demand, in part due to stimulus funds, has supported robust sales and gross profits. The industry’s limited chip supply has led to retail customer, particularly in hot selling models, getting vehicles first.“As it relates to the hot selling products as you point to, the OEMs are really great at this. And while the chip shortage is there, they've really been shifting their production to the faster selling vehicles. […] everyone is showing high margins. We didn't all of a sudden get that much better, it's simplistically supply and demand. There is that point where you're missing a lot of sales because you just don't have the inventory. […] the industry performs well and stability exist when there's probably a 60 to 70 days supply in the market. And right now with all the government spending that's going on and people coming out, the demand is going to be high right now, and the fear is the inventory won't be there to match the demand.” -David Hult, CEO, Asbury Automotive Group“As of the end of the quarter, we had a 41-day supply of new vehicle inventory, indicating we have well over a month's supply of vehicles on the ground and an adequate supply of in-transit that are replenishing our on-ground inventory every day. However, new vehicle margins may remain elevated in the near term due to continued microchip and other supply chain shortages, coupled with elevated consumer demand levels driven by additional stimulus funds. While select OEMs are experiencing reduced level of inventory, we currently have sufficient inventory to balance the current supply and demand trends expected over the coming months.” – Christopher Holzshu, President, and CEO, Lithia Motors“There is no question that there is more demand than supply, that is the headline. On the new vehicle side, there supply is tight, but shipments and production are disrupted with the chip crisis and will be for the rest of the year. But it's nothing like a year ago during the pandemic when we had the factory shutdowns. […] we've adjusted pricing to reflect that, and you've seen the improvement in our front-end gross. […] There is no reason to rush things out the door. You can’t easily replace it.” - Mike Jackson, Chairman & CEO, AutoNation“I've been amazed in the recent months, how we've continued to maintain pretty impressive sales levels with declining inventory levels. […] Also, the OEMs have adjusted. It seems that the only vehicles they're making are the ones that sell the fastest. So when they come off the truck, they go right to a retail customer. […] we're getting to the point where inventory is a problem, if not at this moment very soon. So ideal for us is about 45 days supply when we mix all of our different brands together. And as you saw, we ended the quarter at little over 30. And we're actually fine in the 30s. But we're a big truck market. When you get very far below 30 days of supply, you have trouble having many of the configurations that the truck customers want. And so that's where it starts to get a little challenging for some of our brands.” - Earl Hesterberg, President and CEO, Group 1 AutomotiveTheme 2: Service and parts continue to lag vehicle sales for many dealers, though those struggling for inventory are relying more on fixed ops. While a return to “normal” levels of miles driven should increase service demand, opinions among public dealers were mixed as to the degree there was pent-up demand from consumers deferring maintenance during the pandemic.“Obviously pent-up demand is a big driver. And we are starting to see that coming out of March where we actually started to finally see some real big volume increases year-over-year were great, but what we're really trying to do is figure out when will we start to get to a normalized recovery over what was really the 2019 kind of year, if we use that as a base case. And in the quarter, we saw ourselves about 5% up over that 2019 level. And prior to the pandemic last year, we were projecting a double-digit -- a low double-digit increase in our parts and service business. So we definitely see that trend continuing into April and we expect that to continue through the summer months as we kind of rally into customers coming -- normalizing their lives again and getting back on the road and driving their vehicles and then needing parts and service work.” – Christopher Holzshu, President, and CEO, Lithia Motors“We expect good things out of parts and service for the rest of the year. We see the traffic counts building. Our gross for RO is quite good as we've made some adjustments during the pandemic on that better inspections, better reporting, better selling skills with customers. And we we've added over 300 technicians back to our dealership base in the last 12 months. Very few hourly technicians, which tend to be less productive than flat rate technicians, and that helps us be more productive as a business. And we expect good things as miles driven continue to increase. And if vehicle supplies do become an issue, people will hold on to their cars and they will be in our shops more. […] The customer pay business is extremely strong […] but warranty we don’t control, and warranty has been a bit weak. […] it’s been collision and warranty, which had been soft over recent quarters.” - Earl Hesterberg, President and CEO, Group 1 Automotive“Well, there is no question that miles driven have come down […] in January, we were down 16% in parts and service revenue. Now, that’s really swung around. So, people are getting out. […] So, I think we’ve got to look sequentially how we’re going to look from March to April. This year will give us probably a better picture. But, I can say that there is definitely more momentum and more interest in the shop. […] So we still have some real opportunity there and just a matter of getting people out and that's strictly miles driven will drive that.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroup“March came back so strong, it was actually ahead of '19 pace numbers. And as we sit here in April, we're experiencing the same. So, the customers are back on the road, the service business is back. […] while we're feeling it on the variable side with some shortages with inventory, thankfully Parts and Service is picking up on that. […] We think there’s a lot of pent-up demand.” -David Hult, CEO, Asbury Automotive GroupTheme 3: While many dealers tout incremental sales on their online platforms, it’s important to understand which sales replace would-be in-person dealership transactions and which the company would not have been able to achieve, such as sales to customers where the dealer doesn’t have a physical dealership.“97.8% of our Driveway customers during our first quarter were incremental and had never done business with a Lithia dealership before. […] 43% of our [Driveway] sales are out of region and our average shipping distance is 732 miles […] so we're not really getting into that cannibalization of our existing pipeline.” -Bryan DeBoer, President and CEO, Lithia Motors“There is a lot of incremental [online] sales that we would not have received, and I made that comment, because looking at the information we weren't doing business with [those customers] before.” -David Hult, CEO, Asbury Automotive Group“I think that to a certain extent, it's substitutional where people have the opportunity to buy online, delivery at home, come to the dealership. […] we’re really not growing the business at this point incrementally. And I think that’s going to be the true test where we can tell the analysts in the market, we’ve actually grown our overall business by using the online tool.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroupTheme 4: While Lithia at least reports transactions in terms of price to revenue, multiple companies specified they think in terms of EBITDA multiples. While this might not be true for smaller acquirers, it may affirm the reasonableness of correctly applied EBITDA multiples from the publics.“[W]e generally think more about it as a multiple of EBITDA than revenue. And it's kind of in that high single-digit range, and returns are mid-teens.” - Joe Lower, CFO, AutoNation“[W]hen we evaluate an opportunity, we're looking at EBITDA multiples and then factoring in the synergies we think we can achieve, and then we look at the IRR relative to our cost of capital. And we need to see a margin there to deliver an accretive deal.” - PJ Guido, CFO, Asbury Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
Making Sense of 2020: Part 3
Benchmarking Cash Flow From Financing Activities
In previous posts, we analyzed the operating performance and investing decisions of the companies in our benchmarking universe. This week, we examine the financing decisions of those companies and apply those observations to family businesses.Big Picture FindingsThe difference between operating cash flow and investing cash flow creates a “gap” that is filled by financing activities.When operating cash flows exceed investing outflows, cash is available to distribute to capital providers, whether in the form of repaying debt, repurchasing shares, or paying dividends.When investing outflows exceed operating cash flows, a business must finance the resulting shortfall by borrowing from lenders or selling new shares to investors.
A company’s cash balance serves as the release valve when financing cash flows do not perfectly align with the “gap” between operating and investing cash flows.
Table 14 summarizes the aggregate sources and uses of cash for the small cap companies in the Russell 2000 during the three years ending with 2020.
In “normal” years (i.e., 2018 and 2019), the small caps typically invest a bit more than cash flow from operations, leaving a net hole to be filled by financing activities. Of course, 2020 was far from “normal.” As we have described in the previous two posts in this series, operating cash flow increased during the year despite weak earnings because of non-cash impairment charges and reduced working capital balances. Meanwhile, companies were cautious on the investment front, curtailing both capital expenditures and M&A activity. The net result is that during 2020, operating cash flows exceeded investing cash flows by approximately $46.6 billion.
So what did the companies in our universe do with this cash windfall?
Net debt issuance. Although it was not necessary to fill a financing gap, the companies in our dataset continued to borrow money in 2020, albeit at a slower pace than prior years. Rather than repaying debt, small cap public companies elected to borrow more funds during 2020.Net share issuance. During 2018 and 2019, the small caps were hesitant to issue net new shares. However, in 2020 share repurchase volume fell over 20% (from $22 billion to $17 billion) while share issuance volume doubled from $22 billion to $44 billion. The net result is that – as with debt – the companies in our dataset elected to raise new equity despite
not “needing” it.Dividends paid. The companies in our sample also took a conservative posture regarding dividends paid. In the aggregate, dividend payments fell by nearly one-third, from $13 billion to $9 billion.
Aggregate financing inflows supplemented the positive financing gap to boost cash balances for the small caps by nearly $76 billion, compared to a net change of about $2 billion in 2018 and 2019.Digging a Bit DeeperTable 15 summarizes the same sources and uses of cash data, but on a quarterly basis during 2020.Net Debt IssuedAs the reality of the pandemic began to dawn on corporate managers in March 2020, the first action item for many companies was drawing down credit facilities to boost cash reserves to help weather a storm of unknown length.
After loading up on proceeds from borrowings, the companies in our dataset returned some of the funds to lenders in the second half of the year as the economic impact of the pandemic became a bit more transparent.
Net Share IssuanceAfter tapping the debt markets in the first quarter, companies turned their attention to the equity markets to secure pandemic funding over the balance of the year, as shown in Chart 17.In the second quarter, share repurchases slowed to a trickle while proceeds from share issuance more than doubled from Q1 levels. Share issuance proceeds remained at elevated levels through the remainder of the year although repurchase volumes did approach more normal levels as corporate managers became more optimistic about the prospects for the economy.
Dividends PaidChart 18 compares aggregate per share dividends paid in the fourth quarter of 2020 to the fourth quarter of 2019.During 4Q19, 336 small cap companies paid common dividends (approximately 30% of the total dataset). During 4Q20, 103 of those companies (31%) either suspended dividends entirely or reduced the amount paid. While 98 of the companies increased dividend payments, the typical increase was modest. The remaining 135 dividend payors made no changes to the amount of per share dividends between the two periods. On a net basis, the number of small cap companies paying common dividends shrank by approximately 20% from 4Q19 to 4Q20.
Change in Cash BalancesAs shown in Chart 19, the small cap companies stopped hoarding cash in the third and fourth quarters of 2020.In total, the small cap companies in our sample added almost $76 billion to their cash offers during 2020. As the economy recovers from the pandemic, we will monitor how management teams elect to put their cash stockpiles to work.
Questions for Family Business DirectorsOur analysis of the financing decisions of public small cap companies during 2020 highlights some important questions for family business directors to deliberate during 2021.How did your lenders treat you during the pandemic? Were your existing credit facilities flexible enough to meet your needs, or should your family business be shopping for new lender relationships? It continues to be a borrowers’ market, and now may be the time to lock in favorable rates.What does your family think about issuing equity to non-family investors? For many decades, this was an automatic “no” for most families, but we expect the increasing availability of capital from family offices and other potentially “friendly” equity investors to be one of the biggest trends in family business over the next decade.Have your family shareholders accumulated liquid wealth outside of their holdings in family business stock? Having a nest egg outside the family business can reduce the overall risk of the family even if it means using a prudent amount of leverage inside the family business. When bad things happen (and COVID isn’t the last bad thing we will see), family shareholders with more diversified personal balance sheets tend to sleep a bit better.Do you have plans to deploy any excess cash balances that may have built up on the family businesses balance sheet? While rushing into ill-conceived investments is not a good idea, harboring lazy capital can weigh on long-term family returns.
It is important for family businesses to make financing decisions with strategic intent rather than out of convenience. Did the financing decisions your family business made in 2020 promote the long-term sustainability of the family business, or were they short-term decisions reflecting emergency conditions? Use the more favorable business conditions of 2021 as an opportunity to make sure your financing decisions “fit” your family business.
Making Sense of 2020: Part 3
Benchmarking Cash Flow From Financing Activities
Benchmarking Cash Flow From Financing Activities
Themes from Q1 2021 Earnings Calls
Part I: E&P Operators
Things appear to be on the upswing, albeit with cautious optimism, in the exploration and production (“E&P”) space.Most of the eight E&P operators we tracked reported that operations in the first quarter were relatively stable. This was in spite of winter storm Uri, which wreaked havoc from New Mexico and Texas northeast through upstate New York and New England.It may be worth examining the effects of Uri on E&P operators’ Q1 performance more in-depth, with a focus on how natural gas prices may have affected revenues vs. any associated increase in operating expenses or the intangible costs stemming from marketing and sales disruptions.Regardless of Uri’s net effect on financial performance, the ultimate trending phrase in E&P operators’ earnings calls was “positive free cash flow,” indicating continued upward trajectory out of the crude abyss.Deleveraging remains a primary goal for many operators. Several have resumed their dividend programs, while others have announced special (i.e., non-recurring) dividends to project their positive outlook to investors.In tandem with this bullish perspective, few E&P operators seemed overly concerned with the potential tax implications stemming from regulatory changes brought forth by the Biden Administration.ESGContinuing the trend we saw in the 2020 Q3 and Q4 E&P operator earnings calls, the Q1 earnings calls featured increased discussions regarding ESG topics. For some operators, the commentary covered basic items such as reduced greenhouse gas ("GHG") emissions and quarter-over-quarter reductions in flaring. Other operators had more comprehensive talking points related to ESG topics in the context of company operations on a forward-looking basis.“In March, we issued a press release announcing changes to our executive compensation program and outlining our new greenhouse gas emissions reductions targets. Comprehensive changes to our executive compensation program included accountability for achieving both quantitative and qualitative ESG goals in the near and medium term.”–Joe Gatto, President & CEO, Callon Petroleum“[This year] we introduced methane-related KPIs into our executive compensation program. We've committed to make a substantial multi-year community investment of $30 million over the next six years to widen the path for the middle class in our local community while growing the local talent pipeline. We have redoubled our efforts to spend local and hire locally. 100% of our new hires will be from our area of operation and will maintain that - we will maintain at least 90% local contract workforce.” –Yemi Akinkugbe, Chief Excellence Officer, CNX Resources“This year will also be an exciting year for Antero's ESG initiatives as we make progress toward our 2025 best in class goals. These … include achieving net zero carbon emissions, reducing our industry leading GHG intensity and methane leak loss rates. We also plan to complete and publish our TCFD analysis with our 2020 ESG performance results later in 2021.”–Glen Warren, CFO, Antero ResourcesReturn of Capital to ShareholdersIn recent earnings calls, many E&P operators suggested that they would resume dividend and share buyback programs when positive free cash flow, and in some cases higher-priority deleveraging initiatives, made it conducive to do so. As noted in the introduction, this time has come for many operators in Q1.“We reinstated a quarterly dividend of $0.11 per share, … this is double our previously issued dividend, which has been temporarily suspended at the onset of the global pandemic. We believe this is expected to be sustainable given our strong cash flow generation and interest expense savings from our significant debt reduction.”–William Berry, CEO, Continental Resources“Going forward, our goal is to continue growing the regular dividend. We have never called for suspending the dividend and we remain committed to its sustainability. … Now, EOG is positioned to address other free cash flow priorities by returning additional cash to shareholders. The $1 per share special dividend [announced May 6] follows through these consistent long-tailed priorities.”–Tim Driggers, CFO, EOG Resources“So, for the quarter we repurchased 1.5 million shares at an average price of $12.26 per share at a total cost of $18 million. We still have ample capacity of around $240 million under our existing stock repurchase program…”–Nick Deluliis, CEO, CNX ResourcesProposed Tax ChangesAmong the potential energy tax changes under the Biden-Harris Administration,the most prominent talking point discussed by E&P operators in the Q1 earnings calls was the proposed change to disallow the reduction of taxable income stemming from intangible drilling costs (“IDCs”), and the subsequent increase in taxes and reduction in future free cash flow. The discussion and response to questions about these proposed tax changes overwhelmingly suggest that most of the operators we tracked do not foresee any material tax payments for at least the next four years, due primarily to substantial net operating losses (“NOLs”) that may be used to offset future taxes.“We are not a cash taxpayer in the U.S. this year. And at prevailing commodity prices, we don't expect to be paying U.S. cash federal income taxes until the latter part of this decade. This holds true even if the tax rules for IDCs are changed or if the corporate tax rate has increased. We have significant tax attributes in the form of NOLs in addition to foreign tax credits. These attributes will be used to offset future taxes.”–Dane Whitehead, CFO, Marathon Oil“Our plan through '26, we're not material cash taxpayers during that plan. Most of it's the way we treat sort of the NOLs and utilize those as regards to the cash taxes that we would have to pay, and managing and optimizing that versus sort of the IDCs and the other attributes that you have on the tax side. So, the color we've given to date is no material cash taxes through 2026 is the current plan.”–Don Rush, CFO, CNX Resources“We have substantial NOL carryforwards at a federal and a state level. So, if you look at it in a current regime, putting off a free cash flow at the level that we are, certainly, you convert to cash taxes at some point. We see it being five to seven years in the future in a current regime.”–John Hart, CFO, Continental ResourcesOn the HorizonWhile we selected three primary themes among the Q1 E&P operator earnings calls, several other notable topics were also discussed. Perhaps chief among them, the general consensus is that significant production growth is not desirable at this juncture. Steady operations is the name of the game at the moment. Furthermore, operators are seeing inflation in field service provider costs, which are expected to continue growing, though it remains to be seen just how those may affect future margins.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. With increased volatility in the energy sector these days, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.
April 2021 SAAR
SAAR has continued its impressive run in 2021, increasing for the second straight month to 18.5 million. This is a 3.1% increase from March 2021. As we have mentioned in our previous SAAR blog post, comparing spring 2021 SAAR to 2020 does not hold much merit, especially in April which experienced the weakest sales of the pandemic in 2020.For those of you who are curious however, April SAAR is up 112% from last year.Compared to April 2019, a better comparison in our view, April 2021 is up 12.1%. Because of strong demand, OEMs continue to rely less on incentive spending. According to JD Power, average incentive spending per unit in April is anticipated to be $3,191, a decline of $1,762 from April 2020 and $382 from April 2019. Still, average transaction prices are expected to reach another month high, rising 6.8% from last month to $37,572. This is the highest ever for the month of April and the second highest of all time behind December 2020. Incentive declines and price increases serve as a major win for dealerships this month.In regards the expected April statistics, Thomas King, president of the data and analytics division at JD Power notes:“While falling numbers of vehicles in inventory at retailers is the primary risk to sales results in the coming months, to date, low inventories have not had a material effect on aggregate sales results. Instead, they have enabled manufacturers and retailers to reduce discounts and consumers are demonstrating a willingness not only to buy vehicles closer to MSRP, but also to buy more expensive vehicles.”Inventory Scarcity Continuing to be in PlayThough pent-up demand and higher levels of disposable income continued to drive SAAR growth this month, a surprising factor we considered to be a headwind may have actually boosted sales for the month: the microchip shortage. As the shortage continues to drag on and has started affecting other industries and big names (such as Apple), the shortage has become a household topic and consumers are taking notice. Behind the increase in April SAAR may be consumers rushing to dealerships to snag a vehicle before they become more difficult to find in the coming months.Automakers, keen on not having to completely shut down productions, are trying to work around the chip shortage by removing features, which may be incentivizing consumers to pay up for them now.As Automotive News reports, Nissan is leaving navigation systems out of thousands of vehicles that typically would have them because of the shortages. Ram no longer offers its 1500 pickups with a standard "intelligent" rearview mirror that monitors for blind spots. Renault has stopped offering an oversized digital screen behind the steering wheel on its Arkana crossover. All of these feature cuts being for the same reason: to save on chips. This may become more prevalent going forward this year as the chip shortage is anticipated to continue.Despite automaker’s best efforts, inventory levels are suffering. While April inventory levels are not available yet, NADA forecasts that they likely will be at a decade-long low with no relief in sight. According to BEA, the inventory to sales ratio for March (the most recent data available) is at the lowest levels of the reported data going back to 1993, at 1.36 (though the chart below only shows data through 2015).
According to Auto Forecast Solutions, the semiconductor microchip shortage has caused worldwide production to fall off to 2.29 million vehicles. Current forecasts put projected total vehicle production losses from the global chip shortage at 3.36 million units, with 1.11 million from North American production.
With production flagging, dealers are having to draw down inventories to maintain and grow sales. However, April’s strong sales figure is unlikely to be sustainable as inventories cannot be drawn down forever, which explains why NADA forecasts 2021 SAAR of 16.3 million, or 11.9% below the April figure.
Fleet Customers SufferingWhile the inventories of auto dealers are down, inventories for fleet customers are down even more, as OEMs continue to prioritize production for retail customers over fleet customers. Retail sales in April are estimated to be up 114% from April 2020 and up 23% from April 2019 according to Wards Intelligence. Meanwhile, fleet deliveries increased by 88% from April 2020, but fell by 42% from April 2019.This is especially poor timing for fleet customers as travel has begun picking up again and rental car companies and other fleet buyers are in need of inventory as many had to sell chunks of their fleets in order to preserve money during Covid-19, creating a situation that many are referring to as “car-rental apocalypse.” Due to the new car shortages, they are having to look elsewhere.As Yahoo News reports, Hertz is "supplementing its fleet by purchasing low-mileage, pre-owned vehicles from a variety of channels including auctions, online auctions, dealerships, and cars coming off lease programs," a Hertz spokesperson told Insider in an email statement.The result of all of this is that rental cars may cost consumers over $500 a day for an SUV, compared to prices of $50 a day 2 or 3 years ago. Until the chip shortage is back under control, travelers may be stuck having to pay sky high prices for rental vehicles on their next vacation.Looking ForwardThe best phrase we can think of to describe the auto industry going into May is “something’s got to give.” While demand for vehicles is still being fueled by pent up demand and traveling picking back up due to Americans getting vaccinated and a return to normalcy, the microchip shortage isn’t going away anytime soon.According to Mike Jackson, AutoNation’s CEO, that expiration date might even be 2022, as he notes “we performed despite the disruption from the shortages created by the chip disruption, which we expect to fully continue for the rest of this year."Stay turned for our blog next week when my colleague David Harkins breaks down the Q1 earnings calls and what the other leaders in the industry are noting about this year’s prospects.However, despite the lack of chips, if consumers are willing to make some sacrifices in terms of the number of features their vehicle has, SAAR may not see huge declines. If that is not something they are willing to do, the supply constraints may hinder SAAR’s recent run.
Making Sense of 2020: Part 2
Benchmarking Cash Flow From Investing Activities
Benchmarking Cash Flow From Investing Activities
Recent SPAC Boom Largely Leaves Out Oil & Gas Companies
The rise of SPACs, or special purpose acquisition companies, has been the hottest trend in capital markets during the past year. However, after years of poor returns and increasing investor emphasis on ESG (environmental, social, and governance) issues, oil & gas companies were largely left out of the recent SPAC mania.We look at a few oil & gas companies that were early adopters of the SPAC structure, the recent pivot of SPACs towards energy transition companies, and take a look forward to see what the future might hold for the few remaining oil & gas-focused SPACs.Previous Energy SPAC TransactionsEnergy companies were early adopters of the SPAC structure as a means to go public.Private equity firm Riverstone was one of the first to launch an energy-focused SPAC with Silver Run Acquisition Corp. in 2016. The SPAC combined with Centennial Resource Production later in the year and renamed itself Centennial Resource Development. Riverstone followed with Silver Run Acquisition Corp. II in 2017, which acquired Alta Mesa Holdings and Kingfisher Midstream to form Alta Mesa Resources. However, Alta Mesa filed for bankruptcy in 2019. Another early energy SPAC suffered the same fate. KLR Energy Acquisition Corp., which went public shortly after Silver Run in 2016, acquired Rosehill Resources and filed for bankruptcy in 2020.Fortunately, some have fared better. TPG Pace Energy Holdings merged with Magnolia Oil & Gas in 2018. Currently, the Eagle Ford operator’s stock price is well above the initial SPAC IPO price of $10. Vantage Energy Acquisition Corp., sponsored by energy-focused private equity firm NGP, announced acquisition of QEP’s Bakken assets for $1.725 billion in 2018. The transaction later fell through, and Vantage liquidated, with shareholders receiving $10.22 per share. QEP’s Bakken assets wererecently acquired by Oasis (from QEP’s new owner Diamondback) for $745 million.The Pivot Toward Energy TransitionGiven the troubled performance of oil & gas SPACs, overall poor returns from the sector, and increasing emphasis on ESG issues, several SPACs that were originally targeting oil & gas companies have pivoted and acquired (or announced acquisitions of) “energy transition” companies.Apollo touted its expertise “in the upstream, midstream and energy services sectors” in Spartan Energy Acquisition Company’s prospectus, though ultimately acquired electric vehicle manufacturer Fisker. Switchback Energy Acquisition Corporation, sponsored by NGP (which previously sponsored Vantage), was rumored to be targeting companies in the minerals space, but recently completed its acquisition of ChargePoint, which develops electric vehicle charging stations. And Alussa Energy Acquisition Corp., headed by James Musselman (former CEO of offshore E&P company Kosmos), has announced its planned acquisition of FREYR, a Norwegian battery manufacturer.The trend of capital moving away from traditional oil & gas companies and toward energy transition companies does not look like it will abate soon. Several private equity funds historically focused on oil & gas have sponsored SPACs specifically targeting energy transition companies.Riverstone has moved away from the Silver Run naming convention and now has three “Decarbonization Plus” entities that are publicly traded, with a fourth that has filed an S-1. While the entities reserve the right to seek a business combination with a company operating in any sector, I think it’s safe to assume that an acquisition of a company focused on developing hydrocarbons is off the table.First Reserve, which has historically invested in traditional oil & gas companies, launched their first SPAC, First Reserve Sustainable Growth Corp., in March. As the name implies, the SPAC’sstated focus areawill be “opportunities and companies that focus on solutions, processes, and technologies that facilitate, improve, or complement the ongoing energy transition toward a low- or no-carbon emitting future.”After NGP’s success with Switchback’s acquisition of ChargePoint, it sponsored Switchback II, which intends to search for target companies “in the broad energy transition or sustainability arena targeting industries that require innovative solutions to decarbonize, in order to meet critical emission reduction objectives.” That language wasn’t included in the original Switchback prospectus. Another NGP SPAC, Switchback III, has a similar language in itsS-1but has not yet gone public.Warburg Pincus sponsored two SPACs that went public in March. While no specific industry focus was discussed in the prospectuses, the documents did specifically state that “oil and gas companies are not anticipated to be the target.” This is consistent with Warburg’s recent transition away from investment in the oil & gas sector.Is SPAC Capital Available for Oil & Gas Companies?While most recent energy-focused SPACs are seeking business combinations in the energy transition space, there are a few remaining SPACs that may target more traditional oil & gas companies or assets.East Resources Acquisition Company went public in July 2020, raising $345 million. It is headed by Terry Pegula, who sold his previous company, Appalachian operator East Resources, Inc., to Shell for $4.7 billion in 2010. The SPAC’s prospectus states that “there is a unique and timely opportunity to achieve attractive returns by acquiring and exploiting oil and natural gas exploration and production (‘E&P’) assets in proven basins with extensive production history and limited geologic risk.”In November 2020, Breeze Holdings Acquisition Corp. raised $115 million. Managed by several former EXCO executives, the SPAC intends “to focus on assets used in exploring, developing, producing, transporting, storing, gathering, processing, fractionating, refining, distributing or marketing of natural gas, natural gas liquids, crude oil or refined products in North America.”Most recently, Flame Acquisition Corp. raised $287.5 million in February 2021. The SPAC intends to target“a business in the energy industry, primarily targeting the upstream exploration and production (‘E&P’) sector, midstream sector and companies focused on new advancing technologies that are transformative and provide the potential for and means to achieve greater profitability in the broader energy sector,” adding that “many businesses in the E&P industry or broader energy value chain could benefit from access to the public markets but have been unable to do so.” The company is headed by James Flores, the former CEO of Sable Permian. Gregory Pipkin, former head of Barclays’ upstream investment banking team, is a member of the board.It remains to be seen whether these SPACs will endure their oil & gas focus or try to capitalize on the trend towards renewables (like so many other energy-focused SPACs). However, with multiple SPACs targeting that space and increasing investor skepticism regarding lofty growth projections (as evidenced by the stock price performance of former SPACs Nikola, Hyliion, Romeo Power, and XL Fleet, among others), the acquisition of oil & gas assets at an attractive valuation may be well received by investors.ConclusionThe increasing popularity of SPACs helped push tremendous amounts of capital toward energy transition companies, with traditional oil & gas companies largely sitting on the sidelines. However, the tide may be turning, as SPAC IPOs have slowed and some energy transition company valuations have come crashing down from their previous (stratospheric) levels. While SPACs aren’t the complete solution to the dearth of capital available to oil & gas companies, a well-received transaction by one of the few remaining oil & gas-focused SPACs would certainly be a welcome development.Mercer Capital cannot help you sponsor a SPAC, though we have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Multiple Expansion Drives 70%+ Returns for RIA Stocks Over Last Year
Over the last year, many publicly traded investment managers have seen their stock prices increase by 70% or more. This increase is not surprising, given the broader market recovery and rising fee base of most firms. With AUM for many firms at or near all time highs, trailing twelve month multiples have expanded significantly, reflecting the market’s expectation for higher profitability in the future. For more insight into what’s driving the increase in stock prices, we’ve decomposed the increase to show the relative impact of the various factors driving returns between March 31, 2020 and March 31, 2021 (see table below).Click here to expand the table aboveFor publicly traded investment managers with less than $100 billion in AUM, trailing twelve month (TTM) revenue for the year ended March 31, 2021 declined about 8% year-over-year. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a lower EBITDA margin. The net effect is that TTM EBITDA declined about 20% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared better, with profitability generally increasing despite the market downturn during the year ending March 31, 2021. These firms saw positive revenue growth across the board, although in many cases the revenue growth was partially offset by margin compression.For both groups, expansion in the TTM EBITDA multiple was the primary driver of the stock price increases. The larger group (AUM above $100 billion) saw the median multiple increase 70%, while the smaller group (AUM below $100 billion) saw the median multiple more than double.The multiple expansion between March 31, 2020 and March 31, 2021, while extreme, is not surprising given the trajectory of the market over the last year. While EBITDA was down ~20% year-over-year for the smaller group (and up ~5% for the larger group), the market values these businesses based on expectations for the future, not on LTM performance. As of March 31, 2020, AUM (and run-rate profitability) was down significantly, and depressed market prices continued to impact revenue for 2-3 quarters for many firms. But the market recouped its losses relatively quicky and continued to trend upwards. Today, AUM for many firms is hovering at or near all time highs.What’s Your Firm’s Run-Rate? The multiple expansion seen in the publicly-traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The baseline for estimating future performance is the firm’s run-rate performance today. RIAs are unique in that run-rate revenue can be computed on a day-to-day basis using the market value of AUM and the fee schedules for client accounts. After deducting the firm’s current level of fixed and variable costs, run-rate profitability can also be determined.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. As AUM has increased for many RIAs, so too has the run-rate revenue and profitability. The significant improvement in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple expansion observed over the last year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the growth of this firm since March 31, 2020 is not unusual relative to that exhibited by publicly traded investment managers and many of our privately-held RIA clients. During the second quarter of 2020, ABC Investment Management billed on $1.75 billion in AUM at an effective realized fee of 65 basis points, resulting in revenue for the quarter of $2.8 million. After subtracting compensation expenses and overhead, ABC generated $660 thousand in EBITDA for the quarter. AUM grew rapidly as the market recovered, such that by the first quarter of 2021 the firm was billing on $2.8 billion in AUM at the same fee of 65 basis points. For the full year, ABC Investment Management generated $14.2 million in revenue and $4.6 million in EBITDA.As of March 31, 2021, however, the firm’s run-rate performance was significantly higher than its performance over the last twelve months. ABC’s $2.8 billion in AUM was generating $18.0 million in annualized revenue at the effective realized fee level of 65 basis points. Assuming the same level of fixed costs and the appropriate increase in variable costs to reflect the higher revenue, ABC was producing run-rate EBITDA of $7.3 million at the end of the first quarter. That’s a 57% increase relative to EBITDA over the last twelve months.Implications for Your RIAAs always, valuation is forward looking. In relatively stagnant markets, there might not be much of a difference between LTM and ongoing performance. But given the shape of the market recovery over the last year, the difference today can be material, as the example above illustrates. If you’re contemplating a transaction in your firm’s stock, it’s worth considering where your firm is at today, not just what it’s done over the last year.
Making Sense of 2020: Part I
Benchmarking Cash Flow From Operations
Here at Family Business Director, we believe in the power of benchmarking for family businesses. Done well, benchmarking provides managers and directors with valuable insight and context for evaluating the operating performance of the family business and the strategic investing and financing decisions made by the directors. We published benchmarking guides in 2019: The 2019 Benchmarking Guide for Family Business Directors, and 2020: The2020 Benchmarking Guide for Family Business Directors.We are organizing the 2021 edition of our benchmarking guide using the statement of cash flows as our guide.This week, we review the components of cash flow from operations.Next week, we will consider investing activity, turning to financing decisions the following week.In our final installment, we will look at market performance and shareholder returns.
It is no secret that COVID-19 was the story of 2020. To assess more clearly the effect of the pandemic of the firms in our universe, we analyze results on a quarterly basis. We’ve drawn our data this year from the SEC filings of revenue-generating companies in the Russell 3000 index (excluding financial institutions, real estate companies, and utilities).Operating PerformanceEverything good in business starts with revenue. In Chart 1, we summarize aggregate revenue trends during 2019 and 2020.
Chart 1 demonstrates that – in the aggregate – smaller companies felt more pain from the pandemic than their larger counterparts. For the large cap companies, revenue fell less than 10% during the second quarter before resuming year-over-year growth in the back half of the year. In contrast, revenue growth for the small caps turned negative in the first quarter, bottoming out with a nearly 20% reduction in the second quarter, with lower revenues persisting into the third and fourth quarters.
Financial analysts refer to the relationship between the change in revenue and change in operating expenses as operating leverage. Simply put, if some portion of a company’s operating costs do not vary directly with revenue (i.e., are fixed), revenue growth is likely to trigger expanding margins, while decreasing revenue reduces the operating profit margin.
Chart 2 compares the relationship between change in revenue and change in operating expenses for the small cap companies in our data set for 2019 and 2020.
Throughout 2019, expense growth outpaced revenue growth, causing operating margins to compress on a year-over-year basis. This trend was exacerbated in the first half of 2020 before moderating in the second half of the year. Chart 3 illustrates the impact of operating leverage on the operating margins of the large and small cap companies.
Since the revenue shortfall in 2020 was greater for the small cap companies than the large caps, the negative effect of operating leverage was more pronounced for the small cap firms in 2Q20, with the aggregate operating margin for the group decreasing by 542 basis points from 2Q19, compared to a 218 basis point reduction for the large cap companies.Working Capital to the RescueIn contrast to operating income, net income is burdened by interest costs, income taxes, impairment charges, and other unusual items. As shown in Chart 4, the small cap companies reported an aggregate net loss in the first two quarters of 2020. After breaking even in the third quarter, the group crept back into the black in the fourth quarter.
However, as shown in Chart 4, the earnings weakness in 2020 did not prevent these companies from generating more operating cash flow than in 2019 ($127 billion compared to $117 billion). How was that possible?
Table 5 summarizes the composition of operating cash flow for 2018 and 2019.
Net income was $61 billion lower in 2020 than 2019 for the small cap companies in our data set. However, $36 billion (60% of that difference) was attributable to non-cash charges to earnings (i.e., impairment charges). The balance of the difference is primarily attributable to working capital. One silver lining to the cloud of shrinking revenue is the release of working capital.
As shown in Chart 6, cash provided by liquidating working capital was augmented by more diligent cash management practices, as the cash conversion cycle for small cap companies fell from 52 days at the end of 1Q20 to 39 days at the end of 4Q20.
Of note, the large cap companies in our data set generally manage working capital more aggressively than their small cap counterparts, as shown in Chart 7.
Questions for Family Business DirectorsThe benchmarking data raises some critical questions for family business directors as the U.S. economy continues on the path to recovery.It’s clear that larger firms fared better than smaller firms. What is less clear is why. Assuming your family business is not the size of a large cap public company, what steps did you take to preserve existing revenue sources and find new revenue sources in the pandemic? If you found new revenue sources (for example, e-commerce), what steps are appropriate now to preserve those revenues as the pandemic recedes?Operating Leverage: We suspect that operating leverage ultimately has more to do with flexibility, creativity, and ingenuity than the traditional dichotomy of “fixed” versus “variable” costs. What did the pandemic teach you about your family business’s ability to adapt and manage operating expenses in the event of a negative shock to earnings? Looking forward, are there any “austerity measures” that should probably become the new normal for your family business?Working Capital: If your family business did generate less revenue in 2020, was it able to liquidate working capital accordingly? Do you adopt any working capital management techniques during the pandemic that should continue? If you are expecting revenue to recover in 2021, have you identified and secured the necessary financing sources to support the accompanying increase in working capital needs? What appeared to be a large cash balance at the end of 2020 can be depleted quickly if strong revenue growth triggers larger working capital balances.The pandemic did not affect all industries equally. As shown in Chart 8, revenue for some industry sectors actually increased during the year.ConclusionThe observations in this article relate to the data set as a whole. For more targeted insights and observations, give one of our professionals a call to talk about a more customized benchmarking analysis for your family business.
Prepping for a Potentially Big M&A Year in 2021
Barring another recession or material reduction in bank stock valuations in the public markets, M&A activity should improve as 2021 progresses.However, some boards that would like to sell may have a hard time accepting a lower price versus what was obtainable a couple of years ago.One way to bridge the bid-ask gap is to consider transactions with more rather than less consideration consisting of the buyer’s common shares. Cash deals “cash-out” shareholders who then reinvest after-tax proceeds. Stock deals allow the target’s shareholders to remain invested in a sector that still trades cheap to longer-term valuations.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to view the video!
Capital Gains Taxes and Family Businesses
Don’t Let the Tax Tail Wag the Family Business Dog
“The perfection of taxation consists in so plucking the goose as to procure the greatest amount of feathers with the least possible amount of squawking.” So said Jean-Baptiste Colbert, King Louis XIV’s finance minister in regard to 17th century tax policy.As it stands, your family goose may be subjected to some additional plucking soon. It was “leaked” last week (in his 2020 campaign plan) that the Biden administration is planning to nearly double the federal capital gains tax rate on taxpayers earning more than $1 million from 20% to 39.6%. In states with high taxes, the combined blended rate could top 50%.Are you and your directors about to start squawking? Or are you already hoarse? While we steer clear of politics here at Family Business Director, we do aim to inform business owners on the three key financial decisions family businesses face: dividend policy, capital structure, and capital allocation. Clearly a move of this magnitude could leave certain planning strategies less advantageous and could possibly affect key financial decisions. Below we briefly touch on the capital gains tax and provide some helpful reminders for family business owners.What Is the Capital Gains Tax?From the Tax Policy Center, a capital gain is realized when a capital asset is sold or exchanged at a price higher than its basis. Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less. Under current law, short-term capital gains are taxed as ordinary income at rates up to 37%; long-term gains are taxed at lower rates, up to 20%. Taxpayers with modified adjusted gross income above certain amounts are subject to an additional tax of 3.8% on long- and short-term capital gains stemming from the Affordable Care Act.Family shareholders face the prospect of capital gains taxes upon the sale of the business or other significant assets. This could be commercial property, stock holdings, or a business interest that has appreciated over time.Don’t PanicFrom a cursory reading of the financial press and the short-lived market dip, public equity markets appear to be buying gridlock and selling tax hikes. Barron’s writers, Goldman Sachs analysts, and financial twitter prognosticators all seem to point to either a more modest change (increase to 28%-30% rather than 39.6%) or some watered-down version of the proposal. We note that just two months ago eight Senators who caucus with the Democrats voted against a $15 minimum wage, giving further pause to the idea that 50 plus 1 is enough to ram anything through both chambers of congress. Family businesses would be mindful not to count their tax chickens before they hatch – or are even laid.Do Take a Second LookWhile we don’t want to talk out of both sides of our mouth, taking a look at some appreciated assets, especially if they are readily liquid, could take some tax risk off the table. Many of the family businesses we work with have considerable stock portfolios outside their main operating businesses. Consider having a second conversation with your financial advisor to see if you could take advantage in some large winners in the current environment. And for future planning, check with your advisors to see if you can spread events that trigger capital gains over multiple periods to avoid the $1 million income level. Like-kind exchanges and other tax-planning strategies may be worth a second read if the preferential tax treatment goes away.Remember the Big PictureAs we have written about continuously in the blog, family business directors have longer-term objectives than meeting next quarter’s numbers. Family business directors plan with long-term family wealth and succession in mind. As we noted in dissecting the world’s largest family businesses, almost half of the 750 companies in the list have been in business for over 70 years. Over that same time, the capital gains rates have changed dozens of times, oscillating between high teens to just under 40% (albeit briefly in the mid-to-late 70s). What your family business means to you, whether it’s a growth engine or a source of lifestyle, likely won’t change dramatically as a result of your capital gains tax exposure. Remember, running your business and fostering long-term wealth creation is the ultimate goal of any family business director.ConclusionWhen thinking about your current business situation, the toughest time horizon to have is short term. Should we accelerate plans to sell so we can avoid a larger tax bill? Should we realize some gains in the family securities portfolio to avoid the possibility of an increase in long-term capital gains rates? We think long-term minded family business directors are in prime position to ride through the tax waves and steer their family ships safely on their long voyages. Give one of our family business professionals a call today to talk about balancing tax concerns with the long view on your family business.
Out of the Crude Abyss
It has been almost a year since crude prices went into the abyss on last April 20th. What a day that was: OPEC’s shoe had already dropped, and the realities of COVID-19’s short term consequences panicked the global oil market into a historic backlog. Crude tankers were stranded on the seas, storage filled up, and for a short while production had nowhere to go.The havoc wreaked on markets was severe. Demand was projected to drop between 20% and 35% by some (consumption actually dropped about 22% per the EIA). Reserve lives for some major producers dropped by around 10 years and between them reported losses north of $60 billion in 2020. To be fair, there are a couple of ways to look at this: one is a market decline in interest in these commodities; another could be rooted in the demand from investors for more nimble balance sheets coupled with the growing ability to develop acreage relatively quickly. Beyond the decline of reserves, (both through production decline and economic characterization), the bankruptcy casualty counts also skyrocketed as I have discussed before. According to the latest Haynes & Boone data, the count was 35 new bankruptcies in the second and third quarters of 2020 and over $50 billion in total debt going into bankruptcy for the full year.What a difference a year makes.Recently WTI closed at over $63, and it has spent most of the past month at or above $60. Many analysts now predict oil to stay in the $60’s (or higher) for the rest of 2021 (EIA on the other hand projects the mid-$50’s). It appears that low prices may have been a cure for low prices. The Dallas Fed came out with their quarterly Energy Survey a few weeks ago and its results were quite shocking to many. Its business activity index was at its highest reading ever in the five-year history of the survey.
Guarded optimism among industry players is creeping back into the picture: “We are optimistic that we will have a weaning of excess oil supply, and more importantly, suppliers of oil and gas, that will lead to a slightly higher sustainable price.” said a respondent to the Dallas Fed. The S&P’s SPDR Oil and Gas Production ETF which dropped to around $30 (split adjusted) in March 2020 is now trading around $80. Production and CapEx spending are emerging as well in response to rising demand. Global oil demand and supply are moving towards balance in the second half of this year, per the IEA’s latest monthly report. In fact, producers may then need to pump a further 2 million bbl/d to meet the demand. OPEC, which has been withholding supply in tandem with other producers including Russia, this week raised its forecast for global oil demand this year. OPEC expects demand to rise by 70,000 bbl/d from last month's forecast and global demand is likely to rise by 5.95 million bbl/d in 2021, it said.
Upstream Economics: Back In BlackIt must be relieving to be “let loose from the noose” of low prices. A lot of producers should be singing AC/DC nowadays. It is now profitable to drill a lot more wells than a year ago. Heck, back then existing wells were not profitable, much less undrilled ones. In terms of reserve metrics, I have said before that value erosion usually starts at the bottom categories of a reserve report and moves upwards. Value accretion moves in reverse. The increased pricing is making larger swaths of reserves economic again.
Even so, one thing that is different this time around may be the cautiousness of investors and producers to jump back on the drill bit right away. Investors have already been pulling valuations down as their standard tilted more towards shorter term returns as opposed to longer term reserves. Additionally, the Fed Survey was littered with comments expressing concern about the Biden administration’s policies being more aggressive towards regulation and ESG, thus promoting caution for aggressive drilling. In fact, the American Petroleum Institute (of all organizations) is now considering carbon pricing frameworks. Lastly, OPEC+ could yank the rug out from shale producers again if they are perceived as ramping up too quickly, according to Pioneer’s CEO. (It is notable though that Pioneer just bought West Texas producer DoublePoint for $6.4 billion. That’s approximately $30,000 per flowing barrel and $40,000 per undeveloped acre).
Next StepsSo where does this leave us? Well, in a lot better place for producers and investors than last year – that’s to be sure. The companies that have hung in this past year and made it are starting to see some improvement. That’s also good because those that utilized PPP money have been in need of price help once the government subsidies ran out. In addition, with all of the attention towards electric vehicles replacing the combustion engine, we must remind ourselves that only 1% of the U.S. light fleet is EV and that light vehicles only make up 25% of crude oil use. Demand will not be chopped out from oil’s feet just yet.Markets are fast moving and unforgiving at times, but it appears with $60+ oil prices for 2021, that the upstream business can now start to slow down, look around, and evaluate what direction to go next.Originally appeared on Forbes.com.
Bull Markets Breed Complacency for Investors AND RIA Management Teams
Know Why Your Firm is Growing
Forty-three years ago, Mercedes Benz began offering anti-lock brakes as an option on its top-end S-class sedan. ABS had been the norm for commercial airliners and some commercial vehicles for years, but it took considerable development from supplier Bosch to make the feature “affordable” for passenger cars (equivalent to about $4500 today). Anti-lock brakes improved stopping distances in hard braking and wet conditions dramatically. Initially, however, it also increased the accident rate.As with “self-driving” or semi-autonomous features being developed today like automatic braking and lane-keeping, the early days of ABS found Mercedes owners a little too secure in the capabilities of their vehicles. Overconfidence leads to complacency, and complacency leads to accidents. Long before Tesla drivers were photographed asleep in their moving vehicles, Mercedes drivers were rear-ending cars (because they overestimated their brakes) and getting rear-ended (because they overestimated the brakes of the car behind them).The speed with which equity markets have recovered over the past year has the potential to lead to a similar level of complacency, and RIA management teams would be well advised to keep both hands on the wheel.The risk we not infrequently see is that lengthy periods of strong market performance necessarily lead to upward trends in AUM and revenue that mask underlying problems. Just as institutional asset management clients learned decades ago to evaluate portfolio performance on a relative basis, rather than absolute return, RIA management teams need to look a step or two beneath the surface to understand why their firm is growing.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies. Even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior. So, we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA. Over a five-year period, this RIA boasted aggregate revenue growth of nearly 40%, increasing from $3.7 million to $5.1 million. AUM growth was even more substantial, nearly doubling from $600 million to $1.1 billion. Revenue grew every year, which would lead one to have great confidence in the future of the firm.Looking deeper, though, we notice a couple of unsettling trends. The five-year period of measurement, 2016 through 2020, represents a bull market from which this RIA benefited substantially. Cumulative gains from market value were over $600 million, more than the total growth in AUM and masking the loss of clients over the period examined (net withdrawals and terminations of over $100 million). Markets cannot always be counted on for RIA growth, so client terminations, totaling $183 million over the five-year period, or nearly one-third that of beginning AUM in 2016, is cause for concern. This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients.Further, there appears to be loss in value of the firm to the marketplace. Realized fees declined four basis points over five years. Had the fee scheduled been sustained, this RIA would have booked another $336 thousand in revenue in 2020, all of which might have dropped to the bottom line. Small changes in model dynamics have an outsized impact on profitability in investment management firms, thanks to the inherent operating leverage of the model. But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue or changes in total AUM.So, we would ask, what’s going on? Did this RIA simply ride a rising market while neglecting marketing? Are clients concerned about something that is causing them to leave? Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM? If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance? Is their realized fee schedule actually declining, or is it not? Is the firm negotiating fees with new or existing clients to get the business? Did a particularly lucrative client leave? What is happening to the fee mix going forward?Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM. Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data. All should. Some drivers have too much confidence in new technology, and some RIA managers have too much faith in the upward lift of the market. The risk to both is the same: ending up in the ditch.
M&A Focus: The Pioneer-DoublePoint Deal
After what felt like an eternity of quiet transaction activity in the O&G industry, the M&A market in 2021 has been off to a more active start in 2021.According to S&P Global Market Intelligence, the industry announced 117 whole-company and minority stake deals in the first quarter of 2021, an increase of 28 transactions from the same period last year. The combined deal value has also increased from $3.86 billion to $26.4 billion, as supermajors like Exxon Mobil Corp., Royal Dutch Shell PLC and Equinor ASA divested assets and corporate consolidation continued. The trend continued early in the second quarter.In this post, we discuss the Pioneer-DoublePoint transaction (the “Transaction”) that could foreshadow for more M&A activity to come.Transaction Summary & Asset DetailsOn April 1, 2021, Double Eagle III Midco 2 LLC, wholly owned by DoublePoint Energy, LLC, announced that it entered a definitive purchase agreement to sell all leasehold interest, subsidiaries, and related assets to Pioneer Natural Resources Company (PXD) in a transaction valued at $6.4 billion. DoublePoint is a Fort Worth, Texas-based upstream oil and gas company that is backed by equity commitments from funds managed by affiliates of Apollo Global Management, Quantum Energy Partners, Magnetar Capital, and Blackstone Credit.According to Piconeer’s Investor Presentation, the Transaction adds approximately 100,000 Tier 1 Midland Basin net acres to Pioneer’s existing assets. The bolt-on acquisition will lead to the combined company owning approximately 920,000 net acres in the Midland Basin, making it the largest producer in that area. The deal is expected to close in the second quarter of 2021.The purchase price is comprised of the following:Approximately 27.2mm shares of Pioneer stock (PXD) based on Pioneer’s closing share price as of 4/1/2021 ($164.60). After closing, PXD shareholders will own approximately 89% of the combined company and existing DoublePoint owners will own approximately 11%.Cash of $1.0bnApproximately $0.9bn of liabilities that includes debt of $650mm at 7.75% and approximately $300mm of reserve-based lending and working capitalPer PXD Investor PresentationThe Transaction implies the following valuation metrics:
Pioneer anticipates approximately $175 mm in annual synergies related to G&A, interest, and operations. The company expects to save approximately $15 mm in G&A by reducing DoublePoint’s expense by 60% in the second half of 2021. Pioneer also plans to refinance DoublePoint’s bonds after closing to save roughly $60mm. Last, the company projects about $100 mm in operational savings. According to Pioneer’s Investor Presentation, the acquired acreage is highly contiguous and largely undeveloped, adding greater than 1,200 high-return locations. Although the exact amount Pioneer attributed to PDPs and PUDs is unknown, this suggests that PXD most likely associated option value to the undeveloped acreage in their purchase consideration.
Mixed Market Signals
Investors responded relatively well the day of the announcement (prior to the press release), as PXD’s share price increased 3.64%, closing at $164.60 on April 1. However, the stock has since produced mixed signals. The next trading day, April 5, the stock closed at $152.18, a 7.55% decrease from the announcement. The stock closed at $147.10 on April 21, a 10.63% decrease from April 1. The company has still performed well in 2021, as PXD share price is up 29.63% year-to-date. PXD has followed similar trends to the broad E&P value index (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP) since the beginning of year, so this decrease may be geared more towards industry sentiment rather than deal reaction.
On April 5, 2021 Fitch Ratings released a statement that Pioneer’s ratings are unaffected by the company’s deal announcement with DoublePoint. On April 22, 2021 Fitch affirmed Pioneer’s long-term issuer default ratings and unsecured debt ratings at BBB. Fitch also assigned a BBB rating to Pioneer’s 364-day unsecured revolving credit facility. Fitch notes that their rating outlook for PXD is stable. Pioneer’s credit rating outlook is a testament to its strong balance sheet and 2021 estimated net debt / EBITDAX of 0.9x.
ConclusionThe Pioneer-DoublePoint transaction could set the stage for an active M&A market relative to a quiet 2020. Also, Pioneer’s Fitch Rating could serve as a positive signal for utilizing leverage in future deals. It will also be interesting to monitor deal values as it relates to what buyers are willing to pay for specific producing and non-producing assets (to the extent that the information is disclosed). If an industry recovery is in sight, transaction activity could continue its healthy pace, but also has the potential to soften if uncertainty looms, causing the bid-ask spread to widen if buyers and sellers are not on the same page.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Dealership Working Capital
A Cautionary Tale Against Rigid Comparisons
We have previously written about six events that can trigger the need for a business valuation. In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation. The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer. For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets. Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations. These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below.
A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital should not always be a rigid calculation. An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements. Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end. The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations. A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc. For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset.
Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders. The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP. All have contributed to record performance for dealerships. The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements? Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven? The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation. For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages. According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24. Statistical data from 2014 through February 2021 can be seen below:
So how should the working capital of an auto dealership be assessed? Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information.
Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end. In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below.
A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date. Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales.
We can also look at the manufacturer’s requirement. This particular dealership had a net worth requirement and the more traditional working capital requirement. These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency.
All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash. It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations.
Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million. Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement. The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash. Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000. This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods. First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure. This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below:
Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above.
The final assessment of working capital focuses directly on the cash and equivalents. As discussed, management indicated that the Company had operational cash needs of $5 million. Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures. This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below:
Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future.
This example highlighted a dealership with excess working capital that was reflected in excess cash. Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations. As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership. However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations.
For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation.
ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership. The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value. Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales. None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation. Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes. Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation. For a valuation of your auto dealership, contact a professional at Mercer Capital today.
Dealership Working Capital
A Cautionary Tale Against Rigid Comparisons
We have previously written about six events that can trigger the need for a business valuation. In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation. The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer. For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets. Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations. These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below.
A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital should not always be a rigid calculation. An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements. Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end. The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations. A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc. For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset.
Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders. The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP. All have contributed to record performance for dealerships. The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements? Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven? The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation. For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages. According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24. Statistical data from 2014 through February 2021 can be seen below:
So how should the working capital of an auto dealership be assessed? Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information.
Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end. In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below.
A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date. Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales.
We can also look at the manufacturer’s requirement. This particular dealership had a net worth requirement and the more traditional working capital requirement. These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency.
All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash. It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations.
Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million. Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement. The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash. Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000. This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods. First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure. This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below:
Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above.
The final assessment of working capital focuses directly on the cash and equivalents. As discussed, management indicated that the Company had operational cash needs of $5 million. Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures. This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below:
Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future.
This example highlighted a dealership with excess working capital that was reflected in excess cash. Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations. As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership. However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations.
For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation.
ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership. The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value. Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales. None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation. Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes. Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation. For a valuation of your auto dealership, contact a professional at Mercer Capital today.
Middle Market M&A Amidst a Recovering Economy
By mid-2020, traditional brick and mortar retailers, including well-known brands such as J.C. Penny, J. Crew, and Pier One, were christening what many believed to be the first wave of post COVID-19 bankruptcies. At the time, our view was that companies impacted by the COVID-19 pandemic might look for relief via M&A while opportunistic buyers might look to take advantage of lower valuations in the market. While some industries have fared worse than others, the unprecedented fiscal aid pumped into the economy seems to have warded off a wave of bankruptcies in the middle and upper market, or at least prevented a surge at the scale many were predicting. M&A deal volume recovered in the second half of 2020 after coming to a near halt in the initial months of the pandemic. Deal volume, while increasing, does generally remain below levels seen in 2018 and 2019. All the while, capital has flooded the market, with a good amount of it ending up parked in banks, resulting in bank deposits increasing over 20% in 2020.Data per Epic Aacer, Available online at: https://www.aacer.com/blog/january-2021-bankruptcy-filings-continue-historic-slideWhile nothing is for certain, it appears that the worst of the economic risks tied to the pandemic could be behind us. Estimates range widely, from as early as July 2021 to as late as 2022, but the U.S. now has a path to reaching herd immunity through the administration of multiple vaccines. As it stands in March 2021, over a quarter of the U.S. population has received at least one dose of a vaccine. The public markets have viewed the rollout favorably, and while one explanation for the market’s strong 2020 performance might be summed up by a blend of a low-risk free rate amidst asset inflation, it is undeniable that valuations in the public markets are pricing in some level of a continued post-pandemic recovery.As the public health crisis continues to improve, one would expect deal volume to increase in tandem. Prior to the pandemic, many market observers had concluded that small to middle market M&A activity was poised for an uptick, as a generation of baby boomers was expected to retire and in turn monetize their stake of private company ownership. That generational trend remains in-tact post COVID. The Biden administrations’ efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term, as sellers seek to position transactions to be taxed at current tax rates.While the middle market M&A environment has not witnessed the downward shift in values that one might have expected following the economic shutdown of the early pandemic period; neither has it seen the run-up in values that was exhibited in the public markets throughout the second half of 2020 and into early 2021. If the public markets provide a meaningful measure for general economic expectations, then how long until these higher expectations are priced into middle market M&A values? At a minimum, the downside pandemic-related risks that were initially so prevalent appear to have diminished. As with most things in this environment, risks are very industry specific and there are many industries that have exhibited (and will likely continue to exhibit) dramatic negative shifts in valuations. Overall, however, transaction multiples appear to have declined only a small amount from pre-pandemic levels.
As my colleague Jeff Davis concluded in a recent piece for this blog, the availability of debt financing for most family businesses in 2021 should be favorable, likely with a low cost of credit and lenient terms by historical standards. Jeff noted some exceptions, such as hotels, retail CRE, restaurants, and tourism-related businesses, but on the whole banks are eager to invest. Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high. In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing. Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle.
For family business directors, 2021 should be an opportune time to consider making an acquisition. General indications on valuation suggest that the private company M&A market has not been priced-up at anywhere near what has been seen in the public markets. While this difference may be caused by a public market over-valuation issue that is “corrected” in the short-term, it suggests that there could be positive momentum in private company valuations as the economy continues to move through subsequent stages of the post-pandemic recovery. A good M&A deal can be made even better with favorable financing, which should be available to many borrowers in the current environment.
We can’t predict the future, but those who take a buyer’s view of the M&A market now might be rewarded with enhanced returns. With pent up demand and a high availability of capital, we anticipate a rise in M&A activity over the next year with the best valuations and financing deals likely favoring the early bidders.
Strong Gains in the Wealth Management Industry Propel RIA Aggregators to New Highs
Oh What a Difference a Year Makes…
Nearly all sectors of the stock market are up over the last year, but that’s especially true for the RIA industry. Even if most wealth management firms don’t employ any debt in their capital structure, their performance is very much levered to the stock market due to its direct effect on AUM balances, and the operating leverage inherent in the wealth management model. RIA aggregators are even more levered to market conditions, since they typically borrow money to purchase wealth management firms. It shouldn’t be too surprising that our aggregator index is up 140% over the last year.
After a rough Q1 in 2020, wealth management firms have fared particularly well over the last year, with favorable market conditions and rising demand for financial advisory services. During times of excessive volatility and market turmoil, individual investors rely on their advisors to stay the course and rebalance portfolios in accordance with their investment objectives. Wealth management firms have capitalized on this reliance as the number of advisors charging financial planning fees on top of asset-based fees or commissions increased 72% in 2020.
Despite steady gains over the last year, wealth management firms still face challenges pertaining to fee pressure, succession planning and connecting with millennials who are more interested in robo-advisors and fintech products than being counseled by their parents’ advisor. Additionally, the switch from in-person meetings to digital communication is viewed by many as another obstacle. According to a recent Schwab study, 35% of advisors viewed clients’ ability to connect virtually as one of the biggest challenges to their business in 2020. On the flip side, 37% of advisors view leveraging technology infrastructure to be able to seamlessly work remotely as one of the biggest opportunities to their business.
Source: Schwab Advisor Services’ 2020 Independent Advisor Outlook StudyAnother near-term opportunity is the pending reversal of some or all of the Tax Cuts and Jobs Act of 2017, and the implications it has for estate planning in 2021. Biden’s current proposal cuts the Unified Tax Credit (the exemption on gift and estate taxes) in half from $23.2 million to $11.6 million for married couples and from $11.6 million to $5.8 million per individual. As a consequence, many high net worth families will have significant gift and estate planning needs from their advisors to avoid a substantial increase in their embedded estate tax liability next year.On balance, 2021 should prove to be another challenging but favorable year for wealth management firms that focus on their clients’ needs and take advantage of rising demand for financial planning services. Industry headwinds remain, but we’re confident that the industry will prosper, diversify, and expand.
Valuation Implications of a 28% Corporate Tax Rate on Blue Sky Multiples
Will Dealerships Become Less Valuable if Tax Rates Rise?
2017 Tax Cuts and Jobs ActTo get an idea of how Blue Sky multiples might change with an increase in the corporate tax rate, the simplest way may be to look at what happened the last time the rate changed. Fortunately for this analysis, we don’t have to go back too far. In December 2017, former President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. Shortly after his inauguration, President Trump indicated a goal of “15 to 20%” for the federal corporate tax rate, down from 35% at the time. Fast forward to September 2017, the Trump administration and congressional Republican leaders announced a tax framework that included a 20% federal corporate tax rate, which eventually settled at 21% when the bill was signed into law on December 22, 2017.On a statutory basis, a dealer structured as a traditional C corporation making $1 million in pre-tax earnings went from net income of $650,000 to $790,000, or an increase in value of 21.5% assuming no change in the P/E multiple. While this generally comports with the returns of the S&P 500 in 2017 (which increased 19.4%), this increase happened gradually over time. While there are many other contributing factors, it is evident in the chart below that the market likely priced in any favorable tax changes gradually throughout the year.
Because the market generally trended upwards in 2017, it would be difficult to point to any one period of rapid increase related to optimism surrounding lower corporate taxes. However, because the market has historically trended upwards, it can be more difficult to attribute the rise to specific policies. While this paints with more broader strokes for the market, let’s consider Blue Sky multiples.
Blue Sky Multiples Before and After TCJAWhile after-tax earnings likely rose for most dealers due to the tax law change, pre-tax profits by definition would not be impacted. Theoretically as noted above, a buyer should be willing to pay more for a higher return, so the value should increase if earnings go up. With the earnings stream utilized in Blue Sky multiples unchanged, an increase in value should be seen in higher multiples.From Q3 2017 - Q1 2018, there were no changes in the range of multiples for any brands despite the material decrease in corporate tax rates. This begs the question: Why not?If dealership values had increased by 21.5%, the average Blue Sky multiple would have increased from 4.85x in Q3 2017 to 5.89x in Q4 2017. This change also could have been more gradual throughout the year. However, multiples were largely unchanged.From Q1 2017 to Q1 2018, only five brands saw a change in their Blue Sky multiples. Subaru multiples improved by one full turn of pre-tax profits in Q2 2017 (from 4x-5x to 5x-6x), while Toyota, Honda, Chevrolet, and Buick-GMC saw more modest increases in Q3 2017. From then until Q1 2018, there were no changes in the range of multiples for any brands despite this material decrease in corporate tax rates. This begs the question: Why not? Well, there are numerous potential reasons.State of the IndustryIn the Q4 2017 Haig Report, private dealership values were judged to have fallen by an estimated 2.6% from the year-end 2016 due to increased expenses. Despite generally favorable macroeconomic conditions in the U.S., auto sales and gross profit per vehicle retailed were starting to trend down at the same time that dealership expenses are increasing, reducing profits. With years of annual volumes above 17 million, there were concerns about declines. While volumes in 2018 and 2019 were below the 2016 peak, they remained above 17 million. SAAR for 2015 through 2019 is shown in the below graph for perspective.
As the pandemic reminded us all, volumes do not directly correlate with profits. In order to gain a broader perspective of the auto dealer market conditions, we’ve considered the stock price returns of the S&P 500, the Russell 2000, and the publicly traded franchised dealers in 2017.
The S&P 500 paced the group with the aforementioned 19.4% return. Lithia was just behind at 17.3% as it continued to buy up dealerships which the market viewed favorably. The return on the Russell 2000 was 13.1%, well above all other auto dealer stock prices whose returns ranged from 5.5% (AutoNation) to negative 19.4% (Sonic). The trend was particularly bad through the end of August with all non-Lithia dealers down between 6.7% and 23.0%. SAAR followed this general trajectory and caught a nice bounce in September, which coupled with optimism over favorable tax treatment potentially aiding in the rebound.
Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset gains, leading to minimal change in Blue Sky multiplesAfter the passage of the tax law and with some time to analyze any impacts, the Q1 2018 Haig Report noted positive and negative trends thusly:Positive Trends: “This remarkable era in auto retailing continues. We have enjoyed many years of low interest rates, cheap gas, and rising employment. Consumer confidence remains near its 17-year high and household wealth has never been greater. It’s true that dealership profits (and values) peaked a couple of years ago, but they remain close to record levels. The much-predicted downturn in sales has not yet happened. Congress even gave dealers a nice boost by lowering taxes and walking back pressure from the CFPB. Negative Trends: "While sales remain strong, there are some troubling vibrations coming from the disruptive influences of technology. Dealers continue to suffer from the degradation of gross profits due to the shift in pricing power from the retailer to the consumer thanks to various digital tools. And over the next five to ten years, electrification, ride sharing and autonomous vehicles loom as threats. Some well-respected industry leaders predict that the best days of auto retail are behind us, that profits will never return to current levels and that many dealerships will end up closing their doors.”Despite lower taxes increasing after-tax cash flows, it appears declining industry conditions offset these gains, leading to minimal change in Blue Sky multiples. To take the analysis a step further, we consider the specific tax structures of privately held dealerships and transaction considerations, rather than comparing it solely to publicly traded companies which are required to be structured as C corporations.Tax Structure of Largest Auto GroupsBlue Sky multiples are calculated on adjusted pre-tax profits. This enables comparison between dealerships subject to different income tax rates. Differences in total corporate income taxes paid are usually due to two reasons: state/local tax rates and ownership structure (C corporation vs pass-through). First, let’s address state/local tax rates. Language in the Haig report from editions before and after the tax law change note, “dealerships in states with no income tax usually bring premiums to dealerships in high tax states.” This means that for a given range, say 5x-6x, dealerships subject to lower taxes are more likely to receive a pre-tax multiple on the upper end of the range. While not all dealerships necessarily fit into this range, one can infer that local tax rate differences may not ultimately impact the multiple by more than one turn of pre-tax earnings.Dealerships in states with no income tax usually bring premiums to dealerships in high tax statesMany dealers may also structure their companies to be taxed at individual rates (S corporation, LLC, etc.) instead of corporate rates (C corporation). The pass-through tax structure has been popular because it avoids “double taxation” when a dealer pays corporate income taxes on profits then taxes on distributions from net income to dealers after the payment of corporate taxes. For a pass-through dealer, their marginal tax rates only declined from 39.6% to 37.0%. While the initial tax framework proposed by Republicans included a maximum 25% rate on pass-throughs, the TCJA instead offered a 20% deduction for Qualified Business Income (“QBI”). For dealers in the top marginal income tax bracket, this could mean a pass-through rate as low as 29.6% (37% x [1-20%]). Implied increases in values are demonstrated below:
As noted above, Blue Sky multiples derived from private dealership transactions are applied to pre-tax earnings, enabling comparisons regardless of elected corporate structure. This is intuitive because a buyer is unlikely to be concerned with the corporate structure of the seller. While corporate taxes declined, many dealerships are structured in this way. Therefore, a negotiation between a buyer and seller is likely to balance favorable income tax treatment against other factors on pre-tax income. As discussed above, industry conditions were relatively stable if not modestly declining.
Anticipated Impact of Increasing Corporate Tax RatesUnder the Biden plan, a 28% corporate tax rate would decrease after-tax earnings for C corporations by 8.9% all else equal. However, as we saw after the TCJA, not all else is equal. The reverse may be occurring in 2021 with rising taxes being offset by more favorable industry conditions as many auto dealers finished 2020 with record profits despite a global pandemic.In 2021, rising taxes may be offset by more favorable industry conditionsHeading into 2021, looming threats associated with scale continue to exist, though this is not exclusive to smaller dealers. With online-only used retailers attracting plenty of equity capital from the public markets, larger players in the industry are feeling the pressure to grow themselves. This levels the playing field as buyers are equally incentivized to grow as sellers might be to capitalize on high exit multiples, forgoing the need to make significant technological investments.ConclusionSo, what does the TCJA tell us about the proposed increase in corporate tax rates under the Biden administration? The short answer is it depends. Buyers and sellers are likely more focused on determining the run-rate, or core earnings of dealerships after record profits in 2020 than what rate may or may not apply to them. Fear of rising taxes may motivate sellers to cash in, which would weigh on value if there’s excess supply of dealerships for buyers to choose from. In 2017, the opposite was likely true as bolt-on acquisitions became more costly as dealers were less motivated to cash out as more income fell to their bottom line. As we’ve demonstrated, an increasing federal corporate tax rate may impact some dealers, but for most that are structured as pass-through entities, changes in the top marginal tax bracket for individuals is more likely to impact dealer principals. And while the corporate income tax rate is important for the future earnings of a dealership, sellers are likely to be more concerned about the taxes they would need to pay after selling their business.Mercer Capital provides business valuation and financial advisory services that consider the potential valuation implications of changes in legislation and how this impacts auto dealerships and their principals. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.
Valuation Lessons from Credit Union & Bank Transactions
In recent years, credit unions have been increasingly active as acquirers in whole bank and branch transactions. This session focuses on the top considerations for credit unions when assessing and valuing bank and branch franchises in the current environment.For bankers, this session should enhance your knowledge regarding how credit unions identify potential targets, assess potential opportunities and risks of a bank or branch acquisition, and ultimately determine a valuation range for target banks and branches.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to watch the video!
Solvency Opinions: Oil & Gas Considerations
The Key QuestionAs 2020 progressed, a record number of oil & gas operators and related oil field service companies filed for Chapter 11 bankruptcy, which provides for the reorganization of the firm as opposed to full liquidation (Chapter 7). In addition, consolidation by way of merger and acquisition (“M&A”) activity occurred, albeit such activity was at a 10-year low in 2020.
Regardless of whether a company files for Chapter 11, is party to an M&A transaction, or executes some other form of capital restructuring – such as new equity funding rounds or dividend recaps – one fundamental question takes center stage: Will the company remain solvent?The Four TestsAs noted in our overview of solvency opinions last November, leveraged transactions that occurred pre-COVID-19 will continue to be scrutinized, with many bankruptcy courts considering the issue of solvency retroactively. Due to increased energy price volatility in the first and second quarter of 2020, many operational and dividend programs were suspended.As oil & gas prices have stabilized and appreciated over the past one to two quarters (in its April Short-Term-Energy Outlook report, EIA projects WTI and Brent to average $58.89 and $62.28 per barrel, respectively), a large number of oil & gas operators have significantly reduced their debt, and are considering or have resumed their operational plans and dividend programs, albeit perhaps not exactly as before their suspension.Emerging from the chaos of 2020 with lower leverage, leaner and more efficient operations, higher commodity prices, and the continued low interest rate environment, it is not unreasonable to think that oil & gas companies may consider increasing leverage again as operations continue to recover or expand and boards approve the return of capital to shareholders by way of resuming regular or even special dividends.Often, a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.A solvency opinion, typically performed by an independent financial advisor, addresses four questions:Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?Will the company be able to pay its debts (or refinance them) as they mature?Will the company be left with inadequate capital?Does the fair value of the company’s assets exceed its liabilities and capital surplus to fund the transaction?A solvency opinion addresses these questions using four primary tests:Test 1: The Balance Sheet Test – Does the fair value and present fair salable value of the Company’s total assets exceed the Company’s total liabilities, including all identified contingent liabilities?
The balance sheet test takes the fair value of the subject firm on a total invested capital basis and subtracts its liabilities.
Test 2: The Cash Flow Test – Will the Company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature?
The cash flow test examines whether projected cash flows are sufficient for debt service. This is typically analyzed along three general dimensions, including the determination of the company’s revolving credit facility to manage cash flow needs over the forecast, the possible violation of any applicable covenants, and the likely ability to refinance any remaining debt balances at their maturity.
Test 3: The Capital Adequacy Test – Does the Company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction?
The capital adequacy test is related to the cash flow test and examines a company’s ability to service its debt with sufficient margin after giving effect to the proposed transaction. While there is no bright line test for defining “unreasonably small capital”, we typically evaluate this concept based upon pro forma and projected leverage multiples utilizing management’s projections as a baseline scenario and alternative downside scenarios to determine if there is “unreasonably small capital” under more stressed conditions.
Test 4: The Capital Surplus Test – Does the fair value of the Company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as calculated pursuant to Section 154 of the Delaware General Corporation Law)
The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but includes the par value of the company’s stock (or entire consideration received for the stock if no par value is given), in the amount subtracted from the fair value of the company’s assets.Solvency Considerations within Oil & GasPerforming a solvency opinion requires careful consideration of numerous factors even when everything clearly appears to be more or less favorable in a proposed transaction that involves increasing leverage. It may be opportune to pursue a dividend recap as debt is cheap and the company is already exhibiting strong growth in an industry potentially starting to recover. A company may increase leverage despite already having sufficient cash on hand for a special distribution, but it wants to maintain flexibility to act on unexpected growth opportunities that may arise. Perhaps the company’s trajectory is so great that even its downside case(s) would be a lofty goal of the next closest competitor. Still, the independent financial advisor must maintain a critical eye, taking a medium- to long-term perspective with a skeptic lens, to determine that the company may reasonably remain solvent.Now, consider the oil & gas sector in 2020. Under the assumption that additional debt is needed just to survive, never mind paying special dividends, many additional questions to approaching the company’s baseline forecast and downside scenarios arise:If the fair value of the company’s assets is already greatly diminished in the current down cycle, how much should you temper – if at all – the downside future scenario(s) when conducting the capital adequacy test? An appropriate stress test scenario for a company at the top or mid-point of the business cycle may look far different from an appropriate stress at the bottom of the cycle.How will the balance sheet test fare given the concurrent decrease in asset fair value and increase in liabilities? Even if the capital adequacy and balance sheet tests do not raise any red flags on their own, the cash flow test may reveal significant concerns. Is there enough flexibility with the existing revolver to address cash flow needs over the forecast, or will it need to be increased? Could the revolver even be increased, if needed?Can the company financially perform well enough over the next three to five years that future (likely) higher interest rates won’t be overly burdensome if the company must refinance maturing debts?And while due diligence and financial feasibility studies are expected to be performed beforehand, what covenant violations are likely to occur and when (in the context of the forecast scenario)? Will the new debt be “covenant-light” and relatively toothless, or will the company find itself that much more constrained when the fangs sink in and the situation is already likely to be dire?
While conversations regarding these questions and their implications may likely expose sensitive topics, these discussions must be candid if the independent advisor is to develop a well-founded and defensible opinion on the prospects of solvency.
Mercer Capital renders solvency opinions on behalf of private equity firms, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure. For more information or if we can assist you, please contact us.
March 2021 SAAR
After a tumultuous February due to weather conditions, March SAAR has bounced back with a vengeance. March SAAR of 17.75 million units is the second-highest of all time for the month, just shy of March 2000. There are two main factors driving this increase. While the winter storms had a negative impact on February SAAR, it likely caused pent-up demand that helped drive sales in March. Beyond simple delays, flooding forced some to replace damaged vehicles. Secondly, the Biden administration passed a Covid-19 stimulus bill at the beginning of March, and $1,400 paychecks hit many Americans’ wallets. This influx of cash may have also spurred a massive increase in vehicle sales.Now more than 12 months into the Covid-19 pandemic, we don’t think that comparing March 2021 SAAR to March 2020 SAAR is prudent due to the change in the economic landscape (it’s a 56% increase for those of you who were curious). For the next couple of months, this year-over-year comparison will continue as spring 2020 SAAR values were horrendous as dealers scrambled to grapple with the challenging operating environment. We will instead try to show both a comparison to 2020 and 2019 levels. Even with this adjustment, March SAAR for 2021 was an increase of 44% compared to 2019.Driving March SAAR were sales of light trucks which accounted for 78.1% of all new vehicle sales in March 2021. This metric is a slight uptick from the 74% they accounted for in March 2020. Breakdown of SAAR by vehicle type as presented by NADA is below for March 2021:Inventory and Production ProblemsThe March record sales levels come at the same time as lean inventories and production problems plague the industry. Thomas King, president of data and analytics at J.D. Power, noted this:“At an aggregate industry level, Q1 inventories have been sufficient to meet consumer demand and delivered the opportunity for manufacturers and retailers to sell those vehicles with smaller discounts. Manufacturers who are experiencing supply chain challenges are prioritizing the production of their most profitable and desirable products, minimizing the net effect. There is no question that sales of specific models in specific geographies are being disrupted by low inventories, but consumers are nevertheless demonstrating their willingness to buy despite having fewer vehicles to choose from the in-retailer inventory.”It will be interesting to see how long inventory levels can meet demand, and if consumers will continue to be as flexible on car model choice. This factor likely hinges on the continuing chip shortage and how that impacts manufacturers during the rest of the year. We have discussed the chip shortage at length in a prior blog post, and it ultimately could pose a problem to the current growth trajectory.At the end of February, dealers had 2.7 million vehicles in stock or being shipped to stores, a 26% drop from the same month last year. The lack of availability has been more acute for crossovers and SUV models, including Jeep’s Wrangler and Chevrolet’s Tahoe, whose stock is running between 43-70% lower than last year. Pickup trucks are the most recent type to be impacted by the shortages, with dealers having about 414,000 trucks at the end of February, about half of what they had a year earlier. As a result, many consumers have had to order models from the factory or pick up vehicles in transit to dealerships.Long gone are the initial pandemic incentives to drive consumers to dealerships, and buyers are having a harder time finding bargains. According to JD Power, average incentive spending per unit is expected to total $3,527, a decrease of $888 and $262 relative to March 2020 and March 2019. High demand is driving record transaction prices, and reduced incentives are improving gross profit margins and overall profitability for dealers. JD Power notes that average transaction prices are expected to reach $37,286, just below the all-time record set in December 2020.Fleet SalesWhile new vehicle retail sales have been booming, fleet vehicle sales have not seen the same resurgence and remain depressed. According to NADA, manufacturers are prioritizing production of the most popular and profitable segments for retail customers. Fleet customers have had their orders pushed back or canceled for the 2021 model year in some cases. Fleet buyers typically get discounts for buying in bulk. Fleet sales have struggled mightily during the pandemic and have not seen the same type of rebound experienced by retail sales.JD Power notes that fleet sales are expected to total 180,200 units in March, down 33% from March 2020 and down 51% from March 2019 on a selling day adjusted basis. Fleet volume is expected to account for 12% of total light-vehicle sales, down from 26% a year ago. Fleet sales struggled inordinately compared to retail partially due to a decline in travel amid the pandemic. Although the introduction of a vaccine and more consumer confidence in travel should have been a bright spot for bringing back fleet sales, the reallocation of vehicles to retail due to the chip shortage is another blow to an already struggling segment of the industry. With supply low, OEMs are prioritizing buyers willing to pay top dollar, so fleet buyers are losing that allocation.ConclusionLooking toward the rest of the year, vehicle sales success is going to be contingent on being able to acquire inventory. Consumer demand is high, and if dealerships can navigate the chip shortage and lack of models, they may see more numbers like that posted in March. However, if the chip shortage worsens and dealerships are unable to acquire inventory, this may be a headwind.If you have any questions on SAAR and what it means in the broader context of a valuation of your dealership, please do not hesitate to reach out to any member of the Mercer Capital Auto Team.
The Economics of Family Shareholder Redemptions
Enterprising families elect to “prune the family tree” for manifold reasons. For some, intra-family tensions have reached a breaking point, for others, there are different perspectives regarding the long-term prospects for the family businesses, and in yet others, different shareholder clienteles emerge with unreconcilable risk and return preferences.Regardless of the reason, significant shareholder redemptions are among the least understood corporate transactions. In this week’s post, we consider the economics of family shareholder redemptions from three perspectives: the selling shareholder, the family business, and the remaining shareholders. Balancing these competing perspectives is one of the greatest challenges of executing a significant redemption.In this week’s post, we consider the economics of family shareholder redemptions from three perspectives. Balancing these competing perspectives is one of the greatest challenges of executing a significant redemption.The Selling ShareholderWhen it is time for one or more shareholders to make a graceful exit, the economic interests of the selling shareholder diverge from those of the Company and the remaining shareholders.For the departing shareholder, sustainability of the family business ceases to be a guiding principle. The departing shareholder wants to maximize his or her proceeds from the sale of their stake, regardless of the burden such a purchase price could place on the business going forward.Most selling shareholders want cash when they sell their shares: trading one piece of paper (a stock certificate) for another (an interest-bearing note) is rarely perceived as a meaningful benefit. Selling shareholders presumably have some plan for deploying proceeds from a sale and receiving cash for their shares is likely an essential component of that plan.
Knowing what selling shareholders want is just one-third of the picture, however, we also need the perspective of the company itself and the remaining shareholders.The CompanyWe use “the Company” to refer to the management team, employees, and other stakeholders who are not shareholders but do have a vested interest in seeing the family business grow and persist as an independent company.Cash used in a redemption is cash that is not available for investment in productive assets that can help the Company grow. If a redemption is going to occur, the Company is one of only two parties that can pay for it. Companies pay for shareholder redemptions by either (1) not making corporate investments in productive assets that would otherwise be made, (2) using existing liquidity, or (3) borrowing funds. Each of these options, in their own way, diminishes the Company’s ability to grow or flexibility to respond to emerging strategic opportunities or threats.From the perspective of the Company, these negative outcomes can be mitigated by paying the redemption price over time, using a note that is subordinated to all other corporate obligations, bears interest at a favorable (i.e., low) rate, and has flexible repayment terms.The redemption price matters to the Company because a price that is set too high may spark a “run on the bank” which leads to sale of the business. On the other hand, a price that is set too low may also prompt shareholders to explore selling the Company as the only way for those shareholders to “unlock” the value that has been created over the preceding years and decades. Regardless of the path taken, the Company would generally prefer to avoid a sale of the business.Above all, the Company craves certainty. If there are going to be claims on corporate cash flow for redemptions, the Company wants to be able to plan around the amount and timing of those obligations.
We were careful to distinguish between the Company and the remaining shareholders because – while there is significant overlap between the two – the interests of the two parties do not align perfectly. So we need to consider the perspective of the remaining shareholders separately.Remaining ShareholdersIf the Company doesn’t pay for the redemption, the remaining shareholders must. If there is no interest in bringing in a non-family source of equity capital, the remaining shareholders will pay for the redemption through diminished dividends or smaller ongoing redemption pools.There are only two potential sources of return for family shareholders: income return from dividends and capital appreciation from a growing value per share. From the perspective of family shareholders, funding a significant shareholder redemption reallocates at least a portion of their return from the income return bucket to the capital appreciation bucket. Since the benefit of capital appreciation is deferred to the future (perhaps even to one’s heirs), many family shareholders value current income more highly than capital appreciation. These shareholders find the prospect of trading away current income for greater capital appreciation distasteful.In view of this shift in return components, the remaining shareholders naturally want the increase in capital appreciation to exceed the decrease in current income associated with a significant redemption. How can this be accomplished? By paying a discounted price and/or financing the redemption with a shareholder note, which is what the selling shareholders naturally want to avoid…The Great Balancing ActAs we said at the beginning of this post, enterprising families have a variety of reasons for pursuing a significant shareholder redemption. Regardless of the reason, executing a large redemption is a great balancing act. There are three parties to the transaction, each of which brings a unique perspective and set of needs and preferences to the deal. Structuring a redemption requires each of those parties to understand the perspectives of the others and acknowledge that tradeoffs will be inevitable. Careful modeling of the financial consequences of the redemption on each of the three constituencies is a necessary component of completing a redemption.Financial modeling of the transaction should be situated in a broader context of what the real goals of the transaction are and what tradeoffs each of the parties to the redemption is willing to make.Necessary, but not sufficient. Financial modeling of the transaction should be situated in a broader context of what the real goals of the transaction are and what tradeoffs each of the parties to the redemption is willing to make. Only when the goals and tradeoffs are identified will the parties be able to identify a financial model that supports the great balancing act that is a family shareholder redemption.ConclusionIf you suspect it might be time to prune your family tree, give one of our family business advisory professionals a call to discuss your situation in confidence. Our professionals have the experience, modeling expertise, and perspective to help you get your redemption transaction.
Q1 2021 M&A Update
An RIA M&A Frenzy
Despite the hiatus in M&A beginning with the onset of COVID-19, 2020 was a strong year for RIA mergers and acquisitions, and 2021 is expected to be even stronger.
Many of the same forces that have spurred M&A over the last five years drove deal activity in late 2020 and early 2021. Fee pressure in the asset management space and a lack of succession planning by wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick.
There has been growing interest over the last few years from private equity and permanent capital providers who find investment managers’ recurring revenue streams and availability for operating leverage attractive. Investors, hungry for alpha in a low-yield environment, are driving up deal prices leading more firms to hang up a for-sale sign.
Additionally, deal activity was bolstered by the low cost of credit and lenient financing terms by historical standards. As Jeff Davis, our bank guru, explains;
“Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high. In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing. Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle.”There is a growing number of banks interested in lending to the space. Live Oak Bank pioneered an SBA vertical in lending to RIAs and investment advisor Oak Street Funding has played a role in a substantial portion of leveraged transactions in this space, and most recently SkyView began offering financing solutions for RIAs.Further, the Biden administration's efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term as sellers seek to position transactions to be taxed at current tax rates.What Does This Mean for Your RIA?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. In a market this competitive, acquirers need to distinguish themselves on more than price. Sellers are often looking for buyers who can help them achieve scale, reduce the load of managing a business, and/or expand their reach or distribution capability.
If you are considering an internal transition, know there are more ways to finance the buy-out than there used to be. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the founding generation with more immediate liquidity and potentially offer the next-gen cheaper financing costs.
If you are an RIA considering selling, there are many options, and it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference.
RIA Industry Extends Its Bull Run Another Quarter
Publicly Traded Asset/Wealth Managers See Continued Momentum Through First Quarter as Market Backdrop Improves
It was about a year ago that share prices for publicly traded investment managers hit rock bottom, as investors reacted to the downside of having a revenue stream tied to the overall market. Since then, it’s been a straight-line recovery that’s continued through the first quarter of 2021, riding the wave of the larger bull market.Today, most individual stocks in our indices are hovering near 52-week highs. Aggregators have fared particularly well over the last twelve months on low borrowing costs and steady gains on their RIA acquisitions. Traditional investment managers have also performed well over this time on rising AUM balances with favorable market conditions.
The upward trend in publicly traded asset and wealth manager share prices since March 2020 is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, many of these public companies were already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. The fourth quarter was also favorable for publicly traded RIAs of all sizes as shown below.
As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances.
Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The first quarter was generally a good one for RIAs, but who knows where the rest of 2021 will take us.
Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions
The Opposite, Break-Even or Something In-Between?
My favorite TV show is Seinfeld. It's seemingly about nothing, but the situations and characters still resonate today.One of my favorite Seinfeld episodes is “The Opposite.” A brief (and incomplete) summary of the episode: George decides to turn his life around by doing the exact opposite of what he would usually do, and finally finds success, while Jerry keeps breaking even in life. Jerry marvels how things always just even out for him.What does this have to do with auto dealer valuations and the relationship of rent and real estate values in dealership acquisitions? In this post, we examine if the rent factor and value of the real estate all even out, just as Jerry Seinfeld’s character did in "The Opposite."The Impact of Rent and Real EstateOften dealership operations are organized in two entities: an entity holding the underlying real estate and an entity containing the dealership operations. We have chronicled the importance of normalization adjustments in the valuation process of the dealership operations including an assessment of rent. Since these entities are often owned by related parties, the level of rent should be examined.Dealers that own both the real estate entity and the dealership operations entity can control the amount of rent charged. Hypothetical buyers will assess the market rental rate and make adjustments to the valuation to keep this in line with the market.An ExampleWhy would dealers want to shift value and/or rental income to the real estate entity? Let’s examine this through an example highlighting increasing real estate values and one highlighting decreasing real estate values.Real estate is valued based upon a return of Net Operating Income. In our example, we assume a constant capitalization rate of 8% or a capitalization factor of 12.5x the rental income. In our example, this capitalization factor, or multiple, is higher for the real estate than the Blue Sky multiple of 6x, so the impact of the value of the real estate will have a greater impact on the overall acquisition value. Since Blue Sky multiples average around 6x, and range generally between 3-10x this will typically be the case. Fortunately or unfortunately, auto dealers cannot manipulate the underlying value of the real estate itself. Most, if not all auto dealership acquisitions will require a fair market value appraisal of the underlying real estate.Based on the assumptions above, the dealership operations would have a value of $3,000,000 (EBT of $500,000 times a Blue Sky multiple of 6x) and the real estate would have a value of $3,000,000 for a total acquisition value of $6,000,000 as seen below.Appreciating Real Estate ValuesIn times of appreciating real estate values, let’s assume the fair market value of the real estate increases by 15% to $3,450,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would increase to $276,000 and the resulting increase in rent would decrease normalized earnings to $464,000. While the real estate value climbs, the implied blue sky value for the dealership operations declines slightly since earnings are lower due to increased rent. However, the overall total acquisition value (operations + real estate) would increase by 4% ($6,234,000 vs. $6,000,000), despite the 7% decline in blue sky value as seen below.Depreciating Real Estate ValuesNow let’s examine the alternative where real estate values are declining. Let’s assume that the fair market value of the real estate declines by 15% to $2,550,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would decrease to $204,000 and the resulting decrease in rent would increase normalized earnings to $536,000. While the real estate value declines, the implied blue sky value for the dealership operations increases since earnings are higher due to decreased rent. However, the overall total acquisition (operations + real estate) would decrease by 4% ($5,766,000 vs. $6,000,000) despite the 7% increase in blue sky value seen below.
For comparative purposes, we can also view this graphically:
Seen differently, a 15% increase in FMV rent with no change in the cap rate of blue sky multiple shifts approximately 5% of the total value to the real estate. About the opposite is true for a 15% decline.
ConclusionsThe relationship between rent and fair market value of the real estate has an impact on the components of an auto dealer acquisition. While the impacts may be opposite and felt on both sides of the two entities, the impact on the real estate can have a greater effect given lower capitalization rates and/or higher capitalization factors than most implied blue sky multiples.Back to the Seinfeld episode, does the rent factor and value of the real estate all even out? While a decrease in annual rent will materialize in a greater implied blue sky value all other things held constant, the total effect would not mitigate a corresponding decline in real estate values.While auto dealers that own both the dealership operations and the real estate can control the charged rental rates, they cannot influence the ultimate value of the real estate. Frequently, the rent paid by a dealership is either higher or lower than true market rent as dealers are more concerned with running the day-to-day operations of their business than trying to pinpoint rental cap rates. A proper valuation of the dealership operations will assess and adjust the charged rental rate to reflect the perceived fair market value of the real estate.To discuss the impact of the rental rate or for an assessment of the valuation of your dealership operations, contact a professional on Mercer Capital’s Auto Team.
Analyzing the Relationship of Rent and Real Estate Values in Dealership Acquisitions
The Opposite, Break-Even or Something In-Between?
My favorite TV show is Seinfeld. It's seemingly about nothing, but the situations and characters still resonate today.One of my favorite Seinfeld episodes is “The Opposite.” A brief (and incomplete) summary of the episode: George decides to turn his life around by doing the exact opposite of what he would usually do, and finally finds success, while Jerry keeps breaking even in life. Jerry marvels how things always just even out for him.What does this have to do with auto dealer valuations and the relationship of rent and real estate values in dealership acquisitions? In this post, we examine if the rent factor and value of the real estate all even out, just as Jerry Seinfeld’s character did in "The Opposite."The Impact of Rent and Real EstateOften dealership operations are organized in two entities: an entity holding the underlying real estate and an entity containing the dealership operations. We have chronicled the importance of normalization adjustments in the valuation process of the dealership operations including an assessment of rent. Since these entities are often owned by related parties, the level of rent should be examined.Dealers that own both the real estate entity and the dealership operations entity can control the amount of rent charged. Hypothetical buyers will assess the market rental rate and make adjustments to the valuation to keep this in line with the market.An ExampleWhy would dealers want to shift value and/or rental income to the real estate entity? Let’s examine this through an example highlighting increasing real estate values and one highlighting decreasing real estate values.Real estate is valued based upon a return of Net Operating Income. In our example, we assume a constant capitalization rate of 8% or a capitalization factor of 12.5x the rental income. In our example, this capitalization factor, or multiple, is higher for the real estate than the Blue Sky multiple of 6x, so the impact of the value of the real estate will have a greater impact on the overall acquisition value. Since Blue Sky multiples average around 6x, and range generally between 3-10x this will typically be the case. Fortunately or unfortunately, auto dealers cannot manipulate the underlying value of the real estate itself. Most, if not all auto dealership acquisitions will require a fair market value appraisal of the underlying real estate.Based on the assumptions above, the dealership operations would have a value of $3,000,000 (EBT of $500,000 times a Blue Sky multiple of 6x) and the real estate would have a value of $3,000,000 for a total acquisition value of $6,000,000 as seen below.Appreciating Real Estate ValuesIn times of appreciating real estate values, let’s assume the fair market value of the real estate increases by 15% to $3,450,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would increase to $276,000 and the resulting increase in rent would decrease normalized earnings to $464,000. While the real estate value climbs, the implied blue sky value for the dealership operations declines slightly since earnings are lower due to increased rent. However, the overall total acquisition value (operations + real estate) would increase by 4% ($6,234,000 vs. $6,000,000), despite the 7% decline in blue sky value as seen below.Depreciating Real Estate ValuesNow let’s examine the alternative where real estate values are declining. Let’s assume that the fair market value of the real estate declines by 15% to $2,550,000. If annual rent is kept at a constant capitalization rate of 8% with more of a long-term view, annual rent would decrease to $204,000 and the resulting decrease in rent would increase normalized earnings to $536,000. While the real estate value declines, the implied blue sky value for the dealership operations increases since earnings are higher due to decreased rent. However, the overall total acquisition (operations + real estate) would decrease by 4% ($5,766,000 vs. $6,000,000) despite the 7% increase in blue sky value seen below.
For comparative purposes, we can also view this graphically:
Seen differently, a 15% increase in FMV rent with no change in the cap rate of blue sky multiple shifts approximately 5% of the total value to the real estate. About the opposite is true for a 15% decline.
ConclusionsThe relationship between rent and fair market value of the real estate has an impact on the components of an auto dealer acquisition. While the impacts may be opposite and felt on both sides of the two entities, the impact on the real estate can have a greater effect given lower capitalization rates and/or higher capitalization factors than most implied blue sky multiples.Back to the Seinfeld episode, does the rent factor and value of the real estate all even out? While a decrease in annual rent will materialize in a greater implied blue sky value all other things held constant, the total effect would not mitigate a corresponding decline in real estate values.While auto dealers that own both the dealership operations and the real estate can control the charged rental rates, they cannot influence the ultimate value of the real estate. Frequently, the rent paid by a dealership is either higher or lower than true market rent as dealers are more concerned with running the day-to-day operations of their business than trying to pinpoint rental cap rates. A proper valuation of the dealership operations will assess and adjust the charged rental rate to reflect the perceived fair market value of the real estate.To discuss the impact of the rental rate or for an assessment of the valuation of your dealership operations, contact a professional on Mercer Capital’s Auto Team.
Real-World Tips For Family Business Succession
In this series of posts, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out.
A business owner pitting his children against one another aiming to name the successor to a business empire, slow-burning ancestral battles, intra-family posturing, legal battles, helicopters, and yachts? No, I am not talking about my time in the family business, but HBO’s Succession, a series diving into how a family will “contemplate what the future will hold for them once their aging father begins to step back from the company”. But what the family undertakes throughout the series is a Hollywood-ized version of what all family businesses undergo throughout their life cycles.
Knowing all families will eventually have to face succession, it’s somewhat surprising that the majority of family businesses have no succession plan at all. PWC’s 2021 Global Family Business Survey found only 30% of family businesses have a formal succession plan, which is an improvement from 2018 (15%) but still represents a huge challenge for business continuity and success.
What can family business directors do to ensure a successful succession plan to the next generation? We assume that most directors would prefer to avoid the machinations and drama sufficient to fill out multiple seasons of a TV show. Here are three lessons I saw (and continue to observe) with my family’s company.Succession Is A Marathon, Not A SprintFamily business leaders focused on generational wealth creation understand that decisions made today will impact the business well into the future. How are you building your business to ensure it can succeed without the incumbent generation? My father-in-law worked tirelessly to build a business with my wife and I that was sustainable and scalable based on processes rather than key people. This was not an overnight process and one that is still ongoing.The goal of these strategies and conversations is to create a business structure that will function well when the next generation matures into leadership. As Travis W. Harms wrote in a previous blog post, are your senior executives focused on building a business that can flourish in their absence? My family talked regularly about operations as well as what the business would be with the next generation in charge, thanks in part to humility and grace from all parties.Create a Contingency PlanMy family’s long-term goal is for the next generation to slowly acquire ownership in the family business over five-to-fifteen years. What happens if things change drastically mid-stream? Business transition does sometimes proceed according to schedule, but often succession timetables accelerate unexpectedly. The New York Times had a piece recently highlighting stories from two sons whose fathers died without a succession plan. The article highlights stories of the stress put upon families when they don’t plan for succession, and the psychology that leads to plan-less exits: an unwillingness to let go, a refusal to listen to wise counsel, and the absence of a clear identity outside the role as family business leader.How did my family address the very real risk of an unexpected succession? Our next-generation took ownership of part of a life insurance policy on the key principal in the incumbent generation. If the unthinkable occurred, the next generation would have liquidity and flexibility to decide what direction to take in the absence of the incumbent leader. The proceeds would also help with any tax liability in a sudden bequeath of familial ownership interests. This strategy is quite simple but allowed us to focus on the long-term strategy of succession.Understand Where You Are GoingEventually, all family businesses will transact in some manner, whether through an orderly transaction with a third-party buyer, a succession plan, or any number of less favorable outcomes. Clearly define where you want to go, even if you do not necessarily understand how to get there. Make sure you have the buy-in from all family stakeholders and everyone knows the ultimate destination. In my family, there are each member of the next generation knows which seat on the bus they ultimately want to sit in. These seat assignments have emerged from a lot of conversations, time, and value-alignment, something I wrote on previously in aligning family goals and business objectives. Getting the right people on the bus makes for a smoother ride as the family business matures and the family continues to grow.ConclusionA B+ succession plan today is better than an A+ plan later. Starting the succession planning process now – understanding that it will evolve – should spur family business directors to actionable plans that will help everyone sleep better at night.Mercer Capital has a long history of working with family business owners in crafting and structuring the transactions needed to support the succession plan process. Let us know if we can help you and your family today.
Eagle Ford Benefits From Commodity Price Increases Despite Challenges
The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Eagle Ford.Production and Activity LevelsEstimated Eagle Ford production declined approximately 23% year-over-year through March. This is the most severe decline observed for all of Mercer Capital’s coverage areas, with production in the Bakken, Permian, and Appalachia down 19%, down 8%, and up 3%, respectively. In the immediate aftermath of the Saudi/Russian price war and historic rout in oil prices, the Eagle Ford’s production decline was less severe than what was seen in the Bakken, though the rebound in the Eagle Ford was also more muted. During the fourth quarter of 2020, Eagle Ford production trended downward once again and appears to have been materially impacted in February 2021 by the cold weather that disrupted power supplies throughout Texas.
However, the Eagle Ford’s rig count has generally been rising over the past six months. Total rigs in the Eagle Ford stood at 31 as of March 26, down over 50% from the prior year, but more than 3x higher than the low of 9 rigs observed in September 2020. Bakken, Permian, and Appalachia rig counts were down 71%, 42%, and 19% year-over-year, though have all rebounded from the September lows (though not as dramatically as the Eagle Ford’s rise since then).
While recent data has been noisy, and the Eagle Ford’s current rig count should keep production relatively flat, based on legacy production declines and new-well production per rig.
Commodity Prices Stabilize, Though Uncertain Demand Dynamics RemainThe first quarter of 2021 was relatively good for commodity prices, though they exhibited more volatility than in recent quarters. Front-month WTI futures began the quarter at ~$48/bbl and increased to a peak of $66/bbl before ending the quarter at ~$59/bbl. Henry Hub natural gas front-month futures prices broke above $3/mmbtu in February 2021, though regional spot prices were much more volatile as cold weather disrupted gas production and transmission while also increasing demand for heat and electricity.Financial PerformanceThe Eagle Ford public comp group had a banner year for stock price performance over the past twelve months, with Penn Virginia, Silverbow, Mongolia, and EOG up 334%, 215%, 187%, and 102%, respectively. All except EOG outperformed the broader E&P sector, as proxied by XOP (which was up 157% during the past twelve months). However, that stock price performance is largely driven by the exceptionally low starting point in March 2020, as the Saudi/Russian price war and reduced demand due to COVID-19 lockdowns created significant concern among investors regarding the financial position of E&P companies, especially those with significant leverage. Stock prices for the four companies remain below all-time highs.EOG Doubles Down on “Double Premium” LocationsIn their Q4 2020 earnings call and presentation, EOG touted its inventory of “Double Premium” locations, which meet EOG’s new return hurdle of 60% Direct After-Tax Rate of Return (ATROR) at $40 oil and $2.50 natural gas. While not clearly defined, EOG describes Direct ATROR as including “the costs associated with drilling and completion operations and well site facilities.” All-In ATROR, which is more akin to a full-cycle calculation, “includes such costs as well as (i) the costs associated with other facilities, lease acquisitions, delay rentals and gathering and processing operations and (ii) geological and geophysical costs, exploration G&A costs, capitalized interest and other miscellaneous costs.” Per EOG’s presentation, roughly half of EOG’s 11,500 premium locations fit the underwriting criteria to be classified as “double premium.”However, E&P companies have long been criticized for touting well-level IRRs and other bespoke financial metrics that imply phenomenal economics, but don’t seem to result in corresponding corporate-level returns. We’ll see if EOG’s more stringent underwriting standards translate to shareholder returns.ConclusionThe Eagle Ford was among the regions hardest hit by low commodity prices. The recent increase in rig count bodes well for stemming production declines, though more rigs are likely needed for material production growth given natural declines in existing production. However, with investors and E&P management teams focused on returns rather than growth, current commodity prices may not lead to the expansion in the activity that’s been seen in previous cycles.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Human Input in Investment Management Is a Feature, Not a Bug
In the mid-1970s, sports car racing requirements changed such that manufacturers could only race models that were also widely available through dealer networks. Porsche responded by developing the 930 Turbo, a 911 Carrera with upgraded suspension, larger brakes, and an uprated version of its six-cylinder boxer motor enhanced by a large diameter turbocharger. The 930 turbo became popular with enthusiasts as it was the fastest car built in Germany. For unskilled drivers, it was also quite dangerous. With a twitchy, short wheelbase prone to oversteer and non-linear gushes of power from the turbocharger, it was all too easy to spin – even in ideal conditions. As a consequence, the 930 Turbo earned the nickname that has stuck with it: the Widowmaker.To those who enjoy a direct connection with the road, the difficulty of controlling a vintage 930 Turbo at the limit is a feature, not a bug. The short wheelbase and rear-weight bias that produce oversteer make the car responsive, not dangerous. And the surge of power from the turbocharger makes the car undeniably fast – so long as it’s pointed in the right direction. If you can stay ahead of the car and master the capabilities of a 930 Turbo, you know you’re a good driver.Is human input in investment management a feature, or a bug? A generation of CFA charterholders have endured a curriculum that forcefully documents the futility of active management. The second decade of the millennium seemed to back this up, as anyone who owned anything other than a long-only position in an S&P 500 index fund probably regretted it. Even in an innovation economy, a cap-weighted index that favored big tech beat most alternatives. Thinking seemed overrated.Then the pandemic hit, and suddenly all asset pricing was non-linear. With a K-shaped recovery, an unsteady bond market, sagging dollar, a resurgence in value stocks, and talk of inflation, there’s no idiot-proof approach to investing.Does the market agree? Affiliated Managers Group share price sagged for years, dropping along with prospects for the active managers it acquired over the years. AMG hit bottom on March 20, 2020, closing under $50 per share. It’s approximately triple that today – back to levels it hasn’t seen since the summer of 2018. Franklin Resources’ shares are trading at double what they were a year ago, as are Silvercrest, Diamond Hill, Federated, and T. Rowe Price. Not every publicly traded asset manager has performed that well, but the turnaround in fortunes on many firms’ five-year charts is worth a look.Sometimes it seems like investment management is going to be entirely performed by one cloud server. We talk with many in the wealth management space who think active asset management has already been entirely supplanted by indexed products. And we know more than a few asset managers who think wealth management services could be performed just as well by robo-advisors. Our experience has been that human input finds unique solutions, secures and strengthens relationships, and ultimately provides clients with the best outcomes. Algorithms can be great tools, so long as their user has great skills.The capable but tricky 930 Turbo was not the start of a trend. Today, automakers are focused on building cars that will be self-parking, self-driving transportation vessels to mindlessly convey occupants in hermetically sealed cocoons. Even current iterations of the Porsche Turbo have all-wheel drive, traction control, automatic transmissions, and enough engine management systems to make them practically idiot-proof. But dumbing down driving doesn’t produce better drivers, any more than dumbing down investment management improves investment outcomes. Thinking still matters in this industry, thankfully. It’s also more fun.
What’s in a Multiple?
Blue Sky Multiples Improved in 2020 After a Rocky Start, and Buyers Weigh Multiple Years of Earnings
Multiples and Methodologies Moved Considerably Through 2020Prior to the tumultuous 2020, Blue Sky multiples for many brands could be relatively stable over numerous quarters. As seen in later charts, multiples don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM. However, the Covid-19 pandemic increased volatility in the economy to such a level that Blue Sky multiples reacted in a similar fashion regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the next year. Throughout most of 2020, Haig’s reported Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Now into 2021, Haig reports that buyers are using a three-year average of adjusted profits from 2018 through 2020 as the best prediction of future profits. This comports better with the approach taken by Mercer Capital. Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Given the longer product life cycles, we have historically and continue to take a more long-term approach when assessing the ongoing earning power of an auto dealership.Dealers will likely need to ramp back up staffing levels and advertising to support sales, but strong demand relative to constrained supply has led to higher gross profits for dealers. While dealers are optimistic that the cost savings will be “sticky,” we note ten years of slow, consistent growth since the Great Recession led dealers to such an environment where there were excesses that could be cut out of the cost structure. We see earnings and sales levels normalizing which only bolsters the need to consider earnings in a multi-period context.Illustrative Example: LexusTo show the variance in Blue Sky values in 2020, we’re going to take pre-tax earnings for average luxury dealerships as reported by NADA and apply them to the appropriate multiple. Since Lexus was one of the largest movers and has the widest range, we’re cherry picking them as the best illustrative example.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 6.5x to 8.0x for Lexus dealerships. With 2019 pre-tax earnings of $2.2 million for the average luxury dealership, implied Blue Sky value for the average franchise would range between $14.5 million and $17.9 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $13.4 million to $16.7 million. By Q4 2020, multiples and earnings each increased significantly, and Lexus was up to a range of 8.0x to 10.0x as seen on the below graph.
We note the range for Lexus dealerships has widened to two full turns of pre-tax earnings, or rather, two full years of profits. Applied to the three year average pre-tax earnings of the average luxury dealership, the difference in an 8x or 10x multiple represents a $5.3 million difference. High end multiple dealerships would have seen a value increase of $9.6 million ($16.7 million to $26.3 million) in that time, or 57.3%. While this appears high and all dealerships have their own unique characteristics, for context, the S&P 500 index was up 45.3% from March 31 to December 31.
Without any context on the reported multiples (the red and green lines above), one might think that values were stagnant in Q4. However, the multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings. For the average luxury dealership, 2019 pre-tax earnings were $2.2 million, which were below 2018. Factoring in the higher earnings of $3.4 million in 2020, the 3-year average is $2.6 million. So, as seen on the graph, a dealership on the top end of the range saw their value increase by approximately $4 million as higher earnings are applied to multiples that held firm.
Multiples reported by Haig are now being applied to 3-year average earnings instead of 2019 earnings.Deal Activity Can be Positively Correlated to MultiplesA multiple is a function of risk and growth, and certainly the outlook in March 2020 was higher risk than in in quarters prior to the pandemic. However, as seen below, very few transactions actually occurred during the initial economic decline as sellers were less interested in disposing of their most valuable asset at bargain prices. We note deal activity in 2020 was positively correlated with multiples, which makes intuitive sense and indicates a seller’s market in the back half of the year.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations partially recovered in Q2. With reduced uncertainty and higher profits, every brand except Volvo and VW received a higher blue sky multiple in Q3 2020 than Q4 2019 (pre-pandemic). In Q4 2020, the only multiple range that changed was that for Toyota which crept into the lead for mid-line imports.Luxury BrandsLuxury Blue Sky multiples followed the overall trend described above with drops in Q1, partial rebounds in Q2, then improved multiples in Q3, all relative to Q4 2019 multiples and earnings. Lexus saw the highest increase, from 6.0-7.5x in Q1 2020 to 8-10x in Q4. On the other end of the spectrum, Infiniti, Cadillac, and Lincoln continue to languish as brands without multiples, commanding a Blue Sky value range of up to $1.5 million. Each of these brands suffers from a myriad of issues, including costly facility upgrade requirements, which tend to weigh on Blue Sky values.Mid-Line Import BrandsMid-Line Imports multiples also followed the overall trend, as only VW’s Q4 wasn’t higher in 2020 than 2019 (each 3.0x – 4.0x). Nissan’s Blue Sky multiple in Q1 2020 declined to a paltry 1.5x on the low end, the lowest ever reported by Haig for any brand dating back to 2013. This was driven by troubles that began before the pandemic as corporate turmoil and an aging lineup weighed on dealer profits. At Q4 2020, this had rebounded to 3.0x – 4.0x, the highest for the brand since Q2 2018. Dealers that held on during the last few years have been rewarded. As noted previously, at the top end of mid-line imports, Toyota snuck its nose ahead of Honda, to pace the segment at 6.25x – 7.25x, on par with Jaguar/Land-Rover and Audi. Q2 and Q4 2020 were the only two quarters on record in which Toyota dealers have outpaced Honda, albeit only at a quarter turn multiple difference. Meanwhile, Subaru has caught up to Honda at 6.0x – 7.0x, a gap that has steadily narrowed since Subaru was closer to a 4.0x-5.0x multiple in 2016.Domestic BrandsDomestic franchises continue to move largely in lockstep with each other as Buick-GMC remains just below the others who command a 3.5x to 4.5x multiple. Domestics continue to outpace many of the mid-line imports, reminding everyone that vehicle pricing power is not the sole consideration in these multiples. Luxury vehicles frequently receive the highest multiples. However, three luxury brands continue to not even receive a multiple while Volvo and Acura are on par or below their domestic counterparts.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership and its corresponding franchise rights. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.
Eagle Ford M&A
Transaction Activity Slows Amid Challenges of 2020
Over the last year, deal activity in the Eagle Ford was relatively muted after the impact that the Saudi-Russian conflict and COVID-19 had on the price environment. M&A deals were largely halted in the second quarter of 2020 as companies turned to survival mode amid challenging realities. Frankly, transaction due diligence was most likely last on companies’ agendas. However, announced, and rumored transactions in the Eagle Ford picked up, relative to early 2020, towards the second half of the year as a price recovery began to take hold.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. Relative to 2019, deal count decreased by four, and median deal size declined by approximately $74 million, however it is important to note the small sample of disclosed deal metrics.Chevron Adds to Eagle Ford Play and Global Portfolio with Noble AcquisitionOn July 20, 2020, Chevron announced that it was acquiring Noble Energy, Inc. in an all-stock transaction valued at $10.38 per Noble share, based on the price of Chevron’s stock before the announcement and an exchange ratio of 0.1191 Chevron shares per Noble share, representing an approximate premium of nearly 12% on a 10-day average based on the closing prices as of July 17, 2020. The total enterprise value of the deal (including debt) was pegged at $13 billion in the transaction press release. The deal closed on October 5, 2020, marking the completion of the first big-dollar energy deal since the market turmoil began in March 2020. The acquisition makes Chevron the second U.S. shale oil producer behind EOG Resources, Inc. Noble’s international plays also add 1 Bcf of international natural gas reserve to Chevron’s portfolio. Noble Energy’s domestic plays include the Permian Basin, Denver-Julesburg Basin, and the Eagle Ford.Ovintiv Further Deleverages with Eagle Ford Asset SaleOn March 24, 2021, Ovintiv Inc. agreed to sell its South Texas assets for $880 million to Validus Energy (portfolio company of Pontem Energy Capital), a privately owned operator. The transaction occurred roughly two weeks after sources rumored that Ovintiv was in advanced discussions to divest its Eagle Ford assets. The deal announcement comes shortly after Ovintiv’s debt reduction initiative outlined in February 2021, which includes generating approximately $1 billion by divesting certain domestic and international assets. In 2019, Ovintiv’s debt increased to nearly $7 billion after its purchase of Newfield Exploration. The company aims to reduce debt by 35% to about $4.5 billion by 2022 in order to gain investor confidence. The company announced that the transaction will allow them to reach the debt target by the middle of next year. Ovintiv has divested two geographic positions in consecutive quarters, with the first sale being their Duvernay position in Q4 2020. The company’s Eagle Ford position was purchased for $3.1 billion in 2014 from Freeport-McMoRan Inc. The company expects the deal to close in the second quarter of 2021.ConclusionM&A transaction activity in the Eagle Ford was fairly quiet throughout 2020 before Chevron’s $13 billion deal with Noble Energy. The Chevron-Noble Energy transaction and the Ovintiv-Validus deal could be foreshadowing a busier M&A market in 2021, whether companies try to bolt onto previous acreage, or are forced to divest to pay down debt.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, we provide investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. Our Professionals also have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence
Six Events That Trigger the Need for a Valuation
Auto dealers, like most business owners, are focused on many aspects of their business: daily operations, strategic vision, competition, industry conditions, the state of the economy, etc. It is less common for auto dealers to be concerned if/when their business might need to be valued. Often, they are made aware of the need for these services by their trusted advisors including attorneys, financial planners, accountants, etc.What are common events that trigger the need for a valuation for an auto dealership?1. Estate Planning/Wealth TransferOver time, successful dealerships can accumulate tremendous value. Estate planning allows the first generation of a family to transfer wealth to the next generation through various mechanisms.Individuals and couples can take advantage of the lifetime exemption amounts by transferring value up to the current taxable exemption of $11.7 million for individuals or $23.4 million for couples over their lifetime.1 Gifting strategies can also utilize the annual exclusion amount of $15,000 per individual.Implementation of these strategies includes many different structures requiring the valuation of the auto dealership and the specific interest being transferred. A proper valuation assists in protecting the integrity of these transactions. Failure to support the concluded figures with a proper valuation can often lead to these transactions being challenged or audited, causing a later described litigation dispute.2. Death of a Dealer Principal/OwnerFor certain estates, an income tax return and Form-706 will have to be filed in a timely manner after the date of death. If the decedent is an owner of a business, or in this case an auto dealership, the value of the decedent’s interest will have to be valued. The valuation will need to be performed by a qualified business appraiser that can support the value of the dealership and specific ownership interest through accepted methodologies.3. Buy-Sell AgreementIn a prior blog post, we discussed the seven elements of a highly effective buy-sell agreement. This document, along with other corporate governance documents, describes the process and criteria for a business valuation and often requires an initial valuation to set the stock price for triggering events that will be governed by the document. Further, some buy-sell agreements require updated valuations at regular intervals or upon the occurrence of future triggering events. Following the provisions in these documents and maintaining regular valuations can aid in limiting or avoiding litigation disputes.4. Strategic PlanningBusiness valuations can also assist auto dealers with strategic planning. Not only can a valuation provide an indication of value at a specified point in time, but successive or regular valuations can track value over time. These valuations could be helpful for auto dealers contemplating incentive programs to reward ownership to key management. Auto dealers can also discover the value drivers of the current appraisal and set goals to enhance value through the improvement of those value drivers over time.5. Potential Sale of DealershipAt some point, successful dealers may reach the point where they contemplate a possible exit event. If there isn’t a viable second generation to continue the operations, a sale of the dealership may be the next best option.The auto dealer industry proved to be resilient and adaptable posting strong profitability for 2020 and continuing into 2021. Industry transaction activity also appears high for both public and private acquirors. Most auto dealers that have owned a dealership for a period of time have likely been contacted at one point or another with some interest either by phone or through the mail.If you have not had a recent business valuation, how can you evaluate any offers or know what your dealership is worth? A business valuation can inform you as to the value of the dealership and manage expectations to assess potential offers.6. Litigation DisputeThe next three events that we will describe all fall under the umbrella of litigation, but each is a unique event.Shareholder DisputesShareholder disputes can come in many forms: breach of contract, wrongful termination, damages, etc. In any of these scenarios, the value of the entire dealership and a specific ownership interest will be contested. A valuation and possibly testimony can assist the attorneys and/or triers of fact determine the outcome of the case. Certain components of an auto dealership’s value, such as Blue Sky Value, can also be critical to the case. Taxation DisputeIf a proper valuation was not utilized in an estate planning transfer or if the valuation is being challenged by the IRS, another form of litigation involving a taxation dispute could arise. These disputes require similar elements as in a shareholder dispute – valuation of the dealership, value of specific ownership interest, and possibly testimony. A unique element of taxation disputes is that generally an expert’s valuation report also serves as their direct testimony should the matter end up in trial. The valuation report must communicate the expert’s methodology and support for their conclusions for the value of the dealership and any applicable discounts such as lack of marketability, lack of voting rights, etc. Family Law DisputeWhile not a popular topic, dealers or their spouses in the midst of divorce would also be in need of a business valuation and potential expert witness services. In a divorce, all of the couple’s assets and liabilities need to be compiled and valued to assist the attorneys and trier of fact in the division of assets and other matters.Some assets, such as bank accounts and real estate, are easier to value. Other assets, such as business assets can be more difficult to value. In the auto dealer universe, these business assets can consist of more than one entity. Many dealerships are organized where the dealership operations and franchise agreements are contained in one entity, while the underlying real estate may be owned by a separate asset holding entity.In this example, both entities would need to be valued and the methodologies to value each are different. Some auto dealers may also own additional entities such as separate repair and body shops or re-insurance companies that also might require a business valuation.ConclusionBusiness valuations are triggered by numerous events. By knowing the events that dictate the need for a valuation, auto dealers can be more educated in the use of these services. As we have previously written, the auto dealer industry is unique to valuation in the methodologies employed, the terminology communicated, and the financial information utilized. When a valuation need arises, auto dealers are best served by someone who is both a valuation expert or an industry expert.Contact a professional at Mercer Capital to assist with you a business valuation or consultation of your auto dealership and related businesses for any of these events or others.1 The lifetime exemption amounts, estate income tax rates, and corporate income tax rates could all be subject to change with the new administration in the White House and change of control in the Legislative Branch. These changes could have a dramatic impact on business valuations and the need for related services.
Value Finally Outperforms Growth After Twelve Year Lull
Value Stocks Are Finally Besting Growth, But Is It Sustainable?
Growth-style investments have outpaced their value counterparts by a considerable margin since the Financial Crisis of 2008 and 2009. Propelled by an 11-year bull market from 2009 to 2020 and additional lift to tech stocks in a work-from-home environment, growth investing dominated value-oriented equities until just a few months ago. Now, the long-running trendline appears to be rolling over.With rapid vaccination rollouts and continued improvements in the global economy, value stocks, which were especially depressed by the pandemic this time last year, have soared relative to growth strategies over the last few months.
If you believe in mean reversion, value’s comeback was inevitable and probably has some room to run. We’ve blogged about this before (Are Value Managers Undervalued?), and while we were a bit premature on the timing (we’re never wrong), it appears that this mean reversion is finally taking place. We don’t know how long this value resurgence will last, but given the duration and magnitude of growth’s prior reign (see first chart above), it’s not unreasonable to assume it could endure for a few more years at least.
On the flip side, growth-oriented investment firms may finally have to deal with poor returns (relative to the market) in addition to prevailing industry headwinds like fee compression and asset outflows to passive products. Most value asset managers have already adapted to this double whammy, so growth firms should prepare for potential AUM losses if we’ve really hit another inflection point in the value versus growth rivalry.
Value firms, on the other hand, are finally starting to shine. After years of outflows and subpar returns, publicly-traded value managers, Gabelli (GBL), Diamond Hill (DHIL), and Pzena (PZN) have significantly outperformed the S&P 500 (navy blue line below) since the vaccine announcement in early November.
[caption id="attachment_36465" align="alignnone" width="800"]Source: S&P Global Market Intelligence[/caption]
This recent outperformance suggests that value’s dominance could persist a few more years if the market is anticipating significantly higher inflows, AUM balances, and ultimately greater revenue and earnings figures in the coming quarters. Increased investor optimism surrounding the share prices of value firms is perhaps the best indication of a value resurgence even if we have only just started seeing that in the actual numbers.
Value firms may finally be enjoying their heyday, but sector risks remain. Much of this resurgence is attributable to continued vaccination rollouts and a swift economic recovery, and any setbacks on either of these fronts could derail value’s recent momentum. Since most U.S. indices are trading close to an all-time high, the market doesn’t seem too worried about this, but last year has shown us how quickly investor sentiment can change. The quest for yield in a zero interest rate environment has also increased demand for value stock dividends, but the recent rise in Treasury yields could curb their relative advantage.
It’s too early to call it a full recovery, given the decade-plus dominance of growth preceding this uptick, but recent progress is promising for the sector. We may again be premature in calling this, but we are taking note of what appears to be an important inflection point for the active management industry.
Building the Future Family Business
Family Business Director is excited to be a sponsor of this week’s Transitions Spring 2021 conference produced by Family Business Magazine. The theme for the conference is “Building the Future Family Business.” The conference offers a wide range of sessions in support of that theme, including (to name just a few):Getting Past the PastDefining the Family for the FutureEffectively Transitioning Your Legacy and WealthNon-Family Executives: When Is the Right Time to Bring Them In?Killing the Goose? How to Avoid Laying a (Golden) EggDriving Diversity and Inclusion in the Family BusinessFamily Business Senior Executive Compensation Study Results
The Transitions conferences are the perfect venue for enterprising families to gather and learn from the experiences of other families who have dealt with (or are currently dealing with) common challenges in a family business. The sessions – led by both family business leaders and subject matter experts – are informative and relevant and cover timely topics. And the opportunity to meet and build connections with other enterprising families is not easily replicated.
We are looking forward to leading a breakout session on Wednesday (12:10-12:50 EDT) on the role of diversification in the family business. As your family thinks about building the future family business, how should the concept of diversification be considered in your planning? We hope to guide an interactive conversation among attendees around the following topics:What is diversification, and what are the benefits of diversification to family businesses?Are there any reasons for family businesses not to diversify?How does diversification affect investment decisions?From whose perspective should diversification be evaluated?How do diversification concerns affect leverage and dividend policy decisions?How does the “meaning” of your family business intersect with diversification decisions?
While COVID appears to be on its way out of our lives, it is still not feasible to host large conferences on an in-person basis. However, the staff at Family Business Magazine have done a great job of providing a virtual conference experience (complete with 1:1 networking opportunities) that promises to replicate some of the best features of in-person events. Plus, you can wear your yoga pants.ConclusionIf you are attending, please look us up and reach out; my colleague Atticus Frank and I would enjoy meeting you and spending a few minutes with you. If you’ve never attended a Transitions event before, this conference will be a great opportunity for you to try it out. We have complimentary registration for the first four individuals who would like to attend. Just shoot us an email at harmst@mercercapital.com and we will hook you up.We look forward to seeing you there!
Chasing Waterfalls: How Volatile Equity Structures Are Changing Returns
Oil and gas asset values have experienced tremendous volatility over the past year. They have almost returned to where they started in 2020. However, most investors have experienced that unpredictable possibility differently than their assets have since they are not actually participating directly in assets. I am not just talking about debt leverage effects here either. Instead, people are investing in an entity that, in turn, owns and operates a group of assets. These equity and entity structures can change volatility exposure depending on how it is constructed. This includes what is known by multiple names, but generally called an equity distribution waterfall. Investopedia defines a distribution waterfall as “a way to allocate investment returns or capital gains among participants of a group or pooled investment.” The operative word there is “allocate.”Distribution waterfalls are mechanisms to allocate not only profit but also risk. Frequently found in joint venture arrangements and other financing structures such as DrillCos, distribution waterfalls have become a popular arrangement in recent years. The possibilities of an equity allocation are technically and practically endless yet generally negotiable. However, they often follow a typical framework. First, there is usually language in agreements for return of capital provisions, often followed by a preferred return provision. Lastly, residual returns are then usually subject to some form of payout split between investors. Some investors provide capital at the outset of the project which is a key economic factor for the distribution waterfall. Other investors provide non-capital contributions such as management expertise, technology, or assets in-kind. These different contributions can be beneficial to the entity by improving capital efficiency, synergizing expertise, creating optionality in varying respects or accelerating development timing.Things get interesting when contributions convert into distributions from a sale or liquidity event. Each investor can have different return profiles depending on the waterfall structure. Incentives can vary too. Sometimes they can be aligned, other times not so much. Take a hypothetical and simplified example; An upstream partnership is formed between an investor with mostly capital and a knowledgeable management team. $10 million of capital is provided to fund the assets in a domestic play with $9 million contributed by the investor and $1 million by the management team. No debt is procured. Each investor agrees that the distribution waterfall will begin with a return of each investor’s capital pro-rata, then secondly earn a 7% preferred return, lastly, residual cash flow is split 70/30. The management team runs the business and is reasonably compensated during this time. In five years, they sell the assets for $13.5 million.[caption id="attachment_36425" align="alignnone" width="777"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption]
The returns for the partners might look something like this:
[caption id="attachment_36429" align="alignnone" width="618"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption]
At first glance, this appears pretty simple. The payout made it only through the first two tiers of the waterfall with no residual cash flow to split in the 70/30 tranche. Everyone makes out the same. However, look at what happens when the total equity returns notch up to say $20 million in that same five-year period in this structure:
[caption id="attachment_36427" align="alignnone" width="640"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption]
Both investors benefit in this scenario, but now the management team (general partner) has much higher relative return metrics relative to its original investment. In fact, they’ve more than doubled the limited partners’ returns from an IRR perspective and had over one turn better from a cash-on-cash perspective. That is great, however, this example assumes strong returns. That has not been the reality for most oil and gas ventures in the past year. What happens when asset values go down?
First, holding periods are sometimes extended if they can be to attempt to ride out the storm. In addition, further investments, and capital expenditures typically get trimmed, which can conserve cash but this can also generate strain on business plans, growth and holding periods leading to disagreements between management and investors on which path to take. Take the same example and assume a $5 million total return pot:
[caption id="attachment_36428" align="alignnone" width="614"]Hypothetical example of the waterfall analysis | Source: Mercer Capital[/caption]
The limited partner in this example has lost 9x as much as the general partner management team because they had that much more to lose. Now, most parties prefer not to absorb that type of loss so what can also happen is the parties can extent holding periods in the hope that the time value optionality can prove fruitful to higher asset values later down the line. This can work, but not always.
The math is relatively straightforward in a liquidity event. But what about transactions that occur prior to a liquidity event? How do you account for the different payoff structures for components of the capital stock?
This is increasingly relevant as liquidity events have been deferred considering market conditions, and management teams are having difficult conversations with sponsors as portfolio companies are being consolidated (often referred to as “SmashCos”). NGP did this last year with some of its portfolio companies. Quantum Energy Partners did this for two of its Haynesville Midstream companies as well.
This brings up a delicate issue of how to re-allocate management’s equity ownership. The payoff structure of the waterfall is critical, as the value of a capital component does not necessarily equal its value under a liquidation scenario today. Just like stock options, certain capital components have optionality that results in incremental value over what is implied by the company’s current value. I have dealt with these option pricing models and scenario analyses, and sometimes they can reflect significant value beyond what a simple waterfall allocation might imply.
What is clear is that returns for the same asset can diverge quickly among different equity classes can end up being dramatically different over the course of an investment. Therefore, how they are set up can heavily influence the sometimes-delicate dance between equity holders. When asset values are high, then tensions among investors tend to ease, but in environments such as what we have seen recently, it can exacerbate them too.
Originally appeared on Forbes.com on March 10, 2021.
Common Valuation Misconceptions About Your RIA
Old Rules of Thumb, Recent Headlines, and the Endowment Effect
As a financial analyst, a CFA charter holder, and a generally reasonable person, I know that Zillow isn’t accurate; but as a homeowner, I can’t help myself. When I am walking around my neighborhood, I always have the Zillow App open, and am speculating about how the “Z-estimate” for my house compares to my neighbors’. And, of course, my house always is better. Why? Because I own it. It’s called the endowment effect. I (as a homeowner) am emotionally biased to believe that something (my house) is valued higher than the market would ascribe, simply because I already own it.And you, the owner of an RIA, may believe your firm is valued higher than the market value too, and old rules of thumb and recent industry headlines amplify the problem.Old Rules of Thumb: Your RIA is Worth 2% of AUMWe have cautioned the use of AUM and Revenue-based multiples before, and an example has proven to be the best way to communicate the unreliability of such metrics. Consider, Firm A and Firm B, which both have the same AUM. Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM.
The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile, but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x—a multiple which is unlikely to be considered reasonable in any market conditions.
Recent Headlines: Your RIA is Worth 10x EBITDADeal activity in the investment management space has been increasing over the last decade as consolidation has increased and outside investors realized the attractiveness of a recurring revenue stream paired with minimal capital investment. But the headlines touting impressive deal multiples really seemed to pick-up in 2019 with Goldman’s acquisition of United Capital. However, most of the acquisitions that warrant headlines are of larger investment managers, which due to their sheer scale, are less risky and therefore warrant a higher multiple.Mixing old rules of thumb, with recent headlines, and the endowment effect typically results in over valuing, which stems from an underestimation of non-systematic risk.Underestimating Non-Systematic RiskMost investment managers understand that their firm, like any publicly traded company in their clients’ portfolios, is exposed to systematic and non-systematic risks. And most seem to understand that investment management firms are subject to certain industry-wide risks such as the move from passive to active investment products and fee compression. But many investment management firms also have significant “firm-specific risks” that make their firm riskier than a much larger investment management firm. Many small to mid-sized investment management firms suffer from client concentrations, aging client bases, unclear succession plans, a lack of scale, and minimal asset growth (absent market appreciation).Unfortunately, understanding the value of your RIA is not as easy as applying a multiple to your AUM or run-rate EBITDA. Value is a factor of cash flow, growth, and risk. We’ve written a lot about investment management firm valuations:RIA Margins – How Does Your Firm’s Margin Affect Its Value?What Are RIA Valuations TodayValuing RIAs
But, don’t hesitate to give us a call if we can be of assistance.
February 2021 SAAR
Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January
As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was. Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices. As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid. Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!
February 2021 SAAR
Several Factors Put Pressure on February SAAR, Contributing to a 5.4% Decline from January
As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was. Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices. As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid. Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!
Under Pressure: Managing Family Business Stress
In this series of posts, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out.
On my first day in the family business, a key manager called me at the end of the day with a fiery introduction, peppering questions on the new guy (rightfully so). I was caught off balance after a long day. I hung up disheveled. Day one… phew.Pressure and stress are often a part of a new, exciting work environment. But I was feeling a different type of heat.I was wading deep into family business waters and I was in it up to my neck. But as comes with running any business, the conversations and problems did not wait at the office for me. Business was the topic of dinner conversations, and it replaced a lot of Netflix binging.There is nothing wrong with working hard on a new venture. Pressure and stress are often a part of a new, exciting work environment. But I was feeling a different type of heat.What any family business director can appreciate is the complexity in cultivating the family enterprise. When I was struggling with expanding our concert business, I was not just stumbling in my job, but a part of me felt I was failing the family. A portion of our family’s wealth, its legacy, and reputation hinged directly on my performance.My mindset, plus the job itself, contributed to my stress levels. After a few months, I was beginning to lose sleep. While we have written an entire book on the top 12 issues that keep family business directors awake at night, the issue here was not something to be analyzed on the balance sheet. It was something more fundamental to my approach to the family enterprise.Three Ways to Promote a Healthy RelationshipAfter this realization, I knew I needed to change my mindset and behavior to return to a good place with my work. Below are three things I did to help foster a healthy relationship with the family business.1) DisengageI don’t mean quit. I mean take a break. Set up specific times to not talk about the business. My wife and I worked to set up ‘”no-work zones” (the master bedroom), and certain times we would not talk about the business, like Saturday mornings (family day) and after 9 pm. This is not just because I was stressed – we would catch ourselves wanting to talk about some big win too. We knew, however, that lowering these boundaries for positive business issues would make it easier to break the rule for bad news, too.2) CommunicateIn my situation, I felt stress mostly from a sense of failing my boss (my father-in-law). I was running an enterprise that affected his capital investment and the name he had built up over the previous 35 years. As we have written previously around tough family business conversations, a good tip is to tackle the conversation head on. I waited too long to take that advice and was stressed longer as a result. When I finally talked to my father-in-law on the issue, he presented our dynamic in a way that was clear, reassuring, and de-stressing. From then on, we kept in closer contact not just on how the business was progressing, but my mindset surrounding our family business dynamics. I felt considerably less stressed on a family level and performed better on a business level.3) Remember the Advantages of Your SituationNot to sound glib, but family business enterprises offer a special opportunity for family members and stakeholders. If you are going to work all day, why not work with people you like? People usually look at me with wide-eyed disbelief but working with my wife was a blast. This is not the case for everyone, but for us it was rewarding.Additionally, the ability to create long-term family wealth and a business culture that reflects your family values are enticing benefits to any job-seeker. The long-term focus of family business presents a model that, despite the “shirtsleeves-to-shirtsleeves” adage, allows family businesses to be more sustainable and longer-lasting than their publicly traded counterparts. From 1955 to 2019, nine out of ten Fortune 500 companies merged, went bankrupt, or contracted to such a degree that they fell from the list. That is a 90% failure rate. Chasing next quarter’s numbers appears not to inculcate long-term sustainability.ConclusionWhile we don’t claim to be psychologists, we do have experience both in family business issues and analyzing them. We often can read between the lines, recognize sensitive areas in a family business structure, and offer advice and structure to avoid stressful pitfalls. Making sure you leave room to breathe, being transparent in your communication, and remembering why you wanted to be a part of your family business can all help to recenter your focus and maintain a healthy family–business dynamic.Give us a call if you think our real-world family business experience can provide a different perspective in your next valuation engagement.
Mineral Aggregator Valuation Multiples Analysis
Market Data as of March 12, 2021
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below. Mineral Aggregator Valuation MultiplesDownload Analysis
2021 RIA Practice Management Insights Conference Recap
We want to thank everyone who attended or participated in our inaugural RIA Practice Management Insightsconference last week. We set out last year to create a conference geared towards the back-of-house issues that are critical to success, but don’t get as much attention as themes like M&A and consolidation at many conferences. To that end, we were fortunate to be able to compile a speaker list full of well-known experts on various practice management topics like firm culture, marketing, managing your tech stack, and more.Our opening keynote was delivered by the legendary Jim Grant of Grant’s Interest Rate Observer, whose presentation traced the origins of central banking from Victorian England through present day, providing a unique perspective on current asset prices. To wrap up the event, we were pleased to have Peter Nesvold of Nesvold Capital Partners deliver our closing keynote focused on the state of the industry and predictions for the future of wealth management.Other speakers included the following:Louis Diamond of Diamond Consultants spoke on advisor recruitment and acquisitions, and how to craft a world-class value proposition and targeting strategies.Matt Crow and Taryn Burgess of Mercer Capital spoke on compensation strategies, and how to best structure your firm’s compensation to recruit and retain talent.Matt Sonnen of PFI Advisors hosted a live recording of the COO Roundtable Podcast featuring guests Kara Armstrong of CapSouth Wealth Management and Nick Maggiulli of Ritzholtz Wealth Management.Kristen Schmidt of RIA Oasis spoke about the importance of your entire tech ecosystem.Matt Crow moderated a panel discussion on creating a collaborative firm culture featuring Terry Igo of SanCap Group, Sonya Mughal of Bailard, and Colin Sharp, the former COO of Riverbridge and now co-founder of Knoxbarret.Megan Carpenter of FiComm Partners spoke on developing a “New Skool” marketing mindset to drive business growth.Brooks Hamner and Zach Milam of Mercer Capital spoke on succession planning for RIAs.Steve Sanduski of Belay Advisor moderated a panel discussion on delivering value that goes beyond products and planning featuring Julie Littlechild of Absolute Engagement and Seth Streeter of Mission Wealth.
Thanks again to everyone who attended and to everyone who helped make the event a success. We plan to publish updates regarding next year's conference as they become available. So, stay tuned and we hope to see you next year!
Q4 2020 Earnings Calls
Sales Return Quicker than SG&A Expenses, But Inventories Continue to Lag Amid Chip Shortages
Fourth quarter earnings calls started similarly to the previous quarter, with significant increases in earnings per share as lower volumes were supported by higher margins and SG&A expense reductions related to personnel and ad spend continue to benefit dealers. Executives generally believe a portion, though not all, of this expense savings will be sustainable. Productivity has increased as employment levels have remained low despite improving activity.Long-term, however, low headcount and insufficient ad spend maybe a drag on incremental sales.February 2021 SAAR was already anticipated to be down from February 2020. February 2020 was the last month prior to the pandemic, did not have supply constraints related to chip shortages, and had a leap day fall on a Saturday.To compound problems, winter storms in certain areas of the country kept more people at home than mask mandates have in recent months. Most earnings calls occurred before the storms or there was little mention of them. AutoNation referenced January volumes in line with projections, affirming their forecast of approximately 16 million for 2021, though there was no discussion of the impact of the winter weather. Sonic indicated the storms closed some stores in their Texas, Birmingham, and Nashville markets, though they anticipate a quick rebound. Total volumes were down 12.6% in February 2021, but declines were closer to 5% after adjusting for selling days. However, we expect to see significant year-over-year improvements as we reach the one-year milestone of the pandemic.The proliferation of SPACs in 2020 and continuing into 2021 has been an interesting byproduct of the pandemic. While this has typically been for more speculative operations including EV startups, an article from Automotive News indicates some franchised dealers are mulling the possibility of accessing public capital markets through a SPAC. LMP Automotive, an ecommerce and facilities-based auto retailer already traded on the NASDAQ, closed on its first wave of auto dealerships on Friday, bringing the publicly traded group to seven. With these acquisitions, LMP will be considered in future earnings calls blogs.On the other hand, the number of public players could well decrease in 2021 as Lithia indicated consolidation amongst the public players may be the best way to ward off competition from used-only players like Carvana. Franchise agreements have long been seen as a hurdle for such significant consolidation, which was downplayed by Lithia. This prompted the question on future calls, and while many anticipate continued consolidation within the industry, Group 1 expressed doubts OEMs would approve such a deal, and AutoNation flat out rejected the notion as they are already the largest public auto dealer.Theme 1: Microchip shortages represent the latest hiccup in dealers’ quest to restore inventory levelsWe sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupWe're quite inventory constrained right now. As you know and we expect the new car inventory situation to continue to be constrained for probably the first half of the year. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveNew vehicle inventory levels remain constrained and we expect demand to exceed supply for an extended period. Given these dynamics, we remain focused on optimizing our business in the current operating environment. We expect industry sales to approach 16 million in 2021 with strong retail sales growth compared to last year. We have seen a solid growth in ‘21, with January trends in line with our annual forecast. - Mike Jackson, Chairman & CEO, AutoNationTheme 2: SG&A to gross profit anticipated to be structurally lower going forward after efficiencies gained during the pandemicSo we have to be below 70% [SG&A as a % of gross profit]. I think to be competitive. I think the world's moved on. So, yes so certainly we would expect to be significantly below a 70% level. As we've mentioned previously, although we do not expect this level to be sustainable, we do expect there to be significant improvement going forward versus pre-COVID levels. - Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveDuring 2020, we took targeted measures to improve operating efficiencies and manage expense throughout our entire organization, fundamentally improving our cost structure. As a result, we achieved all-time record adjusted SG&A expenses as a percentage of gross profit of 68.1% for the fourth quarter of 2020, down 560 basis points from 73.7% in the fourth quarter of 2019. Full year 2020 adjusted SG&A expenses as a percentage of gross profit were 72.9%, 400 basis points better than 2019. For 2021, we expect to continue to see a benefit of our permanent SG&A reductions. - Jeff Dyke, President, Sonic AutomotiveSG&A expense as a percentage of gross profit declined 940 basis points to 69.7% and declined 800 basis points on an adjusted basis to 71.1%. Our success in this area can be attributed to a reduction in T&E, advertising, vehicle maintenance, administrative, personnel and other fixed costs. We estimate that approximately 125 million to 150 million in SG&A costs have been eliminated across our various businesses. - Roger Penske, Chairman & CEO, Penske Automotive GroupWe also remain very active in managing expenses and we achieved SG&A as a percentage of gross profit of 61.4%. Our focus on gross profit and expense management once again produced a great quarter. […] We also changed our production per employee when the downturn hit, and we stayed disciplined with that. […] I think we'll certainly be in a much better position from an SG&A standpoint than we were pre-COVID. But where exactly […] I think there's too many variables to call that right now. “We sat here a quarter ago and thought by the end of the first quarter days’ supply would be back up to normal. But because what's going on with the microchips and some other things, it's probably going to bleed well into the second quarter before inventories gets back. - David Hult, CEO, Asbury Automotive GroupTheme 3: Lithia suggests public consolidation may be beneficial for entrenched franchised players seeking to ward off competition from rapidly growing used competitors. While other players doubt the likelihood of OEM support, industry-wide consolidation is anticipated to continueWe do believe that the best way to combat the entire industry is that the public should roll up, okay? And whether or not that can or can happen, we will tell you this, it's not restricted from framework agreements. We believe that we have strong relationships, and our national limitations in those 3 or 4 manufacturers that do have a ceiling established doesn't preclude us from buying any of the other public or joining forces. I do also like the fact that many of them appear to be replicating some of the strategies that we've been focused on over the last 3 years. And we're pleased to see that because I believe that the new car retailers, if we can cut off the stream of used vehicles to the used car new entrants in the space, and all they can really get is auction cars or late-model cars, the margins that we can make in the over 3- year-old cars are massive that the new car dealers could have a stronghold on the space for decades to come, even if electrification changes thing or connectivity or all the other things that are in all – in the back of all of our minds over the coming quarters, years and decades. - Bryan DeBoer, President, and CEO, Lithia MotorsI think there is a natural consolidation that needs to occur among the U.S. auto retail networks. There are simply too many dealers in many of the brands, not all of them, many of the brands to operate in efficient privately owned distribution network. […] And it's becoming more and more a big player game just because of capital investment and amortizing technology costs and the cost of developing people and things like that. So, I think that trend accelerates and that is the reason that there will be a lot of acquisition opportunities as they have been in the past few years […] And I think that will benefit the remaining larger retail groups. And I think it will benefit the OEMs. And so I think there, we're going to continue to move to an era of bigger partners for the OEMs. And - so I think that is very much a catalyst for these M&A opportunities. Now, the advantages of scale you know it would seem that we're not nearly as big as many other groups, yet we've been able to create a cost structure that's just about as competitive as any. So there is a diminishing point of return on scale, I think but there is a benefit to diversity of markets and brands that we can continue to benefit from. And there is potentially a widening of the gap between the ability to operate efficiently - for a smaller operator compared to a bigger operator. - Earl Hesterberg, President and CEO, Group 1 AutomotiveWhat I have experienced is that when you become as large as we are and you make an acquisition, takes a brand Z and you already own 25 brand Z stores and you want to buy number 26 and number 27, and the negotiation with the manufacturer, they will ask, okay, we will improve number 26 and number 27, but let me tell you what you have to do from store one through 25in order to get approval for the next increment. And if you really add that demand on to what you are acquiring, it really changes the return on investment and so the higher you climb the mountain the more difficult it becomes to keep climbing. […] So, the whole issue of consolidation whether two smaller public traded companies could come together, I can’t say, because I don’t have one of the smaller ones. But I can tell you as far as us acquiring one. I don’t see that’s just going to happen, because you immediately run into a problem of too much density in a given market that you are going to have to divest a significant part of what you just thought, at least that would be for us. So, overlap and too much density in the given market is a real genuine issue for us and so we will not be acquiring any other publicly traded company. I don’t see it pay off to the finish line. - Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
Five Economic Indicators for Family Businesses
Family business directors generally take the long view relative to their publicly traded counterparts, providing a reprieve to constant market updates and daily market volatility. Successful family businesses plan for the next generation, not just the next quarter.However, family businesses cannot simply put their heads down and ignore economic trends outside their family’s industry. Below is a snapshot of five economic indicators we are currently watching for the Family Business Director blog.COVID-19 Cases and VaccinationsCases and hospitalizations continue to decline across the U.S., and as of this writing, 23% of the population over the age of 18 has received at least one dose of a COVID-19 vaccine, with a large portion of vaccines administered to the most at-risk populations.In addition to the vaccine rollout, family business directors should closely monitor local government ordinances and policy shifts as the pandemic (hopefully) subsides. It is critical to communicate with your shareholders about how these changes affect the operations of your family business, especially if dividends or capital expenditure were curtailed during the pandemic.Interest RatesAfter reaching a nadir in August 2020 (0.52%), treasury yields have ticked upward in early 2021, touching over 1.6%, the highest level since February 2020. Yields rise as prices fall, and yields are currently being driven by inflation expectations and business confidence despite Federal Reserve actions. While inflation is a concern, a steepening of the yield curve should be bullish for economic activity, since such changes often prompt a flight from safety and into riskier assets.While we will not opine on where rates are going, we do know that they have an impact on the Three-Legged Stool of Family Business: dividends, capital structure, and asset mix. Higher interest rates lead to higher borrowing costs and increased costs of capital. This can directly impact capital structure and a company’s ability to fund shareholder distributions. Family business directors should look at their credit agreements and decide if now is the time to increase leverage at historically low borrowing costs.Higher interest rates also impact applicable federal rates or AFR. These rates are significant for estate planning because they establish the threshold interest rate for private loans. As we wrote in May, low AFRs present an opportunity to family shareholders in estate planning. The mid-term and long-term rates stand at 0.62% and 1.61%, respectively, for the March 2021 publication. While these are higher than rates observed in 2020, they still represent an opportunity to family businesses.The Labor MarketNonfarm payrolls increased 379,000 in February, compared favorably with expectations of 210,000 new jobs. Matthew C. Klein at Barron’s had a great piece diving into the jobs numbers and highlighted that the numbers were even better than the headline numbers. Unemployment ticked down slightly to 6.2% from 6.3% month-over-month.However, several of our clients have recently highlighted tightening labor market conditions and a difficult hiring environment. In their view, the current stimulus programs have shrunk the labor force, which may cause businesses to use job placement services and temp agencies which tend to push up labor costs. Talks of increasing the federal minimum wage would also affect many family businesses. Directors and managers should take another look at their openings and pay rates to ensure key positions are filled and that labor costs expectations implied in their corporate budgets are realistic.InflationEconomists continue to be divided on the outlook for inflation. CPI readings have marginally crept upward on a backward-looking basis, but key commodities, including oil, lumber, steel, and chemicals, are seeing steeper price appreciation. A recent Wall Street Journal article highlights rising costs for a variety of businesses, including a mattress company, plastic storage box retailer, and furniture manufacturer. Family business directors should analyze not just their key input costs but think about the impact of broader inflation on their businesses (customers, wage rates, product pricing) as well.Sentiment IndicatorsAs had been the case throughout the pandemic, economic opportunities and losses have not been uniform, with some industries and companies thriving while others are on life support. On balance, though, the Conference Board’s “Measure of CEO Confidence” hit a 17-year high in February, as business leaders expect to cut fewer jobs and plan to raise employees’ pay. Consumer confidence also rose across the U.S. in February according to the Conference Board, albeit below lofty readings registered before the pandemic set in during early in 2020.This contrasts sharply with the confidence of small business leaders, measured by the National Federation of Independent Businesses’ Optimism Index. The January reading stood at 95.0, the lowest level since May of 2020. The NFIB cites the fact that smaller businesses have been more drastically impacted by COVID-19 restrictions and policy, as well as generally higher uncertainty than that reported by larger companies. We understand COVID-19 has not been kind to family businesses. From BanyanGlobal Family Business Advisors's latest family business survey: "In the current survey results, 66% of respondents report that the crisis has had a significant or minor negative impact on their business, and 22% report a positive impact."Family business directors do well to keep a close watch on the sentiment and confidence of their suppliers, competitors, and customers as they craft budgets and investment plans for the coming year and communicate expectations to family shareholdersBonus: What We Didn’t CoverYou may have noticed that we did not mention the S&P 500. There are considerably more qualified experts to discuss the markets (Randall Forsyth’s “Up and Down Wall Street” is one of our favorite weekly summaries), but we would remind our readers that the stock market is not the economy. While we are admittedly ‘value-tilted’ in our outlook, most observers would agree that stock market activity reflects a wide range of factors and can change course with little warning. Family business directors may be best served to treat Mr. Market as an acquaintance, not a best friend.ConclusionWhile we do not necessarily recommend keeping CNBC on all day in your office, savvy family business directors would be wise to keep their ear to the ground. Mercer Capital writes quarterly in detail covering numerous indicators, trends, and economic readings (subscription required), and considers this data when working with family business owners. Give us a call if we can help you read the economic tea leaves.
Themes from Q4 2020 Earnings Calls
Mineral Aggregators
Last week, we reviewed the fourth-quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregators' fourth-quarter 2020 earnings calls.Status of M&A Activity Transaction activity was quiet for the majority of 2020 as commodity prices plummeted and companies entered survival mode. Aggregators explained that the bid-ask spread between buyers and sellers was wide throughout the year, but some believe that 2021 will offer a more active M&A environment due to their favorable outlook of an industry recovery.I think what we saw in late '19 and all of '20 is that the sellers, many of whom had acquired their assets in a different commodity environment and more active M&A environment, more expensive M&A environment, frankly. We're not looking to part with those assets in a cheaper, less expensive, less active M&A environment. And so, you just – you had a bit of a mismatch between sellers and buyers who had had their cost of capital beat up pretty hard. – Jeffrey Wood, President & CEO, Black Stone MineralsThe acquisition market was slow in 2020 as sellers did not want to part with assets at low prices, buyers were dealing with the high cost of capital and limited new capital availability and/or unwillingness to take on additional debt. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWhen you look at the buyer and the seller, where you had an unsustainable, for example, commodity price period, it makes it more difficult for either the buyer or the seller to transact. And so that has been an impediment, but I think coming out on the other side of that cycle, having been at a more – a less volatile environment at a more constructive macro environment should be beneficial. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsI think it’s all trending in a rational direction on the M&A front and I expect – not only us but also our other public peers to benefit from that. And then the other thing I’d say is people are getting used to selling for equity. We’re not going to lever up this business. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersRig Count & Production Recovery in SightAggregators were pleased to see a production and rig count recovery in sight. Production curtailments were put in place in response to the challenging price environment beginning in Q2, but many believe that the worst is behind the industry. Production levels remain down year-over-year, but companies are optimistic that they will continue to rise.In the fourth quarter, we began to see a strong recovery in drilling activity on our acreage, with a 30% increase in our rig count, coupled with good sequential improvements in commodity prices and revenue. We are optimistic about 2021 and the continuation of improvements in drilling activity, which is demonstrated by a 14% increase in the Baker Hughes Lower 48 rig count in February 2021 relative to year-end 2020. – Bob Ravnaas, Chairman & CEO, Kimbell Royalty PartnersAs of year-end, there were 38 rigs active on our acreage, and the count has grown to 50 rigs by the end of January. This is above the 29 rigs operating on us at the end of the third quarter, but it's down sharply from activity levels we saw a year ago. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWe saw the rig count in those basins in the mid-500s in February of last year and then saw them decrease to around 150 rigs during the third quarter. In the fourth quarter, we saw a 40% rebound in the rig fleet, followed by a further 15% increase so far in the first quarter of 2021. As a result, we sit today up approximately 70% from the low point, but still around 300 rigs short of February a year ago. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsViper also benefited from third-party operated well performance and timing of wells being turned to production outperforming our prior conservative expectations, which had been lowered due to the uncertainty presented by the volatile oil prices experienced early last year. – Travis Stice, CEO, Viper Energy PartnersAggregators Acting on Priorities Since mid-2020, a central theme of E&P companies and aggregators was to shore up balance sheets. Most aggregators delivered on their deleveraging agenda, whereas others, like Brigham Minerals, had no debt and were able to capitalize on the low-price environment. Aggregators are optimistic that their leverage levels will not be of concern entering the new year.Our first strategic priority was to further strengthen our liquidity and balance sheet position. We moved very early on in the year with aggressive actions to reduce our costs and reduce our debt. Over the course of the year, we paid down a total of $273 million of outstanding borrowings under our credit facility, funded by the proceeds from 2 asset sales that we completed in July, and from retained cash flow. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsThe company paid down $21 million of debt in 2020, and we plan to continue to allocate 25% of cash available for distribution to pay down a portion of our credit facility each quarter. – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty PartnersThe truly unique nature of Viper's business model is highlighted by the fact that during the fourth quarter alone, we were able to declare a $0.14 distribution, repurchase over 2 million units, and repay over $40 million in debt. Over the past nine months, we have now reduced total debt by $110 million or roughly 16% over this period. – Travis Stice, CEO, Viper Energy PartnersIn an entirely differentiated position, Brigham entered this disruption with no debt and flushed with cash. Having lived through tremendous volatility in the past, we were compelled to take bold action to compound value for our shareholders when others could not or did not want to. – Bud Brigham, Founder & Executive Chairman, Brigham MineralsConclusionBud Brigham, Founder and Executive Chairman of Brigham Minerals, summed up the last year in a nutshell on the company’s fourth-quarter earnings call, “The entirety of 2020 was filled with unprecedented volatility, triggered by the COVID-19 pandemic and the OPEC crisis from crude oil pricing to rig counts to frac crews as well as individual company performance. We started 2020 with $60 oil. Amazingly, it briefly went negative, and then oil spent most of the year around $40 to $45 per barrel. Markets have been healing. And today, we sit here with oil above $60 per barrel.” Aggregators seem ready to turn the page and enter 2021 with bullish hopes of a full industry recovery.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership. Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators. Contact a Mercer Capital professional to discuss your needs in confidence.
Mortgage Banking Lagniappe
2020 was a tough year for most of us. Schools and churches closed, sports were cancelled, and many lost their jobs. There were a select few, however, that thrived during 2020. Jeff Bezos and Elon Musk saw a meteoric rise in their personal net worth over the past 12 months. Mortgage bankers are another group showered with unexpected riches last year (and apparently this year).As shown in Figure 1, long-term U.S. Treasury and mortgage rates have been in a long-term secular decline for about four decades. Last year, long-term rates fell to all-time lows because of the COVID induced recession after having declined modestly in 2019 following too much Fed tightening in 2018. The surprise was not an uptick in refinancing activity, but that it was accompanied by a strong purchase market too. Housing was and still is hot; maybe too hot.
Overlaid on the record volume (the Mortgage Bankers of America estimates $3.6 trillion of mortgages were originated in 2020 compared to $2.3 trillion in 2019 and $1.7 trillion in 2017 and 2018) was historically high gain on sale (“GOS”) margins. The industry was capacity constrained after cutting staff in 2018 when rates were then rising.
Private equity and other owners of mortgage companies set their eyes on the public markets after many companies attempted to sell in 2018 with mixed success at best. During the second half of 2020, Rocket Mortgage ($RKT) and Guild Mortgage ($GHLD) made an initial public offering and began trading while seven other nonbank mortgage companies have either filed for an IPO or announced plans to do so. Also, United Wholesale Mortgage ($UWMC) went public by merging with a SPAC.
The inability of several (or more) mortgage companies to undergo an IPO at a price that was acceptable to the sellers has an important message. The industry was accorded a low valuation by Wall Street on presumably peak earnings even though many mortgage companies will produce an ROE that easily exceeds 30%. The assumption is that earnings will decline because rates will rise and/or more capacity will reduce GOS margins.
While it is likely 2020 will represent a cyclical peak, no one knows how steep (or gentle) the descent will be and how deep the trough will be. Mortgage companies may produce 20% or better ROEs for several years. One may question the multiple to place on 2020 earnings, but book value could double in three or four years if conditions remain reasonably favorable.
Community and regional banks with mortgage operations have benefitted from the mortgage boom, too. Although various bank indices were negative for the year, it could have been much worse given investor fears surrounding credit losses and permanent impairment to net interest margins given the collapse in rates. In a sense, outsized mortgage banking revenues funded reserve builds for many banks and masked revenue weakness attributable to falling NIMs.
The average NIM for banks in the U.S. with assets between $300 million and $1 billion as of September 30, 2020 is shown in Figure 2. The NIM fell 45bps from 3Q19 to 3Q20 due to multiple moving pieces but primarily reflected an increase in liquid assets because deposits flooded into the banking system and because the reduction in the yield on loans and securities was greater than the reduction in the cost of funds.
Unless the Fed is able (and willing) to raise short-term policy rates in the next year or two, we suspect loan yields will grind lower as lenders compete heavily for assets with a coupon (i.e., loans) because liquidity yields nothing and bonds yield very little. Deposit costs will not offset because rates are or soon will be near a floor. Fee income and expense management are more critical than ever for banks to maintain acceptable profitability. When analyzing the same group of banks (assets $300M - $1B), banks with higher GOS revenues as a percentage of total revenue tended to be more profitable. As shown in Figure 3, median profitability was ~15% greater in the trailing twelve months for banks more engaged in mortgage activity than those that were not.
Selling long-term fixed-rate mortgages for most banks is a given because the duration of the asset is too long, especially when rates are low. The decision is more nuanced for 15-year mortgages with an average life of perhaps 6-7 years. With loan demand weak and banks extremely liquid, most banks will retain all ARM production and perhaps some 15-year paper as an alternative to investing in MBS because yields on originated paper are much better.
As for 30-year mortgages, net production profits for 3Q20 increased above 200bps according to the MBA for the first time since the MBA began tracking the data in 2008. Originating and selling long-term fixed rate mortgages has been exceptionally profitable in 2020.
Mortgage banking in the form of originations is a highly cyclical business (vs servicing); however, it is a counter-cyclical business that tends to do well when the economy is struggling and therefore core bank profitability is under pressure. We have long been observers of the mortgage banking conundrum of “what is the earnings multiple?” It is a tougher question for an independent mortgage company compared to a bank where the earnings are part of a larger organization. Even when outsized mortgage banking earnings may weigh on a bank’s overall P/E, mortgage earnings can be highly accretive to capital.
In the February issue of Bank Watch, we will explore how to value a mortgage company either as a stand-alone or as a subsidiary or part of a bank to understand in more detail the true valuation impacts of mortgage revenue.
Originally appeared in Mercer Capital’s Bank Watch, January 2021.
Mortgage Banking Lagniappe (Part II)
The January Bank Watch provided an overview of the mortgage industry and its importance in boosting bank earnings in the current low-rate environment. As we discussed, mortgage volume is inversely correlated to interest rates and more volatile than net interest income. In this article, we discuss key considerations in valuing a mortgage company/subsidiary, including how the public markets price them.Valuation ApproachesSimilar to typical bank valuations, there are three approaches to consider when determining the value of a mortgage company/subsidiary: the asset approach, the market approach, and the income approach. However, since the composition of both the balance sheet and income statement differ from banks, several nuances arise.Asset ApproachAsset based valuation methods include those methods that write up (or down) or otherwise adjust the various tangible and/or intangible assets of an enterprise. For a mortgage company, these assets may include mortgage servicing rights (“MSR”). The fair value of the MSR book is the net present value of servicing revenue minus related expenses, giving consideration to prepayment speeds, float, and servicing advances. MSR fair value tends to move opposite to origination volume. For example, MSR values tend to increase in periods marked by low origination activity. Other key items to consider include any non-MSR intangible assets, proprietary technology, funding, relationships with originators and referral sources, and the existence of any excess equity.Market Approach Marketmethods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Historically, publicly traded pure-play mortgage companies were a rare breed; however, the COVID-19 mortgage boom has produced several IPOs, and others may follow. There are many publicly traded banks that derive significant revenues from mortgage operations, especially in this low-rate environment.The basic method utilized under the market approach is the guideline public company or guideline transactions method. The most commonly used version of the guideline company method develops a price/earnings (P/E) ratio with which to capitalize net income. If the public company group is sufficiently homogeneous with respect to the companies selected and their financial performance, an average or median P/E ratio may be calculated as representative of the group. Other activity-based valuation metrics for the mortgage industry include EBITDA, revenues, or originations.Another relevant indicator includes price/tangible book value as investors tend to treat tangible book value as a proxy for the institution’s earnings capabilities. The key to this method lies in finding comparable companies with a similar revenue mix (high fee income) and profitability.When examining the public markets, there are generally two types of companies that can be useful in gathering financial and valuation data: banks emphasizing mortgage activities and non-bank mortgage companies.Group 1: Banks with Mortgage Revenue EmphasisFigure 1 details the first step in identifying a group of banks with significant mortgage operations. First, financial data from the most recently available quarter (4Q20) regarding banks with assets between $1 billion and $20 billion were identified. Once that broad group of banks is identified, it is then important to segment the group further to identify those with significant gain on loan sales as a proportion of revenue and particularly those with higher than typical mortgage revenues/originations as opposed to SBA or PPP loan originations.Group 2: Non-Bank Mortgage CompaniesNon-bank mortgage companies found favor with the public markets in 2020 as beneficiaries of the sharp reduction in mortgage rates. In 2021 investor sentiment has faltered due to the impact of rising long-term rates on consensus earning estimates. Several companies undertook IPOs, while another company went public via merging with a SPAC. This expanded the group of non-bank mortgage companies from which to derive valuation multiples and benchmarking information. Figure 2 includes total return data for non-bank mortgage companies.
Notable transactions include the following: Rocket Mortgage (NYSE: RKT) raised $1.8 billion via an IPO at an approximate $36 billion valuation in August; Guild Holdings (NASDAQ: GHLD) raised ~$98 million in a November IPO; United Wholesale Mortgage (NYSE: UWM) went public in the largest SPAC deal in history (~$16 billion) that closed in 2021; and Loan Depot (NYSE: LDI) went public during February by raising $54 million.
Other pending IPOs based upon public S-1 filings include Caliber Home Loans and Better.com. Amerihome Mortgage Company had filed a registration statement but apparently obtained better pricing through an acquisition by Western Alliance Bancorp (NYSE: WAL) during February that was valued at ~ $1.0 billion at announcement, or about 1.4x the company’s tangible book value.
While this activity is positive for mortgage companies, the IPOs were downsized in terms of the number of shares sold with pricing below the initial target range or at the low end of the range as investors hedged how far and how fast earnings could fall in a rising rate environment.
For guideline M&A transactions, the data is often limited as there may only be a handful of transactions in a given year and even fewer with reported deal values and pricing multiples. However, meaningful data can sometimes be derived from announced transactions with transparent pricing and valuation metrics.
After deriving the “core” earnings estimate for the mortgage company as well as reasonable valuation multiples, other key valuation elements to consider include: any excess equity, mortgage servicing rights, unique technology solutions that differentiate the company, origination mix (refi vs. purchase; retail vs. correspondent or wholesale), geographic footprint of originations/ locations, and risk profile of the balance sheet and originations (for example, agency vs. non-agency loans).
Income ApproachValuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. For banks, the discounted cash flow (“DCF”) method can be a useful indication of value due to the availability and reliability of bank forecast/capital plans. However, due to the volatile and unpredictable nature of mortgage earnings, this method faces challenges when applied to a mortgage company. In certain situations, the DCF method may not be utilized due to uncertainties regarding the earnings outlook. In others, the DCF method may be applied with the subject company’s level of mortgage origination activity tied to a forecast for overall industry originations and historical gain on sale margins.Given the potentially limited comparable company data and the difficulty associated with developing a long-term forecast for a DCF analysis, the single period income capitalization method may be useful.This method involves determining an ongoing level of earnings for the company, usually by estimating an ongoing level of mortgage origination activity and a pretax margin and capitalizing it with a “cap rate”. The cap rate is a function of a perpetual earnings growth rate and a discount rate that is correlated with the entity’s risk. Whereas we would likely use recent earnings in the market approach, in the income capitalization method it makes sense to normalize earnings using a longer-term average, which considers origination and margin levels over an entire mortgage operating cycle.Mortgage earnings and margins are cyclical. Due to the volatile nature of mortgage earnings, a higher discount rate is normally used. Therefore, a mortgage company’s earnings typically receive a lower multiple than a bank’s more stable earnings.ConclusionA mortgage subsidiary can be a beneficial tool for community banks to increase earnings and diversify revenue. This strategy, while clearly beneficial now, can be utilized throughout the business cycle. As rates fall and net interest income faces pressure, gains on the sale of loans should increase (and vice versa) to create counter-cyclical revenues. As we’ve discussed, the inherently volatile income from a mortgage subsidiary is not usually treated equally to net interest income in the public markets. Although, when it comes to price/tangible book value multiples, profitability is critical whether it is driven by mortgage activity or not. There are many factors to consider in valuing a mortgage company.If you are considering this line of business to diversify your bank or desire a valuation of a mortgage operation, feel free to reach out for further discussion.Originally appeared in Mercer Capital’s Bank Watch, February 2021.
Themes from Q4 2020 Earnings Calls
E&P Operators
As discussed in our recent blog post regarding tempered mineral and royalty valuations despite recent oil price gains, sentiment towards the oil & gas sector turned bullish as the fourth quarter progressed, with WTI crude spot prices surpassing $40/barrel and – more importantly – generally staying the course on an upward trajectory to close out the year. Over the fourth quarter, WTI spot prices rose 21% from $40.05/barrel at the close of September 30 to $48.35/barrel at December 31. Similarly, Brent spot prices increased 27% from $40.30/barrel to $51.22/barrel over the fourth quarter.One key factor supporting this price appreciation was OPEC’s decision to not flood the global market with crude oil. The election in November concluded with the election of Biden to the White House, a Democratic majority in the House, and uncertainty in the Senate as Georgia would have runoff elections in early January with its two seats – both held by Republican candidates – challenged by Democratic candidates.Despite little indication as to what, precisely, the legislative branch would look like following the Georgia Senate runoff elections, the national election results up to that point made it clear that the oil & gas industry would most likely face headwinds from Washington D.C. with respect to industry operations. Energy prices, however, did not seem to reflect a change in course either way. In this post, we capture the key takeaways from fourth quarter 2020 earnings calls from E&P operators.Heightened Caution Regarding Price VolatilityThroughout the earnings calls, the absence of COVID-19 as a factor of uncertainty was particularly striking. The majority of references to the pandemic were in passing, usually to provide context of the operational status in the fourth quarter 2020 relative to the same period in the prior year. Only one company executive, Harold Hamm of Continental, directly cited the role of public optimism regarding vaccinations as a driving factor behind the recent rebalancing of global crude oil inventories.It appears as though the impact of the COVID pandemic on energy demand is no longer considered as much of a wildcard in E&P operators’ forecasts as it was earlier in the year.While the pandemic is no longer a surprise, with operators fairly optimistic about short-term (1 to 3 years) projections, there is still the poignant memory of crude oil futures prices dipping into negative territory nearly a year ago. Yes, it has almost been a year already. The memory is indeed still very fresh, and operators are looking to protect themselves accordingly, whether via hedging or with greater conservatism regarding return of capital to shareholders by way of dividends.“Our hedge book really helps on just the comfort and confidence and what these cash flows look like for the next several years with approximately 90% [of volumes hedged] in 2021. We already have a material position in 2022. And then if you look at 2023 and 2024, it's getting close to almost being 50% hedged…”–Don Rush, CFO, CNX Resources Corp.“Historically, [Occidental Petroleum has not] regularly engaged in hedging, preferring to realize the prices over the cycle, that delivers the most buyer shareholders. But we did…take on an oil hedge in 2020 that had a collar in 2020, but then it also had a call provision in 2021.”–Rob Peterson, CFO, Occidental Petroleum Corp.“[We are] sticking with our priorities of managing capital expenditures supportive [of a] flatter production profile, then combined with protective hedges allows for maximum free cash flow generation, strong liquidity and debt reduction in long-term price recovery...”–Roger Jenkins, CEO, Murphy Oil Corp.“Our primary focus will be debt pay down, but we are also focused on the eventual reinstating of our dividend… At this time, we would like to build more protection against price volatility by paying down debt, but our management and the board are aligned in wanting to see the return of a sustainable and growing dividend sometime in the near future.”–John Hart, CFO, Continental Resources, Inc.Positive Free Cash Flow Despite the price volatility leading up to the fourth quarter, many operators either posted annual free cash flows well in advance of projections, or at least finished 2020 on a positive note.“2020 marked the most successful year we've seen as an E&P and, frankly, as a public company going back to the late 1990s, as measured by free cash flow…Our original guidance for 2020 free cash flow is around $135 million, compared to over the $356 million that we actually posted.”–Nick Deluliis, President & CEO, CNX Resources Corp.“Our fifth consecutive year of free cash flow, we said, we'd generate $200 million. We generated nearly 40% more, $275 million.”–William Berry, CEO, Continental Resources, Inc.“Even as activity levels increased in the fourth quarter and we returned to paying deferred dividends and cash, we still generated approximately $800 million of free cash flow…”–Rob Peterson, CFO, Occidental Petroleum Corp.“Free cash flow during the quarter was $155 million.” –Glen Warren, Jr., Antero Resources Corp.ESGCompared to our review of themes in the third quarter E&P earnings calls, the fourth quarter earnings calls had a bit more discussion concerning ESG initiatives, including plans of action beyond “we expect to publish our ESG plan soon.”“Our enhanced oil recovery projects [have] turned into an ability for us to create a new business that not only will add additional value for our shareholders over time but reduces emissions in the world. We'll be the leaders in helping to test direct air capture technology, put it in place, make it operational and commercial, and that will provide an opportunity for others to expand it in the world.”–Vicki Hollub, President & CEO, Occidental Petroleum Corp.“From a big picture perspective, if you look at sustainability and ESG…we translate what that means into really three crucial legs. One, you got to be transparent… Two, tangible, okay, these things, these targets, these metrics need to be measured. They need to be tangible. Like what did we actually deliver on? And then the third piece of this is actions, right. I think it's pretty simple across those three, but despite all the talk and the volume of stuff that's being bantered about across those metrics, I think those three things are lacking quite a bit. We want to be in the camp of, ‘Hey, here's what we're going to do, transparently. Here's what we're going to measure and accomplish tangibly. And then here's what our actions were that were consistent with those two things.’” –Nick Deluliis, President & CEO, CNX Resources Corp.“Our operations team continues work on minimizing our environmental impact such as building a new produced water handling system, as well as utilizing bi-fuel hydraulic frac spreads on all well completions in Canada, which results in considerable CO2 emissions reductions. While smaller changes individually, they add up to a larger impact over time.” –Roger Jenkins, CEO, Murphy Oil Corp.On the HorizonThroughout 2020, the oil and gas sector was rife with uncertainty regarding the COVID pandemic and its short- and long-term impacts on the energy markets. From some perspectives, there were 47 E&P operator bankruptcy filings in 2020. The worst year in the past 5 years in terms of the number of E&P operator bankruptcy filings was 2016, with 70 filings. However, some E&P operators proved that operational and capital discipline could still result in free cash flow sufficient to reduce debt and return capital to shareholders.Despite the upward trend in crude oil and natural gas strip prices in the fourth quarter and generally favorable sentiment that the trend would likely continue into and through 2021, there was very little commentary on expectations of increasing rig activity.Perhaps more surprisingly, and with the exception of Murphy Oil’s earnings call, there was also not much discussion regarding the Biden-Harris administration and its actions and intentions, which generally provide for stronger headwinds coming from Washington D.C. than what the industry has been used to over the prior four years.We expect a clearer picture of E&P operators’ perspectives regarding future changes in the “boots on the ground” and regulatory environment in our next review of first-quarter 2021 earnings call themes.For more information or to discuss a valuation or transaction issues in confidence, please contact us.
The Three-Legged Stool of Family Business
Our family business advisory practice is focused on three strategic financial questions that weigh on family business directors and can keep them awake at night.In no particular order, the three questions are:1. What is the right dividend policy for our family business?We define dividend policy broadly, encompassing both how family businesses pay regular and special dividends and how they craft shareholder redemption programs.2. What is the right family business capital structure?Every family business has a capital structure, whether it is the product of intention or inattention. Capital structure for family businesses often reflects both business fundamentals and family risk tolerances and history.3. What is the right asset mix for our family business?Answering this question requires careful analysis of company strategy, how potential projects are identified, and the use of cash flow projections.Clients often solicit our advice because they are struggling with one of these questions. But, in our experience, the questions can’t really be tackled in isolation. Each question comprises one leg of the three-legged stool of the family business. As an engineering-minded client recently pointed out to us, while it is impossible for a three-legged stool to wobble, it can be crooked. If the three legs are not designed to work together, the stool won’t be level, and won’t hold anything valuable for long.We would like to use the following image to show how the three legs of the stool relate to one another.Relationship between Dividend Policy and Capital StructureWhether through dividends or share redemptions, returning capital to shareholders affects the capital structure of the family business. This is true if dividends are paid out of operating cash flow, or if a special dividend or redemption is paid out of incremental borrowings. As a result, dividend and redemption decisions cannot be made apart from capital structure decisions. This requires family shareholders to think through the inherent tradeoffs that often arise between the desire for more substantial dividends and a preference that the family business be conservatively financed.Relationship between Capital Structure and Capital BudgetingThe mix of debt and equity financing employed by the family business influences the weighted average cost of capital, which serves as the foundation for hurdle rates used in capital budgeting analyses. Setting the appropriate hurdle rate for capital investment requires more than a little finesse on the part of family business directors. Set the rate too high, and the growth of the family business may be stifled as the company continually loses out on investment opportunities to more aggressive bidders. If the hurdle rate is too low, the family business will be willing to make capital investments when returning capital to family shareholders would be the more prudent choice. A too-low hurdle rate can become a self-fulfilling prophecy, pulling down shareholder returns over time through over-investment in the business.Relationship between Capital Budgeting and Dividend PolicyShareholder returns come from two, and only two, sources: dividend yield and capital appreciation (i.e., growth in share price over time). While it may be only natural for family shareholders to want to maximize both sources of return, funds distributed as dividends or used for share redemptions are not available to finance capital investments that support future increases in share price. This tradeoff is unavoidable and suggests that dividend policy cannot be established in isolation from the investment opportunities available to the family business. Finding the right mix of dividends and reinvestment for future growth requires balancing what are often the competing claims and needs of different generations within the family, or even among different branches of the same generation.Keeping the Stool LevelNo, a three-legged stool will never wobble, but it won’t necessarily be level, either. No one would set an irreplaceable family heirloom on a stool that isn’t level. You can only keep the stool level if all three legs are working together.ConclusionWe assist our family business clients in making sure all three legs are working together by helping directors identify what the business means to the family, benchmarking key metrics to relevant peers, and improving shareholder communications.Give one of our senior professionals a call today to discuss how we can help secure a sustainable future for your family business.
January 2021 SAAR
SAAR Hit Highest Levels Since the Pandemic Began, but Several Factors Could Hinder February’s Growth Prospects
January 2021 SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) increased to 16.6 million from 16.2 million in December. Though this is a decline of 1.4% from the same period last year, this is the highest that SAAR has been since the pandemic began. Light truck sales were behind this growth, as they captured 77.8% of all new vehicles sold in the past month. Below is a full breakdown of vehicles sold by type for the month.
[caption id="attachment_36204" align="alignnone" width="940"]Source: NADA[/caption]
The year began with some inventory constraints (down 20% from January 2020), and as such, manufacturers have not had to spend as much on incentives such as those that were offered at the beginning of the pandemic. According to JD Power, the average incentive from manufacturers on new vehicles is on pace to be $3,639 per vehicle, a decrease of $510 from a year ago. Furthermore, lean inventories mean that cars are spending less time on the lots.The average number of days a new vehicle sits on a dealer's lot before being sold is expected to fall to 51 days, down from 70 days from last year. Average transaction prices, according to JD Power, are expected to be up 8.4% compared with January 2020.Thomas King, president of the data and analytics division at JD Power noted this about January SAAR: “January continues the strong performance observed in Q4 of 2020 and points to a positive outlook for the balance of 2021. The growth in retail sales is encouraging, especially as it is being achieved with higher transaction prices and lower incentive levels. While retail demand remains strong, non-retail sales are still recovering, which is hampering total vehicle sales and SAAR.”As King noted, fleet sales are continuing to struggle as widespread travel is still down due to the COVID-19 pandemic. According to Ward Intelligence, retail sales are estimated to have increased by 7% from January 2020, as fleet sales dropped by 24%. Retail sales have been up year over year in four of the last five months, while fleet sales have declined for 13 straight months. For SAAR to fully recover, it might depend on a reverse in these declines. With vaccines being distributed, consumers may have renewed sense of confidence in their travels and could bring back demand.With February’s SAAR release coming in the next few days, there are already some insightful forecasts available for where the numbers will fall. Cox Automotive is anticipating February's sales pace to reach nearly 16.3 million, down from January’s 16.6 million pace. Despite this projected decline, the circumstances in February could have made things much worse. The two most significant events being the chip shortage and the winter storms through Texas and the South.Global Chip Shortage Continues As recently mentioned on this blog, the chip shortage is a pervasive issue for auto dealers going forward. According to LMC Automotive, the global chip shortage is expected to reduce North American production by some 230,000 units in the first quarter. For perspective, multiplying this by 4 for a simple annualization would reduce 2021 volumes by nearly 1 million. Consulting firm AlixPartners expects the shortage will cut $60.6 billion in revenue from the global automotive industry. Different manufacturers are anticipating different levels of impact (see table below).
This is an unfortunate situation, as many dealerships were counting on inventory recovery in 2021 to help boost sales, and the full extent of the situation is still unknown. As we’ll note in next week’s post, public auto dealer execs continue to kick the inventory stabilization expectations can down the road now to mid-2021. With the February SAAR release on the horizon, those numbers may shed more light on this ongoing situation.
Storms Ahead for February SAAR (Literally)The event that might have the most immediate impact on February SAAR is the winter storm that went through Texas and the South between February 13–17. I’m based in Mercer Capital’s Dallas office and during that time we had no choice but to work remotely (the pandemic has given us lots of practice with remote working). Some of my coworkers were without power and water for days, sending videos of water pipes bursting in apartment buildings around them. Luckily, I only lost water for one day and my biggest tribulation of the week was forgetting to buy groceries before the storm and as a result, walking 2 miles to an open taco store and buying 15 to last me for a few days. Many were not so lucky, and we hope that everyone is recovering and getting back to normal from that time period.As a result of the storm, the concerns of most people across the state were around making sure they had food, water, and energy, and probably not trying to get out and buy a new car. This week of “shut down” may have an impact on overall February SAAR. However, as Texas and the rest of the south continues to thaw, the industry is anticipated to recover, though, in some areas, infrastructure damage and continuing water scarcity could depress some Texas markets for days to come.However, there may be a silver lining for Ford dealerships. Ford confirmed that it had seen an 18% spike in online searches for the F-150 during the power and water crisis in Texas. What could be driving these searches? News broke that Texas truck owners were using the generators on F-150s to heat homes. As one 2021 F-150 hybrid owner stated, “You’re living your life normally, and all of a sudden, you’re thrust into the dark… I think it got around 9 degrees. It’s been in mid-20s and low 30s. You don’t expect that in south Texas. You don’t expect to lose power when we have nuclear, natural gas, wind, and solar power. The truck gave us light at night, TV access to catch the news and weather. It helped give us a little bit of heat and a good pot of coffee.”Furthermore, Ford sent letters to its Texas dealers encouraging them to use the hybrid trucks as needed. "Due to the urgent and unprecedented weather situation in Texas, a number of our local dealers are using all-new Ford 150s equipped with Pro Power Onboard to help in their communities. Approximately 415 trucks fall within this effort. We're proud to pitch in to help Texas in this time of need." Mike Levine, Ford North American product communications manager said.We hope that this post finds everyone affected by the winter storms safe and with power and water, and that March has better weather in store. If you have any questions about SAAR and what it might mean for your dealership, feel free to contact any of the professionals on the auto dealer team at Mercer Capital.
Mercer Capital’s Value Matters® 2021-03
Charting the Course of the Build Back Better Bill
Failing to Plan Is Planning to Fail
Just Because Everyone Else Is Doing It, Doesn’t Mean You Should Ignore Succession Planning
Next week, during the inaugural RIA Practice Management Insights conference, we will set aside some time to answer your questions about succession planning. Roughly two-thirds of RIAs are still owned by their founders, and only a quarter of those have non-founding shareholders. We won’t solve all the pieces to the succession planning puzzle in our session, but we’ll address succession planning strategies, and what works best under different circumstances.We’ll cover some of these in more detail next week, but here’s a preview of our thinking about various succession planning (and exit) options.Sale to a Strategic BuyerIn all likelihood, the strategic buyer is another RIA, but it could be any financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario sometimes makes the most economic sense, but it does not afford selling principals much control over what happens to their employees or to the company’s name.Sale to a Consolidator or Roll-up FirmThese acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a Financial Buyer This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or Permanent) CapitalMost permanent capital investors are family offices, or investment firms backed by insurance companies, that make minority investments in RIAs either as a common equity stake or revenue share. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option is not always as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal Transition to the Next Generation of Firm Leadership Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes a lot of time and at least some seller-financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in one transaction. Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo DealMany sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered.If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. Let us know what questions you have at the conference next week.Only 1 WEEK until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?
Define Your Values: Aligning Your Family Goals with Business Objectives
In this series of posts, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out.What Do We Want To Be When We Grow Up?My father-in-law, my wife, our family business consultant (my wife’s uncle), and I met almost every Tuesday for breakfast while I worked in the family business. We would eat then get to business: put out fires, analyze metrics, and identify problems and opportunities. This exercise, popularized by Michael Gerber’s TheE-Myth, would be called working in the business. Stuff to keep the wheels churning, sales coming in, and keep the lights on. But this morning we were going to work on the business. Not just the business, but the ‘family’ part of that business.The waitress brought an entire carafe of coffee, and my father-in-law and his brother an entire pitcher of unsweetened tea. Maybe they sensed we would be there a while.We frequently had these conversations, even before I joined the family enterprise. Why? We were attempting to align our business aspirations with our family goals. What type of company did we want to run? What size business did we dream of operating? How fast did we want to scale? Who’s on the bus?As Travis Harms of Mercer Capital has written previously, the meaning of a family business is a function of both family and business characteristics. The meaning of the family business, in turn, influences the dividends, investing, and financing decisions of the company. What our family values are will define our business.Some may say “Why bother?, Why not just run, run, run in the business? Revenue cures all ills!”According to a Harvard Business Review article, some 70% of family-owned businesses fail or are sold before the second generation gets a chance to take over. Perhaps there is more to family business sustainability than just beating next quarter’s estimates.What our family was doing, collaboratively, was nurturing a business culture conducive to our family’s values, and one that meets a key objective: family wealth continuation.“Shirtsleeves to shirtsleeves in three generations" is an oft-quoted adage warning of the typical rise and fall of family wealth. “Family wealth is not self-perpetuating” is the very first sentence of Family Wealth: Keeping It in the Family by James Hughes Jr., a sixth-generation counselor-at-law, and astute family wealth preservation expert. Or in modified Yogi-ism: What is the quickest way to get one million dollars? Run a family business and start with two million.How does someone align the goals of the family with their business? Here are a few practices I picked up in my family’s business, and ones we still practice.Understand Your Family’s ValuesWhat does your family value? What gets people up in the morning? Make sure you are having conversations within the family to determine what drives your family’s bus and where you want to go. Do not just assume because you are driven by landing the next big client or profit chasing that the next generation will be also. Entrepreneurship generally is not passed through the bloodstream. Remember, if your goal is family business continuity, crafting a value structure that reflects both incumbent leadership and future leaders in your family is essential.A value that was important to our family business was to work hard and have fun. Simple and perhaps hackneyed, but we worked intentionally to live it out. After a long few weeks on an acquisition, my wife and I were in the office on a Sunday afternoon as the closing approached. We had been working when my father-in-law walked over and said “Let’s go rent jet skis.” He knew that while we could have kept working, making sure we break away to enjoy ourselves was equally important.Work On the Family, Not Just In the BusinessAn article that has made a lasting impact on my outlook came from an opinion piece in the New York Times: The Myth of Quality Time. The author makes the case that we cannot capture deep familial bonds and friendships in a quick outing or weekend-sized bite. The "quantity" of our time, as opposed to "quality," is what spurs connection and deep friendships.The same lesson applies to our family businesses. Working on our family values and understanding what the family stakeholders deeply want and need does not come from a weekend skiing in Beaver Creek (I really wish it did). Continuously and frequently having conversations about family values and where the business is going allows for easier shifts when you steer off course or want to change directions. Think like a cruise ship: the captain will start making turns miles away from shore before coming into port. If you are trying to turn close to land, you are too late.Be RealisticA well-respected founder of a wealth management firm and friend offers a key principle regarding his firm’s investment strategy: Don’t Eat the Goose! What he warns his clients about is the excesses of greed and taking just a little too much from "the Goose" (or their diversified dividend paying portfolios).For family businesses, while we want to ensure family values and objectives are aligned, we also need to consider the effect on business operations and business continuity. Perhaps you run a small local phone company that generates $250,000 in free cash flow annually. Your son, however, after spending time in Silicon Valley, has the idea to start-up a streaming-entertainment business utilizing the family business's cash flows. Making sure to hear and understand the values of family stakeholders and their dreams, while also being realistic, could help you to craft a strategy workable to both the family business and value structure for the long haul.ConclusionWhile aligning family and business objectives can seem daunting, or even counter-intuitive, we know there are numerous multi-generation family businesses throughout the United States with wide ranges of family stakeholders. We are fortunate enough to get to work with many of them daily and learn from them. Understanding your family’s values, maintaining a healthy process of inculcating these values on your organization, and keeping your feet on the ground can all help to align your business goals with your family goals. Mercer Capital professionals can help you think about your family business' next move. Feel free to give us a call.
Held by Production
Oftentimes differences are a matter of perspective. Put another way – one person’s loss can be another person’s gain. One of the thematic differences between producers and mineral owners is their perspective on “Held By Production.” It elicits very different reactions depending on what side of the term one is on, and has a leverageable impact on value. With rig counts dropping to around half of last year’s count, how much acreage will be available for re-leasing this year? In this post, we decided to spend some time exploring this concept and its impact on the energy industry.What Is Held By Production?Held By Production (“HBP”) is a mineral lease provision that extends the right to operate a lease as long as the property produces a minimum quantity of oil and gas. The definition of HBP varies contractually by every lease it governs which is often misunderstood. We have had discussions with several people, including peers (as well as knowledgeable industry participants) who did not have a clear grasp of HBP and its exact meaning. Some people thought HBP was governed by state law, regulatory agencies, or even accounting rules. However, the truth is that the facts and circumstances that shape a lease as it pertains to HBP, are all negotiable. Therefore, by extension, the outcome of lease negotiations can have a spectrum of results: from being deemed balanced, to favoring the lessor (i.e., the mineral owner) or the lessee (i.e., the producer).
A large percentage of public company leases are HBP. In prior management calls, management teams have noted that the Permian Basin was about 95% HBP due to decades of prior drilling. Why might someone be more attracted to an operator’s stock that has a large percentage of leases HBP? Investopedia puts it this way:The “held by production” provision enables energy companies to avoid renegotiating leases upon the expiry of the initial term. This results in considerable savings to them, particularly in geographical areas that have become “hot” due to prolific output from oil and gas wells. With property prices in such areas generally on an upward trend, leaseholders would demand significantly higher prices to renegotiate leases.What Does the Term "Held By Production” Mean to Mineral Owners (Lessors)?Mineral owners should have an understanding of how their lease terms impact drilling activity (and by extension – royalty payments) on their properties. Lessors are challenging operators’ decisions not to drill on their land, even if prospects appear to be good. As a result, mineral owners are more interested in how certain clauses and term structures function in their leases.Therefore, it is important for mineral owners to understand two lynchpin concepts as they pertain to defining HBP: the Pugh Clause and the Implied Covenant to Develop.Pugh ClauseThe Pugh Clause is named after Lawrence Pugh, a Crowley, Louisiana attorney who developed the clause in 1947, apparently in response to the Hunter v. Shell Oil Co., 211 La. 893 (1947). In this case, the Louisiana Supreme Court held that production from a unit, including a portion of a leased tract, will maintain the lease in force as to all lands covered by the lease even if they are not contiguous.
This clause is most often cited today in pooling for horizontal wells. There have been situations (depending on the clause’s language) whereby one well might maintain a large area (thousands of acres) defined as HBP. This is to an operator’s advantage and a mineral holder’s chagrin.
However, this can be negotiated in the mineral holder’s favor – particularly in active markets and basins. For example, a few years ago Mercer Capital had a client that had a large tract of land in the Eagle Ford Shale and was being courted by many eager operators. Ultimately, they negotiated a lease with an operator who contractually obligated the company to drill three wells per year on the property for the duration of the lease. Not too long after the lease was negotiated, the price of oil dropped in half and the operator was much less enthusiastic about having to drill three wells per year.
There are several nuances and factors to Pugh clauses (and similar lease clauses) that we won’t explore here, but suffice to say, it is a critical factor to defining a property as HBP or not.Implied Covenant to DevelopAnother aspect of lease law is centered around the concept called “Implied Covenant to Develop.” Sometimes a lessors’ alternative is to attempt to find remedy through the implied obligation that the lessee failed to develop and operate the property as a reasonably prudent operator. Forcing an implied obligation generally occurs through a lawsuit and is difficult to prove. However, implied covenants have been addressed by courts from all producing states as well as the Supreme Court of the United States.There are several potential examples. One example is discussed in this Gas & Oil Law blog.Consider an oil and gas lease taken on 200 acres. Let’s say that thirty years ago one well was drilled on the 200-acre lease and that this well unit only included 40 acres. Under the implied covenant to reasonably develop, a judge may very well cancel the lease to the remaining, unused 160 acres (200 acres – 40 acres = 160 acres). How could a judge do that? The basic question that needs to be answered is whether or not the oil and gas producer has behaved as a reasonable oil and gas producer would in similar circumstances. If any reasonable producer would have drilled more than one well on the 200-acre lease, then a reviewing judge might void the lease to the remaining 160 acres. However, if the existing well was not a very good well, then it might be that the producer did behave reasonably when they decided not to drill additional wells.ConclusionDepending on which side of the negotiation one is on, HBP can be a favorable (or unfavorable) contributor to value. As such, it is crucial to have an analyst who possesses knowledge from all sides of industry negotiations.Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.
Seven Factors of a Highly Effective Buy-Sell Agreement for Auto Dealerships
A Roadmap to the Valuation Process
A few of our recent auto dealership valuation engagements have involved disagreements among family members and the next generation or what might otherwise be termed a business divorce. Inevitably, one of the first questions I always ask "Is there a buy-sell agreement or governance document that will provide a roadmap into the valuation of the business and the respective subject interests?" Often the answer is "I’m not sure, I don’t know, or maybe but we haven’t reviewed it in some time."We’ve also encountered plenty of examples where these documents exist, but they are either poorly written, do not contain the necessary information, or have not been contemplated in many years since the drafting of the document. In Stephen Covey’s popular management book, he discussed the seven habits of highly effective people. In this post, we cover seven factors of a highly effective buy-sell agreement for auto dealerships and also touch on several other considerations.1) Standard of ValueThe standard of value establishes the parameters for how the auto dealership will be valued. It should be clearly defined and give clear indications for how the participants in a hypothetical transaction should be viewed: buyer, seller, motivations, knowledge of facts, etc. The most common standard of value is fair market value and is generally defined as a hypothetical buyer and a hypothetical seller both having reasonable knowledge of the business and all relevant factors and neither being under any compulsion to buy or sell.The other most common standard of value in buy-sell agreements is fair value. Simply put, fair value is fair market value without consideration of any applicable discounts for lack of control and lack of marketability for the subject interest. Fair value is often used in legal proceedings. The difference between these two standards of value and the lack of clarity in defining which standard is governed by a company’s buy-sell agreement is often the impetus to litigation.2) Level of Value Level of value is a valuation concept describing the differences between various “levels” of a company’s value. Levels of value can include financial control, strategic control, marketable minority interest, and non-marketable minority interest. Each level has a distinct difference in the amount of control one can exhibit over the operations of a business and/or their ability to sell an interest in that business. For the layperson, the levels of value ultimately dictate whether premiums or discounts would be applied to the subject interest being valued.3) Define Triggering Events If the goal of a buy-sell agreement or governance document is to provide a roadmap for the valuation, then it’s important for these documents to define the events that will be governed under their parameters. These events are often referred to as triggering events and can include the death of an owner, termination of an owner, divorce, change of control, etc. By defining the triggering events, it will be clear when the document will be enacted and enforced and when it will not apply. For example, selling or gifting a minority interest in the business to future generations is not likely to be a triggering event in this context and almost certainly would not be valued at anything besides the nonmarketable minority level of value.These events can also have unique ramifications on auto dealerships. For example, each franchised dealer has a dealer principal that has to be approved by the manufacturer. The death or divorce of a dealer principal can also pose challenges as the transferability of that interest and title of dealer principal is not guaranteed and cannot occur without approval from the manufacturer.4) Avoid Formula Pricing Often these documents contain a formula or a methodology to value the business. The formula might consist of the applicable financial information to consider and the multiple to apply to those metrics to determine the value. At the time of the drafting of the buy-sell, these formulas might establish the shareholder's perceived value of the business. If considerable time has passed between the drafting of the document and the triggering event, these formulas and concluded values could be stale and outdated. As we’ve previously discussed in this space, the auto dealership industry is unique from a valuation perspective. Traditional formulas such as EBITDA multiples often utilized in other industries are not as informative in this industry. The drafting attorney may not be as familiar with the nuances of auto dealership valuation. Even if an industry-appropriate metric, such as a Blue Sky multiple or formula is used, it is likely be dated in a short period of time. National auto brokers (Haig Partners and Kerrigan Advisors) publish and update these Blue Sky multiples by manufacturer quarterly. As we’ve seen during the COVID-19 pandemic, operational conditions and perceived franchise values can change both quarterly and over a longer time horizon. Additionally, dealerships could evolve over time and acquire or divest of different franchises that could drastically change their operations and perceived value.Finally, what adjustments are to be considered? Even if a buy-sell agreement has language providing for a multiple to be updated with the current market environment, significant one-time or non-recurring income or expense items can inflate or depress value.5) Specify Valuation DateThe buy-sell agreement should explicitly define the date to be used for the valuation. Typically, the date of valuation would be at or near the triggering event depending on its proximity to the timing and availability of current and reliable financial information. A proper valuation should consider what is reasonably known or knowable as of the date of valuation. Any ambiguity in defining the valuation date or the financial information to be used could have a significant impact on value. Since franchised auto dealers must submit monthly financial statements to the manufacturer, an appropriate valuation date might be set to be the month-end prior to the triggering event.6) Defining Appraiser Requirements Who should perform the valuation? Often buy-sell agreements will utilize language such as a “qualified appraiser” and may even include certain valuation credentials such as an Accredited Senior Appraiser (ASA), someone who is Accredited in Business Valuation (ABV), or a Certified Valuation Analyst (CVA) from national valuation accrediting organizations. Since the auto dealership industry is so unique, these credentials may not be enough. Should your buy-sell agreement also require that the appraiser have specific industry experience? Finally, independence is key. We recommend selecting a third-party valuation firm with experience in valuing auto dealerships so that the appraiser will be qualified and unbiased.7) Make It a Living Document How often does a company have a buy-sell agreement or governance document drafted only to be placed in an electronic file, a desk drawer, or a file cabinet and never reviewed or contemplated again? The value of an effective buy-sell agreement is to provide a roadmap for how to value the dealership at a triggering event. If the document was never used since drafting, can it be reliable?Effective buy-sell agreements are not only drafted, but they are utilized. Some require ongoing valuations at annual anniversaries or other timeframes to provide the owners with a value indication that could be used for strategic planning or contemplation of an upcoming triggering event.If the document didn’t clearly contain the items in this post and was never used since drafting, it could create confusion leading to litigation or the buy-sell agreement could be ignored in an eventual litigation. Frequent use or at least consideration of the terms considered in the document are likely to be much more relevant in a litigation context.Conclusion and ConsiderationsAn effective buy-sell agreement can provide a roadmap to defining the valuation process through many challenging events during the lifetime of an auto dealership. As we’ve discussed, the document should contain and clearly define these seven elements, among others, to accomplish that goal.Other considerations to contemplate are the premise of value, funding mechanisms for repurchase, and managing expectations. The premise of value will establish whether to determine the value of the dealership if it continues as a going-concern business as opposed to liquidation. Funding mechanisms and repurchase requirements can also dictate the mechanical treatment of certain assumptions in the valuation such as the impact of recognizing life insurance proceeds at the death of an owner to establishing a market for the subject interest that could possibly impact the applicable discount for lack of marketability.Does your auto dealership have a buy-sell agreement or governance document? When was it drafted? Who drafted it? Does it contain and discuss these seven key items? If it contains formula pricing, would buyers and sellers find the methodology employed reasonable today? These are all items that need to be considered.To discuss the impact of your buy-sell agreement, assist you and your attorney in drafting an effective buy-sell agreement, or determine the valuation of your auto dealership at a triggering event, contact a professional at Mercer Capital today.
How RIA Owners Can Rethink Compensation
Money Talks
Salary and bonus discussions are some of the most stressful conversations business owners have each year, and RIA principals are no exception. Since personnel costs are by far the largest expense item on an RIA’s income statement, it is understandable that these principals frequently question (and are questioned about) their compensation decisions. While there is no one-size-fits-all formula for compensation, we have discovered three ways to ease some of the anxiety around these discussions.1) Define the Philosophy of Your Compensation ModelCompensation can do more than simply reimburse your employees for their time, but only if it is well planned and communicated. A good compensation model can help your company attract, retain, and motivate talent. We often think about compensation in four buckets.2) Pay Bonuses More FrequentlyOne benefit of a recurring revenue business is that a firm’s performance can be calculated on a more frequent basis. Paying bonuses quarterly, or even bi-annually, can take away some of the stress that annual bonus discussions bring. Additionally, quarterly bonus discussions provide an opportunity to deliver meaningful feedback to your employees on a more regular basis. Employees do their best work when they feel valued; why not remind them of that more than once a year?3) Compare Your Margins to PeersWhile there is significant variation in how RIA owners think about compensating their employees (and themselves), there is some uniformity across the industry as to how much RIAs should pay out in total compensation. As shown below, publicly traded RIAs with under $100 billion in AUM pay out roughly half of revenue as compensation.
Considering this metric along with typical operating margins for RIAs (usually 20% to 30% depending on size, type, and location) can help you gauge whether your compensation expenses are in sync with the market.
To learn more about more on common compensation questions join us atRIA Practice Management Insights, as Matt Crow and I spend a half-hour answering your question about RIA compensation practices.
Only 2 WEEKS until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?
What Is a Fairness Opinion And What Triggers the Need for One?
Based on available public data from S&P Global’s Market Intelligence platform, there were 25 merger and acquisition announcements in 2020 related to oil and gas companies at the entity level (including natural gas midstream and utility companies). These 25 announcements represented at least $16.2 billion in total deal value, notwithstanding three deals where the value was not publicly disclosed. On a quarterly basis, there were eight announcements in Q1 2020, eight in Q2 and Q3 combined, and nine in Q4.While the trend in the quarterly announcements is not very surprising, one phrase, in particular, creeps up with increasing frequency when reviewing transaction details as 2020 progressed: “Fairness Opinion.”In Q1, only one of the eight transactions was reported to have had a Fairness Opinion conducted. None of the two transactions announced in Q2 had Fairness Opinions, but two of the six announced deals in Q3 did. As the Oil and Gas industry began to get somewhat comfortable again, Q4 finished out strong with nine announced deals. However, nearly half of them were accompanied by Fairness Opinions. We examine this trend from a monthly perspective in the following chart:
Irrespective of what industry or sector a company may operate in, a fundamental question arises as mergers and acquisitions persist and company boards and management teams survey their options when a proposed transaction is put on the table: is it fair to all direct stakeholders?
What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued. On this point, we note that among the six deals announced in 2020 where a Fairness Opinion was conducted, only one of the six had Fairness Opinions conducted on behalf of both the buyer and the seller; the opinions performed for the other five deals were solely on behalf of the sellers in those transactions.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important? There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability. In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions. The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials. Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith. Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction. In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best”; Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction. The financial advisor must look at pricing, terms, and consideration received in the context of the market. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial. This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a prox.yThe reasonableness of compensation that may be paid to executives as a result of the transaction.
Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have nearly four decades of experience in helping boards assess transactions as qualified and independent financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.
Financing Options Abound for Family Businesses in 2021
A long-time Wall Street saying speaks to the availability of credit for mid-size and larger family businesses that seek to raise debt capital in 2021:If the ducks are quacking, feed them.Barring a change in the economic backdrop, as uncertain as it is, the availability of debt financing for most family businesses in 2021 is good. Further, the cost of credit will be low and most likely the terms will be lenient by historical standards.There are exceptions, of course. Hotels, retail CRE, restaurants, and tourism-related businesses face greater scrutiny. Retail malls and strip centers without a grocery or other essential business are tough financing propositions. Trepp, which tracks the commercial mortgage-backed security (“CMBS”) market, reports that it is not uncommon for servicers to sell troubled retail CRE loans at huge discounts and to auction large albatross retail properties in which no one shows up to bid.At the other extreme are companies such as Carnival Corporation, which operates multiple cruise lines. Carnival raised $3.5 billion on February 10 via a 5.75% senior unsecured offering due March 2027. Demand was sufficiently robust to boost the offering from a planned $2.5 billion. During July 2020 Carnival sold $775 million senior secured second priority notes due February 2026 with a 10.50% coupon.Four Options to Obtain Debt CapitalFamily businesses have four broad options to obtain debt capital:Commercial banksNon-bank commercial finance companiesPrivate credit fundsCorporate bond market
Each financing option has its pluses and minuses.Commercial BanksHistorically, commercial banks offered the cheapest source of funding to family businesses albeit with plenty of covenants and perhaps personal guarantees compared to more expensive unsecured long-term financing available from the bond market. Those precepts are changing in a yield-starved world in which investors (and banks) accept lower yields with fewer covenants (i.e., “covenant-lite” is now a standard for syndicated leverage loans).Non-Bank Commercial Finance CompaniesNon-bank commercial finance companies differ from banks in that they do not have deposit funding, are less levered than commercial bank and generally charge higher rates than banks to produce a competitive ROE. Commercial finance companies offer deep expertise in a given asset class to be financed, and the subject asset rather than a blanket lien on the firm’s assets and cash flow serves as the collateral.Private Credit FundsPrivate credit, which runs the gamut from publicly traded BDCs to funds sponsored by private equity firms, has existed in its current form for a few decades; however, private credit has exploded as a major source of financing since the 2008 recession because leverage lending by banks was restricted somewhat by regulators and because investors can earn attractive yields on capital that is levered by the manager. Plus, the sponsors earn management fees on the assets in addition to the coupon on their capital. Family businesses may find credit funds to be expensive, but generally, they can move quickly and will allow for more leverage than a commercial bank that originates loans for its balance sheet. There also is an advantage to having an ongoing dialogue with the fund that can make decisions to modify a loan or advance additional funds, unlike a bond offering.Corporate Bond MarketFor financing needs that are sufficiently large, a corporate bond offering that is broadly distributed or privately placed with a few investors offers family businesses multi-year fixed rate financing at historically low rates though not as low as short-term commercial bank borrowings. Also, corporate bonds usually entail interest only payments until the bond matures at which point the issue will have to be refinanced or repaid with existing corporate liquidity. Among the downsides of a corporate bond financing is limited flexibility should something go awry at the company whereas a loan from one or a few banks will entail more flexibility to renegotiate terms.Are We Currently in a Borrower's Market?There is so much capital available for lending, yet loan demand is weak because the U.S. is (or was) in a recession.Loans in the commercial banking system declined for the first time in a decade in 2020 and only the second time in 28 years while deposits increased over 20%. Some of the reduction reflected corporate customers tapping the bond market to raise cheap long-term capital to refinance existing indebtedness. Further, banks have tightened commercial and CRE loan standards since last March based upon the Federal Reserve’s quarterly survey of senior lenders.Tighter standards at commercial banks notwithstanding, there is a basic reason why the ability to obtain financing in 2021 should be a borrower’s market: cash and near-cash equivalents yield nothing while government and corporate bonds yield little. Banks and investors are sitting on sizable cash piles that must be lent to produce a return.To get a sense of the pressure on yields, consider high yield corporate bonds (rated BB+/Ba1 or lower). The ICE BofA High Yield Index yielded 4.10% on February 10, well below prior lows seen in mid-2014 and early 2020 of ~5.25%. The peak yield of ~22% occurred in November 2008. This time around, yields grew to approximately 9% in late March 2020 before the Fed announced a plan to buy corporate credit and thereby restore liquidity to what had become a very illiquid market.Also, the yield investors demand over comparable duration U.S. Treasuries (i.e., the option adjusted spread) is near a record low.Investors are all-in, and our assumption is that commercial banks will not be willing to sit too long on excess deposits because revenue pressures are intense at banks amid an extremely low yield environment.ConclusionWe conclude with two final points for family businesses about what the bond market is saying about credit.First, the message of the U.S. Treasury market yield curve conveys is positive (assuming the Fed has not completely distorted market pricing). Typically, the shape of the yield curve points to investor expectations about future economic activity. A steeper curve as measured by the spread between market determined long-term rates and short-term rates that are heavily influenced by Fed policy rates points to a stronger economy in 12-18 months. Since Pfizer made the first vaccine announcement the curve has steepened. A flatter or inverted curve indicates a slowing or recessionary environment.Second, Fed Chair Powell has been emphatic the Fed will not raise short-term policy rates until after 2023, even if inflation takes off. Following the 2008 recession, the Fed first raised rates in December 2015, seven years after the zero-interest rate policy (“ZIRP”) was adopted. The futures market for Eurodollars, one of the most liquid markets in the world that settles based upon 90-day LIBOR, has priced in only 75-100bps of an increase by the mid-2020s.
For family business directors, 2021 is an opportune time to evaluate financing needs to support growth investments and shareholder redemptions, and diversification needs.
Public Auto Dealer Profiles: Lithia Motors
From 1996 to 2002, six new vehicle retailers became publicly traded companies. While these companies have expanded their footprint, there have not been any more publicly traded new vehicle retailers since. Online used vehicle retailers have recently IPO’d and EV startups have used SPACs to come to market during the pandemic, but these are not comparable to privately held franchised dealerships that can sell new vehicles.This is the first in a series of profiles of these six public new vehicle dealerships. The goal of these profiles is to provide a reference point for private dealers.Dealers may benefit in benchmarking to public players, particularly those that are significantly larger with numerous rooftops. Smaller or single point franchises will find better peers in the average information reported by NADA in their dealership financial profiles. Public auto dealers also provide insight as to how the market prices their earnings.We’re starting with Lithia Motors (LAD) because of their targeted annual acquisitions of $3-5 billion in revenue, which will require plenty of deals with private dealerships, representing a potential exit strategy. Lithia has also already reported their 2020 earnings, so the early bird gets the worm.Lithia Motors Locations and BrandsBased in Medford, Oregon, Lithia has over 200 locations throughout the U.S. largely focused on the West Coast, Texas, and the Northeast. Management indicated 100% of consumers in the U.S. were within a 400-mile radius of the company’s fulfillment network, with this density shrinking to 100 miles in the northwest and 200 miles in the Southwest, South Central, and Northeast.
According to the Automotive News Top 150, Lithia sold the third most new retail units in 2019 at just over 180 thousand, trailing only AutoNation and Penske Automotive Group. Lithia added seven dealerships in 2019, making it the most acquisitive dealership in the country that year, a trend they carried into 2020 and is anticipated to go forward.
As seen in the table below, nearly 45% of Lithia’s revenues in the last quarter came from Toyota, Honda, and Chrysler. While just under 30% of the company’s revenue came from luxury vehicles (8% BMW/Mini), luxury volumes made up only about 22% of unit sales. Lithia is relatively balanced, seemingly agnostic to brand and segment.
Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. With numerous acquisitions and industry-wide improving gross margins in 2020, Lithia’s revenue and gross profit have grown at an annualized rate of 9.2% and 13.7% in the past three years. Lithia’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume-based incentive fees, operating income can be negative for dealers before accounting for these profits. For Lithia, other income (excluding interest expense) amounts to only 7.4% of pre-tax profits due in part to differences in reporting.Implied Blue Sky MultipleIn this blog, we’ve discussed how Blue Sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied Blue Sky multiple investors place on Lithia Motors. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Lithia’s Blue Sky value per share is approximately $228. With pre-tax earnings per share of approximately $26.8, Lithia’s implied Blue Sky multiple is 8.53x.
Luxury franchises trade for multiples in this ballpark, but luxury makes up only approximately 30% of Lithia’s sales. For comparison, domestic brands make up a similar percentage for Lithia with multiples closer to 4x. Still, the scale of Lithia’s operations and significant growth profile lend it to higher multiples, and there would certainly be intangible assets other than franchise values.
Primary Pitch to Investors: Growth and “Driveway”Seeking to meet the market’s insatiable demand for growth, Lithia unveiled its five year growth plan halfway through 2020. The company is targeting annualized revenue growth of 31% for the next five years with a goal of $50 billion in revenue (from $13 billion in 2020). Lithia describes itself as the largest participant in a fragmented $2 trillion revenue industry, combining both the traditional new franchise retailers and the used-only auto retailers.Lithia has emphasized and invested in its omnichannel efforts called “Driveway.” This is an eCommerce solution the company compares to Carvana and Carmax. Lithia notes a higher gross margin than Carvana, and the company’s long-term strategic advantage lies in the combination of an eCommerce option for consumers supported by a larger network of traditional retail locations, which increases options for online shoppers in adjacent markets. Lithia sources 60% of its inventory from trade-ins, giving it robust offerings in the online used vehicle space.In 2018, Lithia also invested $54 million in a partnership with Shift Technologies, which competes with Driveway, Carvana, Carmax, and Vroom. According to the most recently available filing, Lithia owns 13.8 million shares of Shift, which went public via SPAC in October, worth approximately $140 million based on last close.The company’s recent investor presentation showed the company added $3.5 billion in annualized steady-state revenue, though it does not specify the impact of the pandemic on this estimate. Lithia’s acquisitions also required an intangible investment of 25% of annualized revenues indicating the company may have paid greater Blue Sky values in 2020 as Haig Partners and Kerrigan Advisors each indicated market multiples increased in 2020 despite declining revenues.Seeking to acquire strong brands and grow profits, Lithia highlights five keys when acquiring dealerships:New Vehicle Market Share: Lithia looks to improve dealerships that are underachieving the OEM’s market share performance goals. They target improvement from 75% of the OEM target to 125%.Used Vehicle Units: The company seeks to triple the number of used vehicles sold per store per month.F&I Profit: By focusing on cross-selling F&I, Lithia seeks to improve GPUs from $700 to over $1,450.Service & Parts: Similar to improving market share targets, the company seeks to improve CSI scores. In addition to improving relations with customers, this focus positively influences relationships with manufacturers.SG&A Reduction: Lithia seeks to use its scale to reduce SG&A expense to below 65% from approximately 90% for its targets pre-acquisition.
In summation, Lithia aims to improve pre-tax margins of its targets from under 1% of revenues to above 3%. To quote the CEO, Bryan DeBoer, on the recent earnings call, “Lithia’s model has always been to buy value-based investments that underperform.” Targeting dealerships with thin profit margins also allows Lithia to grow revenues and increase its distribution network while potentially reducing the amount of Blue Sky paid. However, as noted in the Haig report, lower margin dealerships can often attain higher Blue Sky multiples, resulting in favorable returns for sellers as well.ConclusionLithia’s aggressive growth strategy may pay off if they don’t overspend on dealerships over the next five years. Depending on which markets they target, they’ll also need to be strategic to avoid cannibalizing their current sales as they expand. Investors may well reward them if they hit their growth targets, but private dealerships also stand to benefit from an aggressive buyer in the market. This will be particularly true if Lithia falls behind its growth targets, as private dealers looking to exit may be able to extract more blue sky value out of the deal. Dealers in markets competing with Lithia may also see a shift in their pricing strategy, as the company touts 43% of its transactions with customers as “negotiation free,” potentially implying more competitive (read: lower) prices.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance and strategic investment initiatives of the public new vehicle retailers gives us insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
All EBITDA Is Not Created Equal
Awaiting kick off on the afternoon of the big game, one of the perennial features of the interminable pre-game show is the obligatory head-to-head matchup segment, in which the network analysts go through the starting lineups position by position, comparing the relative strengths and weaknesses of the quarterbacks, linebackers, kickers, waterboys, etc. The conceit of the segment is that, while both teams will field the same basic positions, not all cornerbacks are created equal. If the analyst can reliably discern which team has the advantage at the most individual positions, perhaps that will reveal the winner ahead of time. For our part, we predict that Kansas City Tampa Bay will win by 10 22 points.All of which got us to thinking about, well, EBITDA (earnings before interest, taxes, depreciation, and amortization). In the world of family-owned and other private businesses, EBITDA is the most commonly cited performance measure. Much like left tackles, every company has EBITDA, but some EBITDA is better than others. Why is that?What Is EBITDA and Why Does It Matter?EBITDA is an example of a non-GAAP performance measure, meaning it is not a line item on audited financial statements. EBITDA gets a lot of attention because it is a proxy for the operating cash flow that is, in turn, available for a broad variety of corporate purposes. EBITDA is especially popular in the M&A markets because it is a measure of the discretionary cash flow available to a potential buyer of a business.EBITDA also promotes comparability across firms by “normalizing” for structural features of how those companies are organized, financed, and assembled. This is best seen by considering the various adjustments to net income that are made to arrive at EBITDA. We will start from the bottom of the income statement.Income Taxes - Many family businesses are organized as tax pass-through entities (S corps or LLCs) and report no corporate income tax expense. Because taxes are excluded from EBITDA, all companies are on equal footing, regardless of their tax structure.Interest Expense - Financing operations with debt rather than equity does not directly influence the operating results of the business. As with taxes, interest expense is excluded from EBITDA, allowing direct comparison of performance by different companies having different capital structures.Depreciation Expense - Depreciation expense is a non-cash charge that accountants use to allocate the cost of long-lived assets to the accounting periods during which the assets are expected to be used. As you might guess, a lot of assumptions go into those calculations, each of which potentially impairs the comparability of reported earnings to those of other companies that may make different assumptions. Since EBITDA ignores depreciation charges, it erases that potential obstacle to comparability.Amortization Expense - Some companies grow through acquisition, while others grow organically. If acquirers pay more than the value of the net tangible assets of the target companies, they must write off the excess in the periods following the acquisition. Companies growing organically do not have comparable amortization expenses. Thus, EBITDA is comparable for businesses, whether they grow through acquisition or organically.Limitations of EBITDAThe following chart (Exhibit 9 from our whitepaper, Basics of Financial Statement Analysis) illustrates the five basic uses of EBITDA.
Importantly, of these five uses, only three provide direct returns to capital providers: paying interest, repaying debt, and distributing to owners. The other two, paying taxes and capital expenditures, do not directly accrue to the benefit of shareholders.
This is generally obvious with regard to taxes but requires more finesse for capital expenditures. We can divide capital expenditures (in the economic rather than accounting sense) into two groups:
Maintenance Capital Expenditures - Family businesses focused on sustainability recognize that a portion of operating cash flow must be set aside each year to maintain productive capacity. Depreciation expense is an imperfect proxy for this obligation. The reality of this maintenance capex burden lies at the heart of legendary investor Warren Buffett’s infamous tooth fairy warning on EBITDA.Growth Capital Expenditures - But not all capex is maintenance capex. Family businesses also invest to grow (whether through M&A or organic investments). Since these investments should only be made if the expected returns exceed the company’s cost of capital, these “elective” expenditures are made in lieu of distributions to capital providers in the expectation that they will generate long-term benefits that more than makeup for the deferral in distributions.
The point of all this is that a dollar of EBITDA is not just a dollar of EBITDA. The quality of a dollar of EBITDA depends on how much of that dollar is allocable to taxes and maintenance capital expenditures. Consider the two companies summarized in the following chart.Company A and Company B both generate the same amount of EBITDA, yet Company B’s EBITDA is of much higher quality because taxes and maintenance capital expenditures consume a much smaller portion of EBITDA than for Company A. Accordingly, investors will likely assign a higher EBITDA multiple to Company B than Company A (all else equal). This is borne out when we look at data for non-financial companies in the Russell 2000.
The value assigned by the market to each dollar of EBITDA follows a predictable pattern as depreciation & amortization consumes a greater portion of EBITDA. Ideally, we would look at depreciation only, but the data aggregation services generally only provide the aggregate number. Even so, the point stands.
ConclusionSo, should family business directors be as dismissive toward EBITDA as Warren Buffett? We do not think so, although it is important for directors to take Mr. Buffett’s reservations to heart and understand that not every dollar of EBITDA is created equally. This is important for two reasons. First, doing so helps directors take EBITDA multiples with the appropriate grain of salt. Since the value of a dollar of EBITDA depends on the quality of that dollar, quoted EBITDA multiples should be evaluated with due caution. Second, this underscores the importance of incremental EBITDA. Once taxes and maintenance capital expenditures have been covered, marginal dollars of EBITDA are of the highest quality (and therefore most valuable). As a result, improving EBITDA margins can have a multiplicative impact on the value of your family business by both providing more EBITDA and justifying a higher multiple.And that is a winning game plan.
The Chip Shortage Is Making It Feel Like 2020 All Over Again
Last year, many of our blog posts touched on the subject of inventory shortages due to plant closures from the pandemic. However, after stay-at-home orders were relaxed and plants got up and running again, there were high hopes among the major public dealers that inventory levels would return to pre-COVID levels in 2021 and dealerships could meet consumer pent up demand. However, manufacturers are facing a new obstacle on the production line that is a threat to reaching these inventory goals. All over the world, automakers (and other industries) are grappling with a shortage of computer chips.In this blog post, we discuss the necessity of chips in the auto making process, how the chip shortage came to fruition, how it is affecting the industry, and what all this might mean for auto dealers going forward.Small But MightyWhen considering all of the different digital products that you might use on a day to day basis, there is likely one specific thing that they all have in common: computer chips. While cars might not be the first thing to pop in your head when you’re thinking about digital technologies, they also rely on them for many different functions.A mainstream car has more than 100 microprocessors.As OEMs continue to innovate and more features become standard, consumers have benefitted from an enhanced experience while vehicle prices have increased. These advances have also increased the reliance on semiconductors, which have become a crucial part of the supply chain. Car companies can use them to power the modern-day technology in their vehicles, such as the engine, Bluetooth capabilities, seat systems, collision and blind-spot detection, transmissions, Wi-Fi, and video displays.As Kristin Dziczek, a senior industry analyst with the Center for Automotive Research (CAR) notes, “Today’s automobiles use a huge number of computer chips, chips in the engine, chips in the seat, chips in everything, but they’re in tight supply right now.” A mainstream car has more than 100 microprocessors.How It StartedLike many other production struggles that have occurred in the past year, the COVID-19 pandemic is at the root of the shortage of chips. With the new normal of being indoors, demand for electronics increased substantially, boosting demand for microchips. Xbox and Playstation also released their latest consoles in mid-November. The last consoles brought to market by these companies was in 2013, so the timing of this launch exacerbated these issues.While demand for electronics was increasing at the beginning of the pandemic, demand for cars had waned, and thus, automakers like General Motors, Toyota, and Subaru, were forced to close factories at the onset of the pandemic. In accordance, this caused overly conservative demand estimates to be made. However, once the plants reopened, demand was much higher than anticipated, and the chips necessary to fulfill the demand just were not there.Chipmakers tend to favor consumer electronics because their orders are larger than those of automakers. The annual smartphone market is more than a billion devices compared with fewer than 100 million cars. Automaking is also a lower-margin business, leaving manufacturers unwilling to bid up chip prices to avoid risking profitability. Automakers in China were the first to feel the impacts of the shortage, primarily due to it being the world’s biggest auto market recovering from the pandemic, but now the shortage has spread to auto manufacturers across the globe.Current ImpactsMajor auto manufacturers are already starting to react to the chip shortage. Ford is the latest, cutting production of its top money maker, the F-150 pickup truck, due to the chip shortages. The impact could be significant, as the Ford CFO John Lawler notes, “Right now, estimates from [chip] suppliers could suggest losing 10% to 20% of our planned first-quarter production.” This could mean a loss of profit of $1 to $2.5 billion in 2021. Ford is proactively trying to mitigate risk in other parts of their vehicles subject to supply chain disruption, and has hinted that they might be investing in battery production to avoid a similar issue on that front.With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021.Ford is not alone in production cuts though, as it joins General Motors, Nissan, Volkswagen, Toyota, Mazda, and Subaru in cutting output due to the semiconductor shortage. With not enough chips in supply, the automaking industry stands to lose $61 billion in 2021, as reported by consulting firm Alix Partners as Bloomberg reported.As of right now, there is no clear answer for when the chip shortage will be alleviated. Macquarie Capital expects auto production to be affected until mid-2021, as chipmakers up their production, while data firm HIS Markit said the shortage could last until the third quarter this year. As the shortage has worsened in the past week, 15 senators have asked President Joe Biden to secure the funding necessary to implement clauses related to chips in the National Defense Authorization Act, in the hopes it could spur production in the U.S.Potential Impacts for Auto DealersOverall dealership supply is most likely going to be impacted by the chip shortage, and for shoppers who have the money to buy new cars and are expecting deals, they may be disappointed by the selection available. This is a major blow to auto dealers, especially after the public companies on their last earnings call were anticipating inventories to stabilize in 2021. Stay tuned for our upcoming earnings call blog post to hear what public dealers prospects on the matter.All else equal, shortages could squeeze profits for OEMs if they are all vying for the same limited amount of chips. These costs would likely trickle down to dealers who would attempt to pass them on to consumers. However, it is a bit too early to say for certain what the overall impact will be on dealership profitability. A lot of it may depend on how significant the disruption ends up being and how long until things normalize once again.Regardless, it is not the optimistic news that many were hoping to kick off 2021 and signals continuing struggles as the industry tries to shake off the effects of this pandemic. Though the current circumstances are uncertain, the COVID-19 vaccine offers some hope that things will begin to stabilize soon. The current microchip shortage may not be ideal in the current circumstances for inventory levels and dealership profitability, but the impacts will not last forever.If you are interested in learning more about how this may impact the value of your dealership, feel free to reach out to any of us on the auto dealer team. We hope everyone is continuing to stay healthy during this time!
Seven Considerations for Your RIA’s Buy-Sell Agreement
Working on your RIA’s buy-sell agreement may seem like a distraction, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, your employees, and your clients.If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.1) Decide what’s fair.In our experience, buy-sell agreements tend to function well when they attempt to strike a balance between the interests of the various stakeholders in an investment management firm, including the founding partners, next-gen management, employees, clients, and the firm itself. By balancing the interests of the various stakeholders, a well-structured buy-sell agreement can be a competitive advantage by facilitating a smooth transition between founding partners and next-gen management. Ultimately, this enhances value for everyone.2) Define the standard of value.Standard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. We wouldn’t recommend getting creative here. Unconventional standards of value can and do lead to different interpretations that can result in wildly different conclusions of value. For most purposes, using one of the more common definitions of Fair Market Value is advisable. Fair Market Value contemplates a hypothetical willing seller and willing buyer, both of whom have reasonable knowledge of the subject asset and neither of whom are under any compulsion to buy or sell. This standard has an almost universally agreed-upon definition and is well established and understood in the valuation and legal communities, all of which helps to remove uncertainty as to its valuation implications.3) Define the level of value.Valuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. For example, a non-marketable minority interest may be worth less than an otherwise identical controlling interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Naturally, sellers would prefer a premium and buyers a discount, but it helps to keep in mind that today’s buyers are tomorrow’s sellers, and today’s sellers are yesterday’s buyers. When transactions are done on a consistent basis over time, it helps to promote a sustainable marketplace for the company’s shares.4) Avoid formula pricing.We often see buy-sell agreements that use a formula to determine value (usually a fixed multiple of a historical performance metric). These formulas often reflect what the principals of the firm thought the business was worth at the time the buy-sell agreement was drafted. As market conditions and the business’ economics change, formula prices can quickly diverge from market value, but the ink on the page remains.When it comes time to buy or sell, perhaps years or decades after the buy-sell agreement was drafted, the formula price will inevitably be benchmarked against the actual buyer and seller’s perceptions on the current market value of the interest. If the formula value is greater than the perceived value, then the selling shareholder may find there are no willing buyers or no reasonable way to finance the sale. If the formula value is less than the perceived value, then the selling shareholder may be incentivized to hold on to their ownership longer than is optimal from the perspectives of the firm, next-gen management, and clients.5) Specify the valuation date.A buy-sell agreement should be explicit about the “as of” date of the valuation. Typically, valuations will consider only what is known or reasonably knowable as of this date. As a result, a difference of just a few days can have a significant impact on the valuation if an unexpected event occurs at the firm. Consider, for example, the death of a key executive. Such an event will often trigger buy-sell agreement provisions, and whether or not the event factors into the valuation will depend in part on the valuation date specified by the agreement. For firms with larger shareholder bases and relatively frequent transactions, it often makes sense to specify an annual valuation date that then applies to transactions throughout the year.6) Decide who will perform the valuation. We recommend selecting a reputable third-party valuation firm with experience valuing investment management firms.7) Manage expectations. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Testing your buy-sell agreement now by having a valuation prepared can help to center or reconcile those expectations and might even lead to some productive revisions to your buy-sell agreement.For more information on RIA practice management issues, register for our upcoming conference, RIA Practice Management Insights. More information can be found below.Early Bird Pricing for the Upcoming RIA Practice Management Insights Conference Ends in 7 DaysMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Take advantage of early bird pricing to receive $100 off conference registration. Offer ends next week.Have you registered yet?
Mineral And Royalty Valuations Remain Low Amid Recent Oil Price Gains
The recent rise of oil prices returning to over $50 per barrel is a welcome sign to mineral and royalty holders across the board. There are inklings of bullish expectations for oil and gas prices in the coming year. However, climbing back up the valuation cliff that these assets fell from in March 2020 is still daunting. There are a lot of factors keeping this asset class from rebounding such as rig counts, capex budgets and supply chain issues. It has slowed royalty acquisitions and divestitures to a crawl and pushed undeveloped acreage values in many areas to multi-year lows.On the other hand, these same factors have led to a rush of estate planning transaction activity. The combination of depressed E&P valuations, the potential for future tax changes and the ability for mineral and royalty holding entities to utilize minority interest and marketability discounts have kept many tax advisors busy in recent months. These low valuations may not last for much longer if some recent bullish sentiment comes to fruition though. In the meantime, let us expound a bit on these forces keeping mineral and royalty valuations in their existing state.Low Upstream ValuationsThere is no need to explain how 2020 was a tough year, though the pain was dire for many upstream companies. Recovery appears to be gaining ground, but the momentum is tentative and some changes in travel habits might become permanent. While E&P company values (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF $XOP) have recovered from their lows in March, the index remains down year-over-year, having declined 38% during 2020.[caption id="attachment_35814" align="alignnone" width="668"] SPDR S&P Oil & Gas Exploration & Production ETF (XOP) | Source: CAPITAL IQ[/caption]
The recent flurry of E&P bankruptcies also is indicative of a challenging operating environment and reduced equity valuations. There are exceptions with assets and situations of highly economic Tier 1 production, and/or acreage that can maintain or have proportionally small value decreases during this downturn, but most E&P companies have suffered alongside commodity prices. One of the significant outcomes from this is that rig counts remain less than half what they were pre-pandemic. This lack of activity is contributing to current oil inventory issues and price gains but is also keeping raw and undeveloped acreage valuations particularly depressed due to the slowdown in prospective development timelines.
Potential For Future Tax ChangesPresident Biden’s tax plan calls for some major changes to the current gift & estate tax regime. Most notably, the estate tax exemption could be reduced from today’s $11.7 million (unified) to $3.5 million (estate) and $1.0 million (gift), and the tax rate could increase from 40% to 45%. The prospects for tax reform likely increased after Georgia’s Senate run-off elections on January 5th which put the Democrats in control of both houses of Congress.While new tax legislation could potentially be made retroactive to January 1, many tax policy experts see that as unlikely.Acreage Values Remain DepressedThese dynamics are keeping values low. Cash flow values are coming back, but not much else. Few are paying for undrilled acreage unless it is extremely high quality. Freehold’s recent $58 million royalty package acquisition demonstrates this. The deal announced in early January included 400,000 gross acres of mineral title and overriding royalty interests across 12 basins and eight states. It traded for about 58x months of prospective cash flow, but the incremental acreage value was minimal (if anything).[caption id="attachment_35815" align="alignnone" width="700"] Royalty/Mineral Transaction Activity | Sources: Energy Net, EIA, and Hart Energy[/caption]
This characteristic is also apparent in mineral aggregators’ stock prices, which remain significantly lower even though oil and gas prices are in a similar spot as a year ago.
[caption id="attachment_35816" align="alignnone" width="700"] Mineral Aggregator Stock Performance: 2020-2021 | Source: Capital IQ[/caption]
Until The Drill Bit Turns…Many things remain uncertain, but for investors in mineral and royalty assets, prices above $50 per barrel again is a start. The more restrictive regulatory environment will likely also buoy prices. However, until production ramps up and future drilling inventory comes into focus, expect that mineral and royalty values will still have a steep cliff to climb.Originally appeared on Forbes.com on January 29, 2021.
Optional Insights on Valuing PUDs and Unproven Reserves
One of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing proven undeveloped reserves (PUDs) and unproven reserves, particularly in today’s volatile price environment. The onslaught of COVID-19 and the Russian-Saudi price war caused significant operational implications with arguably all E&P companies. Companies’ forecasts were no longer reasonable. Drilling stopped and the market took a dive. The implication of these events had impacts on the valuations of PUDs and unproven reserves valuations. While the market approach can sometimes be used to understand the value of PUDs and unproven reserves, every transaction is unique. Why then, and under what circumstances, might the PUDs and unproven reserves have significant value?Public transactions do not disclose the value associated with PUDs and unproven reserves, but instead, they indicate an aggregate value for a bundle of assets. The allocation of that value across the various assets acquired is up for debate. Recent transaction sheds some light on asset pricing in the current environment.Optionality ValueThe answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or as seen with the rise of hydraulic fracturing, drilling technology can drive significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is often most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is especially apparent when the PUDs and unproven reserves are reliant on future production. These types of reserves do not require investment within a fixed short timeframe.PUDs are typically valued using the same discounted cash flow (DCF) model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life, risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF or a reserve adjustment factor (RAF). Historically, in lower oil price environments like we face today, a raw DCF would suggest little to no value for PUDs or unproven reserves in several plays and basins.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore, an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.Adaptation of Black Scholes Option ModelThe PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. The Black Scholes option model is widely used to develop the value of European-style options. The adaptation is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e., five to ten years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside, driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below.
When these inputs are used in an option pricing model, the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the lower end of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately.
If the right to drill is postponed for an extended period, (i.e., five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical, either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by the pool of buyers of this optionality upside.
ConclusionWe caution, however, that there can be limitations in the model’s effectiveness, as we describe in Bridging Valuation Gaps Part 3. Specific and careful applications of assumptions are needed, and even then, Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes-murky marketplace. Today’s marketplace is particularly uncertain, and a quality appraisal is extremely valuable since establishing reasonable and supportable evidence for PUD, probable, and possible reserve values may assist in a reorganization process that determines the survival of a company, the return profile for a potential investment, or simply standing up to third-party scrutiny. Given these conditions, we feel that the benefits of using option pricing far outweigh its challenges.
What Does “The Market” Say Your RIA Is Worth?
GameStop Theory in a Consolidating Industry
Long before Reddit investors discovered that you could Occupy Wall Street more effectively with out of the money call options than you can with tents, Porsche briefly turned itself into a hedge fund and used a similar tactic to try to take over Volkswagen. The story sheds some light on how market pricing does, and does not, reveal the value of a business. Benchmarking the value of an RIA off the behavior of a few aggressive consolidators has similar limitations.Barbarians from BavariaAround 2005, a niche automaker from Stuttgart revealed that it intended to become the largest shareholder of the largest automaker in Germany. At the time, VW Group sold more cars each week than Porsche sold annually, but its share price lagged its industrial scale. Porsche had a CFO with larger ambitions and developed a strategy to use market manipulation to do what seemed impossible. Within a year of its announcement, Porsche’s stake in VW reached 25%, and then 30% by March 2007. Porsche denied mounting a full takeover intent, instead suggesting that it was protecting VW from hostile suitors (an accusation that turned out to be a confession).
[caption id="attachment_35773" align="aligncenter" width="690"]For a brief moment, VW had the largest market capitalization of any company on earth, with a closing price on October 28, 2008, of over $1,100 per share, or over 5x its current share price (data from Bloomberg, L.P.)[/caption]
By late 2008, Porsche’s ownership stake had climbed to over 40%, and it held options to purchase another 31.5%. The burgeoning stock price for VW was recorded as a gain at Porsche – profits that exceeded what Porsche made from selling cars. At the peak, VW was trading for more than 20 times where it was before Porsche started accumulating shares. If Porsche could’ve gained control of 75% of Volkswagen’s stock, it would trigger a change of control, and Porsche could strip VW’s balance sheet with 8 billion euros. Alas, the credit crisis intervened on VW’s behalf and Porsche’s self-inflicted wounds created insolvency that could only be remedied with a sale to, you guessed it, Volkswagen.GameStop TheoryBy now you’ve read plenty about the short squeeze on GameStop and other heavily shorted financial instruments and commodities (today it’s silver). It seems like it was only a few months ago that cryptocurrencies were exciting. We won’t bite at the opportunity to weigh in on whether or not loosely organized hordes of retail investors at aptly-named Robinhood should be allowed to out-manipulate billionaire hedgies.We will, however, consider the valuation implications of unusual market behavior. The investment management industry hasn’t been the target of vigilante options traders, and we’re not aware of any sub-billion-dollar managers launching a leveraged effort to take over, say, Focus Financial. But the RIA press is fond of breathless speculation about ever-higher prices being paid for firms. One of the absolute truths of the current environment for buying and selling investment management firms is that there has never been a larger number of capital providers offering a greater variety of transaction terms.The question is, what does it mean to you and the value of your firm?The Rules of the GameSome things haven’t changed. Valuation operates in an alternative returns world. In other words, the value of any given investment opportunity depends on the rate of return it generates compared to other opportunities with a similar risk and growth profile.Value is a function of cash flow, rate of return (relative risk), and growth. Assuming cash flow is a constant, for valuations to increase, either cash flow growth expectations must be higher or the expected rate of return must be lower – or both.It is through this lens that we have to view the news about industry consolidation. When a particular buyer makes an eye-watering bid for an RIA, one or more of these three basic elements is in play.The buyer has a unique circumstance that allows them to extract more profitability from the target firm than other bidders or than the firm could extract on its own.There is ample reason to be skeptical of this expectation. Investment management is labor intensive, and clients don’t like their relationship or investment people turning over. While there are some back office efficiencies that come from some transactions, it usually isn’t enough to be meaningful. In our experience, most buyers are genuinely interested in the talent-acquisition angle of an acquisition, because good and experienced industry veterans are rarely available.The buyer has a unique expectation of the growth opportunities inherent in an acquisition. Organic firm growth comes from market tailwinds and marketing discipline. It’s hard to forecast market tailwinds, especially in this environment, and marketing discipline can be built more cheaply than it can be acquired.The buyer is willing to accept a lower rate of return than competing bidders. This is the technical definition of winner’s curse. When Goldman Sachs paid up for United Capital, it wasn’t a big enough deal in the overall GSAM universe to dilute earnings, and it sped up Goldman’s foray into serving the mass-affluent. So even though Goldman accepted a lower return on the deal from a closed-form perspective, it had larger implications for the company that justified getting it done. Just because I found an exception doesn’t make it the rule. All else equal, the highest multiple is the lowest earnings yield, so the buyer is just willing to get less out of the deal.Just Because You Can, Doesn’t Mean You ShouldOne of the pioneers of the RIA industry was a smallcap manager who also happens to be the father of a friend of mine. One choice piece of wisdom that he passed on to his kids: “just because you can, doesn’t mean you should.”You can rationalize valuing RIAs higher today because interest rates are low and the space offers one of the few growth-and-income plays that has worked well for several decades. Time will tell, but interest rates are probably low because economic growth is low. If the market is leveraged to the economy, and RIAs are leveraged to the market, the rules of valuation suggest that low rates don’t necessarily defend higher multiples.Investment management firms used to be considered a value investment. If that’s no longer true, will internal transactions be possible? Will firms be compelled to sell into complex financial engineering schemes that cut every analytical corner in an effort to buy high and sell higher? The NPV of financial engineering, over time, is zero (before fees). No SPAC is going to change that.Does the high bidder set the market? On paper, yes. But the market for RIAs consists of tens of thousands of active participants, many of whom are quietly willing to sit out if financial returns aren’t high enough. Full stop.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?
Navigating Tough Family Business Conversations
A Family Business Journey
In this series of posts, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out.
“You’re talking about my wife’s salary? You have a lot of nerve,” I said while banging my fist on my desk. I may or may not have owed a few bucks to the swear jar. My kids’ college funds thanked me.
My family member (removed to protect their identity, in case they stumble upon this post) had asked a question about the overhead expense on our division’s P&L. My wife and I ran this division, and subsequently were a big part of that overhead. The division had solid revenue growth but was struggling to turn a profit. Compensation discussions are fair game for any business – often it is the largest line item.
It was completely legitimate point to raise.
But not here. Not my wife. Not coming from someone I eat family dinners with regularly. This was personal.
How should your family business have discussions around sensitive topics? Perhaps it is a patriarch who has run one too many strategic board meetings, the cousin who refuses to take their Vice President role seriously, or the aunt who is rather loose in defining what a “business meal” is. “No Aunt Millie, this is not a case of defining what 'is' is.”
My father-in-law, who served under his father in his current media company, has a simple family-business goal: He wants to be able to sit and have Thanksgiving dinner together, comfortably.
In nearly eight years of family board meetings and employment, he has shown me how to work towards that goal, even with tough conversations. While we have written previously on what not to say to ensure family harmony, we want to be proactive as well. Here are three tips I picked up from him during my time at our family business to ensure we were willing to pass the Sister Shubert rolls gently, as opposed to throwing them.1. Don’t forget the complex relationship.When I think of my colleagues at Mercer Capital, my relationships are linear and simple. I have teams I work with and people to whom I report. Now, think of a prominent member of your family business. They likely have multiple levels of relationships and titles: parent, boss, fellow board member, in-law, fellow trustee and/or trust beneficiary, or grandparent (all for the same person!). The key point is that different roles have different goals. As CEO, you may want to lead a growing and vibrant organization that plows earnings back into future capital projects. But you are also a sibling, and your sibling wants to maximize real-time income and distributions. When having tough conversations, remembering relationships may make it easier to balance dueling interests with equal consideration and, hopefully, cool heads.2. Attack the conversations head-on.Mercer Capital, fortunately (and unfortunately) has a wide range of experience in assisting contentious (read: litigious) shareholder and familial dissolutions in valuation and financial engagements. The family has a way of getting under our skin and can sow discord – leading to frayed relationships and, ultimately, poor family business outcomes. I could have contained my anger and let the comment go, choosing to complain about the question later in private to my wife. But what would have changed? Not much. And our business cohesion would have likely suffered due to possible resentment. I may have even begun avoiding similar conversations to stave off potential conflict in the future. Instead, after the temperature subsided, we had a meaningful conversation around the tough reality of our P&L. We leveled the conversation to the numbers and got in front of the issue – helping push us forward and keeping our relationship in a good place.3. If possible, have an intermediary.Remember me in the lead? Likely, if our CFO or head of HR were in the room, I would not have acted the way I did. With a family business, it can be helpful to have a neutral third party in the room to mediate or arbitrate contentious issues. Getting bad business news from a third party or professional colleague often stings. Hearing the same thing from your mother? Well, we’ll leave that to the imagination. Trusted third parties or intermediaries often can blunt other complex familial layers and limit the discussion to the business at hand, making tough conversations manageable. It's not easy, but it is manageable.ConclusionUltimately, my family member and I reconciled and have a good relationship today. This family member was older, lower on the organizational chart for this business unit, but higher on the corporate family board chart. There was a hierarchical waltz we danced successfully through the conversation. We also discussed the topic right then and there – the issue did not marinate longer than a minute or so in our P&L review. The one-piece we missed and could have used to avoid tempers flaring was an intermediary. The lack of a neutral moderator left the full, family relationship on display and the conversation veered in a negative direction briefly as a consequence.If you need someone to help you lead these tough conversations with your family, business team, or shareholder base, Mercer Capital has experience in thousands of valuation and financial consulting engagements for family business clients. If your tough conversation has a dollar sign attached, email us or give us a call and let us help you get on the other side of it.
Changing Advertising Trends for Sunday's Big Game
How the Auto Industry Is Spending Advertising Dollars
So it’s the week of the big game. What are you most looking forward to? The game? The food – appetizers and snacks? The halftime show? Or maybe the commercials? Inevitably, all of us probably have this same list of things in some particular order. The festivities will probably look entirely different this year with smaller gatherings and pandemic protocols affecting travel and public viewing at restaurants and sports bars. But what will this year's commercial line up look like?The big game has historically been a showcase for national companies and advertisers to try and leave a lasting impression on a mass audience. Each of us probably has a running short list of the most iconic and memorable ads from prior games: the Budweiser frogs, Wendy’s “where’s the beef?” or Coca-Cola and mean Joe Green tossing his jersey to the childhood fan. But, these advertisements aren’t for the faint of heart – they are very costly. 2021 is no different with Viacom/CBS having an asking price of about $5.5 million for each 30-second spot. The price tag serves as a barrier to entry for all but larger national brands or those few each year trying to splash onto the scene.The auto industry, specifically the OEMs, are no strangers to advertising during this annual football holiday. Looking back over the last five years, an average of seven auto manufacturers have participated with a high of nine advertisers during the February 2016 game and a low of five at the February 2019 game. The chart below displays the number of advertisements in each of the past five games, plus this year’s game.
What’s different in this year’s game? Well for starters, the pandemic has adversely affected television ratings and the public’s consumption of sporting events. The Fox Network, which broadcast last year’s game, had sold out its commercial inventory by Thanksgiving of the prior year. This year’s broadcast partner, CBS/Viacom, only recently sold out its commercial inventory in the past week. Traditional national brands and advertising participants (such as Coca-Cola, Anheuser-Busch/Budweiser, PepsiCo, and Avocados From Mexico) are sitting out this year from running in-game advertisements. How will the auto industry participate? As of this week, only three automotive companies/brands are scheduled to run in-game advertisements which would mark the lowest number of participants in the last five years. In addition to the lower number of auto spots, the messaging choice is also a reflection of trends in the auto industry over the past year: electric vehicles and online/remote retail sales. There are three companies participating in this year’s game.
General Motors – advertisement focusing on their ultium battery technology for use in electric vehicles.Cadillac – advertisement focusing on their lyriq electric crossover vehicle.Vroom – advertisement parodying the pains of the dealership buying experience to highlight their safely delivered, contact-free online buying experience.
Will this year serve to be an aberration or is it a reflection of advertising changes impacting the auto industry and auto dealerships?Auto Dealership Advertising Trends and SpendingAs we have previously discussed, three expense categories that declined in 2020 that helped auto dealerships maintain profitability despite declining retail sales were advertising, personnel, and inventory costs. Let’s examine some of the trends within advertising spending.The auto industry has historically placed heavy reliance on television and print advertising. According to Zenith Media, television is the second largest advertising channel for auto advertisers and as a whole, auto advertisers spend nearly 32% of their advertising budgets on television, whereas the average brands only spend 27% of their advertising budgets on television advertising.How are auto dealerships and auto advertisers adapting? First, consider several statistics revealed by LocaliQ in their Automotive Social Media Marketing strategy article.72% of Americans use at least one form of social media.78% of all car buyers consider social media in choosing their next vehicle.47% of car buyers spend time on Facebook Marketplace according to their study.
Over the past year, the pandemic forced many auto dealerships to shift to offering more online and remote retail services. While overall advertising spending was expected to decline in 2020, the automotive industry had already been spending more advertising dollars on digital media. The chart below shows the total automotive industry’s digital spending in the U.S. for 2017 through 2019, along with anticipated figures for 2020 and predicted figures for 2021.
While advertising spending had been increasing in digital channels prior to 2020 and is predicted to return to prior levels in 2021, the digital component to the overall advertising budget still remains a small percentage. In another view of digital spending, Zenith Media found that auto brands lagged behind average brands in this category also, with only 42% of budgets for the auto brands dedicated to digital channels in 2019 as compared to 49% by average brands.
Where are individual auto dealerships spending more advertising dollars in 2020? One channel highlighted by the studies discussed previously is Facebook. Facebook and Google are the two premier places companies across a variety of industries advertise and according to a study by Dealers United, the average dealership spent nearly $2,300/month in June 2020 as compared to only $1,600/month at the start of the year. These numbers were only expected to maintain those levels or climb higher as the year came to a close.
Digital media advertising allows auto dealerships to optimize the way car users search and shop using mobile devices. These outlets offer the dealership better tools to track their customers, interact with them, and offer a means of customer feedback and improved customer service. The costs for some digital channels can be a fraction of the cost of traditional television and print advertising. Combine lower costs and more targeted advertising, and online strategies seem like a no brainer. Maybe this plays a role in the decline in advertisements at this year’s Big Game.
While the three commercials this year also highlight trends we’ve seen this year with EVs and online sales, there’s another trend among the advertisers. Digital ads may be more targeted and have higher conversion rates/ROI, but there is no substitute for national TV advertising for events like the Big Game if you want to get a big message out to as many people as possible. We see this in politics, which really heats up around election day.
Vroom, GM, and Cadillac are all looking to make big statements. For the traditional brands, GM and Cadillac want to be known as going in on EVs. They aren’t going to be gas-guzzling forever, and they don’t want consumers to view them as the old guard that can’t adapt to new technology. GM recently announced its intention to be fully electric by 2035; advertising an EV during the game is just another way of amplifying this message.
Vroom is also trying to get their name out there. While their IPO may have generated some buzz last year, it seems like just about every IPO this year saw huge gains, so the typical branding advantage of such a jump was probably more muted. Consumers are more likely to have heard of Carvana, as it has a few more years on Vroom, and its car "vending machines" are well known by now. For a company like Vroom to compete, they have to spend considerable advertising dollars on getting their name out there and drive traffic to their site. So far, Carvana seems to be winning this battle, so an ad during this year's game just might help Vroom catch up.
ConclusionThe auto industry and particularly the manufacturers will always maintain some level of national television advertising. Over the last several years and specifically the last year, auto dealerships have shown the ability to adapt their operations including how and where they choose to spend their advertising dollars.As you watch the big game this weekend, pay attention not only to the memorable commercials but which brands are advertising this year and which brands are not. Also, look at their messaging. If you’re an operator of an automobile dealership, how are you choosing to spend your advertising dollars and how has that changed in the last year? What is your message?To discuss how these trends are affecting your dealership and their impact on the value of your dealership, contact a professional at Mercer Capital today.
Mercer Capital’s Value Matters® 2021-02
What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses?
Diversification and the Family Business
The Family Business Director To-Do List
The tyranny of the urgent imposes itself on family business directors just as it does on everyone else. In this series of posts, we offer various to-do lists for family business directors. Each list will relate to a particular family business topic. The items offered for consideration will not necessarily help your family business survive the next week, but instead reflect priorities for the long-term sustainability of your family business.In last week’s post, we reviewed the role of diversification in family businesses. This week’s to-do list includes important tasks for family business directors seeking to discern whether – and how – to diversify the operations of the family business. Thinking about diversification is essential for helping family business directors fulfill their duty to manage the risk of the enterprise. For mature family businesses, prudent diversification can be one of the most important means to promoting sustainability.1. Estimate What Portion of the Family’s Overall Wealth Is Represented by the Family BusinessAs we discussed in last week’s post, attitudes toward the benefits of diversification depend on whether one takes a “business” or “shareholder” perspective. When evaluating diversification opportunities, directors should have a clear understanding of which perspective they are taking and why. If the family’s wealth is concentrated in the family business, the “business” perspective will likely be appropriate. If, on the other hand, family shareholders have significant assets and sources of income outside the family business, the “shareholder” perspective is probably preferable. It is not unusual for larger families to have a mix of diversified and undiversified shareholders, in which case directors need to develop strategies for simultaneously managing the different shareholder “clienteles” within the family.
Family shareholders may chafe at disclosing personal financial information, so this needs to be approached with some tact. First, keep in mind that this is not an accounting exercise that needs to tie to the penny: broad percentages are acceptable. Second, family shareholders may be more willing to be transparent with a trusted third-party intermediary who can collect, analyze, and present aggregate shareholder data on a confidential basis.2. Identify the Primary Long-Term Strategic Threats to the Sustainability of the Existing Family Business OperationsWhat are the risks of failing to diversify? Assessing the strategic threats to the family business can help directors evaluate the most fruitful avenues of diversification for the family business. We find the Porter framework to be a helpful way to think systematically about the strategic position of your family business. The Porter framework organizes strategy under the headings of five basic competitive forces.Threat of New Entrants. How easy is it for new firms to enter your markets? What protects your family business from competition by new industry players?Supplier Bargaining Power. Where does your family business sit along the value chain from raw material inputs to consumers? Is your family business susceptible to supply disruptions? How well could your family business absorb or manage a price hike from your key suppliers?Rivalry Among Existing Competitors. What factors determine market share in your industry? Why do customers choose your family business over competitors?Threat of Substitutes.Is your family business selling steak or sizzle? What are other (existing or future) alternatives for your customers to get their sizzle?Customer Bargaining Power.How diverse is your customer list? What does your family business provide that customers cannot get elsewhere and are, therefore, willing to pay for?
Careful and objective analysis of the strategic threats to your family business can help directors evaluate whether to diversify, by how much, and in what direction.3. Establish a Family LLC or Partnership to Hold a Portfolio of Diversifying Assets (Real Estate, Marketable Securities, Etc.)Depending on family dynamics, it may be desirable to set up a mechanism for diversifying inside the family, but outside the family business. A family holding company structure can deliver both family governance and estate planning benefits. Directors should understand that, from an estate planning perspective, one of the principal benefits of such entities is the ability to transfer wealth at the fair market value of an illiquid minority interest in the family holding entity, which is generally determined net of discounts for the lack of control and lack of marketability inherent in such interests. The use of such discounts for estate planning transactions is potentially at risk under the Biden administration, so it may be beneficial to move quickly.4. Create Opportunities to Provide Seed Funding to Family Members with Compelling Ideas for New Business VenturesEstablished families may be in a position to make seed investments in start-up ventures as a way to both reap diversification benefits and promote engagement on the part of rising next generation family members. This should not involve providing a blank check for every harebrained-scheme your shiftless nephew hatches. Venture investing won’t be right for every family. Moreover, successful venture investing is a disciplined, and occasionally ruthless, process of identifying, funding, nurturing, harvesting, and – often – pulling the plug on unsuccessful ventures. Not every family has the characteristics needed to manage an in-house venture fund, but for those who do, the rewards can be substantial.ConclusionDiversification is too important to keep putting off until next quarter or next year. Give one of our professionals a call to help you get started on knocking out your to-do list today.
Headwinds and Tailwinds for Auto Dealers
Your Flight Itinerary for 2021
If you’ve ever been on a flight, you know that the pilot and plane itself can only do so much in determining how quickly you get to your destination. A key factor is which way the wind is blowing. If the pilot announces that there are headwinds, you can expect your flight time to be on the longer side. The opposite is true with tailwinds, and you can expect to arrive at your destination more quickly under these circumstances.Similarly for auto dealers, sometimes it doesn’t matter what the dealership’s management is like or how good the dealership itself is, as certain headwinds and tailwinds can make it harder or easier to achieve its goals. Below, we have considered some headwinds and tailwinds heading into 2021.Headwinds for Auto DealersRegulations in the Industry As we mentioned in the blog post which looked into how each presidential candidate’s policies would impact the auto industry, the end of the Trump administration most likely points to an end in regulatory rollbacks in the industry.In 2012, the Environmental Protection Agency and the National Highway Traffic Safety Administration issued regulations that would increase average fleet-wide fuel economy standards to 54.5 miles per gallon by 2025. Though President Trump had pushed back on the regulations, the Biden administration has indicated that they are in favor of these regulations and fuel economy and emission standards set by the Obama administration. Although the administration change could prove beneficial to EV manufacturers, especially in terms of Biden’s plan for providing further government assistance for these companies, an increase in regulations could make cars more expensive, which are already historically expensive.Though higher prices due to inventory shortages during the pandemic have helped margins for dealers, further increases in vehicle prices could dissuade consumers from purchasing vehicles. Dealers will have to hope they are able to continue to pass such costs along to consumers, which may prove more difficult with the proliferation of internet shopping, which brings us to our next headwind for traditional franchised dealers.Consumer Confidence IndexWhen consumers are more confident, they are more willing to make large purchases (i.e. vehicles). This makes it an important indicator for determining headwinds and tailwinds for auto dealers. Unfortunately, between the COVID-19 pandemic, unemployment rate jumps, and uncertainties regarding the election, there was a decline in the Consumer Sentiment Index, as seen in the graph below.
As the pandemic rages on and unemployment rates remain high, it’s tough to tell when consumer confidence will return to pre-COVID levels. However, the Biden administration’s plan for a $1.9 trillion stimulus bill could have a positive impact if it is passed.
Internet-Based SalesInternet-based sales for vehicles have had their moment in 2020 with the COVID-19 pandemic. Most notably in this industry was the Vroom IPO, whose success has shown investors are confident that internet-based sales for vehicles will be a larger part of the industry going forward. However, internet-based sales strategies can increase revenue at the detriment of margins as increased price transparency further decreases gross margins, posing a potential headwind for the industry going forward. Vroom and others have been able to undercut prices with significant inflows of capital. However, Vroom’s stock price is down a bit over 40% from August highs. If investors sour on the viability of the online used car sellers, this headwind could turn into a tailwind for traditional franchised dealers.Tailwinds for Auto DealersAverage Age of Vehicle FleetA study from IHS Markit found that the average age of vehicles on the road rose to 11.9 years this year, one month older than in 2019. This increase can be partially attributed to declines in new vehicle purchases as a result of the pandemic. Furthermore, vehicles, in general, are lasting longer and increases in prices have dissuaded some consumers from purchasing new vehicles.While new vehicles made up 6.1% of vehicles on the road last year, IHS Markit predicts the final data for 2020 will be closer to 5%. This increase in the overall vehicle age represents pent-up demand for new vehicles. To the extent the pandemic has persuaded would-be buyers on the margin to forego purchases, increasing vehicle age portends greater demand for parts and service operations, which is a positive tailwind for the industry.InventoryAs we mentioned in our New Year’s Resolutions blog post, inventory is the name of the game in 2021 as production has ramped back up, and many of the public dealerships anticipate their inventory levels to fully recover. Because of the inventory shortages caused by manufacturing shutdowns in 2020, many shoppers who were looking for specific models, especially trucks, might not have been able to find what they were looking for. With inventory recovery on the horizon, many dealerships are hopeful this will no longer be a problem. The stabilization of inventory levels presents arguably one of the largest tailwinds for the industry going into 2021. However, it is important to note that a computer chip shortage that has been garnering attention at the beginning of this year poses a threat to this inventory resurgence.Interest Rates With interest rates near zero and the Federal Reserve chairman Jerome Powell indicating that will continue for the near future, auto dealers stand to gain. Lower interest rates make cars and trucks more affordable for consumers financing these large purchases. If interest rates stay low as they are expected to, most consumers will be able to finance vehicles at affordable rates. This should help to offset our headwind above with rising prices.Public Transportation SentimentWhile the COVID-19 pandemic has been devastating for public transportation, auto dealers may be able to gain a new customer base or expand their current one as a result. With Americans relying further on personal vehicles to avoid being in public areas, cars have become more important than ever to many Americans trying to limit exposure as much as possible. Furthermore, with more companies bringing their employees back into the office, this could have a positive impact on car sales as well.The graphs below show both public transit unlinked trips and vehicle miles traveled. While vehicle miles traveled has almost recovered from pre-pandemic levels and are down only 9% in October 2020 compared to October 2019, public transit ridership has fared much worse, down 62% in the same time period. This decline in consumer sentiment for public transit presents a positive tailwind for the industry.ConclusionWe hope that this post is helpful; however, as 2020 made painfully clear, these are only predictions based on current trends. It’s impossible to know exactly what lies ahead. For now, we can all just hope that the ride won’t be as bumpy as 2020 was.If you’re interested in how these trends may affect your dealership or would like to discuss a valuation issue in confidence, feel free to reach out to Mercer Capital's Auto Dealer team.
RIA Industry Extends Its Bull Run Another Quarter
Continuation of Market Rebound Drives All Categories of Publicly Traded RIAs Higher in Q4 2020
Share prices for publicly traded investment managers have trended upward with the market since March’s collapse. Aggregators fared particularly well over the last nine months on low borrowing costs and steady gains on their RIA acquisitions. Traditional asset and wealth managers have also performed well over this time on rising AUM balances with favorable market conditions.[caption id="attachment_35650" align="alignnone" width="959"]Source: S&P Market Intelligence[/caption]
The upward trend in publicly traded asset and wealth manager share prices since March is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility.
The fourth quarter was also favorable for publicly traded RIAs of all sizes except the under $10 billion in AUM category. This underperformance is largely attributable to the lack of diversification in this index and one company’s (Hennessy Advisors) earnings misses rather than any indication that smaller RIAs have struggled over the last few months.
[caption id="attachment_35651" align="alignnone" width="862"]Source: S&P Market Intelligence[/caption]
As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to COVID-19’s impact on the market. Multiples were inflated in Q2, as prices recovered and earnings lagged—but have metrics have since normalized as prospects for earnings growth have improved with AUM balances.
[caption id="attachment_35652" align="aligncenter" width="518"]Source: S&P Market Intelligence[/caption]
Implications for Your RIADuring such volatile market conditions, the value of your RIA is sensitive to the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter and has now recovered most or all of that loss. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down significantly in the first quarter but has since recovered to above where it was a year ago (see chart above). The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last valuation, while being careful not to count good or bad news twice.While the market for publicly traded companies is one data point that informs private RIA valuations, that’s not to say that privately held RIAs have followed the same trajectory as their larger public counterparts. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds discussed above. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter of 2020. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.You also need to consider the implications of the recent election and Georgia run-off on your clients’ estate planning needs in the face of higher taxes and lower exemptions (What RIAs Need to Know About Current Estate Planning Opportunities) that could go into effect next year. And you should always be thinking about practice management issues (RIA Practice Management Insights) and how your firm can thrive in a chaotic market environment.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The fourth quarter was generally a good one for RIAs, but who knows where 2021 will take us following a wild year for RIA valuations and market conditions.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?
Playing the Match Game: Finding the Perfect Fit Between Buyers and Sellers
Guest Post by Louis Diamond of Diamond Consultants
For most independent RIAs, a future M&A transaction is inevitable. The impetus behind the transaction could be the partners’ desire to retire, gain scale, accelerate growth, meet liquidity needs, reduce the time burden of non-client facing tasks, or some other motive. Whatever the reason, picking the right partner is critical for the success of the transaction. For both buyers and sellers, knowing where your firm fits into the RIA M&A landscape is an important first step towards identifying compatible transaction partners. The universe of RIA sellers can be categorized based on firm culture, the motive behind the transaction, management’s expectations for post-transaction roles, liquidity needs, the status of next-generation management, and the like. As RIA transactions have proliferated in recent years, several different buyer profiles have emerged that address the concerns of these different seller types. In this week’s guest post, Louis Diamond of Diamond Consultants identifies four common buyer profiles and the types of sellers that fit well with each.Louis Diamond will be speaking on the topic of advisor recruitment and acquisitions at our upcoming RIA Practice Management Insights conference, to be held March 3-4. Register now to hear more from Louis Diamond along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.Most acquirers have traits within one of four categories—each offering a unique value to sellers. And having the “right” persona can make all the difference in attracting the right acquisition partners.Many independent firms reach a point in their business lifecycle where they can no longer sufficiently grow or compete on their own. It’s when discussions around finding a way to gain scale and solve for succession hit a wall that firms often consider a merger or acquisition opportunity. Yet finding the right M&A partner isn’t all that easy.As a firm that represents both buyers and sellers, it’s our job to keep a finger on the pulse of the market and listen to many value propositions from prospective buyers. That said, only a handful of firms are truly poised to be meaningful acquirers in this hyper-competitive marketplace. Attributes such as being well-capitalized (given that most sellers expect a decent portion of the purchase price at closing), having a repeatable and battle-tested M&A process, a unique value proposition, and strong leadership are now table stakes in this environment.Buyers and sellers alike often fail to recognize what a marriage between firms can mean for ongoing control, growth and quality of life. Therefore, it is paramount that firm owners are strategic in how they present their value to prospective sellers—and sellers come to the table prepared with clearly identified expectations of the new affiliation.One key area that many buyers often lose sight of – which helps to focus targeting, due diligence efforts and proper alignment – is being clear and honest about what “type of acquirer profile” your firm represents to a prospective seller. It’s equally important to recognize that remaining consistent in this regard is critical; that is, once a firm persona is established, any variances can lead an organization astray of its core competencies and culture, ultimately suppressing enterprise value. And for sellers, recognizing their goals and matching those with one of the four profiles will ultimately translate into a more strategic and focused sale process.The Four Acquirer ProfilesWe find that most acquirers have traits within the following four categories—each of which offer a unique value to sellers.1) Standalone RIAsThese firms are exemplified by a “one brand, one firm, one investment” approach. The most successful acquirers in this group manage more than $1B in assets and have a similar culture, operating structure, and approach as the firms they acquire. They tend to do a small number of deals, so they are typically more strategic in nature than financial. These firms may sometimes allow the seller to maintain an active voice in steering the ship and become a relatively significant equity holder, if so desired. Additionally, all back office and business operations will be taken off the seller’s plate.Another important distinction for those who become an equity owner: There is still the possibility of a significant liquidity event down the road if they take on an investor or sell the firm.Examples: Numerous RIAs have completed a handful of deals and are embarking upon M&A for the first time.Most attractive sellers: Principals who have a longer runway to retirement and are still looking to retain some managerial duties, and those who are primarily focused on a good cultural or local fit. Or an advisor close to retirement who identifies an ideal hand picked successor already at the acquiring firm.Least attractive sellers: Those who value maximum upfront money since these firms are not backed by deep-pocketed investors; those wanting more of a national footprint or brand; or anyone looking to remain fully in charge of operations, since to an extent, investment management and financial planning are standardized across the firm. Also, sellers looking to get a deal done quickly might steer clear of acquirers in this category as these standalone firms tend to be less-experienced deal makers.2) Aggregators or RollupsFirms that are very well-capitalized, prolific deal makers are frequently referred to as aggregators or rollups. They excel at operations, streamlining businesses, standardizing processes, and maintaining strong communities of like-minded advisors. They will take over the entire investment management program, as well as the financial planning process—essentially everything aside from client service. Many firms in this category have cracked the code on organic growth so may have a dedicated business development team, a well-oiled digital marketing or seminar-based lead development system, or be active in the various custodial referral programs.Examples: Mercer Advisors, Beacon Pointe, Mariner, Allworth, and Buckingham.Most attractive sellers: Firms that believe the acquirer has built a “better mousetrap” and are in complete lockstep with the acquirer’s values (i.e., a hard-core focus on financial planning). Also, a good fit those seeking an exit strategy or to gain considerable scale and vastly accelerate organic growth, as well as those who want to step away from the day-to-day operations and just focus on clients.Least attractive sellers: Any principal who is not ready to give up full control.3) Platform AcquirersThese are organizations with many different types of businesses under one roof, but with common middle- and back-office infrastructures. They want sellers to leverage their platform and scale, yet they are all about letting businesses continue to operate in silos.Examples: HighTower Advisors, Kestra Financial (Bluespring Wealth), Stratos Wealth Partners, Sanctuary Wealth PartnersMost attractive sellers: Those who are seeking a partial liquidity event or looking to step back from business ownership, yet still value being involved with portfolio management, financial planning, maintaining their brand, prospecting, and even running their own P&L.Least attractive sellers: Advisors who are close to retirement, yet do not have a succession plan; those who are seeking dedicated resources to fully take on planning, investment management, and day to day client facing responsibilities; and those who are no longer interested in managing a business.4) Financial Buyers or InvestorsThere’s no shortage of capital chasing the independent wealth space as countless private equity firms, family offices, sovereign wealth funds, and diversified financial services companies have made passive investments in larger scale firms. These firms offer prospective sellers the ability to take significant chips off the table by selling a portion of their business. They serve as a strategic growth partner to assist in the sourcing, structuring, and financing of sub-acquisitions, as well as provide the opportunity to retain brand and the client service model.Examples: Focus Financial Partners, Wealth Partners Capital Group, Emigrant Partners, Merchant Investment Management, CI FinancialMost attractive sellers: Those who value maximum upfront cash, retaining day-to-day control of the business, minimizing change, and growing by way of acquisition.Least attractive sellers: Advisors looking to offload the non-client service and business development processes, a firm without an internal succession plan, firms that struggle with profitability and scale, those less interested in focusing on organic and inorganic growth.
A merger or acquisition can benefit both parties involved, provided each are equally motivated with compatible needs and goals. By identifying the unique needs and requirements of each party (prior to engaging in an M&A project), the process of meeting the right match can be far more efficient and lead to a successful marriage.
About the AuthorLouis has guided many of the top teams in the industry as they’ve transitioned to another employee-model firm or launched RIA firms. And as a next generation leader himself, Louis has a passion for representing complex multi-generational teams.A George Washington University magna cum laude graduate with a BBA degree in Finance and International Business, Louis began his career with some of the biggest names in the financial services industry. His time working as a consultant at Ernst & Young, and in wealth management at Morgan Stanley and UBS, well prepared him to understand the financial world from a client’s perspective.We're excited to have Louis speak at our inaugural RIA Practice Management Insightsconference.
2021 Is Still an Optimal Time for Gifting Interests in E&P Companies
Factors That Led to a Rush of Estate Planning Activity in 2020 Largely Remain
December was a busy month at Mercer Capital, and at business valuation firms across the country. Clients sought to make gifts and perform other estate planning transactions ahead of year-end. But the changing of the calendar does not mean that the window for gifting is over. The factors that led to a rush of estate planning transaction activity during 2020 largely remain. The combination of depressed E&P valuations, the potential for future tax changes, and the ability to utilize minority interest and marketability discounts are still present in 2021.Depressed E&P Valuations2020 was a difficult year for many companies, though the pain was acute for E&P companies that were faced with unprecedented demand destruction that led to negative oil prices. Recovery appears to be taking hold, but the pace is uncertain and some changes in commuting and business travel habits might be permanent.While E&P company values (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF) have recovered from their lows in March, the index remains down year-over-year, having declined 38% during 2020.[caption id="attachment_35371" align="aligncenter" width="645"]Source: Capital IQ[/caption]
The recent spate of E&P bankruptcies also is indicative of a challenging operating environment and reduced equity valuations. There are exceptions with assets and situations of highly economic Tier 1 production, and/or acreage that can maintain or have proportionally small value decreases during this downturn, but most E&P companies have suffered alongside commodity prices.
While unpleasant from a net worth perspective, this (hopefully temporary) reduction in value can be a boon for estate planning purposes, allowing taxpayers to gift larger interests, while utilizing less of their gift & estate tax exemption (or paying less in taxes on the gifted interest).
Potential for Future Tax ChangesPresident-elect Biden’s tax plan calls for some major changes to the current gift & estate tax regime. Most notably, the estate tax exemption could be reduced from today’s $11.7 million (unified) to $3.5 million (estate) and $1.0 million (gift), and the tax rate could increase from 40% to 45%. The prospects for tax reform likely increased after Georgia’s Senate run-off elections on January 5th put the Democrats in control of both houses of Congress.While new tax legislation could potentially be made retroactive to January 1, many tax policy experts see that as unlikely. Mercer Capital’s Atticus Frank has a great blog post with additional reading for anyone interested in estate planning for 2021.Consider taking advantage of the current gift & estate tax exemptions in 2021 before they potentially go away.Minority Interest and Marketability DiscountsBy gifting minority interests to heirs, taxpayers can potentially utilize minority interest and marketability discounts to reduce the value of the gifted interest and ease gift & estate tax burdens. These discounts are highly dependent on facts and circumstances surrounding the subject interest. Mercer Capital has successfully defended its minority interest and marketability discounts to the IRS and in other litigated contexts.By gifting minority interests, one does not only benefit from the application of minority interest and marketability discounts during the gifting process. If done as a part of a thoughtfully executed estate planning strategy, gifting can result in a non-controlling ownership interest in an estate, allowing for the potential application of discounts for estate tax purposes as well.Mercer Capital’s Travis Harms has an insightful blog post about this issue. In the post, he runs hypothetical math showing the difference in potential tax liabilities under various gifting scenarios. A thoughtful gifting strategy as part of a broader estate plan can have a significant impact on the proceeds heirs receive from an estate.ConclusionDespite what one might think, the window for gifting transactions has not closed. Mercer Capital provides valuation and other financial advisory services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.
Small/Mid-Sized Asset Managers Can Stay Relevant
Asset Management Industry Outlook
Over the last decade, investors have generally earned a higher net return by investing in passive vehicles rather than actively managed funds. Heather Brilliant, CFA (CEO of Diamond Hill), says the growth of passive investing has allowed “investors to access beta at a much lower price.”However, the strong performance of large cap indices like the S&P 500 between the 2008-2009 recession and February of this year has also contributed to outflows from actively managed products. In March of last year, when the stock market fell due to COVID-19, many of our clients thought this would lead to a reversal in the trend. Active managers could once again shine.When the market quickly recovered and performance was largely driven by a handful of sizeable tech companies, however, active managers continued to struggle to deliver alpha (net of fees). U.S. trailing twelve month fund flows as of November 2020 were negative for all classes of actively managed equity investments and positive for all passive products. Passive market share is now greater for U.S. equity investing than active, a first.
While large asset managers (i.e. BlackRock), are protected by sheer scale, how do small/mid-sized asset managers stay relevant in this environment?
As we noted last week, the multiples observed for publicly traded asset managers are often lower than multiples observed in acquisitions of wealth management franchises. Asset managers are still facing numerous headwinds, as outlined below, and this higher risk profile and lower opportunity for growth is the cause for lower multiples.
Industry HeadwindHow to Stay RelevantUnderperformance Drives Outflows
An asset manager’s clients are more likely to jump ship after short term underperformance than clients of wealth managers. A 2016 State Street Study found that 89% of clients will look elsewhere after just 2 years of underperformance. But outperformance can also drive asset attrition from rebalancing.Educate your Clients
Investors who truly understand the risk/ return profile of their investment portfolio are more likely to tolerate short term underperformance. Most asset managers have a style that will work better in some markets than others.
Asset Management Industry Barbell
Many asset managers are too small to achieve scale yet too big for the investment team to create highly researched and distinguished funds. Some of these firms are capitulating to consolidation, but there are other options.Commit to Capacity Limits
The CEO of Diamond Hill Capital Management, Heather Brilliant, CFA, took the stance in a recent podcast that active management is not a scale game. While many consider this to be a shortcoming of the industry, acknowledging that your firm cannot work for everyone, but can deliver great returns for fewer investors, is key. Her advice lines up with the recent growth of the OCIO industry, which commits more time and energy to individual clients’ needs.
Fee Pressure
As we have written numerous times before, fee pressure in the asset management space has increased over the last decade, as low-to-no-cost products have proliferated and actively managed products have underperformed.Differentiate Products and Trim Expenses
There are two ways to increase the bottom line: 1) increase revenue and 2) reduce expenses. Asset managers can combat fee pressure by differentiating their products by taking a new approach to branding or by considering specialized investment classes such as sustainable investing. But, without buttressing your fees, the only way to save your margin is to clean up the “back of the house.” Investment management techniques and products have developed tremendously and there is a growing focus to match this development in the back office.A Plug for Mercer Capital's Upcoming RIA Practice Management Insights ConferenceWe’ve decided to put together a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.The topic list is unlike that of any other investment management firm forum. We’ve attended and spoken at plenty of great conferences that cover investment products and M&A, so we’re not going to plow that ground ourselves. Instead, we have gathered an impressive list of thought leaders who have built careers out of professionalizing the “back of the house” to support the best investment management products and services.Please join us to get their wisdom on how your firm can evolve to become a more sustainable, profitable, valuable enterprise.Have you registered for the RIA Practice Management Insightsconference yet?
Should You Diversify Your Family Business?
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures
Should You Diversify Your Family Business?
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures
Should You Diversify Your Family Business?
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures
December 2020 SAAR
2021 Predictions for Auto Dealers
Coming into 2020, vehicle volumes in the U.S. were anticipated to dip below 17 million light vehicles sold. The industry had eclipsed this mark in each year since 2014, though 2019 cut it close. Like most industries, automotive retail got off to a strong start in 2020. While SAAR was just below the 17.0 million mark at 16.9 in January and 16.8 million in February, the boost of a leap year falling on a Saturday had total volumes at just shy of 2.5 million, up 4.5% from 2019. While dealers were hopeful volumes would remain high, we all know what happened next in March and April, which put to rest any notion of 17 million vehicles sold. In the U.S., 14.46 million units were sold in 2020 representing a 14.7% decline and the lowest total since 2012. Normalizing only March and April to their 2019 levels, volumes in 2020 would have been 15.7 million, showing nearly half the 2020 decline occurred in just those two months.The decline can also be attributed to a significant reduction in fleet sales as the COVID-19 pandemic’s impact on travel caused several major rental car companies to cancel orders. In December 2020, monthly retail sales appear to have actually improved 0.5% from 2019, compared to a 33% decline in fleet volumes. Viewed another way, fleet sales represented only about 14.3% of total volumes in 2020, compared to a 19.6% share in 2019. We touched on the impact of retail vs total SAAR last month.The pandemic had a material impact on the sales process in March/April and the sales mix from fleet to retail, predictions from before the pandemic about sales volumes weren’t that far off the mark once stay at home orders were relaxed and dealers figured out how to navigate the new protocols. By September, SAAR had returned above 16 million. However, no month in 2020 reached seasonally adjusted volumes of 17 million, a mark reached seven times in 2019 and every month but two in 2018. So, while nobody could have predicted the depths of the pandemic, we see that the initial expectation of a lower run rate may have been correct.Eisenhower once said, “Plans are worthless, but planning is indispensable.” According to Scott Galloway, Professor at NYU Stern School of Business, “the same is true for predictions – they matter for the strategy and data behind them. Predictions are useless, but scenario planning is invaluable.” I find this quote to be even more telling as it appeared in a piece about predictions for 2020, which just about everyone missed.Heading into 2021, we’re going to make some predictions. While they may or may not prove true in 2021, we believe this exercise is beneficial for auto dealers who should be looking forward to what the year might bring and prepare themselves should these trends materialize. While nobody could have predicted their need for Clorox and face masks, the pivot to digital offerings and more targeted advertising was already in motion prior to the pandemic. Intentional planning can help prepare for what lies ahead, whether or not things actually unfold as you project. It’s the preparation itself that’s meaningful.Inventory Constraints Lessen and Fixed Operations ReturnsThis prediction is based on the trends seen at the end of 2020 continuing through 2021. As vaccine distribution ramps up, auto manufacturing should continue as well. The speed of each of these will likely be a significant factor in total volumes in 2021. Fixed operations, particularly collision, were diminished in 2020 with fewer road miles driven. Due to inventory constraints and potential affordability concerns, among other reasons, consumers shifted towards used vehicles. We anticipate normalizing inventories and an improving economy should both tilt the mix back towards more new vehicles. However, the recent increase in used vehicle sales should increase the average age of vehicles on the road, which tends to spur more business for dealers’ service and parts departments. Since this is the highest margin business for auto dealers, we see tailwinds in terms of total profitability. While higher volumes can bring in more bonus money to dealers on the backend, at the end of the day, profitability is what drives value for auto dealers.Crossovers Remain Popular as Low Gas Prices and High EV Battery Costs Don’t Make the Trade-Off Worth It to the Bulk of Consumers, Yet.Pickup trucks accounted for 19.7% of market share, higher than all cars combined (small, midsized, and large) excluding luxury. Combined with crossovers (43.3%), SUVs (8.7%), and vans (4.7%), light trucks accounted for 76.4% of all sales, up from 72.1% in 2019 and 69.2% in 2018. Larger vehicles have become increasingly popular with consumers, and low gas prices and improved MPGs reduce the costs of the trade-up in size. Even inventory shortages and reduced incentives haven’t deterred demand in this segment. Incentives in December 2020 were down 12.7% from 2019, which along with the continued shift to higher priced vehicles, pushed average transaction prices to all-time highs of just over $38 thousand per vehicle.Nearly 96% of vehicles sold in 2020 were gas or diesel-powered, with EVs making up only 1.4% of the market. While there has been significant investment in this space, and an incoming Democratic administration portends a shift towards sustainable fuels, we do not anticipate this to materially accelerate in 2021. Instead, most of the EV progress anticipated in 2021 is more likely to be along the lines of infrastructure investment, legislative assistance, and vehicle improvements. While many manufacturers such as Volvo have made claims their cars will be all-electric by 2030, we see that progress being back-ended. While Elon Musk claimed EV battery costs could be cut in half, but this will still be years from now. Ultimately, until the sticker price can meaningfully compete, EV’s won’t reach the majority of consumers.SAAR of 16 Million (Above NADA’s Forecasted Figure of 15.5 Million)NADA is forecasting a SAAR of 15.5 million in 2021, making our prediction slightly on the bullish side. While the industry appears set for a second straight year below 17 million, improved margins could leave dealers with higher gross profits, which would be a welcomed trade in the industry. According to NADA, headwinds for the vehicle market in 2021 include continued increases in COVID-19 cases, which could lead to production disruptions along the vehicle supply chain. They further noted a global shortage of semiconductor microchips used in many facets of auto production and tight inventory on dealer lots, particularly for pickup trucks. Alternatively, tailwinds for 2021 include a potential economic boom in the second half of the year once a coronavirus vaccination is widely available, and Americans return to work from WFH. Auto retailers also stand to benefit if consumers continue to prefer personal vehicle ownership over rideshare services and public transportation. Finally, low interest rates keep cars affordable, and the Fed has indicated it intends to continue to be accommodative, which should support vehicle demand.Conclusion As auto dealers know, SAAR is a decent gauge on the industry, but it tells us very little on its own. While we believe it’s important to track, we recognize the inherent limitations of just volumes. In the proper context of incentive spending, profitability, and other key metrics, SAAR can be helpful. While dealers can see how their volumes compare to wider industry trends, dealers need to focus on the underlying trends within their local markets to contextualize performance to make sure they are staying ahead of the curve.For an in-depth analysis of how your dealership fits in the auto dealer marketplace, contact a member of Mercer Capital’s Auto Dealer team today.
Silver Linings: Using Crisis to Improve Your RIA’s Health
Guest Post by Matt Sonnen of PFI Advisors
Early in the COVID pandemic, PFI Advisors published an article outlining how RIAs could perform an “Operational Diagnostic” to improve their profitability. Matt Sonnen wrote, “For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals. When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line…”Nine months later, most RIAs and their clients have recovered from the market volatility and ended up having a very good year, at least on paper. Now’s the time for RIA principals to consider how they can advance their firms to be ready to meet the next challenge with greater ease.We’re featuring Matt Sonnen’s wisdom on operational best practices and business strategy in our upcoming conference, RIA Practice Management Insights, on March 3 and 4. Registration is open.
This article is being published a bit early, I realize that. When you go to the doctor with clogged sinuses, a splitting headache, and body aches like you’ve never had, you just want some antibiotics that will get you back on your feet as quickly as possible – you aren’t in the mood to hear a lengthy admonishment over your lack of exercise and eating habits. “Doc – if I survive this thing, I promise I’ll go on a diet and exercise in order to prevent this from happening again, but you’ve just got to help me get out of bed tomorrow, first!” we all say.
The recent pullback in the market is putting stress on RIAs from coast to coast. Revenues are estimated to be down 10 – 15% for the year, putting pressure on profit margins and causing some RIA owners to fret about the viability of their businesses and what cuts they’ll need to endure in the coming months. We’ve written about the need to focus on profits before (What RIAs Should Learn From Uber and Lyft and The Age-Old Debate: Profit vs. Growth – What’s More Valuable?), and much has been published in the past few weeks about the need to focus on profitability in order to survive this downturn. Lecturing RIAs about their profit margins right now is a bit like the doctor lecturing you about your eating habits when you are just trying not to pass out from exhaustion, and your body furiously fights off a bacterial infection. But at some point, it is prudent for you to look at preventative measures that can help you avoid that pain in the future. For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals. When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line…
Why are profits so vitally critical now, you ask? A recent Financial Advisor IQ article quoted the Boston Consulting Group’s finding that “profits in absolute terms at wealth management companies have yet to reach pre-2008 crisis levels.” BCG says, “Even when allowing for some profit growth during 2019, the average firm thus has a much lower buffer to absorb shocks.”
Philip Palaveev recently stated in a Financial Advisor Magazine article, “Much like the [corona]virus, if someone has health issues, they are very vulnerable and perhaps they need to be looking ahead and taking even more precautions.” He continued, “Those firms with less than 25% profit margins have less room to wiggle without going to compensation reduction and layoffs.”
Brandon Kawal of Advisor Growth Strategies agrees with Palaveev’s 25% profitability hurdle, stating in a recent RIAIntel article, “A healthy operating margin – net of owner and employee compensation costs – is generally between 25% and 30%. Less profitable firms could potentially face drastic declines in compensation and even resort to cost cutting.” Kawal continued, “I imagine a lot of owners are sort of stuck in the here and now [tending to clients]. As we go through the coming weeks, it’s going to be time to take a step back and really take a look at the business holistically.”
In his recent article, Don’t Waste This Crisis, Matt Crow of Mercer Capital points out, “The value of RIAs and the future of transactions in the industry ultimately comes down to the health of the individual firms. Fortunately, there is a relatively straightforward way to assess the financial well-being of your firm, and ways of taking corrective action if your firm’s future is threatened.”
Crow recommends RIAs take a look at their ongoing revenue and expenses. Starting with expenses, he advises, “Take your last month’s P&L. Your biggest expense is labor and benefits; it’s not unusual to see labor costs comprising two-thirds or more of an RIA’s total operating costs.” For a simpler calculation, he says to leave out discretionary bonuses and just focus on salaries and benefits. “Once you’ve quantified total personnel costs, look at other fixed costs like rent, research, compliance, technology, systems, etc. Adding all that together will derive your annualized expense base.”
Now it’s time to calculate your adjusted revenue, given the pullback in the markets. Crow points out, “The beauty of the RIA model is that you can know, on any given day, what annualized revenue is. Take your closing AUM as of the most recent trading day, filter it through your fee schedule, and you can tell, based on that day’s market pricing of your client assets under management, what annualized revenue is.”
He concludes, “With annualized revenue and expenses calculated, you know whether or not you’re profitable, and by how much.”
As every episode of G.I. Joe concluded in the 1980’s, “Knowing is Half the Battle.”
The next big question is, “What the heck are we going to do about it?”
There are only two sides to the profitability equation that you can manipulate in order to boost profitability: you can increase revenue, or you can decrease expenses. Given the fact that no one knows how the current economic uncertainty is going to play out and the effect it will have on RIA revenue, it is most logical to focus on expenses. There are hard costs to examine – “Where can we spend less money?” and there are productivity costs to review – “Where are we under allocating resources that we could be more productive and service our clients more efficiently?”
In our opinion, the best way to perform this analysis is through an Operational Diagnostic, where you review each of your core back office systems and workflows and ask yourself a few key questions, detailed below. Maybe you are spending money on systems that your firm is not fully utilizing, and there is a less expensive system that could be implemented without causing any decrease in client service. Maybe you have underspent in certain areas, which is causing too many man hours to be spent on basic tasks. The Operational Diagnostic process should reveal these areas and allow you to more efficiently provide high-touch service to your clients.
Another area to focus on would be Client Segmentation. The goal of any client segmentation exercise is to determine the proper resources to allocate across your client base. Are you profitably servicing every client, based on the complexity of the relationship and the fees they are paying you? Here are some ideas around a Client Segmentation exercise:One last area worth evaluating is what services are you outsourcing vs. conducting in-house? We recently wrote an article expressing our thoughts around building vs. buying your RIA’s client portal. Other areas you may want to consider outsourcing are:PFI Advisors has helped many RIAs think through profitability since our launch in 2015 – whether we are asked, “How do I run my firm more profitably?” or “How do I launch an RIA that will be designed to maximize profitability?” or “How do I successful execute a merger in the most profitable fashion?” We are always here to help RIAs think through these issues, but this analysis can be done in-house as well, following the guides included below.We’ll make it through this, just like we’ve made it through other economic downturns in the past. Matt Crow points out, “The current [environment] threatens our physical health as well as our financial health, so it wears on our psychology much more than most economic downturns.” This one is tough, on many levels. But when the dust settles, and our physical health is assured, use this wake-up call to focus on the health of your business. As management guru and former CEO of Intel, Andy Grove, stated, “Bad companies are destroyed by crisis. Good companies survive them. Great companies are improved by them.”Originally published in April 2020.About the AuthorMatt founded PFI Advisors to help existing RIAs tackle the various operational and strategic issues that arise as they continue to grow, and to help billion-dollar breakaway teams start their own RIAs. He left Focus Financial Partners in 2015 to launch PFI with his wife and business partner to help RIAs become more successful. Matt understands the importance of efficient systems, as he carried out two full system replacements while COO/CCO of Luminous Capital. He has 20 years of industry knowledge and experience to help your firm reach its full potential.For the past two years, Matt has been hosting a monthly podcast, The COO Roundtable. Through interviews with top operations leaders from around the country, the podcast highlights the incredibly important work COOs perform on a daily basis. We are excited to have Matt conduct a live interview at the RIA Practice Management Insights Conferencewith two operations professionals to discuss best practices and general business strategy for the RIA industry. With all the disruptions caused by COVID-19, operations professionals have more leverage with RIA owners than possibly any time in our industry’s history. This is bound to be an insightful discussion. To learn more about The COO Roundtable, click here.
Q4 2020 RIA Transaction Update
Deal Activity Rebounds After Brief Lull; Deal Terms and Multiples Remain Robust
After a brief lull during the second quarter of last year, RIA deal activity surged in the fourth quarter, rounding out a record year in terms of reported deal volume. Concerns about the pandemic and market conditions were quickly shrugged off, as deal terms and the pace of deal activity returned to 2019 levels after the brief pause at the peak of the shutdown.The strong fourth quarter deal activity reflects a continuation of the upward trajectory seen over the last several years. Fourth quarter deal activity was further accelerated by the backlog of deals that had stalled earlier in the year and by the expectation for increases to capital gains tax rates when the new administration takes over. The total reported deal volume in 2020 increased 28% from 2019 levels, and while deal count declined 15% from 2019 levels, the decline was almost entirely attributable to the brief slowdown in the second and third quarters. The average deal count in the first and fourth quarters exceeded the 2019 quarterly average.Deal Terms Remain Robust Deal terms and multiples showed remarkable resilience in 2020.Deal terms and multiples for wealth management franchises showed remarkable resilience in 2020. While the height of the market downturn caused some buyers to exercise caution regarding multiples and deal terms, the effect was short-lived. As equity markets rebounded and the uncertainty diminished, deal terms and multiples quickly returned to 2019 levels, with attractive RIA sellers seeing high single digit multiples of EBITDA and meaningful portions of the purchase price paid in cash at closing.The strength of deal terms is not surprising given the influx of new buyers in recent years. RIA aggregators, strategic acquirers, banks, and private equity have all been elbowing their way to the table, which suggests a continued seller’s market.Consolidators Drive Deal ActivityRIA consolidators and larger RIA strategic acquirers continued to be a driving force behind deal activity. Wealth Enhancement Group, Focus Financial, Hightower, Creative Planning, CAPTRUST, and CI Financial each acquired multiple RIAs in 2020. These firms sustained deal activity during the peak of the pandemic distraction, while smaller acquirers without dedicated deal teams were forced to delay or abandon planned transactions. Consolidators and large strategic acquirers remain an attractive option for many RIA sellers due in part to the lower execution risk resulting from consolidators’ experience in closing transactions.Mega-DealsWhile consolidators accounted for a large percentage of deal activity, these deals are typically relatively small. The uptick in total deal value during the year was driven by several mega-deals among publicly traded asset managers and discount brokerages. Back in February, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days later. In October, Morgan Stanley agreed to buy asset manager Eaton Vance for $7 billion. In December, Macquarie Group (a diversified Australian financial services company) agreed to buy asset and wealth manager Waddell & Reed for $1.7 billion.The differences between these larger transactions and the smaller wealth management firm transactions are noteworthy. The recent mega-deals in the industry between public companies have been focused on sectors of the industry that many analysts believe are declining—asset management and discount brokerage. These sectors have seen significant fee and margin compression in recent years, and as a result, these deals are largely defensive in nature and motivated by cost savings and increased scale to protect margins.In contrast, buyers of independent wealth management firms are typically attracted by recurring revenue, a sticky client base, relatively high margins, and attractive growth prospects due to market appreciation and demographic trends. As a result of these differing motivations and outlooks, the multiples seen for wealth management franchises are often higher than their publicly traded asset management-focused counterparts. In the case of the Waddell & Reed transaction, the multiple paid for the asset management component of the business may have been as low as 5x (see our post, Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No), well below what an attractive wealth management business can expect in the current environment.Internal TransactionsMany of our RIA clients have taken time over the last year to work on back-of-house issues like succession planning. It’s no secret that succession planning is a major issue for the industry, and one of the questions RIA principals must answer when succession planning is whether to engage in an internal or external transaction. Although there has been a proliferation of external buyers and deal terms remain strong, internal transactions can be an attractive option for a variety of reasons. Compared to the stringent structure that an outside buyer might impose, internal transactions can offer greater flexibility for retiring partners. They also sidestep one of the largest issues in RIA transactions—cultural compatibility—since no new parties are introduced and forced to work together.It’s no secret that succession planning is a major issue for the industry.One of the downsides of internal transactions is that the buyers, typically younger firm employees, often don’t have the financial resources to purchase a significant interest outright. The good news is that capital options to facilitate these transactions have expanded significantly in recent years, with various banks, private equity, and minority investors increasing their focus on the sector.Another challenge with internal transactions is that they require a strong next-gen management team to be in place. Without a strong bench, external transactions may be the only option for a founding partner seeking to exit the business. For firms that lack the next-gen management to run the business and turn to external buyers to solve their succession planning problem, it may be difficult to realize full value.We’ll be addressing succession planning along with other operational, back of the house RIA issues at our upcoming conference, RIA Practice Management Insights, to be held virtually on March 3-4, 2021.
Valuation Considerations for Auto Dealership Entities with Multiple Franchises
The valuation of an auto dealership can be a challenging and complicated process. The structure of most auto dealerships consists of an entity holding the actual dealership operations and a separate entity owning the real estate and building. Often the latter is a related party entity that charges the dealership rent for use of the land and building. Occasionally, the real estate and the dealership operations are contained in the same entity.We are all used to the local dealership in our town: Bill Jones Honda, Steve Smith Chevrolet. But what about the larger auto groups that have multiple franchises organized in the same entity? How are they valued and what special valuation considerations apply to them?Financial ReportingFranchised auto dealerships submit dealer financial statements to the manufacturer on a monthly basis. These dealer financials contain valuable information about the various departments, including profitability by department, overall number of new and used vehicle sold, individual models sold, etc. How does that differ for entities that contain multiple franchises under one structure? In our experience, those dealerships submit a combined dealer financial statement to each manufacturer. For example, if an entity owned a Chevrolet and a Honda franchise, they would submit an identical dealer financial statement displaying the combined operations to Chevrolet and to Honda. This can make it difficult to assess the individual financial performance of each franchise.Most dealership financial packages will contain various support schedules that can provide additional insight. There should be a breakdown of new vehicle sales and gross profits by manufacturer provided or the auto dealer would maintain that data.With this information, a valuation analyst can determine the contribution of each franchise to the combined operations by percentage of revenues, gross profit, or new or total units sold. Generally, these combined statements do not allocate the selling, general and administrative expenses by franchise, so individual franchise income statements are typically not available. We will later discuss how to incorporate this information into the valuation of an entity with multiple franchises.Profitability and BenchmarkingEstablishing the ongoing earnings of a dealership is critical to its determination of value under both the income approach and the market or Blue Sky approach. If individual profitability of each franchise isn’t discernable in a combined entity, how do you evaluate the profitability of the dealership?We have previously discussed in this space the use of industry benchmarking tools to assess a dealership’s profitability. One such tool is NADA's Dealership Financial Profiles. These benchmark studies are released monthly and are categorized by the type of dealership including Overall Average, Domestic, Import, Luxury, and Mass Market. An analyst can use these tools to determine a blended overall industry profitability figure for the dealership based on the composition of each franchise to total operations and the specific category of dealership that each franchise represents.The table below lists the average pre-tax income margins for the dealership categories for 2018 and 2019:
For example, let’s say you had a fictitious combined entity with a Chevrolet and a Honda franchise and that each comprised 50% of the total combined operations of the entity. As a guide, you could compile a blended profitability measure of 2.80% for 2019 to account for the domestic franchise (3.10% x 50%) and the import franchise (2.50% x 50%). These comparisons to industry profitability margins are not rigid but do provide a framework to assess the subject dealership's performance against its peers. Since Chevrolet and Honda also would both fall under the “Average” category, one might be tempted to simply pull the average figure. However, as we see in our example, this may lead to a lower benchmark than is ultimately appropriate.
Franchise and Blue Sky Values Multi-franchised entities can also pose a challenge since each franchise has inherent value and all franchise values are not created equally. The perceived franchise value is often reflected in a multiple of pre-tax income referred to as Blue Sky Value. Leading national firms that specialize in auto dealer transactions, such as Haig Partners and Kerrigan Advisors, publish their observed Blue Sky multiples by franchise each quarter.Examples of Haig’s published Blue Sky multiples for the second and third quarters of 2020 based upon dealership category appears in the table below:
Using our previous example of a combined fictitious entity with a Chevrolet and Honda franchise, it’s clear from these Blue Sky multiples that it would be inappropriate to value the entire entity just based on Honda’s perceived value (6.00-7.00X) or Chevrolet’s perceived value (3.50-4.50x) alone. One technique that can be utilized is to establish a blended Blue Sky multiple for the two franchises based on the composition of each to the total combined operations. As we discussed earlier, this can be estimated based upon revenue or units sold composition of the two franchises in the subject dealership. Based on a 50/50 composition of each of these two, it would be reasonable to estimate a blended Blue Sky multiple of 4.75X on the low end and 5.75X on the high end using Haig’s Q3 2020 multiples. (Note: The valuation requires more in-depth analysis than just a high-low average.) A blended Blue Sky multiple would incorporate the inherent difference in values of the two franchises so as to not undervalue or overvalue the combined subject dealership in our example if either an exclusive Chevrolet or Honda multiple were considered.
After a direct valuation of the entity is performed, the corresponding Blue Sky value could be measured against this blended multiple. For example, if the conclusion of value for this example implied a 9x Blue Sky, this exercise would illustrate that the valuation conclusion or some of the underlying assumptions were flawed.
Recent Acquisitions and DivestituresMost valuations of auto dealerships require the analysis of prior years’ performance and results. The golden period for valuation analysts seems to be reviewing five full historical years. In our projects involving entities owning multiple franchises, we often see activity within those franchises owned in those prior five years. It can be valuable to ask if there have been any acquisitions or divestitures of franchises during that historical period of reviewed financials. First, the analyst wants to establish that the comparison of historical years to one another are apples to apples. If an entity had sold off or discontinued a franchise, the earnings related to that particular entity should not be considered in any current value of the subject dealership. In the case of a divested franchise, the impact of those sales and earnings should be removed from prior year results as much as possible. This won’t always be possible for the same reason we can’t construct individual P&L statements by franchise. Again, this is due to the lack of itemized SG&A expenses by the franchise.Conversely, if the subject dealership had recently acquired or added an additional franchise to its operations during the reviewed period, the value of that franchise should also be captured. If the franchise is recently acquired, information regarding the acquisition price and/or consideration paid for Blue Sky could be considered in the valuation analysis, especially if the operating results haven’t fully reflected the integration of the new franchise. Franchise value paid for acquisitions in historical periods can also be helpful information. For example, if a dealership acquired a particular franchise for a Blue Sky value of $10M but the dealership’s performance and earnings from that franchise had suffered in the years following the acquisition, the concluded value of that franchise might be lower today. In this example, the original $10M Blue Sky value for that franchise would have been helpful as a sanity check to the concluded value for that franchise today.ConclusionEntities owning multiple franchises pose unique challenges to valuation compared to a single-franchised dealership. While the conclusion of value for the entity is contained in a single value, we have discussed the importance of evaluating the individual value of the franchises involved or at least examining the concluded value in the context of the earnings and blue sky value inherent within each franchise.Contact a professional at Mercer Capital to discuss the value of your multi-franchised or single-franchised auto dealership.
A 2021 Estate Planning Reader
While we are not political prognosticators, the recent Senate runoff results appear to have given new life to the Biden Administration’s tax policy goals. Numerous publications have written about the Biden Administration’s tax plan and we do not want to duplicate them here. However, we want to take the opportunity to highlight other thought leaders we are reading and what family business owners should be thinking about given recent political developments.How Will Joe Biden’s Tax Plan Impact Estate and Gift Planning?Elliot Davis, a regional accounting firm in the Southeast, highlights two key provisions in the Biden plan: i) the elimination of basis step-ups for inherited assets, and ii) a reduction in the lifetime gift and estate tax exemption. Elliot Davis presents two case studies with the proposed changes – which result in a 10% to 25% increase in the overall tax paid by the estates presented in the case studies. These increases can be partially reduced with proper estate planning.Joe Biden Wants to Change Tax Policy. Here’s What He Might AccomplishKaren Hube at Barron’s highlights Biden’s tax plan and expectations regarding reform. Garrett Watson, a senior policy analyst at the Tax Foundation, ranks two tax increases as being the most likely to succeed: an increase in the corporate tax rate from 21% to 28%, and a bump in the top marginal income-tax rate for folks earning $400,000 or more from 37% to 39.6%, hitting both traditional C Corps and S Corps.
The next most likely change would be a reduction in the estate tax exemption to 2009 levels, moving from the current $11.58 million per person, or $23.16 million for a married couple to $3.5 million, adjusted to inflation. This would also raise the estate tax rate from 40% to 45% beyond the exemption.
Watson does see certain provisions as unlikely. Watson includes an increase in tax rates on capital gains over $1 million from 20% to 39.6% and a new 12.4% payroll tax on earnings over $400,000, citing a combination of political friction and complexity to draft and administer. Watson and other analysts agree that one aspect of Biden’s plan would be dead on arrival in Congress: an elimination of the step-up in cost basis at death.Richest Americans Brace for Higher Taxes, Await Moves by Biden, Senate DemocratsA new concern for estate planners is delivering the news that it may be too late. Bloomberg suggests that Biden and the Congress could make tax hikes effective as of the beginning of 2021 or delay any changes to 2022 or 2023. The threat of a retroactive tax law means wealthy families and investors do not know which rules apply to transactions conducted right now. Bloomberg indicates most advisers see retroactive tax changes as unlikely but urge caution and recommend getting your estate plan in order.After the Georgia Runoff, What Tax Planning Should You Do NOW?Martin Shenkman, an estate planning attorney, provides a comprehensive list of possible tax changes as they relate to gift and estates, as well as income and capital gains taxes. He also lists a number of strategies used by estate planners and potential reductions in the benefits of these strategies, including the use of Grantor Retained Annuity Trusts, Grantor Trusts, and Generation Skipping Transfer Taxes.
We will lay a "wet-blanket" on the more aspirational policy devotee (perhaps at our peril). Democrats will hold both the U.S. Senate (by virtue of future Vice President Harris, a Democrat, being a deciding vote in the 50-50 chamber) and the U.S. House, (222 for Speaker Pelosi’s caucus and likely 213 for the Republicans) with relatively narrow margins by historical standards. This narrow mandate gives Democrats room for only 5 defections in the House on any single piece of legislation, with no room in the Senate.
Considering these realities, we suspect more wide-reaching policy goals promised during the campaign may be tempered to preserve needed political capital for the incoming administration’s key policy objectives.
Additionally, in a January 10th piece from Barron’s, Chris Senyek, chief investment strategist at Wolfe Research noted the average tax-reform bill takes 15 months after a new president is sworn in to become law. If history holds, this fact should give markets, and families, time to digest and plan for future tax changes.Final ThoughtsWe leave you with this advice: the best time to take care of your family and estate plan was yesterday. The next best time is today. We provide valuation and other financial advisory services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.
2021 New Year's Resolutions for Auto Dealers
At the start of a new year, many people, including myself, try to establish resolutions to get the year started off on the right foot. This is especially prevalent this year with most people welcoming 2021 with open arms after the disaster of a year that was 2020. When considering the auto industry in 2020 and predictions for 2021, making some “resolutions” for your dealership to prepare for the year ahead could prove to be helpful. With that being said, here are a few common “New Year’s Resolutions” that can be applied to your auto dealership.Resolution #1 – Keep Up With the TimesAuto dealers that choose to embrace technology could find themselves faring better than those that don’t in an era of e-commerce explosion.As we have discussed previously, the COVID-19 pandemic has pushed auto dealers into the 21st century as they relied more on technology to reach their audience. In March 2020 as the pandemic was beginning, U.S. search interests in “dealerships near me” dropped more than 20% from the prior month. Furthermore, as stay-at-home orders swept across the country, many people could not visit dealerships even if they wanted to. In order to continue to reach customers, offering at least portions of the buying process online became necessary. As the year continued and the pandemic trudged on, consumers dramatically shifted their shopping habits to online, as e-commerce sales are projected to increase by 40.3% in 2020 from the prior year. For dealerships, specifically, 90% of car shoppers prefer a dealership where they can start the buying process online. Although dealerships most likely can’t and won’t reach the digital offering scale of a Carvana, having sleek offerings online is important.Now as we begin the new year, there is some evidence that consumers won’t revert to pre-COVID buying habits. A research paper from McKinsey in early 2020 said trends in China suggest that between three and six percentage points of market share gained by online channels will be "sticky." What does this mean for your dealership? With overall buying habits having shifted, consumers are going to be more familiar with the online purchasing process. Furthermore, experts anticipate the pandemic to continue into 2021. Making an effort to invest in digital technology for your dealership to reach customers could reap dividends as the year goes on.Resolution #2 - Invest in YourselfInvestment in facilities to achieve image compliance could lead to a bump in your dealership’s value.Despite fewer people visiting physical dealerships because of COVID, it could still be worthwhile to consider giving your dealership an upgrade in 2021. As reported in Kerrigan’s Q3 Blue Sky Report:“Image compliant dealerships with low rent command higher multiples. Up-to-date dealerships are more attractive to buyers because they require no additional investment. Dealers also command better pricing when they have an attractive rent factor, lowering fixed expenses. In our experience, dealers frequently own the real estate or hold it in a separate but related entity. But as dealers know, rent factors include other factors include utilities, property taxes, interest, and other hard costs of ownership. Dealerships that can reduce this expense or have a favorable lease if owned by an unrelated third party, stand to have higher earnings, and potentially a higher multiple with lower risk. In general, if a dealership is image compliant and its rent-to-gross profit is below 10%, it is considered to have low rent.”Resolution #3 - Shed Some PoundsAuto dealerships can benefit from becoming leaner and meaner by streamlining SG&A costs to promote a healthier bottom line.A prevalent 2020 trend was cutting SG&A costs. As we mentioned in our Q3 2020 earnings calls post, advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. This decrease in overall SG&A has helped support many auto dealer’s bottom lines as SAAR has been running below 2019 levels.Looking into 2021 and a continuing pandemic, improving the bottom line is going to continue to be important. Advertising costs can be alleviated by choosing alternative and more efficient channels such as social media, as we mentioned previously. Furthermore, with consumers doing more of the car shopping process online, personnel expenses that used to be necessary are no longer so. Auto dealers can take full advantage of this to streamline costs. While many of these costs have already been cut to the bone, dealers will need to be judicious about adding in costs. We had clients coming out of the Great Recession saying they ran leaner than they have previously thought was possible. Ten years of slow and steady economic growth may have led to excess expenses that naturally get trimmed in a downturn. Dealers need to determine which expenses can be removed and which may need to return in order to boost sales, particularly when new vehicle inventory becomes less tight.Resolution #4 - Make GainsWith vehicle manufacturing revving up, it could prove beneficial to offer consumers wider varieties of models.If you have been reading our blog over the course of the year, one of the big takeaways that we have been hammering home is that inventory shortages have plagued the industry all year due to lag from shutdowns. Dealers won’t have needed to read a single word we’ve written to know that for themselves. However, with plants back up and running, many dealerships are expecting inventory levels to normalize in 2021; therefore, there might be pent up consumer demand so dealerships will be working to get the right inventory. While consumers have been more patient in light of the pandemic, that patience won't last forever.As the pandemic continues on, many people are still wary of using public transportation and ride-sharing. In fact, a survey conducted by Google found that 93% of people say they are using personal vehicles more. Furthermore, a recent Cars.com survey reported that 20% of respondents who didn’t own their car were considering purchasing one. Dealerships in 2021 could continue to find new customers trying to shift from public transportation to a personal vehicle.ConclusionThe Auto Dealership team at Mercer Capital wishes you a happy and safe new year! If you have any questions about what your dealership may be worth, please feel free to reach out to us.
6 Valuation Principles Family Business Directors Should Know in 2021
Family business directors will make plenty of difficult decisions in 2021, and many of those decisions will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target. What should you and your fellow directors know about valuation? In our experience, there are six basic valuation principles that can guide directors as they make tough valuation-related decisions in the coming year.1 – The Principle of ExpectationsThe view through the windshield matters a lot more than what you can see in the rearview mirror. Of course, it is important to understand historical financial results, but investors pay for what will happen in the future. If you must choose between explaining the past and projecting the future, stick to the future. If profitable investment decisions could be made by studying history, we’d all be rich. The principle of expectations reminds us to remain oriented to the future.2 – The Principle of GrowthBecause business valuation is based on expectations for the future, it stands to reason that growth is a key factor in measuring the value of a business. How will your business grow? To answer this question, it is often helpful to take a step back and situate your family business in the context of expected growth in the overall economy, industry, and local economy. Do you expect to gain or lose market share? What elements of your current (or potential) business strategy support growth expectations? Is there a compelling growth narrative for your family business that would be convincing to potential investors?3 – The Principle of Risk and RewardFor investments, reward is measured in terms of return. Return follows risk. The principle of risk and reward suggests that an investor considering two possible investments, with one clearly riskier than the other, will require a greater expected return for the riskier investment. Otherwise, there would be no incentive to make the riskier investment.You can think of risk in terms of the variability in future outcomes. The future returns for an asset are always unknown, but some are more uncertain than others. An asset that will return either +25% or -25% is riskier than one that will return either +10% or -10%. In other words, directors need to think about the future not just in terms of a single base case, but also with reference to the range or dispersion of potential outcomes.4 – The Present Value PrincipleThe present value principle describes what is often referred to as the “time value” of money. In short, a dollar to be received at a future date is worth less than a dollar already in-hand. Since valuations are expressed in dollars today, directors need to consider the corrosive effect of time on dollars to be received in the future. The present value principle is closely related to the principle of risk and reward since the riskiness of an investment determines how expected future dollars convert to present value. The greater the risk, the lower the present value of a given amount of future cash flow.5 – The Principle of Alternative InvestmentsThe supply of potential investments exceeds the resources of any single investor. As a result, every investment is ultimately made to the exclusion of some other investment that could have been made. Economists use the term “opportunity cost” to describe the effect of alternative investments. Valuations are never made in a vacuum but are always assessed relative to the risks associated with, and returns available on, alternative investments in the market. The principle of alternative investments confirms that any valuation conclusion is specific to a particular date. The value of any business changes over time in response to continual changes in the value of alternative investments.6 – The Principle of RationalityFinancial markets are vast. Even for small family-owned businesses, there are enough market participants to generally keep everyone honest. Yes, you should be on the lookout for that motivated seller or irrational buyer that could provide a windfall for your family business, but you should not blithely assume that such parties will show up when you need them. Competition among buyers and sellers enforces a pretty strict discipline on valuations. There is an underlying rationality to market transactions, even when that rationality may not be immediately obvious.ConclusionIn our experience, keeping these six principles in view is essential for directors as they deliberate, assess, critique, and develop valuation estimates. For further thoughts on these principles and other elements of valuation, check out our new book, Business Valuation: An Integrated Theory, 3rd Edition, published late last year by John Wiley & Sons.Our colleagues here at Mercer Capital have completed over 12,000 valuation assignments over the past four decades. If you have a specific valuation challenge that you and your fellow directors would like a second opinion on, give one of our valuation professionals a call to discuss your situation in confidence.
Mercer Capital’s Value Matters® 2021-01
2021 Tax Update
Patel v. Patel
In this case, the parties raised the matter to appeals for two issues: 1) whether the trial court erred in awarding Wife alimony in futuro of $7,500 per month, and 2) whether Wife is entitled to attorney’s fees.The parties divorced after a 13 year marriage in which the family was initially solely supported by Wife’s $40,000 annual income. However, at the time of divorce, Husband was earning approximately $850,000 per year and Wife was not employedbut was a full-time student (due to frequent moves but also a mutual decision). The trial court found that long-term alimony was appropriate given Wife’s contribution to Husband’s earning capacity, her inability to achieve his earning capacity despite her efforts at education, and the parties’ relatively high standard of living during the marriage.At the beginning of the marriage, the husband was a full-time medical student earning no income.Across the husband’s education and career, the parties moved from Georgia to Kentucky to Florida to Ohio, and finally to Jackson, Tennessee. During separation, Wife enrolled in a college to obtain a Bachelor’s Degree in Accounting and hoped to eventually enroll in a Master’s Degree program. Wife was a full-time student at the time of trial.Husband testified that he planned to move to Florida and his base pay upon moving to Florida after the divorce would be approximately $450,000. Husband admitted, however, that this figure did not account for the bonuses that Husband had historically received and had caused his income to increase substantially.Wife’s sole income at the time of the divorce amounted to approximately $2,000 per year in dividends.Each of the parties created a budget of estimated forward expenses. During proceedings, each party claimed that the other was controlling the parties’ finances, refusing to permit the other to fund basic expenses. With regard to expenses, Husband claimed as an expense $10,000 per month for savings in the event that he is sued for malpractice and his insurance does not cover the entire award, costs for his parents’ health insurance, considerable maintenance on his car, and large charitable contributions. With regard to Wife’s expenses, Husband contended that they were inflated over historical actual expenses. Husband testified that expenses incurred by Wife following the separation were for extravagant gifts to family that were not representative of the parties’ lifestyle throughout the marriage.Demonstrating the marital estate and standard of living, the parties had accumulated a level of wealth during the marriage, including two cars, several retirement accounts, and savings accounts. Husband paid off the mortgage of their Jackson, Tennessee home during the pendency of the divorce. As such, the parties had no debt at the time of the divorce and considerable assets. During the marriage, the parties also took several vacations, both in the United States and outside the country.The trial court made the following statement on the earnings capacity of each party:Husband’s gross earning capacity is currently about $850,000 per year. His net income based on his effective tax rate for 2016 would be in the range of about $550,000. Husband owes no debt, and will have significant assets from the property division. Wife’s current income is zero essentially, but when she finishes school, if she is able to obtain employment in her field, and achieve a CPA designation, her gross income should be in the range of $55,000 according to testimony. If she pursues a Master’s Degree and achieves it, her earning capacity could increase to $85,000 per year. Thus, there is a significant difference between the Husband’s and Wife’s earning capacity. Their obligations are about the same.The appellate court made the following conclusion on earnings capacity:..the evidence does not clearly and convincingly show that Wife did not significantly contribute to Husband’s career and resulting earning capacity. Rather, the evidence supports the trial court’s finding that Wife made tangible and intangible contributions to the Husband’s increased earning capacity.Considering the factors for spousal support unique to this matter, the trial court found that the alimony in futuro of $7,500 per month alimony was appropriate given: 1)Wife’s contribution to husband’s earning capacity, 2) Wife’s inability to achieve Husband’s earning capacity despite her efforts at education, and 3) the parties’ relatively high standard of living during the marriage. Discerning no reversible error, the appellate court affirmed the trial court in all respects. Also, given the considerable property awarded to Wife in the divorce, the appellate court declined to award attorney’s fees incurred on appeal in this case.A financial expert witness can significantly assist in the court’s determination of divorcing parties’ ability and need to pay in its determinations for spousal support. The analysis is a complex matter and calls for the expertise and analysis of a financial expert. Refer to our piece, “What Is a Lifestyle Analysis and Why Is it Important?” for more information about the process, analysis, and support that can be provided by a financial expert.
What Is a Reserve Report?
A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a report of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules, and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner.
In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies." Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells currently producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, these are asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10.
The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
‘Twas the Blog Before Christmas…
2020 Mercer Capital RIA Holiday Quiz
‘Twas the blog before Christmas, when all through the house
Every laptop was purring, every keyboard and mouse;
The stockings were hung by the chimney with care,
So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter,
I refreshed my Bloomberg to check on the matter.
Then what to my wondering eyes did appear,
But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick,
I listened, engaged, to his every stock pick.
More rapid than eagles his recommends came,
And he whistled, and shouted, and called them by name:“Buy Bitcoin! Buy Apple! Buy Tesla and Google!
’Cause shorting the future will always prove futile!
To the top of the charts, for the big money haul,
Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around,
Down the chimney John Templeton came with a bound.
He was dressed like he owned just a few private jets,
Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back,
Like an entrepreneur with a new public SPAC.
He spoke not a word, but went straight to his work,
And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry!
As he talked a new strat that would guarantee carry!
And out-money calls bought to cover the shorts,
Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head,
Made me want to get all of his thoughts on the Fed –
And vaccines and rates and bullion and more,
But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard,
And up the air-stairs sprang the RIA bard.
But I heard Sir John claim, as he flew out of sight -
"Let your best winners run, and all will be right!"...(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd7CsENq4E17zRc3oaUw9n_2BzGVsq_2BQvhuHonnFZr_2BMGJt.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey If you're having trouble viewing the survey below, click here.
Weather Report for Auto Dealers
Q3 Climate for Blue Sky Multiples, Transaction Activity, and Other Trends
Ever wonder why the local news teases the weather report in the first five minutes of each broadcast before returning to it later in the show? Because everyone wants to know the weather forecast so they can plan ahead.In this post, we provide the weather report for the auto dealer industry with a review of the three recently released industry reviews.Haig Partners and Kerrigan Advisors have released their Third Quarter Blue Sky Reports and J.D. Power just released its U.S. Sales Satisfaction Index. These reports are timely and informative of not only where the auto dealer industry is today, but where it is headed.Transaction Volume Transaction volume often defines the health of the industry. After a turbulent spring and slow climb during the summer, auto dealer transactions are on the rise in the third quarter. According to Haig Partners, transactions for the third quarter topped 95, representing a 9% increase over the same quarter for 2019. As seen in the graph below, public auto dealers have capitalized on their increasing market values, acquiring 21 dealerships in Q3 compared to only 6 in Q3 2019. The monthly average number of dealerships being acquired is currently about 30, compared to 5 or fewer per month in April/May.
[caption id="attachment_35044" align="aligncenter" width="277"]Source: Haig Partners[/caption]
Kerrigan noted the increase in multi-dealership transactions. The much publicized acquisitions of luxury dealerships by Lithia Motors and Asbury Automotive was evidence of this trend. Other contributors include the formation of many special purpose acquisition companies (or SPACs) and investment companies, which we have previously written about.
Many dealerships are on the back side of the family ownership life span, and high multiples are making exits more intriguing. Specifically, Kerrigan notes that multi-dealership transactions are up from 33 to 46, or an increase of 25% from the first nine months of 2019. Q3 2020 is tied for the second most multi-dealership transactions for the same time period in the past 5 years.
[caption id="attachment_35054" align="alignnone" width="702"]Source: Kerrigan Advisors[/caption]
ProfitabilityTwo weeks ago, we discussed the record level Gross Profit Margins per Unit (GPUs) in new and used vehicles and their contribution to the overall profitability of dealerships through October 2020. These metrics only tell part of the profitability story. Auto dealers have also been successfully minimizing their operating expenses during these unprecedented times and Haig points to three specific expense areas: advertising, labor, and floor plan.As we have discussed several times throughout the year, new vehicle supply has been constrained as manufacturing plants have faced temporary shutdowns and other challenges. Dealers have had fewer new vehicles to sell, and consequently, have chosen to spend less on advertising. This lower level of inventory has reduced the cost to maintain the inventory, or floor-plan interest. Lower interest rates have further lowered these costs. As a result, auto dealers’ floor plan costs are currently much less than in a normal operating environment.Finally, personnel or labor costs have been drastically reduced across many dealerships. The lack of foot traffic in showrooms and temporary shutdowns across the country have forced many auto dealers to reduce their staff. Kerrigan notes that few buyers they have spoken to expect dealers to return to pre-COVID staffing levels and are instead choosing to optimize digital sales platforms to help support operations with reduced staff.Blue Sky MultiplesSo far, 2020 has been the tale of three quarters in terms of Blue Sky multiples. Q1 saw a decline in virtually every brand covered by the Haig Report. While Q2 showed some recovery in Blue Sky multiples coinciding with a steady climb in SAAR, Haig has raised the Blue Sky multiple range for nearly every brand in Q3. The only brands not to see an increased rating by Haig for Q3, are Infiniti, Cadillac, and Lincoln. However, Haig has recently reported franchise value ranges for these brands in lieu of Blue Sky multiples for several quarters due to operational struggles.Kerrigan’s Blue Sky multiples have mostly been held steady in Q3 except for a reported increase in three brands: Chevrolet, Buick/GMC, and Volvo. The difference in perspective of these multiples can be explained in the pricing of transactions. With unparalleled profitability experienced by many auto dealers in 2020 due to increased GPUs and decreased operating expenses, buyers must ponder the sustainability of each of these measures, as well as overall profitability. Historically, according to Haig and Kerrigan, auto dealer transactions were often priced based upon the latest year’s earnings. Buyers now need to evaluate the expected level of earnings for the dealerships into the future, a metric that the auto dealer industry has never relied on much. According to Kerrigan, buyers are pricing transactions off of a modified/sustainable 2020 earnings stream. In other words, buyers are adjusting or discounting actual 2020 earnings from elevated levels to a future expectation.Similarly, Haig Partners discusses buyers' pricing transactions based on previous 2019 level of earnings, rather than the heightened/unsustainable 2020 levels.Sales Satisfaction IndexIn addition to transaction volume, profitability, and blue sky multiples, the Customer Service Index (CSI) and Sales Satisfaction Index (SSI) results provide another lens when considering auto dealership valuations. J.D. Power recently released its 2020 SSI report. The results for Luxury Brands are displayed below.[caption id="attachment_35040" align="alignnone" width="696"]Source: J.D. Power[/caption]
It’s interesting to note that the three brands without a reported Blue Sky multiple from Haig (Lincoln, Cadillac, and Infiniti) all scored in the upper half of the results from the SSI for luxury brands. While SSI is clearly important, observing other factors is necessary when considering a brand’s overall perception and value proposition. Each of these three has struggled with some combination of aging models/inventory, introduction of new models, and entrance into the electric vehicle market. The results for the Mass Market Brands are as follows.
[caption id="attachment_35043" align="alignnone" width="653"]Source: J.D. Power[/caption]
Conclusion The current forecast for the auto dealer industry looks bright heading into 2021. Both Haig Partners and Kerrigan Advisors predict Blue Skies ahead for auto dealers, though dealers will certainly recall the rainy days of March and April. Even the successful private auto dealers that have been able to navigate the challenges of 2020 face decisions regarding the future of their dealerships.Conversations regarding profitability and expense levels and their sustainability are prevalent in all auto dealer valuation projects. Contact a professional at Mercer Capital to discuss these questions or to find out the value of your auto dealership.
Taking Stock: Thinking About the Pieces of Your Family Business
Returns, Growth & Risk
Family Business Director has a couple of colleagues who play chess at a high level. Sadly, our admiration for the game far outstrips our ability to play it competently. To our largely uncomprehending eyes, one of the things that makes the game fascinating is the unique attributes of the various pieces. Those who can play the game well seem to have an innate sense not just of what each piece is capable of individually, but also of how the pieces interact with each other. This understanding provides the experienced chess player with an expert feel for what the capabilities are of whatever collection of pieces may be at her disposal at any point in the game.
In this week’s post, we conclude our series on taking a year-end strategic inventory in your family business. Family business directors and managers need to think like a chess player when thinking about different business units within the company. What are they capable of individually, and how do they work together?
Consider a family business with the three operating units:Legacy manufacturing operations in a maturing, but still growing market.A real estate division that owns and manages commercial properties and provides related services to a small group of customers.A new venture that has developed a niche product gaining rapid acceptance in a developing market.
Exhibit 1 summarizes relevant attributes of each business unit.
In taking their year-end strategic inventory, the directors should evaluate the units along three dimensions: return, growth, and risk. We address each in turn.
ReturnThe best measure of return for most family businesses is return on invested capital, or ROIC. We’ve discussed the merits of ROIC at length in other posts (here and here). ROIC is a measure of the efficiency with which a company deploys its capital to generate earnings. ROIC is the product of two sub-measures:Capital turnover: How much revenue does the business generate from a dollar of invested capital?NOPAT margin: How much net operating profit after tax does the business generate from a dollar of revenue?
For a multi-unit family business, it can be helpful to plot the ROIC of the various units using these sub-measures as coordinates, as shown in Exhibit 2.
The dotted lines in Exhibit 2 illustrate capital turnover and NOPAT margin combinations that yield the same ROIC. The legacy and new business lines have comparable NOPAT margins, but the legacy business generates more revenue per dollar of invested capital. As a result, the legacy business currently earns a higher ROIC than the new venture.
Mapping the ROIC coordinates for each business unit helps in thinking about what strategies are available and most likely to improve returns. For example, if the goal is for the new business unit to eventually achieve a 12% ROIC, will that result from increasing turnover, profitability, or some combination of both? Which “path” to 12% has the greatest likelihood of success?
The real estate unit clearly has a different set of attributes. Relative to the legacy and new businesses, it is a low turnover/high margin business, and as such likely presents a unique set of challenges for increasing or maintaining ROIC.
GrowthROIC measures current returns, but just as an experienced chess player thinks multiple moves ahead, family business directors need to incorporate growth potential into their strategic inventory. The goal is to think not just about what the business looks like today, but what it could, should, and might look like in the future. A healthy family business provides capital appreciation opportunities for family shareholders in addition to current returns.The new business does not yet produce as robust an ROIC as the legacy business. However, the capital allocation decision is dynamic. Throwing more capital at the unit with the highest current ROIC may not promote the long-term sustainability of the family business. Capital allocation needs to be calibrated to growth opportunities. Over-allocating capital to the legacy business is likely to drive down capital turnover and hurt ROIC. Likewise, under-allocating capital to the new business may prevent that unit from maturing into a business with a 12% ROIC, which would then pull up returns for the whole company.RiskRisk is not linear. When dealing with a portfolio of multiple assets, you must consider not just how risky each unit is in isolation, but how the units correlate with each other. If the legacy business is having a great year, what does that mean for the new business and real estate segment? When correlations between business units are high, there is not much diversification benefit to the shareholders. In contrast, units with low correlations reduce the overall risk borne by the family shareholders. As noted previously in Exhibit 1, the real estate unit has a low correlation with the legacy and new business units. As a result, the real estate division reduces the riskiness of the overall business. The “job” of the real estate unit is not necessarily to increase return, but to reduce risk.Exhibit 3 illustrates the risk reduction benefits of business units with less-than-perfect correlation (“?”).
If Units A and B move in lockstep (i.e., have a correlation of 100%), combining them does not reduce the risk to the family. However, as the correlation falls, so does the overall risk of the portfolio. Correlation is a matter of degree; no family business units will be perfectly correlated (whether positively or negatively). Family business directors should instead think about correlations on a relative basis. How does the risk of each operating unit interact with the risk of the other operating units? This is important, because focusing on risk and return for operating units on a standalone basis will fail to consider adequately the overall impact of the units on the risks and returns of family shareholders.
ConclusionMercifully, 2020 is ending. As family business directors look back on the year, they would do well to consider what pieces are left on the chess board, where they are, and how they fit together. For a fresh set of eyes and a new perspective, call one of our family business professionals today to discuss your business in confidence.Thank you for reading our Family Business Director this year. We look forward to continuing the conversation with all of you in 2021. Happy holidays!
November 2020 SAAR
SAAR Declined to 15.6 million, Primarily Driven by a Decline in the Number of Selling Days for the Month
After steady increases, SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) experienced its first notable decline since April, dropping to 15.6 million from 16.3 million in October. November 2020 is down by 8.4% compared to the same period in 2019, and through 11 months of the year, new light-vehicle sales are down 16.7% compared to the same period last year. The calendar differences are important to note for this month with November 2020 only having 23 selling days relative to 26 days in November 2019. As Thomas King, president of data and analytics division at JD Power notes:November 2020 is a prime example of why accounting for selling day differences is important in measuring comparable sales performance. After two consecutive months of year-over-year retail sales gains, a quirk in the November sales calendar will result in new-vehicle retail sales appearing to fall 12%. This year, November has three fewer selling days and one less selling weekend compared with 2019. When these calendar quirks are accounted for, new-vehicle retail sales are expected to almost match 2019 levels. While the sales results illustrate the continued strength of consumer demand, that strength is further reinforced by transaction prices hitting another record high, even as manufacturers and retailers continue to remain disciplined on new-vehicle incentives and discounts.While adjusting for calendar differences is important in determining true trends that are occurring in the industry, it is also necessary to consider retail SAAR vs. total SAAR.While retail SAAR includes the daily selling rate for retail auto sales to individual customers, total SAAR also includes fleet sales to businesses, government, and daily rental companies. Because of this distinction, considering just total SAAR alone may not indicate actual consumer purchase trends. This has been especially notable for this year as fleet vehicle sales and rental companies have been inordinately affected by the pandemic compared to auto dealer sales.Though dealerships experienced a decline when they had to shut down due to stay-at-home orders, business picked back up once they could reopen. Fleet sales, on the other hand, are suffering from changes in consumer trends due to the pandemic, rather than government mandates. For example, many businesses have adopted a work from home model to keep employees healthy during the pandemic. As such, rental car needs for business purposes have declined. Furthermore, overall travel, in general, is down as people have been wary to fly, further impacting this market. May was the toughest month with rental units declining 91%, and Hertz announcing their bankruptcy. From March through September 2020, fleet sales have seen an average monthly decline of 53% with November fairing slightly better with a 25% decline from the same time last year.Observing the implications numerically can be helpful to further illustrate this point. As you can see in the chart produced by JD Power, while total SAAR is down 7.6% (unadjusted for calendar dates), retail SAAR is only down 5.1% (also unadjusted). These numbers reflect the brunt of economic difficulty that fleet sales have faced relative to retail sales. An important note is that this graph is primarily for illustrative purposes with both of these SAAR numbers being predictive rather than actual.
Average incentive spending per unit is expected to top $3,800, marking the third straight month of incentives below $4,000, which reflects strong vehicle demand supporting sales. The average new-vehicle retail transaction price in November is expected to reach a record $37,099, topping the previous record last month of $36,755.
While tight inventory constraints have plagued the industry all year, there are signs that things are improving. According to Cox Automotive Senior Economist Charlie Chesbrough, “The tight inventory situation, where available products at dealerships were drawn down to very low levels, reached a peak in late summer. However, factory production has improved while sales pace has slowed, and the combination is allowing dealerships to replenish somewhat. Overall, supply still remains far below last year's levels, and holiday sales may slow if buyers can't find what they want." With factories now operating at pre-pandemic levels, production has not been the hurdle it was through mid-year.
It is important to note potential tailwinds to SAAR going into the end of the year, specifically in terms of the COVID-19 pandemic and ongoing U.S. politics. As of writing this blog post, coronavirus cases are surging throughout the country as a result of colder weather and indoor gatherings to celebrate the holidays. With restrictions being put back in place throughout the country, dealerships may see less foot traffic as people try to limit exposure as much as possible. However, with promising news on the vaccine front in the past month, hopes are high that there may be a return to normalcy on the horizon.
The political climate continues to pose challenges for auto dealerships as a new stimulus continues to be stuck in a divided Congress. Weekly unemployment claims might be starting to be affected by the lack of stimulus with more than 947,000 workers filing new claims for state unemployment benefits the first week of December. Applications have risen three times in the last four weeks and are up nearly a quarter of a million since the first week of November. This is evident when looking at the chart below produced by the New York Times.Conclusion While we think it’s far too early to suggest we might be falling into a second decline, the downturn in SAAR this month shows we are not yet out of this pandemic. An effective and distributable vaccine should boost economic activity and support employment figures and in turn boost consumer spending on items such as vehicles. However, we note that reduced business travel may have long-term impacts on rental businesses, and fleet sales may not return to pre-pandemic levels as a second order impact. We will continue to monitor these trends as I’m sure you and all of our auto dealer clients will.If you want to discuss how SAAR (total and retail) and the greater macroeconomic environment may impact your dealership, contact a member of the Mercer Capital Auto Dealer team today.
How to Use an EV/Production Multiple
Oil and gas analysts use many different metrics to explain and compare the value of an oil and gas company, specifically an exploration and production (E&P) company. The most popular metrics (at least according to our eyeballs) include (1) EV/Production; (2) EV/Reserves; (3) EV/Acreage; and (4) EV/EBITDA(X). Enterprise Value (EV) may also be termed Market Value of Invested Capital (MVIC) and is calculated by the market capitalization of a public company plus debt on the balance sheet less cash on the balance sheet. In this post, we will dive into one of these four metrics, the EV/Production metric, and explore the most popular uses of it.DefinitionEV/Production is a commonly used valuation multiple in the oil and gas industry which measures the value of a company as a function of the total number of barrels of oil equivalent, or mcf equivalent, produced per day. When using this multiple, it is important to remember that it does not explicitly account for future production or undeveloped fields.Common UsesWhile the above definition was provided by Investopedia, the source goes on to explain the meaning of the multiple in the following way:All oil and gas companies report production in BOE. If the multiple is high compared to the firm's peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount. However, as good as this metric is, it does not take into account the potential production from undeveloped fields. Investors should also determine the cost of developing new fields to get a better idea of an oil company's financial health.While some of the above explanation may appear true; the detail, analysis, and reason is lacking. Let’s more fully investigate the above notes:BOE or MCFE. Not all oil and gas companies report in barrel of oil equivalent per day (BOEPD). Those that are primarily dry gas producers will choose to report in MCF equivalent per day (MCFEPD). On the other hand, majority oil producers will report in BOEPD. One take away analysis to consider is that many times the metric a company uses to report production communicates the core production activity of the company (i.e. a company that reports in BOE wants to communicate they primarily target oil, while a company that reports in MCFE wants to communicate they primarily target gas).Premium or Discount. If the multiple is higher compared to its peers, it only appears to trade at a premium, but it does not mean the market value of the company is at a premium or more expensive than its peers. If it trades at a discount to its peers, the same is also true; it does not automatically mean the MVIC of a company is cheaper than its peers. To draw that conclusion, one assumes each of its peers has the exact same future production outlook, the exact same well locations and the exact same management team, just to name a few. Making this assumption in isolation is in error. Instead, analysis should be performed to understand the why behind a perceived “premium” or “discount.”Current or Future Production. The metric uses current production as an indication of value for the company. When using this metric, it could be assumed that (1) the current oil/gas/natural gas liquids mix will stay the same; (2) the current production level will continue on its previously experienced decline rate; and (3) the equivalency formula to translate gas production into oil production (typically 6.1 mcf = 1 barrel of oil equivalent) will not change. This metric fails to account for visibility into future production. When analyzing an E&P company, future production should always be considered.ExperienceWhile this multiple is useful, it also has its shortfalls. As with all multiples, it should never be used as the sole indicator of value. As an example, using this multiple in isolation would give zero value for an E&P flush with acreage and no production.We had a client with investments in an oil and gas company that was facing a transfer of ownership decision. During negotiations certain parties involved were convinced the only way to value, and therefore the only way they would pay for, an E&P was to utilize an EV/Production multiple and nothing else. They backed their position with their transaction experience of buying oil and gas assets as well as their knowledge of industry participants. We believed utilizing that particular method significantly undervalued our client. While the company had very little production, the acreage rights were significant as well as the PV 10 reserve report. We assisted our client through the transaction process by utilizing multiple valuation approaches, not solely the one a potential suitor strongly suggested.Multiples such as EV/Production can provide context for market pricing in the form of a range. We would never recommend using one market multiple as the only value indication for a subject company, particularly a non-publicly traded company. Ideally, market multiples should be used as one of many value indicators during analysis. While there may be facts and circumstances that prohibit the use of multiple value indicators, it is always advisable to (1) understand the implications of using a specific multiple; (2) understand its weaknesses; and (3) use other value indications together. When observing the EV/Production multiple, reconcile the observations with other valuation multiples and valuation indications for a reasonable analysis. For assistance in the process or other valuation analysis for an energy company, contact a member of our oil and gas team to discuss your needs in confidence.
Fresh Start Accounting Valuation Considerations: Measuring the Reorganization Value of Identifiable Intangible Assets
Upon emerging from Chapter 11 bankruptcy, companies are required to apply the provisions of Accounting Standards Codification 852, Reorganizations. Under this treatment, referred to as “fresh start” accounting, companies exiting Chapter 11 are required to re-state assets and liabilities at fair value, as if the company were being acquired at a price equal to the reorganization value. As a result, two principal valuation-related questions are relevant for companies in bankruptcy:Reorganization Value - As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” (ASC 852-05-10) Discounted cash flow analysis is the principal technique for measuring reorganization value. In certain cases, depending on the nature of the business and availability of relevant guideline companies, a method under the market approach may also be appropriate. A reliable cash flow forecast and estimate of the appropriate cost of capital are essential inputs to measuring reorganization value.Identifiable Intangible Assets - When fresh-start accounting is required, it may be appropriate to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradenames, technology, or customer relationships. We discuss valuation techniques for identifiable intangible assets in the remainder of this article.Measuring the Fair Value of Identifiable Intangible Assets When valuing identifiable intangible assets, we use valuation methods under the cost, income, and market approaches.The Cost ApproachThe cost approach seeks to measure the future benefits of ownership by quantifying the amount of money that would be required to replace the future service capability of the subject intangible asset. The assumption underlying the cost approach is that the cost to purchase or develop new property is commensurate with the economic value of the service that the property can provide during its life. The cost approach does not directly consider the economic benefits that can be achieved or the time period over which they might continue. It is an inherent assumption with this approach that economic benefits exist and are of sufficient amount and duration to justify the developmental expenditures.Methods under the cost approach are frequently used to measure the fair value of assembled workforce, proprietary software, and other technology-related assets.The Market ApproachThe market approach provides an indication of value by comparing the price at which similar property has been exchanged between willing buyers and sellers. When the market approach is used, an indication of value of a specific intangible asset can be gained from looking at the prices paid for comparable property.Since there is rarely an active market for identifiable intangible assets apart from broader business combination transactions, valuation methods under the market approach are not commonly used to value identifiable intangible assets.However, available market data, such as observed royalty rates in licensing transactions, is an important input in valuation methods under the income approach such as the relief-from-royalty method. Other market-derived data helps to inform estimates of the cost of capital and other valuation inputs, as well.The Income ApproachThe income approach focuses on the capacity of the subject intangible asset to produce future economic benefits. The underlying theory is that the value of the subject property can be measured as the present worth of the net economic benefits to be received over the life of the intangible asset.Using valuation methods under the income approach, we estimate future benefits expected to result from the subject asset and an appropriate rate at which to discount these expected benefits to the present. The most common valuation methods under the income approach are the relief from royalty method and multi-period excess earnings method, or MPEEM.The relief from royalty method seeks to measure the incremental net profitability available to the owner of the subject intangible asset by avoiding the royalty payments that would otherwise be required to enjoy the benefits of ownership of the asset. When applying the relief from royalty method requires specification of three variables: 1) The expected stream of revenue attributable to the identifiable intangible asset, 2) An appropriate royalty rate to apply to that revenue stream, and 3) An appropriate discount rate to measure the present value of the avoided royalty payments. The relief from royalty method is most commonly used to value tradename and technology assets for which market-based royalty rates may be observed.The MPEEM is a form of discounted cash flow analysis that measures the value of an intangible asset as the present value of the incremental after-tax cash flows attributable only to the subject asset. In order to isolate those cash flows, we first develop a forecast of the expected revenues and associated operating costs attributable to the asset.Next, we apply contributory asset charges to reflect the economic “rent” for use of the other assets that must be in place to generate the projected operating earnings. In other words, the MPEEM recognizes that the subject identifiable intangible asset generates operating earnings only in concert with other assets of the business.Finally, we reduce the net after-tax cash flows attributable to the subject identifiable intangible asset to present value using a risk-adjusted discount rate. The indicated value is the sum of the present values of the “excess earnings” of the expected life of the subject asset.
We often apply the MPEEM to measure the fair value of customer relationship and technology intangibles.
ConclusionThe valuation techniques for identifiable intangible assets are rooted in the fundamental elements of business valuation, cash flow and risk, under the cost, market, and income approaches. However, when valuing identifiable intangible assets, we use valuation methods adapted to the unique attributes of those assets.
Estate Planning When Bank Stocks Are Depressed
Maybe not for the best of reasons, the stars have aligned for bank investors who have significant interests in banks to undertake robust estate planning this year. Bank stock valuations are depressed as a result of the recession that developed from the COVID-19 policy responses, including a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”). The result is severe compression in net interest margins (“NIMs”), while the extent of credit losses will not be known until 2021 or perhaps even 2022.As shown in Figure 1, bank stocks have produced a negative total return that ranges from -27% for the twelve months ended September 25, 2020 for the SNL Large Cap Bank Index to -36% for the SNL Mid Cap Bank Index. At the other extreme are tech stocks. The NASDAQ Composite has produced a one-year total return of 35%–a 70% spread between the two sectors.Valuations for banks are depressed and are comparable to lows observed on March 24, 2020 when market panic and forced selling by levered investors peaked and March 9, 2009 when investors feared a possible nationalization of the large banks. Price-to-tangible book value (“P/TBV”) multiples are presented in Figure 2, while price-to-earnings (“P/E”) ratios based upon the last 12-month (“LTM”) earnings are presented in Figure 3.(Note—while P/TBV multiples are little changed from March 24, 2020, P/E ratios have increased because reserve building and reduced NIMs have reduced LTM earnings).No one knows the future, but assuming reversion to the mean eventually occurs bank stocks could rally as earnings improve once credit costs decline even if NIMs remain depressed, resulting in higher earnings and multiple expansion. Relative to ten-year average multiples based upon daily observations, banks are 30-40% cheap to their post-Great Financial Crisis trading history. In effect, current gifting and other estate planning could lock in significant tax benefits assuming a Japan and Europe scenario does not develop in the U.S. where banks are “re-rated” and underperform for decades.A second reason to consider significant estate planning transactions this year is the potential change in Washington if 2021 sees a Biden Administration backstopped with a Democrat-controlled Senate and House.Vice President Biden’s proposed estate tax changes include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households.The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law.Basis step-up is a subtle but important feature of tax law.Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.Further, he prefers taxing the embedded capital gain at death.Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Fortunately, there are several things bank shareholders can do now to minimize exposure to these potential tax law changes.Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law. Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner.Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year. Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.In the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.The unified credit was not indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were to be phased out.Over the past decade, the law has changed several times, but mostly to the benefit of wealthier estates.That $650 thousand exemption from estate taxes is now $11.6 million.A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of bank stock investors require heavy duty tax planning.That may all be about to change. Vice President Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Talk is cheap. But investors take heed; now may be the time to execute rather than plan.
Originally appeared in Mercer Capital’s Bank Watch, September 2020.
Four Reasons to Consider a Stock Repurchase Program
Bank stocks rallied in the first few weeks of November 2020 as the market’s Thanksgiving dinner came early, and it digested several issues including positive news on the COVID-19 vaccine candidates.While significant uncertainty still exists on credit conditions, COVID-19, and the economic outlook, bank valuations and earnings expectations also benefitted from the yield curve steepening as evidenced by the 10-year Treasury moving up from ~50 bps in early August to ~85 bps in mid-November. Despite the recent rise in bank stock pricing, bank stock valuations are still depressed relative to pre-COVID levels as a result of the recession that developed from the pandemic and ensuing policy responses.A primary headwind for banks is the potential compression in net interest margins (“NIMs”) following a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”).Additionally, credit risk remains heightened for the sector compared to pre-pandemic levels as the extent of credit losses resulting from the pandemic and economic slowdown will not be known until 2021 or perhaps even 2022. Amidst this backdrop, many banks and their directors are evaluating strategic options and ways to create value for shareholders.While the Federal Reserve has prohibited the largest U.S. banks from share repurchases, the current environment has prompted many community banks to announce share buyback plans. According to S&P Global Market Intelligence, more than forty U.S. community banks announced buyback plans in the third quarter and the trend has continued in the fourth quarter with another 36 buyback announcements, including new plans, extensions of existing plans, and reinstatements of previously suspended plans, in October.In our view, there are four primary reasons that many community and regional banks are announcing or expanding share repurchase programs in the current environment.1) Valuations are Lower Relative to Historical LevelsSince the onset of the COVID-19 pandemic, the banking sector has underperformed the broader market due to concerns on credit quality and a prolonged low-interest rate environment.Despite the November rally, bank stocks are still trading at lower multiples than observed in recent years.Furthermore, many banks are finding themselves with excess liquidity in light of weaker loan demand and growing deposits. In a depressed price environment, share repurchases can be a favorable use of capital, particularly when pricing is at a discount to book value and is accretive to book value per share.As shown in the chart below, the average P/TBV multiple has declined for all of the SNL market capitalization bank indices since the beginning of 2020.The decline has been most pronounced for the Micro Cap index, with the average P/TBV multiple for banks with a total market capitalization of less than $250 million falling from 133% to 102%. 2) Favorable Tax Environment for Shareholders Seeking LiquidityCapital gains tax rates are low relative to historical levels and the potential for higher capital gains tax rates has risen under President-elect Biden. As part of his tax plan, Biden has proposed increasing the top tax rate for capital gains for the highest earners from 23.8% to 39.6% (akin to ordinary income levels), which would be the largest increase in capital gains rates in history.While the ability for Biden’s tax plan to become reality is uncertain, many community banks have an aging shareholder base with long-term capital gains and it is an issue worth watching and planning for as poor planning can leave significant tax consequences for the shareholder or his or her heirs.A share repurchase program can provide liquidity to shareholders who may be apt to take advantage of the current capital gains rates that are low by historical standards and lower than the rates proposed by President-elect Biden.3) Relatively Low Borrowing Costs and Sufficient Capital for Many Community BanksDespite the unique issues brought about by the pandemic and the uncertain economic outlook, many community banks are well capitalized and have “excess” capital at the bank level and perhaps even an unleveraged holding company.We have written previously about the idea of robust stress testing and capital planning given the economic environment but note that a recent survey indicated that most bankers believe capital levels are sufficient to weather the economic downturn.Our research also indicates that rates on subordinated debt issuances issued in September of 2020 averaged ~5% compared to ~6% average for 2018 and 2019.These lower borrowing costs and ample capital for many banks in combination with lower share prices enhance the potential internal rate of return for share repurchases when compared to other strategic alternative uses of capital.4) Enhancing Shareholder Value and Liquidity Board members and management teams face the strategic decision of allocating capital in a way that creates value for shareholders.Potential options include growing the balance sheet organically or through acquisition (perhaps a whole bank or branch), payment of dividends, or a stock repurchase program.While M&A has been a constant theme, activity has slowed during the COVID-19 pandemic and Bank Director’s 2021 Bank M&A Survey noted that only ~33% say their institution is likely to purchase a bank by the end of 2021, which was down from the prior year’s survey (at ~44%).Key challenges to M&A in the current environment include conducting due diligence and evaluating a seller’s loan portfolio in light of COVID-19 impacts and economic uncertainty. Organic loan growth expectations have also been muted for many banks in light of the economic slowdown resulting from COVID-19.With organic and acquisitive balance sheet growth appearing less attractive for many banks in the current environment, dividends and share repurchases have climbed up the strategic option list for many banks.A share repurchase program can have the added benefit of enhancing liquidity and marketability of illiquid shares, which potentially enhances the valuation of a minority interest in the bank’s stock.ConclusionIf your bank’s board does implement a share repurchase program, it is critical for the board to set the purchase price based upon a reasonable valuation of the shares.While ~5,000 banks exist, the industry is very diverse and differences exist in financial performance, risk appetite, growth trajectory, and future performance/outlook in light of the shifting landscape.Valuations should understand the common issues faced by all banks – such as the interest rate environment, credit risk, or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.At Mercer Capital, valuations are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. For those banks considering a share repurchase program, Mercer Capital has the experience to provide an independent valuation of the stock that can serve to assist the Board in setting the purchase price for the share repurchase program.
Originally appeared in Mercer Capital’s Bank Watch, November 2020.
Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No
Catching a Falling <em>(Butter)</em> Knife
Last week, Macquarie Group announced its acquisition of Waddell & Reed (WDR) for $1.7 billion. Waddell & Reed is one of the oldest mutual fund and asset management firms in the U.S. with a range of investment styles and insurance products. Waddell and Reed’s asset management division will expand Macquarie’s investment solutions, boost Macquarie’s annuity earnings, and push Macquarie’s U.S. AUM to $276 billion, making it one of the top 25 active managers in the U.S.The transaction marks a shift in Macquarie’s past acquisition strategy, which has historically followed the old saying, “The time to buy is when there’s blood in the street.” The firm’s last large acquisition was in 2010 when it acquired Delaware Funds (with $135 billion AUM) for $428 million. Instead, Macquarie is moving when the market is at an all-time high and paying nearly a 50% premium to WDR’s share price.Not only does this mark a shift in Macquarie’s deal strategy, but it is also the first acquisition by Macquarie’s new CEO. Shemara Wikramanayake, who has been called the most powerful woman in Australian finance, is now dealing with skeptics who ask why she paid such a premium for a business whose AUM has halved over the last six years.Transaction OverviewAt first glance, the AUM and revenue multiples paid by Macquarie Group appear fairly normal for an asset manager, but maybe not for a firm with a 14% EBITDA margin and years of declining AUM.While EBITDA multiples over 11.0x are not unheard of in this space, one would likely expect an impressive growth trajectory to accompany it. To understand the deal multiples implied by Macquarie’s acquisition of Waddell and Reed, we must dig into the details of the transaction.WDR has historically held lots of cash and investments on its balance sheet, for which Macquarie likely paid dollar for dollar. Typically, RIAs hold between 6-8 weeks of operating expenses on its balance sheet as working capital, or approximately 10% to 15% of revenue. With an estimated $437 million of excess working capital on its balance sheet, the price for the operating business is approximately $1.26 billion, which implies multiples more in line with the typical range observed in the legacy asset management space.
Additionally, upon completion of the deal, Macquarie Group will sell WDR’s wealth management division to LPL Financial (a U.S. retail investment advisory firm, BD, and RIA custodian) for $300 million. The adjusted transaction price as a multiple of WDR’s asset management division’s AUM is 1.42%. However, determining the post transaction revenue and EBITDA requires a good bit of speculation.
With AUM of approximately $68 billion and pro forma effective fees of around 65 bps, the post-transaction business will likely generate about $450 million of investment income. A little under 90% of WDR’s underwriting revenue was generated through its advisor network. Post-transaction, Macquarie will be one of LPL’s top strategic asset management partners, which suggests that Macquarie will not lose all revenue associated with its advisor network. As such, we have estimated WDR’s underwriting revenue stream could fall by approximately 80%. There will be expense savings generated by selling this business and additional synergies from merging with Macquarie. However, buyers don’t often pay for something they bring to the table, so WDR was likely only compensated for the cost reductions associated with selling its wealth management business. Thus, we have modeled a range of scenarios with between 50% to 60% cost savings.
Even if Waddell and Reed’s AUM has been falling year-over-year, scale is valuable in the asset management space and we doubt that Macquarie was able to pick up WDR’s asset management business for a 5.0x EBITDA multiple. But the 7x-11x range seems reasonable. Macquarie’s acquisition of Waddell and Reed highlights how the success of legacy asset managers is currently dependent upon achieving scale.
While the $25 per share purchase price represents a healthy premium to the latest pricing, the market has been down on investment managers since March’s sell-off. Paying a premium does not necessarily mean that Wikramanayake overpaid. Some may say that Macquarie is catching a falling knife by buying a business whose assets have been on the slide, but maybe it was just a butter knife…
Measuring Up: Evaluating Your Auto Dealership Against Benchmark Metrics
In a strange year of oddities, 2020 has all of us constantly evaluating life’s basic truths. Market conditions vary drastically across all industries and even geographically within the same industry due to local government restrictions. It’s critical for auto dealers to continually analyze all aspects of their business and be ready to capitalize on industry trends. We previously discussed the use of the NADA dealership profiles as a useful tool to examine timely monthly data based on averages or dealership type. Three specific metrics in the data have reached their highest level since the data was originally published in 2012: new vehicle retail gross profit per unit, used vehicle retail gross profit per unit, and used-to-new vehicle unit ratio.Retail Gross Profit Per New VehicleThis metric considers numerous factors. The numerator is gross profit achieved on the retail sale of new vehicles and is measured by the retail selling price less the cost paid to the manufacturer for the dealership to acquire the vehicle. Industry professionals also often refer to this metric as "front-end margin" meaning front of the showroom and not including elements of fixed operations. The denominator is the total number of vehicles retailed, or new vehicles sold less fleet sales which, as we’ll discuss in a future post, is subject to different operating environments. Over time, auto dealers’ new vehicle gross margins have been compressed as a percentage of retail sales price as consumers have become more knowledgeable about manufacturer costs and sticker prices in the information age. Dealerships aim to create long-term value by placing more new vehicle units on the road in hopes of the continuing service revenue that results from miles driven. These fixed operations tend to be higher margin, which aids the overall gross margin of the dealership. Though as noted above, this is not captured in new vehicle gross margin.As of October 2020, retail gross profit per new vehicle or new vehicle gross profit per unit ("GPU") climbed to $2,355 for the average dealerships as defined by NADA. This eclipses a previous high of $2,226 achieved in 2012. The year-to-date figure represents a nearly $280/unit increase over the average figure of $2,076 from 2012 through 2019. The chart below displays the annual new vehicle gross margin from 2012 through the current year-to-date.Retail Gross Profit Per Used VehicleLike new vehicle GPU, this metric refers to the gross margin achieved on the retail sale of a used vehicle and is measured by the retail selling price less the cost paid to acquire the vehicle divided by total units retailed. Similar to the new vehicles retailed which excludes fleet sales, it should be noted that this metric refers to retail sales only and does not include used vehicles for wholesale. Like its new vehicle gross profit counterpart, this metric has also climbed to its highest point in the observed period, currently at $2,678 per unit. We have previously written about several factors driving this metric including the heightened performance of the used vehicle market in the pandemic due to production shortages and shipment delays for new vehicles as manufacturers have experienced partial shutdowns. Low supply leads to higher prices, and dealers have been able to capture their share of this margin. The year-to-date figure represents a nearly $300/unit increase over the average figure of $2,386 from 2012 through 2019. With rising profitability over lower volumes, it’s clear why this figure is reaching all-time highs. The chart below displays the annual used vehicle gross margin from 2012 through the current year-to-date.Used-to-New Vehicle Unit RatioWith near-record levels of gross profit per new and used vehicles, how has that affected the product mix of vehicles sold by dealerships? The used-to-new vehicle unit ratio measures the amount of used retail units divided by new retail units. This ratio or product mix held fairly stable from 2012 through 2018 ranging from approximately 75% - 80%. Over the last year and a half, this ratio has climbed to 84.8% at the end of 2019 and peaked at 96.3% for October 2020. Used vehicles have become more profitable and have been more available to dealers at times in 2020. This ratio has reached an almost 1:1 relationship. The figure below displays the annual used-to-new vehicle unit ratio from 2012 through the current year-to-date. There are elements of both supply and demand in this figure. As noted in the previous charts, dealers earn more gross profit per used vehicle retailed than new vehicles. That means dealers get more bang for their buck when the used-to-new ratio approaches 1:1. However, customers are historically attracted to franchised dealerships because they want a specific make or model. With the reduction in new vehicle supply, it appears dealers have effectively pivoted their customers from new vehicles to used vehicles rather than losing the sale when their preferred option isn’t in stock. Another factor is likely in play, however. While supply is shifting towards used, demand is as well. With spikes in unemployment this year and the uncertainty surrounding job security for many, consumers are less likely to be able to afford the higher sticker prices of new vehicles, substituting to used as a more reasonable alternative.Potential Impacts and ConclusionHow is your dealership measuring up to these metrics and what impact could they have on the value of your dealership? As always, comparison with industry data should be viewed with some caution as it may not pertain directly to your dealership or the economic conditions experienced in your area. Nonetheless, the levels of these three metrics reflect the auto dealer industry’s ability to adapt to the challenges of 2020.The more important question for these metrics and for the valuation of your dealership, is how sustainable are these metrics for the long-term? The historical graphical information for each suggests that these figures will revert back to previous levels at some point. A majority of our projects for litigation and corporate valuations involve evaluating the expected annual earnings of the dealership for the future. Often, we examine these various metrics and the overall profitability and performance of the dealership over a longer historical period of time than just the latest year to determine the sustainability and future expectation. Just like dealers wouldn’t want to sell their business after a down year, valuations can become too lofty if an outlier year is effectively forecasted as the new normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth, contact a professional at Mercer Capital to perform a valuation or analysis.
Taking Stock: An Asset Class Checklist
Last week, we introduced a series of posts about taking a strategic inventory of the assets of your family business. As the calendar turns to December and 2020 (thankfully!) comes to an end, it is an appropriate time for family business directors and managers to take stock of just where their family business is at this stage in the pandemic. Doing so can help give needed context to discussions about where the family business should be headed.
We tend to think of a family business’s primary assets under seven broad headings. In this week’s post, we offer a checklist for directors and managers.1. LiquidityHow effective have the company’s efforts at liquidity preservation been during the pandemic?How have your ideas of a prudent level of liquidity changed because of the pandemic?What is the status of your borrowing base, or other measures of available capacity, under current credit facilities?Are there any debt covenants that need to be renegotiated or addressed considering current company performance?2. Net Working CapitalHow have collections held up during the pandemic? Have your credit monitoring efforts with clients kept up with changing conditions?Is there obsolete or aging inventory that can be liquidated? Amid cash preservation efforts, is the company maintaining an acceptable order fulfillment rate, or are persistent backorders straining customer relationships?Is the company maintaining appropriate relationships with suppliers? Is the company taking advantage of available financing options in a financially responsible way?3. Property & EquipmentIf the family business has deferred maintenance or capital expenditures during the pandemic, have the deferred items been prioritized for the return of sufficient liquidity?Are there any unproductive operating assets that should be sold?Are there opportunities for the company to acquire existing production capacity from struggling competitors at advantageous prices?If assets are leased from a related entity, do the lease terms reflect market rates?Are there opportunities to negotiate more favorable lease terms on upcoming renewals with third party landlords?How has the pandemic changed the company’s real estate strategy and needs? 4. Workforce IntangiblesIf the family business borrowed money under the PPP loan program, has it properly documented eligible expenses and initiated the approval process for loan forgiveness?How has the family business’s workforce held up during the pandemic? What investments are necessary/appropriate to enhance or sustain long-term productivity, morale, etc.?How has the family business adapted to the work from anywhere model? What opportunities or threats does such a labor model present to the family business?How has the pandemic affected succession planning at key positions throughout the company? Have expected transition dates for senior executives been accelerated or deferred?5. Technology IntangiblesWhat investments in technological infrastructure are necessary for the family business to remain competitive in a “contactless” world?What investments in technological infrastructure are necessary for the family business to remain competitive in a “work from anywhere” world?Has the pandemic accelerated the economic obsolescence of any of the family business’s core technology assets?Is the company’s enterprise resource planning software up to date, and does it provide the right information to the right managers in the right format at the right time?Has the family business deferred any maintenance or development spending to preserve cash during the pandemic? If so, does the company have concrete plans for keeping its technology assets up to date?6. Marketing IntangiblesHow has the family business’s overall brand fared during 2020? Are customers and prospects more, or less, aware of the brand than they were a year ago?Does the family business have a cohesive social media strategy, and is it executing that strategy in a disciplined way?How have traditional marketing channels been influenced by the pandemic?Are there any legacy brands or product lines that are no longer viable and should be eliminated?What opportunities are there for brand extensions or new product lines to meet market demand?Are there new geographies or markets that could prove hospitable to the company’s brand?7. Customer IntangiblesHow have customer retention trends been influenced by the pandemic?What is the trend in the overall cost to identify, attract, and retain new customers?Are there any new emerging customer concentrations facing the family business?Does the company have any customer relationships that are currently unprofitable? What steps can be taken to improve the profitability of those relationships? Has the company analyzed the financial and strategic impact of pruning those customers?Does the family business have appropriate tools in place to measure and manage customer engagement and satisfaction?Is the existing sales organization adequate to meet the current challenges facing the family business?Is the company’s customer relationship management software up to date, and is there a process for capturing new customer data as it is being generated?
Of course, this checklist is just a starting point and needs to be tailored to the specific challenges facing your family business. Some of your family business’s most important assets likely don’t show up on the balance sheet. Taking a deliberate inventory of all the company’s assets – both tangible and intangible – can be a great way for directors to assess the health of their family business and chart a course for the future. In next week’s post, we will take a business unit perspective for your year-end strategic inventory.
The Role of Earn-Outs in RIA Transactions (Part Three)
In last week’s blog post, we covered five considerations for designing earn-outs. To recap, these considerations are as follows:Defining the continuing business that will be the subject of the earn-outDetermining the appropriate period for the earn-outDetermining to what extent the buyer will assist or impede the seller’s performance during the earn-out periodDefining what performance metrics will control the earn-out payment(s)Determining other earn-out features (caps on payments, clawbacks, etc.)
While there is no one set of rules for structuring an earn-out, keeping these conceptual issues in mind can help anchor the negotiation. This week, we look at an example RIA transaction to illustrate how these considerations come into play when buyers and sellers are working out deal pricing and structure.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank (HSB). HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought. HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring an RIA.Following a search, HSB settles on Typical Wealth Management (TWM). TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor). TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm. TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin. Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins.
Given what it represents to be very conservative projections, and which don’t take into account any cross-selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence.
The Buyer’s PerspectiveThe commercial bankers at HSB are not overly familiar with the wealth management industry, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management do not always mix well, and HSB worries whether TWM’s clients will stay if TWM’s senior staff starts to retire. Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors. They create a much less sanguine projection to model their possible downside.
Based on this, HSB management wants to offer about $40 million for TWM, which is about six times run rate EBITDA. This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction.
The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster. Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM. The rest of the payment, if any, will come from an earn-out. Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division. As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to the last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if AUM is significantly enhanced after the transaction, whether by steady marketing appeal or strong market returns. The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA. As long as the management of TWM can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out. Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition/non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both the buyer and sellers are enthusiastic participants in the joint success of the enterprise.
As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for TWM after the transaction to see what the payout structure will look like per the agreement. This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Conclusion: Earn-Outs are Interactive With the Value of RIAsRisk is an unavoidable part of investing. While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly. If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk free rate with no premium return attached. Uncertainty creates opportunity for investors, because opportunity is always a two way street.Pricing uncertainty is another matter altogether. Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of un-likelihood for the performance of a given asset with the value of that security. In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the vacuum-sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections. The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability. The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty. In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections. With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction. Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.
Themes from Q3 2020 Earnings Calls
Part 2: Mineral Aggregators
Last week, we reviewed the third quarter earnings calls from a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from the mineral aggregator third quarter 2020 earnings calls.Theme 1: M&A Activity Is Heating UpThe mineral aggregator space seems to be following the same M&A pattern as E&P operators as of late. Relative to the first half of 2020, consolidation efforts are increasing as aggregators are focusing on potential acquisition opportunities. Industry participants, however, continue to notice a wide bid-ask spread as sellers are often unwilling to sell at current prices.“I would say that, in terms of overall deal flow, we're seeing a tremendous amount of deal flow. If anything, our deal teams are busier now than they ever have. What I would say is that the competition today isn't necessarily with other mineral companies, but in often instances, we refer to kind of reservation price and that's the seller's willingness to part with those minerals.” – Robert Roosa, Founder & CEO, Brigham Minerals“We've been active on the M&A front. We'll still look at acquisitions. We're still working around the clock on acquisitions or submitting bids. It's just more challenging. I mean I think that sellers in this environment need to adjust expectations when the public companies, they're supposed to be the lowest cost of capital trade down so dramatically, us and our peers, that should trickle down to the sellers.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners“There's billions of dollars of minerals held within private equity firms as well as family offices. But in places where they're not meant to be held over the long term. And I think you will see consolidation in the space. And I think there's an opportunity for value creation as a result of that.” – Daniel Herz, President & CEO, Falcon MineralsTheme 2: Curtailment Situation Affects Aggregators Differently Production curtailments continued in some basins, like the Bakken, in the third quarter, while other well curtailments were reversed and put back online in the Permian and Eagle Ford. Some aggregators had the benefit of being active in certain basins where the curtailments were lifted, and others were not so fortunate but remained optimistic that their wells would be back online by the end of the year.“We believe, as of the end of September, all of the curtailed wells are back online and are producing to our benefit, with the barrels of oil selling at substantially higher prices that existed during the curtailment period. Very good news for us all. While the third quarter had limited wells turned online, which is consistent with what we had expected and previously discussed, activity has begun to pick up.” – Daniel Herz, President & CEO, Falcon Minerals“Production curtailments, which were put in place by many operators during the height of the pandemic earlier this year, were largely reversed in the Permian and Eagle Ford during the quarter. However, curtailments were still largely in place on our Bakken assets during the third quarter. We are hopeful that these will reverse in Q4 of 2020 due to improved differentials in commodity prices.” – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty PartnersTheme 3: Natural Gas Continues to Spark InterestNatural gas has shown its ability to remain somewhat stable during a difficult price environment. The commodity’s price stability along with the favorable outlook has aggregators interested. The participants recognize natural gas as an important asset in their portfolio and express their optimism in gas prices moving into 2021.“There's already some optimism in natural gas with '21 forward prices over $3 in MMbtu. And the recent underinvestment in oil projects, both domestically and abroad, combined with the lessening influence of OPEC is setting the stage for an oil rally once demand recovers.” – Tom Carter, CEO & Chairman of the Board, Black Stone Minerals“In addition to our gas weighted daily production, we also have a significant amount of future drilling inventory located across the major natural gas basins in the U.S. with a concentration in the core areas of the Haynesville and Marcellus.” – Bob Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“As Bob laid out a few moments ago, natural gas price futures are projected to be up approximately 50% in the next 12 months as compared to the average prices over the last 12 months, which could generate a significant improvement in cash flow for the company.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners“And just when we thought gas was dead, of course, natural gas prices are above $3 and that's a great call option for us. And we have two rigs running across our acreage position. And we have a nice amount of gas.” – Daniel Herz, President & CEO, Falcon MineralsTheme 4: Banks and Balance SheetsBanks seem to be uneasy with E&P companies’ lending situations, which trickles down to the aggregator space. A continuing trend among E&P operators and mineral aggregators is the effort to shore up the balance sheet to create a healthier company and maintain positive bank relationships during the current uncertainty.“In addition, the balance sheets of many operators are strained and as we go through the fall borrowing base redetermination season. Bank and equity markets remain closed for most E&P companies. This plus a renewed focus on cash returns instead of simply production growth, has limited new drilling capital across Lower-48, which obviously impacts our production levels.” – Tom Carter, CEO & Chairman of the Board, Black Stone Minerals“I mean, you've seen obviously, the banks have had a tough time with energy companies through this down cycle. We want to be as low touch as possible with those banks.” – Kaes Van’t Hof, President, Viper Energy Partners“We're not interested in using cash in this environment just given the fact that we're really focused on cleaning up the balance sheet as much as we can and we don't want to do an equity raise at an unpalatable discount right now to raise the cash.” – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners
Valuation Assumptions Influence Auto Dealer Valuation Conclusions
How to Understand the Reasonableness of Individual Assumptions and Conclusions
There are several life events (large and small) that require an owner of an auto dealership to seek a business valuation – estate planning, a potential sale, shareholder dispute/litigation, divorce, death of an owner, etc. Often the owner of the dealership and their advisors may only view a handful of business valuations during their careers. It is not unusual for the valuation conclusions of appraisers to differ significantly, with one significantly lower or higher than the other.Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.What is an owner or their advisor to think when significantly different valuation conclusions are present? The answer to the reasonableness of the conclusion lies in the reasonableness of the appraiser’s assumptions. However, valuation is more than “proving” that each and every assumption is reasonable. Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.A short example will illustrate this point and then we can address the issue of individual assumptions. In the following example, we see three potential discount rates and resulting price/earnings (“P/E”) multiples. The discount rate or rate of return is a key component in determining the value of an auto dealership under an income approach. While other methods, including Blue Sky multiples are more often used, determining the rate of return applicable to an auto dealership is also an important step in a business valuation.In the table below, we look at the theoretical assumptions used by appraisers to “build” discount rates. We show differing assumptions regarding four of the components, and none of the differing assumptions seems to be too far from the others. So, we vary what is called the equity risk premium (“ERP”), the beta statistic, which is a measure of riskiness, the small stock premium (“SSP”), and specific company risk (“SCR”).The left column (showing the low discount rate of 12.0% and a high P/E multiple of 11.1x) would yield the highest valuation conclusion. The right column (showing the high discount rate of 23.5% and the low P/E of 4.9x) would yield a substantially lower conclusion. That range is substantial and results in widely differing conclusions.In either case, appraisers might have made a seemingly convincing argument that each of their assumptions were reasonable and, therefore, that their conclusions were reasonable. However, the proof is in the pudding. Perhaps, neither the low nor the high examples would yield reasonable conclusions when viewed in light of available market evidence of the particular franchise, and location and profitability of the subject dealership.So, as we discuss how to understand the reasonableness of individual valuation assumptions in business appraisals of auto dealerships, know also that the valuation conclusions must themselves be proven to be reasonable. That’s why we place a “test of reasonableness” in every Mercer Capital valuation report that reaches a valuation conclusion.Auto Dealership Valuation AssumptionsNow, we turn to individual assumptions utilized in an auto dealership valuation.Growth RatesGrowth rates can impact a valuation in several ways. First, growth rates can explain historical or future changes in revenues, earnings, profitability, etc. A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate under the income approach.Growth rates, as a measure of historical or future change in performance, should be explained by the events that have occurred or are expected to occur. In other words, an appraiser should be able to explain the specific events that led to a certain growth rate, in terms of total and departmental revenue and profitability. Auto dealerships experiencing large growth rates from one year to the next should be able to explain the trends that led to the large changes, whether it is new customers, new vehicle models being offered, loss/additional of a competitor, or other pertinent factors. Large growth rates for an extended period of time should always be questioned by the appraiser as to their sustainability at those heightened levels. This is particularly true for auto dealers, which as dealer principals know, experience ebbs and flows of the business cycle.A long-term growth rate is an assumption utilized by all appraisers in a capitalization rate. The long-term growth rate should estimate the annual, sustainable growth that the dealership expects to achieve. Typically, this assumption is based on a long-term inflation factor plus/minus a few percentage points. Be mindful of any very small, negative, or large long-term growth rate assumptions. If confronted with one, what are the specific reasons for those extreme assumptions?AnnualizationIn the course of a business valuation, appraisers normally examine the financial performance of the auto dealership for a historical period of around five years, if available. Since business valuations are point-in-time estimates, the date of the valuation may not always coincide with the auto dealership’s annual reporting period.Dealerships should be able to provide factory financial statements for the year-to-date period coinciding with the valuation date for the current and preceding year. A business appraiser can compile a trailing twelve month (“TTM”) financial statement from those two interim factory statements and the most recent 13th month year-end factory statement. A TTM financial statement allows an appraiser to examine a full-year business cycle and is not as influenced by seasonality or cyclicality of operations and performance during partial fiscal years. The balance sheet may still reflect some seasonality or cyclicality.Be cautious of appraisers that annualize a short portion of a fiscal year to estimate an annual result. This practice could result in inflating or deflating expected results if there is significant seasonality or cyclicality present. At the very least, the annualized results should be compared with historical and expected future results in terms of implied margins and growth.Dealer principals are well aware of monthly volumes of light vehicles sold in the U.S. that are annualized and referred to as “SAAR.” Due to the number of selling days and the inherent seasonality throughout the calendar year, properly determining the TTM financials should reduce the need to consider a complex formula such as that employed in the calculation of SAAR that almost certainly is not used if an appraiser simply annualizes by scaling up a stub period to 12 months.Litigation Recession “Litigation recession” is a term to describe a phenomenon that sometimes occurs when an owner portrays doom and gloom in their industry and for the current and future financial performance of the dealership. As with other assumptions, an appraiser should not blindly accept this outlook.A quality appraiser will compare the performance of the dealership against its historical trends, future outlook, and the condition of the industry and economy, among other factors. Be cautious of an appraisal where the current year or ongoing expectations are substantially lower, or higher for that matter, than historical performance without a tangible explanation as to why.Industry Conditions Most formal business valuations should include a narrative describing the current and expected future conditions of the auto dealer industry. An important discussion is how those factors specifically affect the dealership being valued. There could be reasons why the dealership’s market is experiencing things differently than the national industry. Industry conditions can provide qualitative reasons why and how the quantitative numbers for the dealership are changing. Look carefully at business valuations that do not discuss industry conditions or those where the industry conditions are contrary to the dealership’s trends. Current valuations in 2020 should include a discussion of the local industry conditions and their impact on a dealership’s performance as the effects of the pandemic have varied across states and regions.Valuation Techniques Specific to the Auto Dealer IndustryAs we have previously written, the valuation methods utilized in the auto dealer industry are unique and include an asset-based approach, an income approach, and a modified market approach incorporating concepts of Blue Sky value. It may be difficult for a layperson reviewing a business valuation to know whether the methods employed are general or industry-specific techniques. An auto dealer or their advisor should ask the appraiser how much experience they have performing valuations in the auto dealer industry.Risk Factors Risk factors are all of the qualitative and quantitative factors that affect the expected future performance of the auto dealership. Simply put, a business valuation combines the expected financial performance of the dealership (earnings and growth) and its risk factors. Risk factors show up as part of the discount rate utilized in the income approach of the business valuation.Like growth rates, there is no textbook that lists the appropriate risk factors for the auto dealer industry. However, there is a reasonable range for this assumption.Be careful of appraisers that have an extreme figure for risk factors. Make sure there is a clear explanation for the lowered or heightened risk. Otherwise, this is an easy area to influence a lower or higher valuation of the dealership.Blue Sky Multiples Another typical component of an auto dealer valuation is the use of Blue Sky multiples and the reflection of the concluded value as a measure of Blue Sky. As we have discussed, there are several national business brokers that publish these multiples quarterly by the manufacturer. Be wary of appraisers that do not reference Blue Sky multiples or explain their concluded values as a measure of Blue Sky. Also, be wary of appraisers that apply Blue Sky multiples to used vehicles or other metrics that are not widely recognized by the auto dealer industry.Another critique could be the range of Blue Sky multiples examined and how they are applied to the subject dealership. Take note of an appraiser that applies the extreme bottom or top end of the range of multiples, or perhaps even a multiple not in the range. Be prepared to discuss the multiple selected or implied and how the dealership compares to the range of multiples in terms of the local market (location and urban vs. rural), level of competition, historical profitability, etc.... we believe Blue Sky multiples are very helpful, at least for explaining value.In our review of appraisals performed by other firms, particularly those without considerable auto dealer experience, we see Blue Sky multiples either won’t be rigorously analyzed or may not even be mentioned. While this may not be a red flag to a layperson, we believe Blue Sky multiples are very helpful, at least for explaining value. To confirm the reasonableness of an appraisal that does not mention Blue Sky multiples, dealer principals can calculate it themselves. Blue Sky value is measured/calculated as the excess equity value over the tangible net assets of the dealership. If the implied multiple from an appraisal is unreasonable in the context of multiples seen for the relevant franchise(s), the overall reasonableness of the conclusion should be questioned.Time Periods Considered Earlier we stated that a typical appraiser examines the prior five years of the dealership’s financial performance, if available. Be cautious of appraisers that simply choose to use a small sample size, i.e. the latest year’s results, as an estimate of the dealership’s ongoing earnings potential. The number of years examined should be discussed and an explanation as to why certain years were considered or not considered should be offered.Some industries, like the auto dealer industry, have multi-year cycles, not just annually (further evidence of the importance of a discussion of industry conditions and consideration of recognized industry-specific techniques in the appraisal).The examination of one year or a few years (instead of five years) can result in a much higher or lower valuation conclusion. If this is the case, it should be explained.ConclusionBusiness valuations of auto dealerships are a technical analysis of methodologies used to arrive at a conclusion of value for the subject dealership. It can be difficult for an auto dealer or their advisors to understand the impact of certain individual assumptions and whether or not those assumptions are reasonable. In addition to a review of individual assumptions, the valuation conclusion should be reasonable.Mercer Capital performs numerous business valuations of auto dealers annually for a variety of purposes. Contact a professional at Mercer Capital to discuss your next business valuation.
Taking Stock: Taking a Strategic Inventory of Your Family Business
Tactics win battles, strategy wins wars. - Pierce BrownFor family businesses, 2020 has been, first and foremost, a battle against the COVID-19 pandemic. As a result, directors and managers have rightly focused on tactics: what steps do we need to take today, next week, and next month to ensure the health of our employees and customers and ensure our family business survives?As glimmers of hope emerge that the pandemic will eventually end, December is a natural time to catch up on some of the strategic thinking that has been put on hold by the coronavirus. While focusing on tactics has been essential to surviving 2020, many family businesses would do well now to turn their attention to strategy. If tactics are about short-term viability, strategy is about long-term sustainability.My wife and I were recently discussing the mix of personalities, temperaments, skills, and interests represented in our extended family. She astutely observed that each person contributes something unique to the family, and that the characteristics that one sometimes finds irksome are often paired with corresponding strengths that would otherwise be missing in the family. This observation readily applies to family businesses. So the first step in your strategic thinking may need to be taking an “inventory” of the assets of the family business.This inventory process fits well with our preferred “asset manager” perspective on family business, depicted below.
Under this perspective, directors and managers are stewards of family capital. Much like professional asset managers select investments on behalf of their clients in order to meet the financial objectives of those clients, family business directors and managers are tasked with allocating family capital to a mix of operating assets that will provide an appropriate combination of risk and return for family shareholders.
One way to re-start a strategic planning process for your family business is to take an inventory of just what assets your family’s capital is currently allocated to, and thinking about what those assets bring to the family business in terms of risk profile and reward potential.
We find that four questions can help spur strategic thinking about your business:
What assets are currently in our portfolio?What are the return and risk attributes of each asset?How do the different assets our family business owns correlate to one another?What assets should be in our portfolio to help ensure the long-term sustainability of our family business?
You can answer the first question from either of two complementary perspectives. First, you can think about your existing asset allocation with respect to broad asset classes (working capital, property & equipment, etc.). Or, you can address the asset allocation question from the perspective of business units or segments: what collection of divisions, segments, or branches comprise our family business today? The following table summarizes these perspectives.
As illustrated above, these perspectives are complementary because the asset class perspective can be readily applied to individual business units. In next week’s post, we will consider the asset class perspective, and the following week we will adopt the business unit perspective.
As the year winds down, we recommend setting aside time to look beyond survival tactics and re-engage in some strategic thinking about your family business. Much like an asset manager would review the portfolio they have constructed with their client, family business directors should review the current asset allocation in their family business. Doing so can help uncover fresh insights and challenge conventional thinking that is due for an update.
Themes from Q3 2020 Earnings Calls
Part 1: E&P Operators
As discussed in our quarterly overview, the oil & gas sector experienced a relatively stable price environment as compared to the volatile energy prices seen in the first half of the year. The third quarter saw the WTI range narrow and hover around $40 per barrel, in line with industry participant expectations of nominally higher prices than in the second quarter.However, the concurrent overlapping impact of (i) discord created by the OPEC/Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic and continued to play a role in the third quarter. As if COVID-19 and the Russian-Saudi price rift wasn’t eventful enough, the regulatory shakeup expected to come from the Biden administration following the November election will add to the mix for what seems to be an already pressing and critical time for the industry. The unfortunate, overlapping timing of these events has made the bankruptcy courts busy with no indication of that trend coming to a halt.In this post, we capture the key takeaways from E&P operator third quarter 2020 earnings calls.Theme 1: Continued Cost Reductions Lower Break-Even PricesOne recurring theme among E&P operators in our prior E&P operator earnings calls was the continued focus on reducing operating costs and capital expenditures in the pursuit of increased efficiencies. All six E&P operators we tracked in our current quarterly overview saw gains along these lines, evident by positive free cash flow in Q3 due to a decline in break-even prices.“Yes, we do see the break-even is roughly $32 next year. I don’t think that’s too dissimilar from where we were before we were indicating kind of in the mid-30s. But it depends on the capital program at any given time and where you’re putting those assets and the productivity.” – William Berry, CEO, Continental Resources, Inc.“Our pro forma maintenance capital corporate breakeven is at a very, very attractive low -- in the low 30s WTI, including the base dividend.” – Scott Sheffield, CEO, Pioneer Natural Resources Company“Impressive downside resilience as evidenced by our low-cost structure and enterprise free cash flow breakeven, approximately $35 per barrel WTI breakeven in 2021, including our dividend…” – Lee Tillman, President & CEO, Marathon Oil Company“Due to sustainable cost reductions achieved this year, maintenance capital and the current dividend can now be funded with oil in the mid-30s.” – Lloyd Helms, COO, EOG Resources, Inc.Theme 2: Continued Emphasis on Debt Reduction and Shareholder DividendsAnother recurring theme in our prior quarterly analysis was the focus by E&P operators on reducing debt and reinforcing dividends. The panel of operators we tracked in this quarterly earnings call review was split almost evenly among those who were still focused on debt reduction and those who put the return of capital to shareholders as their top priority.“The cornerstone of our 2021 plan is maximizing free cash flow to pay down debt… While our dividend has been suspended, but not terminated, both our shareholders and our board are very supportive of bringing the dividend back at the appropriate time after our debt is reduced.” – William Berry, CEO, Continental Resources, Inc.“We are well aware that some of our larger peers are planning to return cash to shareholders. But as we have repeatedly stated, our plan is to apply our free cash flow, alongside our monetization proceeds, towards meaningful debt reduction, until we have significantly lowered our total debt balance.” – Jim Ulm, Chief Financial Officer, Callon Petroleum Company“[With respect to the prioritization of allocating free cash flow] the base dividend will be first. And then second, will be a combination of balance sheet and variable dividend.” – Scott Sheffield, CEO, Pioneer Natural Resources Company“Put very simply, our forward capital allocation philosophy has not changed. We will protect our dividend, spend maintenance capital at most and use excess free cash flow to pay down debt. If our expected free cash flow will not cover our dividend, then we will cut capital to ensure our dividend is protected.” – Travis Stice, CEO, Diamondback Energy, Inc.“[W]e are putting this free cash flow to good use. Advancing our dual objectives of returning capital to our shareholders through our base dividend reinstatement and improving our balance sheet through … gross debt reduction while cutting our 2022 maturity tower in half. Importantly, both the fourth quarter dividend reinstatement and gross debt reduction were fully funded by actual third quarter free cash flow.” – Lee Tillman, President & CEO, Marathon Oil Company“We remain committed to pursuing our objective to strengthen our balance sheet further during upturns. Beyond the regular dividend and debt reduction we regularly review performance scenarios that may present options for additional cash return to shareholders. We haven't ruled out buybacks or a variable or special dividend and we'll consider all options for additional return of cash to shareholders when the opportunity presents itself.” – Tim Driggers, CFO, EOG Resources, Inc.Theme 3: Uncertainty Lies AheadDespite the relative stability of oil and gas prices in the third quarter, E&P operators continue to project significant uncertainty for their industry. The critical near-term factors affecting their forward outlook include regulatory changes for the oil and gas industry as put forth by the Biden administration, an upcoming meeting of OPEC+ producers in December, and the potential timeline of effective and available vaccines to curb the energy demand shock brought on by the COVID-19 pandemic.“There's certainly some significant headwinds on the commodity space right now. I mean we've got the election uncertainty and looming policy changes… We've got COVID that we're still struggling how to contain that. And is there going to be a vaccine anytime soon, and what does that mean to the supply demand recovery? We've got OPEC+ meeting in December to talk about whether they maintain cuts or start easing those cuts, and then we've got a global inventory overhang that's still there. All of those are macro issues that I can't control, and we can't influence.” – Travis Stice, CEO, Diamondback Energy, Inc.“There are still several unknowns that we will continue to evaluate during our budgeting process. The impact of the election, the timing of COVID-19 vaccine and in turn, the return and stabilization of oil demand, especially what OPEC decides to do in during the mid-November to December 1 OPEC meetings.” – Scott Sheffield, CEO, Pioneer Natural Resources CompanyOn the HorizonBroadly speaking, the E&P operator earnings calls suggest an uneasy calm. The question is, has the oil and gas industry emerged from the first major quake and should it expect relatively minor aftershocks, or is it in the eye of the storm, experiencing a brief respite before the tempest picks up again? Overall, it is clear that oil and gas operators can not only weather the storm, but still produce free cash flow that is significant enough to shore up the balance sheet and return capital to shareholders while concurrently maintaining lean operational and capital programs. This modus operandi, however, comes at the cost of highly subdued expectations for growth (with one noted exception among the six E&P operators we monitor).Throughout the earnings calls, we noted that management outlooks that included flat or even slight production declines over the near-term horizon were not considered to be “downside” scenarios, but evidence of, if nothing else, at least sustainable ongoing operations. Additionally, we noted that at least half the E&P operators discussed continued efforts to support and advance various ESG initiatives, including proactively reducing emissions, and imparting stronger positive impacts on the local communities in which the companies operate.Regarding M&A activity, there was not much commentary regarding overall industry trends, but the overriding thesis was brought up in a number of calls that the focus of any such activity should be on “not necessarily bigger, but better.”
Avoiding Buyer’s Remorse
The Role of Earn-Outs in RIA Transactions (Part Two)
One November day in the late 1970s my dad noticed an ad on the bulletin board at work that caught his attention: someone had a Jensen Healey MkII for sale. The MkII was arguably the best product Jensen Healey ever made: a lightweight two seat convertible with a Lotus four-cylinder double overhead cam engine with dual Stromberg carburetors. The Jensen my dad was looking at was far from perfect – it was covered with a couple of years worth of dust and had a crease running down the middle of the fragile aluminum hood because someone hadn’t been careful closing it. It needed a tune up and who knows what else (British sports cars aren’t known for reliability). But at 2,400 pounds and 140hp, when it ran, it ran fast. Dad brought the Jensen home for the long Thanksgiving weekend and we drove it around Miami (due diligence) to decide whether or not to take the plunge.Part Two of Our Series on Earn-OutsLast week, we offered an example, ACME Private Buys Fictional Financial, to shed light on several issues presented by the use of earn-outs in RIA transactions. As explained, gathering comprehensive data on ultimate deal value in investment management transactions is problematic as most post-deal performance doesn’t get reported other than AUM disclosures in public filings. And, if the acquired entity is folded into another RIA, you can’t even judge a deal by that. Sometimes bad deals can be saved by good markets, but hope is not a strategy. Consequently, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better-than-working knowledge of them.Earn-Out FunctionAs noted above, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against potential losses for the latter. In investment manager transactions, earn-outs are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of buyer and seller in a contractual understanding.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price upfront (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.Define the Continuing Business Acquired That Will be the Subject of the Earn-Out.Deciding what business’s performance is to be measured after the closing is easy enough if an RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make measuring performance fairly easy.If an RIA is being rolled into an existing (and similar) investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, staff additions and subtractions, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As a friend’s father used to say: “fair is just another four-letter word.”Determine the Appropriate Period for the Earn-Out.We have seen earn-out periods (the term over which performance is measured and the contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defining investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.There is no magic period that fits all situations.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally, buyer-seller relations can become strained during an earn-out measurement period, and when it is over, no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well-advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.Determine to What Extent the Buyer Will Assist or Impede the Seller’s Performance During the Earn-Out.Was the seller attracted to the deal by guarantees of improved technology, new product options, back-office support, and marketing? Did the buyer promise the seller the chance to operate their business unit without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives required to receive contingent consideration.While bad deals can be saved by good markets, counting on overpromises is not a sound deal strategy. Instead, buyers and sellers should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, and defining the mutual obligations required to achieve shared success. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from his or her counterparty on the front end.Define What Performance Measurements Will Control the Earn-Out Payments.It is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers ultimately are paying for the future profit contribution from the seller, so a measure of cash flow seems like the obvious performance metric to measure the acquired investment management operation’s success. However, there are at least two problems with using cash flow to benchmark contingent consideration.Returns from markets don’t determine long-term success nearly as much as returns from marketing.First, profitability is at the bottom of the P&L and is, therefore, (potentially) subject to manipulation. To generate a dollar of profit at an RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success be sufficiently isolated and defined in an earn-out agreement? It is often more difficult than it seems.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If a rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine long-term success nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added net of assets withdrawn), given a certain aggregate fee schedule (so business won’t be given away just to pad AUM).Name Specific Considerations That Determine Payment Terms.Is the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith?”Earn-outs manage uncertainty; they don’t create certainty.Because these specific considerations are unique to a given transaction between a specific buyer and seller, there are too many to list here. Nevertheless, we have formulated a couple insights about earn-outs over the years: 1) Transaction values implied by earn-out structures are often hard to extrapolate to other transactions. 2) An earn-out can ease the concerns and fulfill the hopes of parties to a transaction about the future – but it cannot guarantee the future. Earn-outs manage uncertainty; they don’t create certainty.Above all, contingent consideration should be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed with the specific buyer and seller in mind.Earn-Outs Are Like WarrantiesWhat happened to the Jensen Healey? Over that fall weekend in Miami, we detailed and waxed the car. My dad was able to get the crease out of the aluminum hood by reshaping it with his bare hands. It was a beautiful car and sounded great under power, but even a five-year-old British sports car in the 1970s was cause for concern, and they don’t come with warranties. My dad had lived with an old Jaguar in his 20s and didn’t mind getting grease under his fingernails, but one evening we were diving the Jensen home from dinner and it ran out of gas. The fuel gauge didn’t work; likely one of a string of problems that would lead my father to a level of buyer’s remorse that he had experienced with other cars and didn’t want to deal with again. He didn’t buy it.Like old sports cars, acquisitions don’t come with warranties, so protecting yourself against buyer’s remorse is critical. Even with escrows and punitive terms, you can’t guarantee that you’ll get what you pay for in an acquisition; but, with a properly structured earn-out, you can at least pay for what you get.
October 2020 SAAR
October lightweight vehicle sales had their second month in a row above 16 million, coming in at an annualized rate of 16.2 million for the month. Though this is down 0.6% from the September SAAR of 16.3 units, it is still a positive sign for the industry that sales have shown notable improvement since the start of the pandemic. As Thomas King, president of data and analytics at J.D. Power noted:“Two consecutive months of year-over-year retail sales increases demonstrates that consumer demand is showing remarkable strength. The strong sales pace is occurring despite tight inventories. The combination of strong demand and lean inventories is enabling manufacturers to reduce new-vehicle incentives and is allowing retailers to reduce the discounts they typically offer on new vehicles.”SAAR for October 2020 is off by 3% from that of October 2019. Light trucks are continuing to bolster sales, coming in at 77% of new vehicles sold in October and 76% of new vehicles sold this year.The average new vehicle turnover from lots to consumers has fallen to 49 days, the first time it has fallen below 50 days in more eight years. 20% of vehicles are being sold after being on a dealer lot for only five days or less.As we mentioned in our Q3 earnings call blog post, public auto dealers noted how vehicle demand has been outstripping supply as manufacturers struggle to get new vehicles to dealers. Among the major public dealerships, there is consensus that this inventory shortage will continue through year-end before beginning to normalize in 2021. However, tighter inventory has contributed to higher gross margins and higher selling prices. In October, these prices are expected to reach another all-time high, rising 7.3% from last year to $36,755. More expensive trucks and SUVs have been drivers of this average transaction increase.Looking toward the rest of the year, not much is anticipated to change unless there is an unexpected relief to the inventory constraints. The sales calendar for November 2020 is shorter than that of 2019 (28 days in 2020 vs. 32 in 2019), so slightly deflated SAAR is expected.Dealership Valuations Looking UpWhen considering the year that auto dealerships have experienced, an outside observer would likely assume that dealership values are down. However, more dealerships are bullish on their valuations over the next twelve months according to a Kerrigan Advisors survey of dealers. The second annual survey found that 33% of dealers expect the value of their stores to rise in the next year, up from 26% in 2019. Another 53% expect values to remain the same, while 14% think their values will be lower. This is a change from 2019 where 60% expected values to remain the same and 14% to expect a decrease. Erin Kerrigan, managing director of the firm, noted "The rebound in auto sales coupled with reduced dealership expenses and higher vehicle margins will result in record industry earnings in 2020.”
As seen in the table above, Subaru, Toyota, Porsche, Honda, and Mercedes-Benz have the highest expected valuation gains. These trends are in line with Blue Sky multiple increases as well, as Subaru’s blue sky multiple has seen an increase to 5.0x – 6.0x, while dealerships such as Infiniti and Cadillac continue to be below blue sky multiple levels.
Some CaveatsThough dealers being bullish on their valuations is a good sign in terms of the recovery of the industry, every dealership is different. While there are many factors that need to be considered when determining the value of a dealership, here are three that are critical, especially when considering the operating in a pandemic.LocationWhile 38% of Subaru dealerships surveyed anticipate valuation growth this year, that percentage is unlikely to be consistent across the country.When determining the value of a dealership, it’s important to consider the local economy where the dealership operates, especially considering stay-at-home orders and business restrictions stemming from the pandemic.In March and April, dealers in the northeast were harder hit by the stay-at-home orders than the dealerships elsewhere. As of today, with the virus surging across the country, looking at the impacts in each specific region is important to determining dealership values.SalesWhile many dealerships are seeing earnings growth in Q2 and Q3, what is the quality of that earnings growth and how do dealerships’ earnings compare to that of prior years?If earnings have only increased due to operation cuts, that growth should be scrutinized a bit. Cutting costs can improve the bottom line in the short run, but it may not contribute to overall company growth over the long-term. We’ve had clients remark how the Great Recession taught them just how lean they could operate. Since then it’s likely that dealers have added back some expenses but the pandemic has again forced cost cutting. The sustainability of earnings in 2020 will depend on how many of those expenses can continue to stay low and how gross profits look once inventories become less scarce.Earnings growth must also be evaluated in the context of pre-pandemic levels, not just improvement from the bottom. The recent pattern in GDP growth is a good example of this. In Q3, GDP increased an impressive 33.1%, after having fallen 31.4% in Q2. While 33.1% is greater than 31.4%, we can see in the graph below that GDP has not fully recovered.OperationsIn an increasingly technological environment due to the pandemic, a dealership’s digital presence can contribute to their overall valuation. A dealership that has invested in their digital offerings has set themselves on a platform for growth.ConclusionThe valuation outlook for many dealerships is positive but dealerships are not created equal. The individual characteristics and performance of each dealership has to be analyzed in any valuation process.Feel free to reach out to us for more information about how current economic conditions may affect your dealership’s valuation or to discuss a specific valuation need in confidence.
The Role of Earn-Outs in RIA Transactions (Part One)
Earn-outs are as common to investment management firm transactions as they are misunderstood. Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants. Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction. Contingent consideration remains a mystery to many industry participantsThis blog series is not offered as transaction advice or a legal primer on contingent consideration. The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry. Instead, we offer these posts to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Earn-Outs Are Fundamental to RIA TransactionsAs the saying goes (which has been attributed to at least a dozen famous figures): "It’s difficult to make predictions, especially about the future." This reality is the single most difficult part of negotiating a transaction in the investment management industry. The value of an RIA acquisition target is subject not only to a large number of variables but also a wide range of possible outcomes:Performance of financial markets (standard deviation varies)Skill of the investment management staff (difficult to measure)Sustainability of the acquired firm’s fee schedule (not as much a given as in the past)Retention of key staff at the acquired firm (absolutely necessary)Retention of key staff at the acquiring firm (absolutely necessary)Motivation of key staff (absolutely necessary)Retention of client assets (depends on third party behavior)Marketing strength of the merged enterprise (tough to predict)
Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe material value to an RIA. But actually, buying an investment management firm is making a bet on all of the above, and most people don’t have the stomach.Only by way of an earn-out can most investment management firm transactions overcome so much uncertaintyReaders of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty. Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role contingent consideration plays in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.If nothing else, earn-outs make for great stories. Some of them go well, and others go like this.From Earn-Out to Burn-Out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of an investment management firm causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.ConclusionThis example highlights the difference in headline deal values (total consideration) and what actually gets paid after the earn-out payment. Sometimes they’re the same but often only a portion of the contingent consideration is realized, which makes total consideration multiples difficult to interpret. We’ll touch on this a bit more in next week’s post on transaction strategies and earn-out parameters.
And Now You Know… The Rest of the Story
Due to the popularity of this post, we feature it again this week. In this post, we discuss return on invested capital, how it's calculated, and why it's important for your family business.
The management team at your family business has been hard at work growing revenue and profits by 50% over the past five years, so the value of your shares must have increased, right? Not necessarily.
Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware that Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital, because it tells you the rest of the story.What Is Return on Invested Capital?Return on invested capital (ROIC) relates the operating performance of a business to the amount of capital used to support the operations of the business. In other words, it measures the efficiency with which family capital is used in the family business. In last week’s post on capital budgeting, we likened the directors and managers of a business to stewards responsible for selecting the capital projects in which to invest family resources.
Return on invested capital measures how well directors and managers are handling their stewardship of family resources. ROIC allows family shareholders to see how much income is being generated per dollar of investment.
How Is Return on Invested Capital Calculated?Exhibit 2 illustrates how to calculate ROIC for your family business.
We need to unpack a couple of the terms in Exhibit 2 that may not be familiar.
Net Operating Profit After Tax (NOPAT) is a measure of earnings that excludes interest expense. Analysts often segregate interest expense from the other expenses of the business for at least two reasons. First, interest does not directly relate to the operations of the business. In other words, interest expense does not fluctuate with revenue and does not compensate employees, pay vendors or suppliers, or otherwise contribute to the operations of the business. Second, interest expense is a function of financing decisions that are often made by someone other than the person bearing operating responsibility. As a result, it is not appropriate to evaluate performance with respect to that expense.Since interest expense is not deducted, NOPAT is like the more common measure of EBIT, or Earnings Before Interest and Taxes. The difference is that NOPAT is reduced for taxes. NOPAT is therefore equal to EBIT less taxes at the effective tax rate. Sadly, Uncle Sam is the first one in line for returns, and NOPAT takes the tax burden into account. Some analysts like to make additional adjustments to derive NOPAT, such as adding back research & development costs. Such adjustments may have merit in certain circumstances, but they do add complexity to the calculations that aren’t essential to gaining the primary insights offered by ROIC.Invested Capital is the sum of all capital provided by shareholders (both common and preferred) and lenders. Since the purpose of ROIC is to measure the efficiency of management’s stewardship of family resources entrusted to the business, invested capital is traditionally measured with respect to book values rather than market values. The average balance for the year in question is the preferred denominator since NOPAT is earned over the course of a year, and a point-in-time snapshot of invested capital may not fully capture the family’s true investment over the course of the year. As with NOPAT, some analysts propose a laundry list of custom adjustments to invested capital. These adjustments may have their place for some companies, but the basic calculation is generally a sufficiently reliable guide.Why Is ROIC Important?Now we’re ready for the rest of the story. Management has worked diligently to increase operating income by 50% over the past five years. Yet, the value of your family shares has been stuck in neutral over that same period. What gives?Focusing on profit alone will not reveal the answer. But a quick calculation of ROIC shows us what has gone wrong. Exhibit 3 presents the ROIC calculations for 2013 and 2018.
As revealed in Exhibit 3, the 50% increase in profitability did not boost the share value because the amount of invested capital used in the business also increased by 50%. In other words, the return on invested capital was unchanged. Since the weighted average cost of capital for your family business is also 10.0%, the incremental earnings did not boost per share values. Knowing that profitability has improved is not enough to know whether the value of the shares in your family business has increased. Earnings are critical but are only half of the story when it comes to management performance and shareholder value. As a director, it’s your responsibility to know the rest of the story when it comes to the financial performance of your family business, and ROIC is the perfect tool to do so.
Mineral Aggregator Valuation Multiples Analysis
Market Data as of November 10, 2020
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly-traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below. Mineral Aggregator Valuation MultiplesDownload Analysis
Solvency Opinions Explained
What a Solvency Opinion Is and What It Addresses
What Is a Solvency Opinion?With the rise of corporate bankruptcies, a lot of leveraged transactions that occurred pre-COVID are going to be scrutinized. The musings here consider solvency opinions conceptually, but many bankruptcy courts, such as the one that oversaw the restructuring of Neiman Marcus, will consider the issue retroactively and may ask stockholders to return distributions that were deemed to have been obtained via fraudulent conveyance.The Business Judgement RuleThe Business Judgement Rule, an English case law doctrine followed in the U.S. and Canada, provides directors with great latitude in running the affairs of a corporation provided directors do not breach their fiduciary duties to act in good faith, loyalty, and due care. However, there are instances when state law prohibits certain actions including the fraudulent transfer of assets to stockholders that would leave a company insolvent.This straightforward statutory prescription has taken on more meaning over the past decade because corporate America has significantly increased its use of debt given very low interest rates. Investors have been willing to fund the increase because negligible rates on “safe” assets have pushed individuals and institutions out of the risk curve to produce income.Transactions that may meaningfully alter the capitalization of a company include leveraged dividend recapitalizations, leveraged buyouts, significant share repurchases, and special dividends funded with existing assets. Often a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.Four QuestionsA solvency opinion addresses four questions:Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?Will the company be able to pay its debts (or refinance them) as they mature?Will the company be left with inadequate capital?Does the fair value of the company’s assets exceed its liabilities and surplus to fund the transaction?
A solvency opinion is typically performed by a financial advisor who is independent, meaning the advisor has not arranged financing or provided other services related to the contemplated transaction. The opinion is based upon financial analysis to address the valuation of the corporation and its cash flow potential to assess its debt service capacity.
Also, the opinion is just that—it is an informed opinion. It is not a pseudo-statement of fact predicated upon the “known” future performance of the company. It provides a reasonable perspective concerning the future performance of the company while neither promising to stakeholders that those projections will be met, nor obligating the company to meet those projections.Test 1: The Balance Sheet TestThe balance sheet test asks: Does the fair value and present fair saleable value of the company’s total assets exceed the company’s total liabilities, including all identified contingent liabilities?
The balance sheet test is a valuation test in which the value of the company’s liabilities are subtracted not from the assets recorded on the balance sheet, but rather the fair market value of the company on a total invested capital basis. The value of the company on a debt-free basis is estimated via traditional valuation methodologies, including Discounted Cash Flow (“DCF”), Guideline Public Company, and Guideline Transactions (M&A) Methods. In some instances, the Net Asset Value (“NAV”) Method may be appropriate for certain types of holding companies in which assets can be marked-to-market.Test 2: The Cash Flow TestWill the company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature?
This question addresses whether projected cash flows are sufficient for debt service. A more nuanced view evaluates the question along three general dimensions:Revolver Capacity: If financial results approximate the forecast, does the company have sufficient capacity, relying upon its revolving credit facility if necessary, to manage cash flow needs through each year?Covenant Violations: Does the projected financial performance imply that the company will violate covenants of the credit or loan agreement, or the terms of any other credit facility currently in place or under consideration as part of the subject transaction?Ability to Refinance: Is it likely that the company will be able to refinance any remaining balance at maturity?Test 3: The Capital Adequacy TestDoes the company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction?
The capital adequacy test is related to the cash flow test. A company may be projected to service its debt as it comes due, but a proposed transaction may leave the margin to do so too thin – something many companies discovered this year in which they were able to operate with high leverage as long as business conditions were good.
There is no bright line test for what “unreasonably small capital” means. We typically evaluate this concept based upon pro forma and projected leverage multiples (Debt/EBITDA and EBITDA/Interest Expense) relative to public market comps and rating agency benchmarks. While management’s projections represent a baseline scenario, alternative downside scenarios are constructed to asses the “unreasonably small capital” question in the same way downside scenario analyses are constructed to address the question of whether debts can be paid or refinanced when they come due.Test 4: The Capital Surplus TestThe capital surplus test asks: Does the fair value of the company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as such capital is calculated pursuant to Section 154 of the Delaware General Corporation Law)?
The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but also includes the company’s capital in the subtrahend (Hey! There is a word we haven’t seen since early primary school. The subtrahend is the value being subtracted.)
Section 154 of the Delaware General Corporation Law defines statutory capital as (a) the par value of the stock; or in instances when there is no par value as (b) the entire consideration received for the issuance of the stock. "Capital" as defined here is nuanced. Often it may be a small amount if par is some nominal amount such as a penny a share, but that may not always be the case. What is excluded is retained earnings (or deficit) from the equity account.The Mosaic of SolvencyThe tests described above are straightforward. Sometimes proposed transactions are straightforward regarding solvency, but often it is less clear—especially when the subject company operates in a cyclical industry. Every solvency analysis is unique to the subject transaction and company under review and requires an objective perspective to address the solvency issue.Mercer Capital renders solvency opinions on behalf of private equity, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure. For more information or if we can assist you, please contact us.
The Buyer You Might Be Overlooking
Considering the Role of an ESOP in Your Family Business
One obstacle many families face when it comes to selling the family business is the potential loss of identity, culture, and jobs that such transactions often leave in their wake. Even if it is the right time for the family to sell, there may be a reluctance to do so for fear that a sale will trigger adverse developments for the company’s employees and communities.If the family business is sold to a competitor, the buyer may elect to discontinue the company’s brand, eliminate “redundant” corporate overhead positions, or close operating facilities in a quest to achieve the cost savings that will help drive returns.Private equity buyers may not take such aggressive actions in the short-run but will look to “flip” the business to another buyer within five years or so. This “exit-driven” mentality is foreign to the sustainability focus of many family businesses and can undermine the family culture that made the business successful in the first place.
A recent article by Paul Sullivan in the New York Timeshighlighted an option available to family shareholders: selling the family business to the employees. Doing so has the potential to avoid the negative outcomes typically associated with corporate sales.
As noted in the article, there are approximately 6,500 employee-owned businesses in the United States and some observers believe that number could increase in the coming years if capital gains tax rates rise under the Biden administration.
Why would a family consider selling all or a portion of their family business to employees? The article identifies three potential benefits.Benefit #1 – Selling to Employees Allows the Family Business to Remain Intact. When the family business is sold to employees, the existing management team will remain in place and the family culture will likely persist in the family business. This is often a critical concern for family shareholders who are wary that a buyer will disregard, or potentially destroy, the legacy of the family among long-time employees and within the communities in which the family business operates.Benefit #2 – Tax Benefits for the Seller and the Company. Sellers in ESOP (employee stock ownership plan) transactions may be eligible to defer capital gains, and potentially avoid taxes that would otherwise be due. Like all tax matters, it’s not always that straightforward, and the specific eligibility rules are beyond the scope of this post. However, we note that many sellers do qualify for these benefits, which can materially enhance the overall economic benefit to the seller from the transaction.Following the transaction, there are tax benefits for the company as well since contributions made (and dividends paid) by the company to the ESOP are tax-deductible. The resulting tax savings increases the company’s cash flow available for reinvestment and growth opportunities.Benefit #3 – Retirement Benefits for Employees. If the company performs well following the transaction, the contributions and dividends from the company, when coupled with growth in the value of the company’s shares, can provide retirement benefits for employees that exceed what would otherwise be available from traditional 401k or profit sharing programs.
Of course, every silver lining has a cloud. There are two primary drawbacks to ESOP transactions for family shareholders.Drawback #1 – Fair Market Value. Whether selling to a competitor or a private equity fund, such buyers may be willing and able to pay a premium price because of the cost savings or revenue synergies that they expect to achieve by implementing the types of corporate changes described at the beginning of this post.Because an ESOP doesn’t anticipate making such changes, the nominal transaction price when selling to employees – known as fair market value – may be less than a strategic or private equity buyer is willing to pay. Depending on the circumstances, the tax benefits described above may offset this potential drawback.Drawback #2 – Regulatory Burden. Because ESOPs are qualified benefit plans, they fall under the purview of the Department of Labor. So in any transaction with an ESOP, the DOL is a not-so-silent third party tasked with ensuring that the ESOP protects the interests of the employee participants. Depending on the complexity of the ESOP, selling stock to employees may require a small raft of attorneys, accountants, trustees, and other advisors to ensure that the transaction and subsequent administration of the ESOP do not run afoul of DOL regulations.
If your family is considering a sale of the family business, don’t overlook your employees as a potential buyer. ESOP transactions are not right for every family but can generate benefits for a broad range of stakeholders.
To discuss the fair market value of your family business and whether an ESOP transaction might be a good fit for your family, give one of our family business professionals a call.
Q3 2020 Earnings Calls
Low Supply and SG&A Reductions Lead to Record Earnings
Third quarter earnings calls started with an optimistic tone, with just about every call reporting record earnings despite revenue headwinds. Advertising and personnel costs that were taken out at the beginning of the pandemic haven’t come back as dealers try to determine how best they can run lean and improve productivity. Tight inventories continue to plague new vehicle volumes, which isn’t expected to get better until the turn of the year. To compensate for this volume decline, dealers have strategically priced the models they did have in stock. Executives noted some points in the quarter where certain models were completely out of stock. Trucks and crossovers have been particularly hot, representing over 75% of vehicles sold.Speaking of crossovers, many executives discussed the point of the transaction where consumers cross over from digital to in-person. During significant shelter-in-place restrictions that caused April lows, dealers were thrust into their online strategies and there were many prognostications about the potential long-term impacts. As the pandemic has persisted, consumers appear to have indicated a preference to beginning the process online, but the desire to test drive the vehicle or discuss the financing has limited the amount of fully online transactions.While Carvana is the new kid on the block in terms of public auto retailing, it’s their used-online operations that franchised dealers are looking to mirror. Across many calls, Carvana’s name was invoked as the key comparative tool to measure how digital offerings match up. While executives all project confidence about their used platforms, it appears clear that the well capitalized online used retailer has an advantage in this area. Still, franchised dealers have their own advantages with access to new vehicles and fixed operations.With consumers still spending a significant amount of time in their homes, the collision business has seen an impact as miles driven has decreased. While miles driven would appear to be the most direct indication of demand for autos, interestingly, executives have noted another trend. With the decrease in rental business and ridesharing, it looks like auto retailing may be regaining market share, which would benefit the industry if this trend continues as the number of miles driven rebounds.The recent Hummer EV unveiling also drew the attention of analysts and executives. The consensus was the hype surrounding the relaunch of a brand that was defunct since the financial crisis was a positive sign for GM, and the shift to electrification will continue. However, many noted the importance of quality models in this shift as consumers won’t be willing to pay up for vehicles (or expensive batteries) that don’t stand up on their own just because they’re electric. This is particularly true with low prevailing fuel costs. While the Hummer EV’s price point allows for good margins, it means volumes will be much lower and ultimately will have less of an impact on dealership profitability.Theme 1:Dealers made significant investments in digital offerings to compete under strict stay-at-home orders. As the pandemic persists, executives believe digital will continue to play a role particularly at the beginning of the shopping experience, though it is unlikely car buying moves fully online.[I]n this day and age 95% of the people are looking online first. – David Hult, CEO, Asbury Automotive Group[I]f a consumer wants to, which is less than 2% of the population right now[,] they can go online, buy a car from end-to-end, no touchpoints […] I think about 15% to 16%, 17% of our customer base right now is completing some percentage of the transaction online before they come to the store to pick it up. […] The consumers are telling us that they want to be able to search our inventory online, but they want to come to a store, sit with an associate that’s got experience dealing with the car that they’re looking at. They want to test drive from a big inventory before they buy a car and make that decision. Our goal in our hybrid approach from A to Z is to allow them, if they want to go A to J or they want to go A to Z, our system is going to allow that to happen. – Jeff Dyke, President, Sonic AutomotiveAbout 80% of our consumers use digital forms in some way during the process. We actually only sell about 1.5% of our cars today on a truly digital end-to-end type of solution. – Bryan DeBoer, President, and CEO, Lithia MotorsTheme 2:Demand continues to outstrip supply as manufacturers struggle to get new vehicles to dealers. Consensus appears to be 2021 before this begins to normalize. Tight inventories have led to higher gross margins.We’ve had of course running conversations with the manufacturers since the spring, and every target has been missed. What we’ve been told we would be shipped, it simply did not happen. I don’t see any change in the fourth quarter from what I understand is coming through, and so now we’re into the first quarter, best case. When I see that they’re able to consistently achieve their shipping targets, then we can talk about what you can sell new. The demand is there at retail. I’m not worried about the demand. […] we’ll either get it through the volume or we’ll get it through pricing. – Mike Jackson, Chairman & CEO, AutoNationAvailability is coming back. I think we’ve got or 1,000 or 1,200 more cars on the ground at this point than we did last month at this time. And that just keeps improving every month. Manufacturing is doing a great job getting inventory back in our hands. The demand is there, and I think we’ll all be back and rolling as we move into the first and second quarter of next year as supplies build. From a used car perspective, […] the supply is endless. – Jeff Dyke, President, Sonic AutomotiveThe substantial improvements in gross profit of over $1,000 per unit compared to third quarter of 2019 are largely attributed to high level of incentives from our OEM partners and a perceived inventory shortage in the country. –Bryan DeBoer, Presiden, and CEO, Lithia MotorsOperators are very savvy, when they cannot replace a vehicle. They don't sell it as cheaply. I mean, that's the simple thing. They know whether they can trade with another dealer, and if they can replace it. So that's driving these high margins throughout the industry. And the ramp up in supply from the OEMs has been far below what anyone in our sector would have expected. We're just now starting to receive a few more vehicles and we're retailing every month. But our new vehicle inventory year-over-year, one point drop something like 12,000 units. So we were still nowhere near back to normal levels. And I'm sure, we're not the only one. So while the reduction in margins going forward will be proportionate to the increase in inventory, there still appears to be a long way to go before the industry is back to normal move vehicle and inventory levels. – Earl Hesterberg, President and CEO, Group 1 AutomotiveAs we sit here today that we’re still benefitting in our GPUs from the lower inventory and we anticipate at this point to benefit throughout the quarter. The virus is starting to heat, but backed up as we all know, assuming factories don't shut down at all, we anticipated some point in the first quarter to get inventory levels somewhat back to normal, and at that point you would assume you would feel it into margins, but we don’t see that happening in Q4. – David Hult, CEO, Asbury Automotive GroupTheme 3:While working from home has led to a decline in miles driven which has negatively impacted collision, other areas of parts and service have come back. Despite fewer miles driven, some executives also believe there is a structural change in demand wherein consumers want their own vehicles.In our products and service numbers that we disclosed collisions in there. Collision for us is running, for 12% to 15%, back, depending upon the market. So that's pulling back our CP numbers. We've been positive for the last few months in service specifically, as it relates to customer pay in warranty. – David Hult, CEO, Asbury Automotive GroupI think we got to think a little bit socially what's really happening, with a vehicle market and personal mobility. […] Personal mobility […] should create some more demand and use cars and also new cars now, not high luxury cars. But I mean, cars that we would use on a daily basis if you needed transportation, because I think combined transportation where two or three people are together, whether it's in a transit, public transit, whether it's a rental car, whether it's Uber or Lyft, I think there's some softness in those businesses, which will drive more automotive sales for us both in new and used. So I think these are things that personal use, will be help us drive a bigger part of the share of the auto business in the future. And I could be wrong. But there's definitely a flight to safety. – Roger Penske, Chairman & CEO, Penske Automotive GroupThere has been a significant shift towards individual mobility as a result of the pandemic and shelter-in-place. This has increased demand across the board from pre-owned through new in every segment. This individual retail demand is lasting and will continue for the next several years. – Mike Jackson, Chairman & CEO, AutoNationConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
RIA Margins – How Does Your Firm’s Margin Affect Its Value?
An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all of these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin?”We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors).At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risk of client concentrations, underperformance, and key staff dependence is significant.Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can flock in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be quite healthy as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers.At the lower end of the spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key-person risk is less because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well.Does a Firm’s Margin Affect What Its Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time.The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid.1 For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 23.4%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher.The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers, while they can have very high margins, tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry.Margin and Value High margins are great, but what really matters to a buyer how durable those margins are. There are a variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II). Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.1 For simplicity, other projection assumptions are omitted.
GM and Nikola Partnership: What Went Wrong and Where Does it Stand?
Even with Halloween, we doubt your weekend was as scary as the past few months have been for Nikola...As we have discussed previously, electric vehicles (EVs) are all the rage with new start-ups trying to capture a slice of the pie that Tesla has been helping grow for years. In response, traditional manufacturers have begun to create EV options of their own.
However, the entry path into the EV space has its drawbacks. For start-ups entering the industry, they may have the technology or innovative idea but lack the scale and access to capital necessary to gain market share and keep up with established competitors. Legacy manufacturers face the opposite problem: while they have the scale and capital, diverting resources into R&D for electric in a rapidly progressing space can lead to minimal tangible gain while it’s established products languish.
To solve this mismatch, a new trend has emerged as manufacturers seek start-ups for their technology in a mutually beneficial relationship, perhaps best exemplified by GM and Nikola’s plan for a partnership. In this post, we look at the original deal, ensuing issues, and current plans. We will also look at what this trend could mean for dealerships going forward, and the importance of the valuation date.The Initial DealIn early September, Nikola stock got a massive boost after announcing a partnership with General Motors. Under the agreement, GM would engineer and build Nikola’s pickup truck named the Badger. In return, GM would take an 11% stake in Nikola and have rights to nominate one person on the board of the startup. This $2 billion equity stake won’t be in the form of cash however, but instead will be in “in-kind” contributions. These contributions include access to General Motors’ global safety-tested and validated parts and components. In regards to the deal, Nikola Founder and Executive Chairman Trevor Milton had this to say:Nikola is one of the most innovative companies in the world. General Motors is one of the top engineering and manufacturing companies in the world. You couldn’t dream of a better partnership than this […]. By joining together, we get access to their validated parts for all of our programs, General Motors’ Ultium battery technology and a multi-billion dollar fuel cell program ready for production. Nikola immediately gets decades of supplier and manufacturing knowledge, validated and tested production-ready EV propulsion, world-class engineering and investor confidence. Most importantly, General Motors has a vested interest to see Nikola succeed. We made three promises to our stakeholders and have now fulfilled two out of three promises ahead of schedule. What an exciting announcement.General Motors Chairman and CEO Mary Barra shared similar sentiments about the deal:This strategic partnership with Nikola, an industry leading disrupter, continues the broader deployment of General Motors’ all-new Ultium battery and Hydrotec fuel cell systems […]. We are growing our presence in multiple high-volume EV segments while building scale to lower battery and fuel cell costs and increase profitability. In addition, applying General Motors’ electrified technology solutions to the heavy-duty class of commercial vehicles is another important step in fulfilling our vision of a zero-emissions future.While Nikola would utilize GM’s fuel cell technology for the Badger, they would still be responsible for the sales and marketing, and the Badger would remain under the Nikola brand name. Though the Badger was first announced on February 10, 2020, production was not expected to occur until late 2022.What Went Wrong?Although the deal was initially anticipated to close on September 30, 2020, Nikola experienced troubles over the weeks prior that led to delays as their value has dropped sharply. Behind this decline in value and trouble sorting out the deal is a litany of allegations. Things began to fall apart just two days after the announcement when short-seller Hindenburg Research released a study claiming Nikola was based on “intricate fraud built on dozens of lies.” Included in these fraudulent claims is an allegation of Nikola staging a 2018 video of its hydrogen fuel-cell truck driving. Hindenburg alleges that the semi-truck was not actually driving, but instead, rolling down a long gentle slope. In response, Nikola stated it never claimed that the car was propelling itself. They also noted the careful wording employed at the time of the vehicle “being in motion” did not necessarily indicate that it was moving on its own accord. This technicality didn’t do much to assuage investors.Another misrepresentation that was alleged is Nikola’s efforts to develop a new kind of battery for use in electric vehicles. In November 2019, Milton claimed that Nikola would unveil “the biggest advancement we have seen in the battery world,” with these claims based on the planned acquisition of ZapGo. However, the acquisition never went through after Nikola stated that ZapGo had nothing more than interesting research with no ability to commercialize it. Despite pulling out of the deal, Nikola’s message about the new advancement in battery technology remained the same, putting into question if there is actually this battery technology in the works at all. This was not the only problem for Nikola in the past month, however, as the Department of Justice and SEC are reportedly probing Hindenburg’s allegations and two women in Utah filed sexual abuse charges against Milton. Ultimately, all of this culminated into a mountain of insurmountable issues for Trevor Milton, who resigned from his position as Executive Chairman of Nikola on September 20th. Post resignation, Nikola stock dropped 17% to $28.35 after already being down almost 27%. As of November 2nd, Nikola’s stock price stood at $18.84. This is a 76.4% decline from the stock’s peak as of June 9th and down 62.3% since the GM announcement spike.What Now?With all of this being said, it’s clear why GM and Nikola haven’t been able to close their $2 billion deal. The question now seems to be under what terms a “new deal” may come, or if there should even be a deal at all. According to several sources, GM is considering revisions to the deal and may seek a higher stake in the startup after its valuation fell due to the allegations. Though there are some new considerations that need to come into play for the deal to occur, some analysts see it still as a viable possibility. J.P Morgan analyst Paul Coster thinks that a new deal could be signed by early December, as he notes, “Nikola needs access to GM’s supply-chain, engineering resource, the Ultium battery, and Hydrotec fuel cells to de-risk the Class 8 truck initiative.” The analyst wrote in a Monday research report, “GM needs to realize a return on billions of dollars of investment in hydrogen fuel cells, and Nikola might be the best available option." He believes that the price target for Nikola is still around that $41 September value and that the stock is currently undervalued. However, with the December 3rd deadline of renegotiations looming, November is going to be critical to getting something put together.TakeawaysThough the GM and Nikola deal is in limbo, we believe more partnerships like this may materialize in the future. With increased emphasis on energy-efficient vehicles going forward, traditional manufacturers are going to need to find ways to meet consumer demand and fuel efficiency regulations. Furthermore, the looming election and the potential for a leadership transition might pave the way for EVs to carve out a more significant spot in the market (if you haven't already, read our blog post on Trump and Biden’s potential policy impacts on the auto industry). Manufacturers may seek partnerships and acquisitions in lieu of creating their own electric vehicle technology. Ultimately, only time will tell, but the struggles of GM and Nikola to close this deal might not be a reflection that these deals are doomed, and instead, a hiccup before other auto manufacturers try to create their own deals with EV start-ups.This GM and Nikola deal sheds light not only on the current EV industry, but also on how important the valuation date is in determining value for deals such as this. In the initial deal, Nikola was going to give 47,698,545 shares of its common stock to GM Holdings in exchange for in-kind contributions. These shares were valued at $2 billion based on the average price per share of $41.93 as of the September 8th Nikola filing with the SEC. When considering this, does it make sense for GM to assume $41 per share, established at the September valuation date, when allegations have led to scrutiny of this number? Especially when the public market has reacted and the stock price has plummeted to under $20 per share? Your answer is most likely no. They should try to get a new valuation closer to the deal close date in order to more accurately determine Nikola’s current value.The same considerations should be made if you are considering buying and selling an auto dealership. Though it can be more difficult to determine value without the assistance of the public market as in the case of Nikola, there are still certain signs that a previous valuation may no longer be applicable. The most common this year has been due to the economic volatility of the COVID-19 pandemic and the ensuing recession. Because of these factors, the fair value of a dealership has most likely fluctuated depending on how they were able to navigate the past year. Proceeding with a deal considering a February valuation could lead to one party paying unfairly. With this being said, due diligence in regard to having a proper and timely valuation is critical to making sure that a buyer and seller both agree to a fair price.If you are interested in how the past year may have affected the value of your dealership, feel free to reach out to us.
What RIAs Need to Know About Current Estate Planning Opportunities
Estate and tax planning matters are an important component of the overall financial plan for many RIA clients. The current tax policy and market environment create unique estate planning opportunities that may not last if economic conditions normalize or if Biden wins in November. This webinar addresses the available opportunities that RIA principals and advisors should be aware of in the current environment.
Original air date: October 28, 2020
2020 Alternative Asset Manager Update
Are Sustainable Investments the Future of Investment Management?
The market for sustainable investments has grown to over $12 trillion in the U.S. and the movement of investable assets into sustainable strategies is expected to accelerate. In this week’s post, we link to the newly published 2020 Alternative Asset Manager Update authored by Taryn Burgess, CFA, ABV. The update reviews the growth of sustainable investing over the last decade and considers the valuation implications for your RIA.2020 Alternative Asset Manager UpdateView Report
Bones of Contention
The Complicated Dynamics of Family Redemptions
Earlier this month, Christie’s auctioned off a 40-foot long T-Rex named Stan. We were not aware there was an active market for such items, but an unnamed investor paid $32 million for Stan’s bones. That’s remarkable in itself, but our interest in the story was piqued upon learning why and how Stan was sold.According to this story in the Wall Street Journal, Stan was found in the South Dakota hills by brothers Peter and Neal Larson in 1992. The brothers had been partners in their fossil-hunting enterprise since the mid-1970s. As happens all too often, unresolved disagreements between the brothers eventually found their way into the courtroom. The broad outlines of the disagreement are familiar to those involved with family business.Peter is the older of the two brothers and owned a controlling (60%) stake in the family business. Younger brother Neal owned a 35% stake, while a non-family partner owned the remaining 5%.In 2012, Peter suspended Neal and subsequently fired him for reasons that are less than clear.In 2015, Neal sued Peter claiming shareholder oppression. Neal’s preferred remedy in the suit was to liquidate the company and split the proceeds.It turns out that fossil-hunting businesses tend to be illiquid. In view of the company’s financial position, the judge ordered that Neal receive Stan in exchange for his 35% interest, with Peter and the other owner retaining all other assets of the business.At the time, Stan had an appraised value of $6 million, which according to the court’s ruling provided a “premium” to Neal.A couple of weeks ago, Neal sold Stan at auction for the aforementioned $32 million, which was 4x Christie’s high-end estimate prior to the sale.
Peter and Neal reportedly continue to live in the same small South Dakota town. The town is small enough that avoiding each other is not practical, but they do not speak. The story of Peter, Neal, and Stan highlights some of the challenges family businesses face when redeeming a significant shareholder.The Challenges of Redeeming Family ShareholdersMany shareholder redemptions occur under circumstances comparable to that of the Larson brothers. One shareholder or family branch will continue to own and operate the business, while the other will have the opportunity to redeploy their net proceeds from the redemption however they choose. Oftentimes, that is truly the best outcome for the family, and may even preserve a modicum of family harmony, since the jointly-owned business is no longer a potential irritant.However, when it comes to family business, it is probably never really over. Even after going separate ways, human nature is to continue looking over one’s shoulder to see how the other guy is doing. In the event of a shareholder redemption, there are three potential outcomes, two of which will create economic winners and losers in the redemption’s wake.Scenario 1: The family business thrives and/or is sold at a premium to a strategic acquirer. Sometimes, unexpected industry or economic tailwinds cause the family business to outperform expectations at the time of the redemption. Or, the remaining shareholders may eventually sell the business to a strategic acquirer who is motivated and able to pay a substantial premium to the redemption price paid by the family business. In either case, the portion of the family that stayed in the business enjoys the benefit of the company’s success, while the family members who were redeemed will naturally feel like the redemption price was unfairly low. Unless they prove to be savvy investors, the redeemed shareholders will fall behind the rest of the family economically. This can add unbearable strain to already tense family relationships.Scenario 2: The family business performs in line with expectations and remains family-owned.If the family business performs in line with expectations and remains family-owned following the redemption, there is a greater chance that both family groups will remain on broadly comparable economic footing, bringing with it an increased likelihood that family relationships can be maintained or even repaired over time.Scenario 3: The family business struggles following the redemption. In other cases, the family business founders following the redemptions. Whether through management miscues, adverse economic and industry dynamics, or because of the leverage used to fund the redemption, returns for the remaining family shareholders can be negative following the redemption. When this happens, the family shareholders that were redeemed become the “haves” and those who stayed in the business become the “have nots.” The family members who go down with the ship are likely to feel that the subsequent underperformance of the family business was attributable, in some measure, to an inflated price paid to the selling shareholders. As with the first outcome, family relationships prove hard to sustain when this happens.Fairness and RiskSo what is fair in a family shareholder redemption?The “fairness” of a redemption transaction cannot be evaluated by looking at the long-term outcomes for the two parties. The challenges encountered in executing a family shareholder redemption reveal the limitations inherent to a point-in-time valuation of any business.The value of a family business at any given time is a function of expected cash flows and risk.When an investor buys a bond from the U.S. treasury, the expected cash flows are known with certainty. Under almost any conceivable future state of affairs, the owner of the bond will receive interest payments when due and will receive the principal payment at maturity.Investors evaluating a family business face a very different situation. However reasonable their projection of cash flows is at the time it is made, it will almost certainly turn out to be wrong, sometimes wildly so. This is the essence of risk. Risk is simply the width of the range of potential future outcomes. The greater the risk – the wider the range of potential outcomes – the lower the value of a business. The lower the value of a business, the higher the potential future returns to shareholders. Investors weigh risk when deciding how much to pay for a given business.
In a risky environment, a bad outcome does not necessarily mean that there was a bad investment decision. In the same way, when Scenarios #1 and #3 above occur, that does not necessarily mean that the shareholder redemption price was “wrong.”
To illustrate, consider the diverging fates of two well-known consumer brands during 2020. The following chart compares share prices for Marriott International (MAR) and Domino’s Pizza (DPZ). The onset of the pandemic was devastating to business and leisure travel. When not traveling, people stay at home and eat pizza.
Does the preceding chart indicate that the share price for either company was “wrong” at the beginning of 2020? No. The shares of both companies trade in a deep and liquid market, and investors in both companies knew that a global pandemic was a possibility (albeit one to which they evidently assigned a low probability). The actual occurrence of the pandemic benefited DPZ shareholders and devastated MAR shareholders. But these differing outcomes do not mean that investors overpaid for MAR shares or underpaid for DPZ shares in January 2020. The buyers of MAR probably regret their purchase, but that possibility is the essence of investing in a risky asset. You may actually earn the higher expected return associated with a risky investment. Those who sold DPZ shares in January are likewise filled with regret, but that does not mean that they received an unfair price. They took their economic chips off the table, avoiding the risk of a massive food safety scandal that could have, but did not, materialize.
ConclusionYour family business probably doesn’t own a T-Rex skeleton. Even so, a family shareholder redemption has the potential to trigger future wealth disparities in your family. Redemptions can make sense for a lot of reasons, but before executing a significant share buyback, directors and family leaders need to be aware of the potential pitfalls and make sure that all of their shareholders are educated about the risks that accompany any transaction. A regular process of recurring valuations can be instrumental in educating family shareholders to the risks that accompany ownership of a family business, provide greater clarity, and help set expectations when a redemption is called for.Give us a call today to talk about how to get that process started for your family business.
Analyzing Sources of Peer Information for Auto Dealers
Data Drill Down
In our quarterly newsletters, we use various data sources to keep tabs on the auto dealer industry. This includes items like SAAR to gauge the health and activity of the industry in terms of volumes. In this post, we discuss other metrics that help us analyze the dealerships we’re engaged to value. The goal of analyzing such metrics is two-fold: we seek to contextualize how the company’s performance compares to peers and whether a dealership is likely to get a higher multiple in the marketplace.
We also strive to provide our clients with an in-depth analysis that can be beneficial to the management of their dealership. Understanding value drivers and performance relative to peers helps dealers understand and, hopefully, increase the value of their business. While sources like RMA (defined below) are frequently used in valuations across industries as a starting point, the auto dealer industry has the luxury of having other unique data sources that can provide further insight to our clients.
Let’s peel back the onion and drill down into these various data sources.RMA Annual Statement StudiesBeginning on the outer layer of our proverbial onion, one of the base resources employed by appraisers for companies in a variety of industries is the Annual Statement Studies: Financial Ratio Benchmarks, as published by the Risk Management Association. We refer to this information simply as “RMA” for short.This annual study allows users to determine the composition of common sized balance sheets, income statements, and other key financial ratios. Though RMA data was initially published to aid banks in determining the suitability of loans, this information is still helpful in the valuation context because it allows us to gain insight into industry financial trends.RMA data is offered by North American Industry Classification System codes (“NAICS” codes). For auto dealers, there are Retail – New Car Dealers (#441110) and Retail – Used Car Dealers (#441120). As seen in the pictures below, the vast majority of peer information comes from new vehicle dealers with over $25 million in sales. Most auto dealers, whether they have one rooftop or several, tend to fall into the over $25 million category. In an industry where vehicles retail around $30 thousand, a dealer only needs to sell about 830 vehicles a year to get to $25 million in revenue, and this doesn’t even consider fleet, wholesale, and fixed operations.While we frequently show both new and used vehicle financial ratios from RMA, the data from new dealers is more likely to be appropriate for a typical franchised dealer, even those with material used vehicle operations.As alluded to previously, this data provides common size balance sheet and income statements. For example, RMA data shows inventory comprises about 60% of total assets, while short-term notes payable (the vast majority of which for auto dealers is floor-plant debt) comprise about 52.8%. Many dealers do not fully finance their used vehicles, which likely plays a role in inventory exceeding short-term notes payable in the RMA data. Inventory as a percentage of total assets and inventory turnover can also be used to determine the amount of inventory held by a dealer.These data points can then be applied to the subject company we are valuing to consider how floor plan debt usage may impact liquidity and expenses and whether they are carrying adequate inventory to support sales.RMA data also provides helpful insights into the following metrics:Working capital as a percentage of salesInventory turnoverAverage Days Outstanding (on receivables and payables)Gross and Pre-Tax profit marginsOfficer/director compensation as a % of sales
While these metrics are helpful in analyzing dealers, it is critical to use caution when relying on this information. We believe the data works better as a starting place, as the average of 2,000 dealerships is not going to be directly comparable to the dealership in question. Therefore, we find it more helpful as a test of reasonableness than some figure to specifically tether analysis.NADA Dealership Financial ProfilesWhile RMA data is a useful starting point, the auto dealer industry has more directly comparable data available. Peeling back the next layer of the onion, The National Automobile Dealers Association (“NADA”) publishes Dealership Financial Profiles on a monthly basis.Like RMA, data from all types of dealerships is compiled in the “Average Dealership Profile.” For dealers with many rooftops, this may give a good overall perspective. However, when valuing a single point location, Dealership Financial Profiles help us to get even more specific.NADA offers data for domestic, import, luxury, and mass market dealerships. This is helpful because while operations can be substantially similar for different brands of dealerships, margins and profit drivers tend to be different for the various types of dealerships. This enhanced granularity allows for better comparisons than the information provided by RMA, and monthly information is also more helpful than annual studies. However, NADA information focuses primarily on the income statement, with minimal information on the balance sheet available (excluding the net debt-to-equity and current ratio). Sales, gross profit, operating profit, pre-tax profit figures are offered for various types of dealerships as seen below for domestic dealerships.
Beyond just margins, NADA data drills down further into the following:
Profitability by department (new, used, and fixed operations)New and used retail volumesF&I penetrationAdvertising, rent, floor-plan interest, and SG&A expenses
Like the RMA data, strict comparisons should be made with caution. Still, these are very helpful data points that can lead to better discussions with dealer principals, both about the performance of the business and potential normalization adjustments for valuation purposes. For example, dealerships frequently rent their facilities from an entity that owns the property. This entity and the dealership operations frequently have overlapping ownership structures, and this provides another data point to help determine if the company is paying a fair market-based rent. Related parties may also perform certain advertising functions, which by nature have fewer data points to determine whether a company is overpaying or underpaying for these services.
As we mentioned above, another advantage of NADA data is the frequency of publication. Monthly information may be subject to seasonal quirks if profitability is stronger during certain months but comparing to prior year periods largely neutralizes this impact.
Using more current information is particularly helpful in the dynamic environment we’ve experienced in this pandemic. For example, in the above figure, revenues and gross profit were down for the average dealership through August 2020, but pre-tax profits actually rose as expenses declined more than gross profit. This analysis would not be possible until the following year of RMA studies. Ultimately, NADA data gets to closer comparisons than RMA, but we can still peel back another layer.20 Group DataIn our valuation engagements, we frequently ask for 20 Group data, which is compiled by OEMs and compares dealers to their peers.Unlike NADA data, the peers in a 20 Group statement will be only the same brand, and selected peers will likely be more similar to the subject company in terms of size or geography (or both). As such, this represents the closest comparison possible.Unfortunately, this data is not always available, and as noted in our other sources, we caution against heavy reliance on such information as necessary valuation adjustments are not frequently considered on dealer financial statements, and therefore, will not lead to fool-proof data points upon which to base valuation adjustments.Blue Sky Transactions DataAnother data source frequently considered in transactions of auto dealerships are Blue Sky multiples, as published by Haig Partners and Kerrigan Advisors.Blue Sky multiples offer different perspectives than the above information. These auto dealer focused investment banks publish indications of dealership intangible value they encounter in the transaction space. For valuation purposes, these multiples can be used in conjunction with peer performance to explain the Blue Sky value of a dealership. If a certain branded dealership typically gets a 5-6x Blue Sky multiple, and the dealership is performing better than their peers, all else equal, they may get a multiple at the upper end or even above this range.However, not everything is all equal. You’d pay more for a dealership that delivers consistently strong returns. But how much of the increased value is due to higher earnings and how much is to a higher multiple?If a company is underperforming its peers, but the buyer believes they can improve performance up to peers, a higher value paid on lower historical earnings implies a higher multiple, so even an underperforming dealer might get a higher multiple than a better performing peer.Multiples are based on some indication of value and some indication of earnings; they frequently describe value rather than prescribe value. Stated more simply, a valuation does not simply derive tangible book value and apply the mid-point of the Blue Sky multiple range to pre-tax earnings. A proper valuation will determine the value of the dealership and be able to communicate why the implied Blue Sky value is reasonable within the context of historical and expected earnings and compare this performance to that of its relevant peers.ConclusionIn total, these various sources offer plenty of perspective into the historical performance and expected value in the marketplace for an auto dealership. Each source offers a different type of insight, and each comes with its own strengths and drawbacks. We have summarized data available from RMA and NADA in the following table.For a better understanding of where your dealership stacks up relative to peers and potentially in the marketplace, contact a member of the Mercer Capital Auto Dealer Valuation team today.
Premise of Value: Why It Is a Critical Aspect of Business Continuity and Financial Restructuring
The conventions for defining value may never be more important than when making decisions related to business continuity and financial restructuring. Countless clients have demonstrated a sense of confusion regarding the various descriptors of value used in valuation settings. More than a few valuation stakeholders have mused that the value of anything (a business or an asset as the case may be) should be an absolute numerical expression and unambiguous in meaning. Unfortunately for those seeking simplicity in a trying time, the conditional cliché “it depends” is critical when defining value for the assessment of bankruptcy decisions and workout financing. The elements that underpin the Premise of Value provide a convenient base for introducing some of the vocabulary used in the bankruptcy and restructuring environment. Gaining a thorough familiarity with the Premise of Value provides a cornerstone for understanding the financial considerations employed in valuing business assets and evaluating financial options.
Defining value is a science of its own and can be subject to debate based on facts and circumstances. With respect to business enterprises and assets, as well as business ownership interests, there are numerous defining elements of value. These elements generally include the Standard of Value, the Level of Value, and the Premise of Value. More confusing is that real property appraisers, machinery & equipment appraisers and corporate valuation advisors may not use the same value-defining nomenclature and may have varied meanings for similar vocabulary. When the question of business value or asset value arises, the purpose of the valuation, the venue or jurisdiction in which value is being determined and numerous other facts and circumstances have a bearing on the defining elements of value.
Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. For the merchant and the merchant’s capital providers, the ramifications of how assets are monetized for the purposes of optimizing returns on and of capital is a key focus of the valuation methods employed in the restructuring and bankruptcy environment. The international glossary of business valuation terms defines the Premise of Value and its components as follows:
Premise of Value - an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; for example, Going Concern, liquidationGoing Concern Value - the value of a business enterprise that is expected to continue to operate into the future. The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place.Liquidation Value - the net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either “orderly” or “forced.”
Orderly Liquidation Value - liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received.Forced Liquidation Value - liquidation value, at which the asset or assets are sold as quickly as possible, such as at an auction
The Premise of Value is a swing consideration for distressed businesses and their lenders. For businesses in financial distress, achieving a return on capital shifts to the priority of asset protection and capital value preservation via a deliberate plan to mitigate downside exposures. In most situations where a business is dealing with an existential financial threat, the preference for the business is to remain a Going Concern (at least initially), whereby the business continues to operate as a re-postured version of its former self. In the context of bankruptcies and/or restructurings, the business that remains a Going Concern is referred to as the Debtor in Possession (DIP).
DIPs remain a Going Concern using the protection of Chapter 11 bankruptcy to achieve a fresh start where their financial obligations are restructured through modification and/or specialized refinancing. Chapter 11 involves a detailed plan of reorganization, which may be administered by a trustee and is ultimately governed under the specialized legal oversight of the courts. Reorganization under Chapter 11 is the preferred first step for most operating enterprises whose business assets are purpose?specific and for which the break-up value of the assets would be economically punitive to capital investors. Intuitive to the Going Concern premise are valuation methods and analyses that study potential business outcomes using detailed forecasts and the corresponding potential of the resulting cash flows to service the necessary financing to achieve the outcome. One valuation discipline among numerous possibilities is the establishment and testing of a value threshold at which the capital returns are deemed adequate to their respective providers (e.g. an IRR analysis) based on the risks incurred. If remaining a Going Concern delivers an acceptable rate of return under a plan of reorganization, then liquidation might be avoided or forestalled.
The alternative to remaining a Going Concern involves the process of liquidation. In bankruptcy terms, a business entity files for Chapter 7 and begins the cessation of business operations and seeks a sale of assets to re-pay creditors based the creditors’ respective position in the capital stack. The “liquidation” premise is generally a value-compromising proposition for the bankruptcy stakeholders with the economic consequences are scaled to whether the liquidation is achieved in an orderly process or a forced process.
Modern, global economies and increasingly technology inspired business models have resulted in a certain amount of disruption, the consequences of which often compromise the value of purpose-specific business assets in obsoleting or excess-capacity industries (e.g. coal in the face of growing energy alternatives and concerns for climate change). Assets that have productive capacity are typically sold in an orderly market and may achieve a value commensurate with the capital asset expenditures expectations of industry market participants. Real property assets and operating assets that can be successfully transitioned or re-purposed are often liquidated in an orderly fashion to maximize value. Specialized assets and/or assets with inferior productive capacity or which are positioned in unfavorable circumstances likely lack the ability to attract buyers due to the deficiencies and/or inefficiencies of relevant markets. Accordingly, the time value of money and the demands of the most senior creditors may suggest or dictate that a forced liquidation sooner is more favorable than a deferred outcome.
Most restructuring and bankruptcies involve a total rationalization of operating assets and business resources. For large integrated businesses, it often occurs that a combination of value premises applies to differing types of tangible and intangible assets based on the go-forward strategy of the business and the availability of markets in which to monetize assets. For example, an initial liquidation may occur with respect to certain business operations and properties to create the resources necessary to achieve debt restructuring or DIP financing. Accordingly, advisory engagements often take into consideration a wide range of options based on the timing of asset sales and the sustainability of continuing operations. The Premise of Value is a quiet but critical defining element for assessing the collective value proposition associated with a plan of reorganization.
Many bankruptcy advisory projects necessarily involve comparing the Going Concern value to Liquidation value. Each premise involves an inherently speculative set of underlying models and assumptions about the performance of the business and/or the timing and exit value achieved for business assets. And, each may be developed using a variety of scenarios with differing outcomes and event timing. Setting aside the qualitative aspects of decision making, the Premise of Value with the best outcome is typically the path of pursuit based on the necessity for an objective criterion required under the legalities of the bankruptcy process and the priority claims of creditors.
A fundamental understanding of the defining elements of value is critical to distressed businesses and their creditors. Valuation advisors are required to clearly detail the defining elements of value employed in the determination of asset values and enterprise valuations. The Premise of Value must be comprehended in the context of other defining elements of value. If you have a question concerning the design and valuation of varying plans of reorganization or bankruptcy strategies, please contact Mercer Capital’s Transaction Advisory Group.
Down and Out: Bankruptcy Valuations Portend Production Declines
Projections and reorganization valuations of some recent oil and gas debtors demonstrate that creditors are aiming to ride existing production out of bankruptcy as opposed to drilling their way out of it.Oil patch producers have been plunging towards bankruptcy for several months now as I have written before. This trend is on pace to continue with WTI still hovering around $40 per barrel. Hopes for even $50 per barrel prices could be cathartic for many, but alas prices have been flat for months now. There are dozens of areas and fields that have become economic at $50 compared to $40. Somewhat ironically, one of the pathways back to higher prices will be the decline of production in the U.S. (if not replaced elsewhere). That appears to be the case for most producers already in Chapter 11 bankruptcy.Whiting is a good example. According to its bankruptcy filings, projections show that Whiting is only expected to spend a paltry $6 million on capital expenditures in 2021 against $300 million in EBITDA. Cash flows are scheduled to be maximized towards claim recovery; particularly its reserve-based lending (RBL) claims of $581 million. As such, production is slated to decline steadily over the next five years as its creditors attempt to recover claims. Creditors’ priorities make sense from their standpoint. Even banks with financially stable clients are not advancing higher borrowing bases right now.Whiting’s midpoint reorganization value as estimated in its bankruptcy documents is also primarily reflective of its cash flows from existing wells and not from prospective future wells and acreage. As such, its valuation, while steady from an EBITDAX multiple perspective, is towards the bottom of Mercer Capital’s range of publicly traded implied production multiples.Whiting is not alone at these valuation metrics. Bruin, another bankrupt operator in the Williston basin, has a reorganization value of 5.4x projected EBITDAX and a production multiple of $18,558. Bruin also is expected to spend relatively little ($15 million) on exploration expenses, however, it also has 1/5th of Whiting’s production. While also at the low end of implied public multiples, Whiting and Bruin are at a higher premium than some in the market right now.Another bankrupt company, California Resources Corp. has a higher production multiple than either Whiting or Bruin. This appears to be driven by substantially higher realized oil prices in California, and also potentially by shallower decline curves that lead to longer lived wells in the San Joaquin and Los Angeles Basins. It’s also remarkable that California Resources plans to spend more than Whiting and Bruin combined in 2021.[caption id="attachment_34208" align="alignnone" width="638"]Source: Mercer Capital Analysis[/caption]
How do these values stack up in the transaction marketplace? Not a simple answer. First, there aren’t many deals happening in this environment and the ones that are happening are not in the Williston or California. One recent deal is Devon Energy’s purchase of WPX Energy. All three reorganization values lag the implied transaction multiple for WPX Energy. A Permian-based operator with an oil tilted production mix, WPX, transacted for $27,198 per flowing barrel according to Shale Experts. However, it is not surprising that it went at a premium to these debtors; with plans to limit future drilling, the debtors’ reorganization values are thus more heavily weighted towards PDP production than any other reserve category.
Additionally, the Permian has been a favored basin compared to the Williston and California in recent years. Amid this year’s turmoil, the Permian is still expected to lead U.S. oil growth for years to come. Depending on who one consults, the basin with the most amount of potential to return to profitability as oil crawls back towards $50 per barrel is the Permian. There are already a few top tier locations that are profitable at $35 per barrel, but those are limited locations and are mostly in the Delaware. Certain areas in the Permian contain several potentially economic locations between $40 and $50. In contrast, most of the Williston’s inventory becomes profitable at above $50 per barrel.
Still, as it stands at around $40 per barrel, only a handful of areas (mostly in the Eagle Ford and Permian) are profitable to drill right now. According to the most recent Dallas Fed Energy Survey, oil prices are expected to rise less than 10% by next year. Accordingly, drilling activity has turned anemic. Rigs, which as recently as a year ago were plentiful across the fruited plains, are as sparse as some endangered species. That will not change until oil gets back over $50 and where differentials between benchmarks and actual realizations are smaller.
In the meantime, production could continue to fall off. Since March, production in the U.S. fell as far as 20% in September. This is a precipitous decline in a short amount of time.
The chart above reflects not only the lack of new drilling, but the steep decline that shale oil wells intrinsically have. This will be a critical consideration in bankruptcy hearings. How steep will decline curves be and how much will revenues (and thus debt recovery) be delayed or impaired by these declines? Additionally, if OPEC fills the supply gap once demand returns, which it is projected to do, U.S. producers could miss some of the comeback especially with current China tensions.
That said, investment prospects remain cloudy as more look to get out than to get in. JPMorgan Chase just announced that it is shifting its financing portfolio away from fossil fuels. Although disputed by many experts, one of BP’s world oil scenarios contemplates peak oil as governments and markets shift away from fossil fuels more quickly than anticipated. ESG investing and stronger investor sentiments towards other fuel sources imply that its possible oil did in fact peak in 2019. If that is the case, then Whiting, Bruin and California Resource Corp’s creditors will be hoping that their debtor’s recovery will pick up alongside improving oil prices. If prices do not recover quickly then they will be joined by many more peers before 2020 ends, which will likely exacerbate more production decline in the U.S.
Originally appeared on Forbes.com on October 13, 2020.
What Time Is it for Your Family Business?
It is harvest time in rural America. Farmers are working long hours gathering the crops that have been planted, fertilized, watered and worried over since springtime. While the cycle of planting and harvesting is an annual one on the farm, for family businesses, the cycle can span decades or even generations.There are many different ways to classify family businesses, but one simple distinction that we find ourselves coming back to often is that between planters and harvesters.Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. Since these companies are focused on sowing the seeds for future growth, family shareholders should expect near-term returns to come primarily in the form of capital appreciation.In contrast, harvesters generate more cash flow from current operations than they are investing for future growth. While there likely will still be some degree of expected capital appreciation for these firms, they offer their family shareholders the potential for greater current income.
So what time is it for your family business? Is it planting season or harvesting season? You can easily tell by taking a look at the statement of cash flows. This generally underappreciated financial statement has three sections.The operating section summarizes the sources of cash flow from existing operations (principally earnings, depreciation and other non-cash expenses, net of changes in working capital).The investing section details the cash flows allocated toward corporate investments, the most significant components of which are capital expenditures and business acquisitions.The financing section reveals whether the company is a net borrower or lender, has issued or repurchased equity shares, and whether or not it pays dividends to shareholders.
We can classify family businesses as either planters or harvesters by simply comparing the first two sections of the statement of cash flows. For planters, total investing outflows exceed operating inflows. Harvesters, on the other hand, generate more operating inflows than investing outflows.
Once you determine whether your family business has been a planter or harvester in the past, it is time as a director to determine whether a change is appropriate in the future. To help us think about the characteristics of planters and harvesters, we examined statements of cash flow for companies in the S&P 600 (small-cap) and S&P 400 (mid-cap) indexes. After screening out financial and real estate businesses, we were left with a sample of 741 companies having median revenue in 2018 of about $1.5 billion. We classified each firm based on aggregate cash flows from 2013 through 2015; 40% of the companies were planters and 60% were harvesters. Exhibit 1 summarizes some characteristics of each group.
In the aggregate, planters invested $1.94 per $1.00 of operating cash flow, compared to $0.57 for harvesters. Harvesters tended to be more profitable, with a median operating margin of 10.0%, compared to 6.9% for planters. The net effect of more aggressive investing was a combination of faster revenue growth and improving profit margins for planters. Of course, return is the ultimate test for shareholders, and over the following three years (2016 through 2018), harvesters generated higher returns than planters (7.8% compared to 3.5%).
Peril and PromiseIt is easy to determine whether your family business has been a planter or harvester in the past. The real question for directors is assessing whether it should be harvest time or planting time for your family business now. Neither planting nor harvesting is inherently superior to the other. Directors need to read the calendar for their family business, understanding the peril and promise of each time.Planting Time: PromiseThe promise of planting time is the opportunity for a greater future harvest. As families grow over time, directors should evaluate the appropriate relationship between family and business growth. Planting time offers the promise that the growth of the business can keep pace with, or potentially exceed, the growth of the family, fueling per capita growth in family capital. What’s more, prudent planting can create opportunities for family members to assume roles of increasing responsibility in the business and promote shareholder engagement.Planting Time: PerilBusiness would be easy if planting decisions could be deferred until harvest outcomes are known. Sadly, that is simply not the case. You have to plant before you harvest. As a result, the principal peril of planting time is the risk that the harvest will turn out to be less attractive than expected. Referring back to Exhibit 1, the planters’ investments did contribute to faster revenue growth and improving margins. However, it is not clear that the incremental benefits from investment were truly sufficient relative to the investment made. The weaker observed stock returns for planters suggest that – for many of the companies – the harvest was not as robust as planned. In other words, the market concluded that at least some of the companies in our sample misread what time it really was, planting when they should have been harvesting.Harvest Time: PromiseIt is nice to be rich, but it’s even better to have money. The promise of harvest time is that the family will finally reap the benefits of the risks and investments of previous generations, turning the “paper” wealth of illiquid business value into liquid, readily diversifiable wealth. Harvest time can facilitate the transition from being a business family to an enterprising family. Harvest time can allow families to reduce their economic risk profile by moving at least some of their hard-won eggs into new baskets. As families grow, diversifying family wealth can be a critical component of overall family harmony and sustainability.Harvest Time: PerilOne of the biggest perils of harvest time is complacency. An over-emphasis on harvesting can starve the family business of needed investment. If the family business does not keep up with the growth of the family, the resulting pressure on per capita wealth and earnings can add stress to family relationships and erode shareholder engagement. Even from the perspective of the family business, the positive impact of investing for growth can be easily overlooked. As shown on Exhibit 1, the harvesters experienced some margin decay over the following three year period, suggesting that at least some harvesters allowed their competitive advantages to wither during the harvest. Directors need to take a balanced view of the long-term reinvestment needs of the business.ConclusionWhile there is some persistence in companies’ investing behavior over time, the companies in our sample did evolve. We reclassified each of the companies in our sample based on cash flow data for the three years from 2016 and 2018. Approximately half of the original planters became harvesters in the succeeding period. Harvest time is not a final destination, however, as about 30% of harvesters turned into planters. From this evidence, we conclude that your family business is never “stuck.” Family business directors need to regularly check what time it is for their family business, and not assume that the characteristics of the past year or decade are appropriate today. So, what time is it for your family business?
Subdued M&A Activity in the First Half of 2020
U.S. M&A activity slowed sharply in the second quarter due to the economic shock resulting from the COVID-19 pandemic. Activity – especially involving lower-to-middle market businesses – is expected to remain muted for the duration of 2020 and throughout 2021 unless more effective therapeutics and/or vaccines are developed that facilitate a more bullish sentiment than currently prevails.Although evidence is currently obscure, M&A markets appear to reflect wider bid-ask spreads among would-be sellers and buyers. Sellers are too fixated on what their business might have transacted for in 2019 while buyers expect to pay less as a result of declining performance and higher uncertainty regarding the magnitude and duration of the current economic malaise.Numerous industries lack sufficiently motivated strategic buyers willing to overlook concerns for their existing businesses to say nothing of the integration of new business. On the other hand, certain financial buyers seem to have returned to the market looking to deploy capital at attractive valuations when and where acquisition financing is available at reasonable terms and pricing.Would-be sellers face a dilemma: sell now for a seemingly compromised valuation; or wait for a recovery in market appetite that is not guaranteed to occur in the foreseeable future.Sellers are also faced with weighing the potential dilution of their future transaction proceeds if political regime/legislative change threatens the currently favorable tax environment.A modest consolation in the near-term for certain sellers may extend from the forgiveness of PPP loans under the CARES Act.As an aside from the current topical focus, sellers are advised to study the requirements and documentation for PPP forgiveness under change of control transaction events.We believe that in the current environment, contingent payments (e.g., earnouts and/or clawbacks) and seller financing will be employed to a greater extent than in the past in order to bridge a widening bid ask gap in deal value.Contingent deal consideration is typically structured such that a portion of transaction consideration is contingent upon the buyer’s achievement of specified post-transaction performance thresholds.The current environment requires careful seller scrutiny of such terms.When reasonably structured and negotiated, contingent consideration results in a symmetrical risk for buyers and sellers.While the economics can vary, earnouts often provide an incremental tranche of deal value that reconciles to that debated 0.5x to perhaps 2.0x turn that comprises the typical bid-ask spread (usually EBITDA based).For the buyer, contingent consideration acts as an insurance policy to insulate against downside future performance. For the seller contingent consideration can deliver deal consideration over and above that at the closing table, thus facilitating upfront liquidity while allowing for potential upside versus a straight all-cash closing. Sellers are advised to be careful about their unwillingness to entertain contingent consideration in the current environment because doing so can be a signal to the buyer of the seller’s concerns about near-term performance (i.e., actions speak louder than words).As always, every transaction is unique, requiring careful assessment of contingent consideration for purposes of productive negotiation.In theory, sellers may have to provide more financing in the post-COVID environment in order to achieve acceptable terms and pricing. We use the qualifier “in theory” because the high yield and leverage loan markets that are an important source of acquisition financing improved sharply as the third quarter progressed with more capital being raised at tighter spreads than the second quarter.An additional concern that has slowed M&A activity is execution.Conducting due diligence during a pandemic is inherently difficult and fraught with its own complications.It is easy to imagine how due diligence would have ground to a complete halt in an era before electronic data rooms and Zoom Video meetings. Nonetheless, travel prohibitions and social distancing protocols have stymied due diligence as most buyers require site visits and face-to-face meetings in order to consummate a purchase agreement.However, issuing a non-binding LOI remains quite doable, and some buyers are eager to secure the optionally and potential exclusivity obtained by an LOI submission.M&A in most industries is pro-cyclical. Challenges notwithstanding, M&A activity should gradually improve if the economy continues to do so and as buyers and sellers adjust expectations to the current environment and business earnings “normalize” in 2021 or 2022.
Managing the Family Business in an Era of Cheap Capital
One of the hottest topics in the financial press these days are special purpose acquisition corporations, or SPACs. According to one report, SPACs have already raised almost 3x the capital for investment during 2020 as they did during all of 2019. SPACs, also known as “blank check companies,” are publicly traded entities that raise capital from investors to acquire one or more companies. As noted on the SEC’s website, the promoters of SPACs have often not yet identified the company to be acquired at the time of the capital raise.SPACs are not new, and there are a few potential explanations for their popularity this year. We suspect that at least part of their appeal, however, can be traced to the willingness of investors to accept more risk to generate higher nominal returns.Despite a few cyclical upticks, interest rates have steadily ground downward over the past decade, with the so-called risk-free rate, or return on long-term Treasuries, falling from about 4.5% in early 2011 to less than 1.5% today. The incremental return premium for investing in stocks instead of bonds, known as the equity risk premium or ERP, eludes direct observation, but Aswath Damodaran – a widely respected finance professor – estimates that the ERP currently stands somewhere between 3.4% and 5.8%. Adding the two components together, let’s assume the current cost of equity for large public companies is around 7.0%.On the debt side, borrowing costs for corporate borrowers are also quite low, with the current yield for BBB-rated issues at less than 2.5%. Adjusting for the tax deductibility of interest payments, the after-tax borrowing cost for investment-grade borrowers is currently less than 2.0%.Assuming a moderate capital structure composed of 20% debt and 80% equity, the resulting weighted average cost of capital for large cap public companies is 6.0%.
For public companies, the almost endless supply of cheap capital (as evidenced by the proliferation of SPACs) is a boon. The low cost of capital makes it easier to justify investment opportunities (whether for capital spending or acquisitions) financially, and investors are willing to provide capital in search of higher returns.
For many family businesses, however, the era of cheap capital may not be an unqualified good. Many families have a deep-rooted cultural aversion to relying on non-family equity capital. The abundance of equity capital searching for a good home is therefore not a benefit they can access, at least not through traditional channels. Such constraints on family capital can also limit practical access to cheap debt financing. As a result, many family businesses cannot load up at the capital buffet as readily as their public counterparts.
As a result, cheap capital can create trigger pressure and tensions in both the business and the family.For the managers of the family business, the reality is that they are competing with firms who are aggressively taking advantage of the low cost of capital. Holding the line on the family business’s hurdle rate for capital investment will likely result in lost opportunities and slower growth. As one of my colleagues is fond of saying, it is an alternative investment world. Family businesses cannot set their hurdle rates and return expectations in a vacuum. Of course, the cost of capital for most family businesses remains well north of 6.0%. However, the returns available to family businesses are influenced by the returns available in the public capital markets. Directors need to be intentional about either (1) accepting lower prospective returns on potential capital investments, or (2) acknowledging that the family business could lose share to competitors.Family shareholders may need to re-calibrate their expectations for the long-term returns on the family business. If a rising tide lifts all boats, the opposite is also true. Shaving 100 or 200 basis points off annual return expectations has a profound effect on per capita wealth over the course of two or three decades, as illustrated in the following chart. Compounded over 30 years, a 1.5% decrease in annual capital appreciation reduces the family’s future wealth by 34%.This can have far-reaching consequences for the family’s lifestyle, community impact, and philanthropic ambitions. Return follows risk. Family business directors need to be closely attuned to family shareholders’ risk preferences and return objectives. If shareholders’ return objectives do not align with their professed risk preferences, there are likely some hard conversations ahead. Candid shareholder communication today can forestall family dissension tomorrow.Selling the family business can serve as a release valve for these building pressures. However, selling the family business does not make all of the family’s problems go away and can even introduce a few new ones. How will your family business adapt to this era of cheap capital?
Low Rates and NIM Margins Spur Bank Interest in the Wealth Management Sector
Executives Seek Revenue Streams That Aren’t Tied to Interest Rate Movements
COVID-19 adversely affected sector M&A for a couple of months when most of the U.S. was under shelter at home/safer in place orders. However, deal activity is recovering quickly and now could be further accelerated as banks look to replace lost interest income with fee-based revenue. An increasing number of clients on the banking side of our practice are showing interest in the wealth management space, and it’s easy to understand why. Long-term rates hovering at historic lows have significantly impaired net interest margins, so banks are exploring other income sources to fill the void. Wealth management is a natural place to start since so many banks already offer financial advisory services of one form or another.
There are many other reasons why banks have wealth managers on their radar:Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow assets under managementHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesSticky client baseAccess to HNW/UHNW client base and opportunity to increase wallet sharePotential for cross-selling opportunities with bank’s existing trust and wealth management clients
These incentives have always been there, but COVID amplified the banking industry’s need to diversify their revenue base, and RIA acquisitions are almost always immediately accretive to earnings. The shape of the current yield curve suggests that long-term rates are likely to stay below historic norms for quite some time, dampening the outlook for bank interest income. Acquiring an RIA or bulking up an existing wealth management practice with experienced advisors is a relatively easy way to pick up non-interest income and improve profitability. Building-up non-interest income is also an effective hedge against a further downturn or future recessions that might require the Federal Reserve to lower rates even further.
Still, there are several often overlooked deal considerations that banks and other interested parties should be apprised of prior to purchasing a wealth management firm. We’ve outlined our top four considerations when purchasing RIAs in today’s environment:With most of the domestic equity markets back to near-peak levels, the financial commitment required to purchase a wealth management firm has likely increased in recent months, lowering the prospective ROI of an acquisition. We often see some temptation to pay a higher earnings multiple based on rule-of-thumb activity metrics (% of AUM or revenue), but we would typically advise against paying above normal multiples of ongoing EBITDA for a closely held RIA, absent significant synergies or growth prospects for the target company.Since many wealth management firms are heavily dependent upon a few staff members for key client relationships, many deals are structured as earn-outs to ensure business continuity following the transaction. These deals tend to take place over two to three years with a third to half of the total consideration paid out in the form of an earn-out based on future growth and client retention. COVID-19’s impact on the markets and economy has elevated the demand for buyer protection, and many banks are now requiring larger earn-out components to protect themselves from future downturns or client attrition.It’s hard to know how the cultures of firms in any industry will mesh after a merger, and this side of due diligence has been most affected by COVID-19, as in-person meetings are still generally being avoided. The culture issue is especially true for bank acquisitions of wealth management firms. Compensation, work habits, client service expectations, and production goals can be drastically different at an RIA versus a bank, so it’s important to consider if these discrepancies could become problematic when the firms join forces. We’ve seen culture clashes blow up deals that looked great on paper.Degree of Operational Autonomy. Wealth managers (and their clients) value independence. Individual investors typically must consent to any significant change in ownership to retain their business following a transaction and may not be willing to do so if they feel that their advisor’s independence is compromised. Senior managers at the target firm will likely need to be assured that the new owner will exert minimal interference on operations and strategic initiatives if key personnel are to be retained.
These considerations manifest the need for an outside advisor to ensure that proper diligence is performed and the transaction makes sense from an economic perspective. Bank boards need practical guidance on finding the right RIA at the right price and assessing cultural differences that could wreck the integration after the ink dries. As always, we’re here to help.
Oilfield Services in 2020
Fork in the Road: Survival or Bankruptcy?
To say that 2020 has been “rough” for U.S. oil and gas (O&G) industry participants would be the height of an understatement. The one-two punch of the Saudi-Russia dust-up over oil market share, and the COVID-19 pandemic, which together spiked oil supplies and made demand plunge, combined to set-up for a record bad year for the O&G industry. Oil prices, that ended 2019 near $60/barrel (WTI), tumbled below $22/barrel in late March, and hit a 2020 low of $17/barrel in April. A much welcome partial recovery during the month of May led to a somewhat stabilized price range of $36-$43/barrel through the third quarter. While $40/barrel oil prices provided at least some relief to O&G industry participants, prices at that level aren’t expected to lead to anything close to a recovery to pre-2020 activity levels. The industry continues to “flow red” with continued bankruptcies piling-up.
Bankruptcy courts have been busy as a result of the O&G industry downturn. Already this year 36 bankruptcies were filed among the production segment operators alone. Industry insider conversations have included concerns that there could be 60-70 additional producer filings by the end of the year.
If those predictions come true, 2020 would represent a record year for O&G-related filings in the annals of the bankruptcy courts. While that may seem like an unusually bad turn for a six-month period of depressed prices, it’s worth noting that the industry was significantly stressed beforehand. Natural Gas Intelligence’s Andrew Baker noted that the anticipated cutbacks in future capital expenditures among the producers for drilling, completions, and other activities in the field will most certainly spread the bankruptcy trend to the oilfield services (OFS) segment that never completely recovered from the 2014 industry downturn. Baker indicated that “many smaller or highly leveraged OFS companies may not be able to hold on” and will be forced to seek the protection of bankruptcy courts.
As Baker referenced, size and financial leverage can generally contribute to an OFS participant business being forced into a bankruptcy filing. In this edition of Mercer Capital’s Energy Valuation Insights blog, we explore some of the many factors that play into making it more (or less) likely that an OFS participant will survive an industry downturn intact, or succumb to market pressures and enter into bankruptcy.
OFS Bankruptcy DifferentiatorsThere are most certainly many factors that may contribute to, or deter, an OFS company’s need to file for bankruptcy protection during an industry downturn. Some are more general and more obvious, while others are more specific and not as readily discerned. Here we address some of the more general factors (margins, financial leverage, and breadth of product/service offerings), some industry specific factors (customer sectors and basins served), and the benefit of industry experience.General FactorsAs in any industry, the ability to survive a downturn in the OFS industry is all about maintaining cash flow, and therefore liquidity. No surprise here, a company generating higher margins in “normal” industry conditions is more readily able to navigate a downturn when the company’s margins are likely to get pinched. As such, bankruptcies during a downturn in the industry are materially more likely among highly competitive sectors of the OFS industry where margins tend to be lower, as opposed to less competitive sectors, where margins tend to be more robust. Beyond general competition levels, a particular OFS company’s margins may be influenced by a number of factors. These include proprietary products or processes, its having embraced efficiency inducing technology and automation, and other factors that contribute to lower cost of sales, or operating expenses. With higher margins, an OFS company is able to endure the margin reductions that come with industry downturns with a significantly lower probability of reaching a financial breaking point....the ability to survive a downturn in the OFS industry is all about maintaining cash flow, and therefore liquidity.Similarly, the degree to which an OFS company makes use of financial leverage to enhance returns can play into its ability to weather an industry storm. Take Company A and Company B that both generate the same operating cash flow margins – margins before consideration of financing costs in the form of interest expenses on outstanding debt. If Company A carries a lower level of debt financing (relative to Company B), its operating cash flow will be greater than Company B’s. The cash flow differential may not be a make-or-break matter during normal industry conditions when both companies are generating significant cash flows relative to their interest expense. However, during periods of reduced cash flow, the more leveraged company may reach a point where operating cash flows are inadequate to meet its interest payments. So, the financial leverage that enhances return during the times of industry strength can be the same financial leverage that leads to distressed liquidity during industry downcycles.An OFS company’s breadth of product or service offerings can also impact the ability to maintain operations during a downturn. Larger OFS participants, with multiple product or services offerings, have the benefit of being able to consider shifting its efforts among various offerings. In that way, the company can emphasize operations where it can continue providing more productive (profitable) lines and deemphasize less productive lines. It may even be in a position to sell-off assets related to less productive lines in order to maintain liquidity to continue operations of productive lines. WorldOil Magazine’s David Wethe cites examples of this type of shifting of products/services in Schlumberger’s sale of its land-rig unit in the Middle East and Precision Drilling’s sale of its Mexican operations as the companies struggled in recent years. Unlike these larger industry participants, smaller companies with very limited product or service offerings, don’t have nearly the same level of flexibility. Among these smaller OFS companies, diversity of offerings may simply not exist. That leaves the businesses without the ability to shift away from less profitable products or services, and therefore make them more prone to the necessity of a bankruptcy filing.Industry-Specific FactorsThe diversity and breadth of the OFS industry brings additional factors that may influence an industry participant being forced into a bankruptcy filing. Despite the misnomer, the OFS industry includes providers of products and services to both oil-focused and gas-focused E&P companies. The graphic below provides some insight as to just how wide an array of products and services are represented within the OFS industry.Sub-Sectors FocusDue to the significant differences between the operations of the OFS industry participants, an industry downturn doesn’t impact all OFS participants to the same degree. For instance, OFS businesses that disproportionately serve the natural gas side of the industry were not as significantly impacted by the precipitous drop in oil prices during the 2020 second quarter. In the same way, OFS participants may be impacted quite differently based on the E&P subsector that they serve. For example, during the 2020 oil price disruption, new drilling operations were much more adversely affected than were continuing production operations. Following a sharp decline in oil prices, exploration operations may be curtailed much more so than production operations. For example, when oil prices are in the $35 to $40 per barrel range, it can be economically beneficial to continue production from existing wells, but quite uneconomically viable to incur the cost of drilling new wells. Even much less economical to incur exploration related expenses. As such, OFS companies whose products or services support production activities – fracking, well maintenance services, and production chemical providers – face less dire circumstance at $35 to $40/barrel prices than OFS companies that support exploration activities – geological, seismic, drilling, and site preparation services.Basin FocusBeyond the differences between serving the oil versus gas subsectors, and the differences between serving exploration versus production subsectors, there are differences in the basins that a particular OFS business focuses on. These differences can generally be categorized into three areas – type of oil, midstream transportation availability, and production cost. Different basins may produce different types (grades) of crude oil (light versus heavy, sweet versus sour, etc.), which require varying levels of refining in order to generate end products. As such, the “price” of oil isn’t uniform across basins, and as a result, a drop in oil demand can impact different basins to varying degrees.[caption id="attachment_34074" align="alignnone" width="726"] http://www.eia.gov/maps/maps.htm[/caption]
Similarly, the midstream transportation assets of a particular basin can influence the price of oil based on the location of the production facilities. Basins, where pipeline capacity is lacking, may have a higher cost of getting the oil to refining facilities and, therefore, require higher prices to justify continued production. In much the same way, different basins can have materially different production costs per barrel depending on the age of the fields and the specific geology of the field.
As with basins that suffer from higher costs in getting produced oil to refineries, basins that have higher production costs (the total cost of bringing oil/gas to the surface) may not have the needed economics to justify continued production at oil prices that allow for continued production from basins with lower production costs. For example, Reuter’s Energy Correspondent, Liz Hampton, notes that oil firms operating outside the Permian basin (in Oklahoma, Colorado, Wyoming, Kansas, and parts of New Mexico) where production costs are higher may be particularly hit hard by oil prices in the $25 to $30/barrel range. On average, producers in those states need oil prices at $47 a barrel to make money.
Liquidity Management and Cost StructureTo this point, we’ve addressed factors that primarily impact the demand for an OFS participant’s products and services. Now we move to factors beyond demand – liquidity and cost structure/control. In a pronounced industry downturn, where cash flows are known to be turning negative for an indeterminate amount of time, liquidity becomes a major focus point. If cash runs out, a previously slow decline in business can rapidly turn into a downward spiral. Managing the company’s liquidity can involve several related actions including reducing costs, drawing down existing lines of credit (before they become difficult to access), and engaging as soon as possible with debt providers. While it may seem that these actions would have the same benefit to all OFS participants, the results of such efforts can vary markedly.In a pronounced industry downturn, liquidity becomes a major focus point.OFS businesses that have closely managed their line of credit, such that they have abundant LOC capacity remaining when a downturn occurs, have flexibility that other OFS businesses lack. Likewise, OFS participants that maintain close debtor relationships are likely to get a better reception when negotiating with their debtors for adjustments to their debt structure, or for forbearance terms.In terms of cost reduction, a company’s particular cost structure plays a significant role in its ability to cut expenses. Businesses with higher fixed costs lack the level of flexibility in cost containment that lower fixed cost businesses have. For example, businesses in which human resources are a larger percentage of total expenses have greater flexibility when considering staff reductions, pay-cuts, furloughs, and reducing hours. Furthermore, the ability to take those type cost containment actions can be easier for OFS businesses where the time to identify and hire qualified employees is shorter, and the cost of training such employees is lower. These factors make it easier to take critical human resource related / cost containment actions, in that any resulting staff losses can easily be replaced, and at a lower replacement cost.Management ExperienceOur discussion of differences among OFS industry participants during a downturn, would be incomplete without addressing the benefit of a management team with deep industry experience. Industry downcycles in highly cyclical industries, can be even more challenging with a management team that has limited experience. Most industries experience some degree of cyclicality, but the O&G industry tends to bring a heightened level of ups and downs, and unexpected supply and demand shifts. Afterall, how many industries can even fathom the idea of the futures market, for their only product, pushing into the realm of negative pricing? How many industries can be so significantly impacted, in such a short period of time, by a market share spat between market participants on the other side of the globe – not to mention those market participants being countries (Saudi Arabia and Russia) rather than individual businesses. Not exactly an industry conducive to downturn survival if the management team has limited industry experience.In a recent management interview with one of our recurring OFS clients, the head of the company expressed how industry experience allows a seasoned management team to act quickly and decisively, and that such actions can make or break an OFS business in an industry wide downturn. He commented that less experienced management teams sometimes suffer from a “drug” known as “hopium” – a tendency to hope that the downturn will be short lived and therefore hesitate to take the necessary decisive action needed to stave off a cash crunch that can rapidly turn into a bankruptcy filing. He further noted that due to his teams’ deep industry experience across multiple O&G cycles, when the combined COVID-19 and Saudi-Russian dust-up hit, his team immediately, as he put it, flipped open to page 5 of their “Oh <bleep>” playbook and began a pre-planned series of actions to enhance liquidity and reduce costs, without allowing unwarranted “hope” to get in the way. As such, their business, while certainly feeling the impact of the downturn, is feeling it much less negatively than other OFS businesses.ConclusionWhile the O&G industry has many systematic forces that impact industry participants across the board, there are many unsystematic forces that lead to marked differences in the magnitude of the downturn’s impact on individual businesses. The OFS portion of the O&G industry is particularly diverse with subsector and basic focus potentially imposing greater, or lesser, downturn risk on a particular OFS market participant. Beyond those demand impacting factors, cost structure and level of industry cycle, experience among management teams have a significant impact on an OFS business’s ability to hold-on during an industry wide downturn and avoid the need for a bankruptcy filing.
Middle Market Transaction Update Second Quarter 2020
U.S. M&A activity slowed sharply in the second quarter due to the economic shock resulting from the COVID-19 pandemic.
Continuation of Market Rebound Drives Most Categories of Publicly Traded RIAs Higher in Q3
RIA Market Update
Share prices for publicly traded asset and wealth managers have trended upward during the second and third quarters after collapsing in mid-March with the broader market. Alt asset managers have fared well over the last year as volatility and depressed asset prices have created an opportunity to deploy dry power and raise new funds in certain asset classes. Traditional asset and wealth managers have generally moved in line with the broader equity market, while leveraged RIA aggregators have seen more volatility, both up and down, as the market bottomed in March before trending upward.[caption id="attachment_33973" align="aligncenter" width="950"]Source: Source: S&P Market Intelligence[/caption]
Looking at the third quarter, traditional asset and wealth managers and aggregators trended upwards in July and August before pulling back as the market dipped in September. While the quarter was volatile, both of these categories ended the quarter up about 4%. The primary driver behind the increase was the increase in the market itself as most of these businesses are primarily invested in equities, and the S&P 500 gained about 8% over the quarter.
[caption id="attachment_33974" align="alignnone" width="856"]Source: Source: S&P Market Intelligence[/caption]
The upward trend in publicly traded asset and wealth manager share prices since March is promising for the industry, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility.
Smaller publicly traded asset/wealth managers have been most affected by these trends, which is reflected in their share price performance over the last year. As shown below, asset/wealth managers with more than $100 billion AUM have performed well over the last year, with the $100 - $500 billion AUM group up 28% and the $500 billion+ group up 4%. Smaller RIAs, those with under $100 billion AUM, have been down over the last year, with the smallest group (under $10 billion AUM) down 14%.
[caption id="attachment_33975" align="alignnone" width="893"]Source: Source: S&P Market Intelligence[/caption]
As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter—reflecting the anticipation of lower earnings due to large decreases in AUM—but have since recovered in the second and third quarters as prospects for earnings growth have improved.
[caption id="attachment_33976" align="alignnone" width="589"]Source: Source: S&P Market Intelligence[/caption]
Implications for Your RIADuring such volatile market conditions, the value of your RIA is sensitive to the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter before recovering most of that loss in the second and third. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down significantly in the first quarter but has since recovered to above where it was a year ago (see chart above). The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last valuation while being careful not to count good or bad news twice.While the market for publicly traded companies is one data point that informs private RIA valuations, that’s not to say that privately held RIAs have followed the same trajectory as their smaller public counterparts. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds discussed above. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. The third quarter was generally a good one for RIAs, but who knows where the last quarter of 2020 will take us in a wild year for RIA valuations and overall market conditions.
Is There a Ticking Time Bomb Lurking in Your Family Business?
Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Is there a ticking time bomb lurking in your family business?”When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs. One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.For more information or help with your buy-sell agreement, don't hesitate to contact us.
Take Advantage of Current Estate Planning Opportunities While You Can
It’s nearly impossible to discuss anything automobile-related without mentioning the name Henry Ford. Henry Ford established the Ford Motor Company in 1903 and also became one of the founding fathers of the automated assembly line mode for the production of his Model T vehicle. One of the famous quotes attributed to Mr. Ford is that “failure is only the opportunity to begin again.” This adage continues to inspire the auto industry today as it attempts to recover from turbulent economic conditions caused by the COVID-19 pandemic, much like its recovery from the Great Recession just a decade ago.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012.While economic recovery is still uncertain as the pandemic continues on and new relief bills are on the ropes, there currently exist potentially attractive estate planning opportunities for auto dealer owners.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012: 1) potentially depressed valuation of assets and businesses; 2) historically low interest rates; and, 3) uncertainty regarding the political administration going forward. Let's delve a little deeper into these three factors.Potentially Depressed ValuationsAt its core, the valuation of a business consists of three assumptions: cash flow, risk and growth. Cash flow can be defined as the expected earnings of a business into the future. With no certainty of the future, historical performance and recent performance can serve as a starting point for those future expectations. The second assumption is risk: what are the risks that the company faces to achieve those expected cash flows? Risks can be internal such as labor and management or risks can be external such as the economy or competition. The final assumption to valuation is growth: how are cash flows expected to grow in the future?All three of these valuation assumptions have been threatened by the pandemic. Recent cash flow has been threatened for most industries, not just the hospitality, retail, and restaurant industries. Certainly, for businesses, operating and economic risks have increased during the pandemic. As far as growth and recovery, we’ve all gotten an education into the alphabet soup of recovery: can the recovery for the general economy be described as v-shaped, u-shaped, w-shaped, k-shaped, or some other letter?Historically Low Interest RatesThose familiar with the concepts of finance and valuation also understand the relationship between interest rates and value. Generally, as interest rates (and risk) increase, the value of the asset decreases and vice versa. The pandemic and summer/fall of 2020 has created a unique opportunity regarding interest rates, as the Fed has brought rates to near zero in order to combat the pandemic.How are interest rates used in estate planning? Attorneys utilize many structures when seeking to transfer family wealth from one generation to the next: Grantor Retained Annuity Trusts (GRATs), Charitable Remainder Unified Trusts (CRUTs), installment sales, interfamily loans, and many other structures. Most of these structures utilize some form of a note/loan between family members. Under current tax law, a family member could not make an interest-free loan to a child or grandchild without that portion of the loan being considered as a taxable gift. To shield that portion of the loan from being a taxable gift, the loan must carry a stated interest rate. The IRS establishes guidelines for these interest rates in the form of Applicable Federal Rates (AFRs), which are determined monthly by the U.S. Treasury. The mid-term AFR rates have been historically low, and below 1% for most of 2020.The mid-term AFR rates have been historically low, and below 1% for most of 2020.How do low AFRs assist in estate planning? In addition to satisfying the IRS’ requirement so that the interest portion of the loan will not be treated as a gift, the lower level of AFRs should motivate estate planning this fall. Often, the structures that attorneys use in this form of planning (discussed above) depend on the cash flow from the asset being transferred (perhaps an operational business as an example) to fund the debt service in connection with the loan. In times of lower AFRs, the debt service is reduced, and it’s easier for the cash flow from the asset to cover the debt service. Additionally, the success of these transfer vehicles is usually dependent on the potential growth and appreciation in value of that asset after it is transferred to the next generation. With historically low AFRs and greater expected rates of return on the transferred assets, there are potential arbitrage opportunities on the spread of those returns.Uncertain Political ClimateThe fall of 2020 brings with it the national election season, and along with it, potential political change. Two important tax provisions that affect estate planning are at stake: the estate tax credit and the step-up basis for tax treatment. The current estate tax credit is $11.6 million per individual, meaning a married couple can shield and pass an estate worth $23.2 million ($11.6 million times two) to their heirs without incurring estate taxes. This provision is set to sunset in 2026 and will return to an amount of $5 million-plus inflation adjustments, expected to settle at a figure between $6 - $7 million per individual. At those levels, the unified estate tax credit limit for couples would lower by approximately $9.2 million, resulting in a greater pool of family estates that would be subject to estate taxes. If a new party wins the White House this fall, this provision could be debated and potentially changed sooner than 2026.Two important tax provisions that affect estate planning are at stake.A second tax provision that aids in estate planning could also be in jeopardy this fall. Among the pillars of Vice President Joe Biden’s proposed tax plan is the elimination of the step-up basis for taxation. Under current U.S. tax laws, the assets of an estate pass to their heirs at a tax value established at death (or alternate date of valuation). The value is transferred to their heirs at this established value at death or a stepped-up basis. Biden’s proposed tax plan would eliminate this step-up basis. Consider an estate portfolio with a value of $10 million and a tax basis of $2 million. Under the current unified estate tax credit, the portfolio example would not be subject to estate taxes and would transfer to the heirs at a stepped-up basis of $10 million. If the step-up basis was eliminated, the portfolio would transfer to the heirs at a basis of $2 million and would also be taxed on the imbedded capital gains of $8 million. There are also discussions that a change in power in the White House could also lead to increases in the capital gains tax rates, which are currently set at 15-20%. Increased capital gains tax rates and the elimination of the step-up basis could greatly diminish the value of a family’s portfolio at the death of the patriarch/matriarch.Unique Estate Planning Opportunities in Auto Dealer Industry TodayAs discussed above, this fall brings a unique opportunity for owners in the auto dealership industry to capitalize on low interest rates for planning tools and potentially lower valuations of the underlying assets being transferred. Last week’s blog covered the market’s update on Blue Sky multiples. Despite market optimism, valuation and blue sky multiples of auto dealerships are still very specific to the individual dealership and consider their unique conditions including financial performance, competition, and local economic conditions among other factors.In a previous Family Business Director blog post, colleague Travis Harms also discussed the impact of real estate on estate planning. It’s very common for the operations of the dealership to be contained in one entity and the real estate where the dealership resides to be contained in a separate asset holding company. Often when owners of auto dealerships desire to transfer their wealth/assets to the next generation, they may have children that are active in the business and they may have children that are not active in the business. We have consulted with owners on a strategy to gift interests in the operating business to the active children and interests in the real estate holding company to the non-active children. Owners/parents often view this strategy as equitable to their children and seek to reward/incentivize the active children with a direct interest in the operations of the dealership.ConclusionNow is a unique time, rife with estate planning opportunities with potentially lower valuation of assets, historically low interest rates, and changing political winds. Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equally. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation. Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning. Mercer Capital has extensive experience providing valuations for estate planning and valuations specific to the auto dealership industry.
Blue Sky Multiples Rebound from Q1 Declines but Full Recoveries Reserved for Top Brands
Blue Skies Ahead?
Last quarter, we sat down (virtually) with Kevin Nill of Haig Partners to discuss M&A trends in the Auto Dealer Industry. He noted amidst the uncertainty, buyers and sellers were either applying pre-COVID multiples to lower earnings or lower Blue Sky multiples to pre-COVID earnings. Sluggish deal volume continued into Q2 with transactions down 16% compared to 1H 2019, but the pace is picking up.In this post, we review Haig Partners' Q2 report on trends in auto retail and their impact on dealership values. We also look at how Blue Sky multiples have rebounded after declines in Q1. While most brands saw a partial recovery, a return to pre-COVID multiples was largely reserved for brands with the highest multiples in their category (luxury, mid-line import, and domestic).The Haig report succinctly described the landscape thusly:When customers couldn’t come into showrooms, dealers responded by selling vehicles online. When inventory levels for new vehicles fell, dealers focused on used car sales and were able to hold for more gross on both new and used vehicles. While waiting for the recovery, dealers reduced advertising, personnel and floorplan expenses significantly. The pandemic forced dealers to adopt new technologies and leaner business practices sooner than they otherwise might have. The result is that most dealers have become stronger during this time of crisis, not weaker. Investors have noticed. The publicly traded franchised groups have higher values today than before COVID, and we have seen the values of private retailers rebound as well. Dealership buyers are betting that the future of auto retail is bright, even when the lift from trillions of dollars of government stimulus spending wears off.Activity Ground to a Halt, but It’s Picking Back UpAccording to Haig, about 25-30 dealerships have been bought/sold each month on average. While the pandemic curbed activity significantly from March through May, there is evidence of pent up demand. Haig indicated that of the 42 dealerships that transacted in Q2, 33 were sold in June.While transaction activity has largely come from private acquisitions as seen above, our review of public franchised auto dealer earnings calls indicates public acquisitions are likely to pick up. Public companies, such as Lithia and Asbury (with its Park Place acquisition) have increased their appetite for acquisition. In order to compete in a digital world, public franchised dealers are looking to scale their operations. Online-centric competitors such as Carvana and Vroom have experienced rapid growth in recent years, though they are used vehicle dealers and thus uninhibited by franchise agreements. In order to add scale, public franchised dealers will need to leverage their relationships with OEMs and be more pragmatic in their growth. Still, scale is anticipated to benefit these players by spreading digital innovation costs over higher revenues.Advantageous Buying Opportunities Were Somewhat Short-LivedAs we mentioned above, deal activity from March through May was paused for numerous reasons. First, having to perform the due diligence process virtually reduces the likelihood of a transaction between two parties that don’t know each other well, even if both sides were eager to press forward. Widening gaps in valuations between buyers and sellers also made sellers less likely to relinquish their assets in a spiraling economic climate at the onset of the virus. After all, for many families, their auto dealership is the principal asset on the family balance sheet, and owners were wise to hold tight to their assets in a spiraling economic climate.According to Haig, COVID caused buyers to pull offers or demand price concessions amid concerns of earnings stability. However, buyers have come back to the table in recent months as profits have been much stronger than initially anticipated. Haig estimated Blue Sky values declined about 10% from 2019 levels in Q1; this figure ended up being only about a 5% dip in Q2. Kerrigan Advisors, another preeminent investment bank in the auto dealer space, sees Blue Sky values actually up 3.3% in Q2 2020 compared to Q4 2019. We’ll discuss the rebound in valuations in depth below.While SAAR has declined, gross profits (on a per vehicle basis) have improved.We see an interesting parallel in the minds of buyers, both of vehicles and dealerships. While SAAR has declined, gross profits (on a per vehicle basis) have improved. Through July, average new vehicle gross was up 7.8% per vehicle retailed compared to 2019, while used vehicles improved 5.1%. Consumers hoped an economic disruption would create a unique buying opportunity, but a lack of new vehicle inventory and interest rate tailwinds allowed dealers to raise prices. People with the financial wherewithal to purchase a new vehicle amid skyrocketing unemployment early on in the pandemic likely got a good deal, but NADA estimates incentive spending per vehicle declined 17% from April to August.Similarly, dealership buyers that were able to successfully negotiate price concessions on transactions already in progress likely got a good deal with the surprising earnings performance. Through July, average dealer sales were down 13.6% compared to 2019, but pre-tax earnings declined only 4.6%. As noted in The Blue Sky Report for Second Quarter 2020, published by Kerrigan Advisors, average dealership profits rebounded from lows to highs in the span of two months.Deals that were scuttled, delayed, or that didn’t even get off the ground, ultimately, may have benefited the seller that chose not to sell at the April lows. And as one of our colleagues has told me during the sell-side transaction process, every day you don’t sell your business, you are effectively buying it back at its current value in the marketplace. Dealers who chose to “re-buy” their dealership in April will be glad they did.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. The lone exception was Mazda whose multiples actually improved over Q4 2019. This likely has less to do with pandemic mitigation as it does with other recent troubles. While Mazda’s franchise sales fell the least (7% decline) of all the major franchises compared to 1H 2019, this may say more about 2019 performance than it does about pandemic mitigation. Its range of Blue Sky multiples has improved in each of the last two quarters, but Mazda still remains slightly below its range of 3.0x – 3.75x from Q3 2019.In Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.Every other brand declined about a half turn of pre-tax profits in Q1 (e.g. Mercedes-Benz fell from 6.50x – 8.0x in Q4 to 6.0x – 7.50x in Q1). Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations rebounded in Q2. However, only Porsche, Toyota, Ford, and Kia rebounded fully to their Q4 multiple range. Hyundai actually saw a modest uptick on the high end to pull even with Kia at 3.0x – 3.75x compared to 3.0x – 3.50x in Q4 2019.Notably, Porsche, Toyota, and Ford have recently been the leaders of their peer group. No luxury brands besides Porsche saw a full rebound to the top end of the pre-pandemic range. After years of tracking at the exact same range, Toyota stuck its nose in front of Honda, whose range only regained half of its pandemic losses. Similarly, Ford's Blue Sky multiples have moved in lockstep with Chevrolet since Q2 2018. Pre-pandemic declines to Ford's dealer valuations allowed Chevy and FCA to pull in front in Q4 2019. Now, all three of these domestic dealers sit at a 3.0x – 4.0x Blue Sky range with Buick-GMC just slightly behind.ConclusionFortunately, while there is still uncertainty about when the economy will return to “normal,” the auto dealer industry appears to have adapted to the circumstances at hand. Valuations have rebounded as earnings have recovered, and the industry has largely avoided the doomsday scenarios prognosticated in March. Still, not many people would have predicted working from home would remain so prevalent heading into October. As Q3 wraps up, we hope dealers continue to navigate these waters as they continue to re-buy their dealership.Blue Sky multiples provide a useful way to understand the intangible value of a dealership, particularly in a transaction context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to get the ball rolling.
How to Communicate Risk to Family Shareholders
Drug maker Abbvie is reported to have spent $460 million on television ads for Humira during 2019. Like all pharmaceutical ads, the TV spots for Humira try to accomplish two things: demonstrate the benefits of taking the drug and acknowledge the risks of taking the drug. In one 60 second ad, the risk disclosures begin at the 27 second mark, meaning that slightly more time is spent on risk disclosure than on drug benefits. And yet, how effective is the risk disclosure? Do ad viewers have any basis for knowing how to incorporate the fact that “blood, liver, and nervous system problems” have happened into their decision-making process?Communicating risk effectively is not just a challenge for drug companies. All companies deal with risk and uncertainty. Making too much of the risk can alienate customers and erode the credibility that might be critical when a threat actually materializes (i.e., “Chicken Little” and “The Boy Who Cried ‘Wolf’”). On the other hand, insufficient risk disclosure can result in liability that threatens the company’s existence. A recent article in the Harvard Business Review addressed this challenge in customer communications. The authors of “The Art of Communicating Risk” offer three suggestions for communicating risk to customers more effectively. In this post, we will review those suggestions, and think about how they might apply to communicating risk to family shareholders.#1 – Stop ImprovisingShareholder communications in many family businesses can best be described as haphazard. Managers and directors attempt to communicate with family shareholders when they feel like there is something important to say or when they have the time. This lack of structure builds uncertainty into the very fabric of a process that should exist to reduce uncertainty. The frequency of shareholder reporting will be different for each family; dependability is ultimately more important than frequency. Do your family shareholders know when they should expect to hear from you next? Furthermore, do you have a consistent format for communicating with family shareholders? Do they know what they can expect to hear from you? Following a consistent reporting format, even when management doesn’t think there is anything especially “newsy” to report signals that directors take the rights and needs of family shareholders seriously. Over time, this builds credibility with family shareholders.#2 – Change the Metric for Success, and Measure ResultsWhat constitutes success for family shareholder communication? Engagement is critical – if a shareholder risk is communicated but no one receives the message, does it really exist? For digital communications, families can easily measure engagement by tracking open and click-through rates over time. Relevance fuels engagement. What are the risk factors that matter most to family shareholders, and are those factors most prominent in your reporting? What risks should your family shareholders be concerned about? And do they know why those risks are important?#3 – Design for Risk Communications from the BeginningThose ubiquitous risk disclosures in pharmaceutical ads that we discussed at the outset are certainly regular (consumers know when they will appear in the ad) and are rigorously consistent (avid TV viewers may have them memorized). But do they actually help consumers? Similarly, we suspect that the laundry list of “Risk Considerations” in SEC filings is not terribly illuminating for many public company shareholders. So the challenge for family business directors is to convert vague warnings about abstract risks into concrete measures of the factors that give rise to risk and the historical frequency of occurrence. This will require carefully considering not only what risks need to be disclosed, but also how those risks can be quantified and put into context.Companies with commodity exposures offer a ready example. Consider a family business whose earnings and financial condition are correlated to the price of zinc. If the company’s gross profit declines when the price of zinc falls below $2,000, a risk disclosure to the family shareholders might include both the percentage of time zinc has traded below that level in the past 20 years, and the frequency with which the price has fallen below $2,000 from the current price during the subsequent three months as shown below.Framing the risk in this way helps provide more intuitive context for family shareholders to evaluate the risk of adverse zinc prices having a negative impact on the earnings and financial condition of the family business.ConclusionCommunicating with family shareholders about risk is not easy, but it is inevitable. Choosing not to communicate about risk is still a communication strategy, just not a very good one. The goal of risk communication is to promote positive shareholder engagement, which is critical to sustaining the family business when adverse events happen.
How Growing RIAs Should Structure Their Income Statement (Part II)
Compensation Conundrums
Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves). This is the second post of a two-part series on compensation best practices for growing investment managers.
Last week, we introduced two common compensation conundrums for RIAsHow to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner
In our last example, we explained how owners of RIAs can structure employee compensation. This week will focus on how to structure partner compensation.Striking the Right BalanceSince RIA owners are often senior managers in their firm, their compensation and distributions are often intertwined and are subject to shareholder preferences regarding how they like to be paid. However, this can lead to problems as growing RIAs expand by bringing on new equity partners.Take the example below of an RIA with four partners with equal ownership considering a 25% equity grant to bring on a new partner who will help the company expand its reach. To minimize their tax burden, the owners historically have not paid themselves a salary and instead were compensated through distributions. However, if they bring on a new employee with a salary and 25% ownership, the new partner would receive higher compensation (including distributions) than the original partners who aren’t taking any salary or bonus.
A similar complication arises for partners that pay out their entire EBOC (Earnings Before Owners’ Compensation) in bonuses to minimize reported profitability. We often see this in places with state dividend taxes but no state income tax. Equity incentives in these situations are rarely enticing to prospective hires since dividend prospects are minimal or non-existent as shown below.
Before bringing on an equity partner, it is key to balance returns on labor (compensation) and returns on investment (distributions). To appropriately relate compensation expenses to reasonable returns on labor, owners should consider compensation levels commensurate with job responsibilities and revenue production. Compensation studies can help determine market levels of salaries and bonus expense, but the range of reported salaries in the RIA industry vary significantly. It is helpful to think about what it would cost to replace yourself if you decided to step away from the business; however, this may not be relevant for younger staff additions, whose market rates often depend on their relevant course experience and educational background.
The return on investment is just the residual income after paying your staff (and yourself) an appropriate (market) level of compensation expense. RIA owners often think of their ROI as a ROS (Return on Sales) since the requisite capital to start these businesses is often quite minimal. In other words, they often think an appropriate return on investment is a reasonable pre-tax margin for an RIA of their size. If, for example, industry compensation costs are 70% of revenue and overhead expenses are 10%, then an appropriate pre-tax margin or ROS is 20% (100%-70%-10%). If your current margins are much higher or lower than industry norms, your compensation expenses are probably not in sync with the market.
Does Money Talk Louder Than Words?Compensation discussions are never easy. If your company is growing and your employees are smart, they will ask for ownership in the business. Even if out-right ownership is not on the table, it is beneficial to align employee incentives with your own. But many owners of growing RIAs make the mistake of waiting too long to share equity ownership and before they realize it, the value of an equity stake in their firm is too expensive for the next generation of leadership to afford.
Neiman Marcus: A Restructuring Case Study
Mercer Capital is a national valuation and financial/transaction advisory firm. The Neiman Marcus Chapter 11 bankruptcy filing raises multiple valuation questions:Fraudulent conveyance (asset stripping) and solvency related to pre-filing asset distributionsLiquidation vs going concern valueValue of the company once it emerges from Chapter 11Allocation of enterprise value to secured and unsecured creditorsFresh start accounting
Neiman Marcus Group, Inc. (“Neiman Marcus” or “Company”) is a Dallas, Texas-based holding company that operates four retail brands: Neiman Marcus, Bergdorf Goodman, Last Call (clearance centers), and Horchow (home furnishings). Unlike other department store chains, such as JCPenney and Macys that cater to the mass market, Neiman Marcus’s target market is the top 2% of U.S. earners.
Among the notable developments over the last 15 years were two private equity transactions that burdened the Company with a significant debt load and one well-timed acquisition. The debt and acquisition figured prominently in the May 7, 2020 bankruptcy filing in which the company sought to reorganize under Chapter 11 with the backing of most creditors.Iconic Luxury Retailer to Indebted MorassHistoryThe iconic Neiman Marcus department store was established in 1907 in Dallas. Over the ensuing decades, the Company prospered as oil wealth in Texas fueled demand for luxury goods. Neiman Marcus merged with Broadway-Hale Stores (later rechristened Carter Hawley Hale Stores, Inc.) in the late 1960s. Additional stores were opened outside of Texas in Atlanta, South Florida, and other wealthy enclaves around the U.S. except for New York where Bergdorf Goodman (acquired in the 1970s) operated two stores.In 1987, Neiman Marcus along with Bergdorf Goodman was partially spun out as a public company with the remaining shares spun in 1999.In 2005, the Company was acquired via a $5 billion LBO that was engineered by Texas Pacific Group and Warburg Pincus. Once the economy rebounded sufficiently from the Great Financial Crisis, the PE-owners reportedly sought to exit via an IPO in 2013. However, the IPO never occurred. Instead, the Company was acquired for $6 billion by Ares Management and the Canada Pension Plan Investment Board (“CPPIB”).In 2014 Neiman Marcus acquired MyTheresa, a German luxury e-commerce retailer with annual revenues of $130 million, for $182 million of cash consideration. During 2018, the entity that held the shares of MyTheresa (MyT Holding Co.) was transferred via a series of dividends to the Neiman Marcus holding company directly controlled by Ares and CPPIB and thereby placed the interest out of the reach of Company creditors.Neiman Marcus filed an S-1 in 2015 in anticipation of becoming a public company again; however, the registration statement was withdrawn due to weak investor demand.Although Neiman Marcus’ common shares had not been publicly traded since 2005, the Company filed with the SEC because its debt was registered. During June 2019, the Company deregistered upon an exchange of new notes and preferred equity for the registered notes. S&P described the restructuring as a selective default because debt investors received less than promised with the original securities.Review of FinancialsFigure 1 below presents a recent summary of the company’s financial performance and position one year prior to the bankruptcy filing. Of note is the extremely high debt burden that equated to 12.4x earnings before interest taxes, depreciation, and amortization (“EBITDA”) for the last twelve months (“LTM”) ended April 27, 2019. Although definitions vary by industry, federal banking regulators consider a company to be “highly levered” if debt exceeds EBITDA by 6x.Moody’s downgraded the Company’s corporate credit rating to B3 from B2 in October 2013 with the acquisition by Ares and CPPIB. Moody’s also established an initial rating of Caa2 for unsecured notes issued to partially finance the acquisition. By the time the notes were deregistered, Moody’s had reduced the corporate rating to Caa3 and the notes to Ca.Moody’s defines Caa as obligations that “are judged to be of poor standing and are subject to very high credit risk,” and Ca as obligations that are “highly speculative and are likely in, or very near, default, with some prospect of recovery in principal and interest.”
Neiman Marcus has struggled with a high debt load since the first LBO in 2005, which has been magnified by the disruptive impact that online retailing has had on department stores. EBITDA declined from $665 million in FY2015 to $400 million in the LTM period ended April 27, 2019; the EBITDA margin declined by over a third from 13.1% to 8.5%, over the same time. By April 2019, debt equated to 12.4x LTM EBITDA and covered interest expense by 1.2x.
By way of reference, the debt/EBITDA and EBITDA/interest ratios for Ralph Lauren (NYSE: RL) for the fiscal year ended March 30, 2019, were 1.0x and 47.1x, while the respective ratios for Dillard’s (NYSE: DDS) were 1.2x and 9.9x for the fiscal year ended February 2, 2019.
At the time of bankruptcy, Neiman Marcus generated about one-third of its sales (about $1.5 billion) online. MyTheresa generated approximately $500 million of this up from $238 million in 1Q17 when certain subsidiaries that held MyTheresa were designated “unrestricted subsidiaries” by the Company. While MyTheresa’s sales increased, the legacy department store business declined as the Company struggled to connect with younger affluent customers who favored online start-up boutiques and had little inclination to shop in a department store.
As shown in the chart below, ecommerce sales as a portion of total retail sales have doubled over the last five years to about 12% in 2019. The move to work from home (“WFH”) and social distancing practices born of COVID-19 in early 2020 have accelerated the trend such that the pre-COVID-19 projection of e-commerce sales rising to 15% by 2020 will likely prove to be significantly conservative.
Bankruptcy FilingNeiman Marcus filed on May 7, 2020 for chapter 11 bankruptcy protection. The COVID-19 induced shutdown of the economy was the final nail in the coffin, which forced major furloughs and the closing of its stores in accordance with various local shelter-in-place regulations. Other recent retail bankruptcies include Lord & Taylor, Men’s Warehouse, Ann Taylor, Brooks Brothers, Lucky Brands, J. Crew with many more expected to file.The initial plan called for creditors to convert $4 billion of $5 billion of debt into equity. The plan does not provide for mass store closures or asset sales, although the Last Call clearance stores will close.As noted, the bankruptcy filing follows a restructuring in June 2019 that entailed:An exchange of all but $137 million of $960 million of 8.0% cash pay and $656 million of 8.75%/9.50% PIK Toggle unsecured notes for $1.2 billion of (i) 8.0% and 8.75% third lien Company notes and (ii) $250 million of Series A preferred equity in MyT Holding Co., a US-based entity that holds the German corporate entity that operates MyTheresa;The issuance of $550 million of new second-lien 6% cash pay/8.0% PIK notes due 2024 with a limited senior secured claim of $200 million from MyT Holding Co. and other MyT affiliates;A partial paydown of the first-lien term loan facility at par with the proceeds of the second lien notes; andAn exchange for the remaining $2.2 billion first-lien credit facility with a new facility and an extension of the maturity to October 2023.
The restructuring did not (apparently) materially impact the Company’s $900 million asset-based credit facility of which $455 million was drawn as of April 2019; or the first lien $125 million debentures due in 2028.
As shown in Figure 4, market participants assigned little value to the $1.2 billion of third lien notes that were trading for around 8% of par when the bankruptcy filing occurred and 6% of par in late August 2020.
The binding Restructuring Support Agreement (“RSA”), dated May 7, 2020, included commitments from holders of 99% of the Company’s term loans, 100% of the second line notes, 70% of the third line notes, and 78% of the residual unsecured debentures to equitize their debt. Also, certain creditors agreed to backstop $675 million in debtor-in-possession (“DIP”) financing and to provide $750 million of exit financing which would be used to refinance the DIP facility and provide incremental liquidity.
DIP financing is often critical to maintain operations during the bankruptcy process when the company has little cash on hand. DIP financing is typically secured by the assets of the company and can rank above the payment rights of existing secured lenders. DIPs often take the form of an asset-based loan, where the amount a company borrows is based on the liquidation value of the inventory, assuring that if the company is unable to restructure, the loan can be repaid from the liquidation of the retailer’s assets.Bankruptcy Path: Chapter 7 vs. Chapter 11Federal law governs the bankruptcy process. Broadly, a company will either reorganize under Chapter 11 or liquidate under Chapter 7.A Chapter 7 filing typically is made when a business has an exceedingly large debt combined with underlying operations that have deteriorated such that a reorganized business has little value. Under Chapter 7, the company stops all operations. A U.S. bankruptcy court will appoint a trustee to oversee the liquidation of assets with the proceeds used to pay creditors after legal and administrative costs are covered. Unresolved debts are then “discharged”, and the corporate entity is dissolved.Under Chapter 11, the business continues to operate, often with the same management and board who will exert some control over the process as “debtor in possession” operators. Once a Chapter 11 filing occurs, the debtor must obtain approval from the bankruptcy court for most decisions related to asset sales, financings, and the like.Most public companies and substantive private ones such as Neiman Marcus file under Chapter 11. If successful, the company emerges with a manageable debt load and new owners. If unsuccessful, then creditors will move to have the petition dismissed or convert to Chapter 7 to liquidate.Most Chapter 11 filings are voluntary, but sometimes creditors can force an involuntary filing. Normally, a debtor has four months after filing to propose a reorganization plan. Once the exclusivity period ends creditors can propose a competing plan.Usually, the debtor continues to operate the business; however, sometimes the bankruptcy court will appoint a trustee to oversee the business if the court finds cause to do so related to fraud, perceived mismanagement and other forms of malfeasance.The U.S. Trustee, the bankruptcy arm of the Justice Department, will appoint one or more committees to represent the interests of the creditors and stockholders in working with the company to develop a plan of reorganization. The trustee usually appoints the following:The “official committee of unsecured creditors”Other creditors committee representing a distinct class of creditors such as secured creditors or subordinated bond holders; andStockholders committee.
Once an agreement is reached it must be confirmed by the court in accordance with the Bankruptcy Code before it can be implemented. Even if creditors (and sometimes stockholders) vote to reject the plan, the court can disregard the vote and confirm the plan if it believes the parties are treated fairly.
Neiman Marcus pursued a “prepackaged” or “prepack” Chapter 11 in which the company obtained support of over two-thirds of its creditors to reorganize before filing. Under the plan, the Company would eliminate about $4 billion of $5.5 billion of debt. The creditors also committed a $675 million DIP facility that will be replaced with a $750 million facility once the plan is confirmed by the court.The Role of Valuation in BankruptcyValuation issues are interwound in bankruptcy proceedings, especially in Chapter 11 filings when a company seeks to reorganize. Creditors and the debtor will hire legal and financial advisors to develop a reorganization plan that maximizes value and produces a reorganized company that has a reasonable likelihood of producing sufficient cash flows to cover its obligations.There are typically three valuation considerations for companies restructuring through Chapter 11 Bankruptcy.Companies must prove that a Chapter 11 Restructuring is in the “best interest” of its stakeholders;A cash flow test must prove that post-reorganization the debtor will be able to fund obligations; and,“Fresh Start Accounting” must be adopted in which the balance sheet is restated to fair value.
Sometimes as is the case with Neiman Marcus there is a fourth valuation-related issue that deals with certain transactions that may render a company insolvent.
Fraudulent ConveyanceA side story to Neiman Marcus relates to the 2018 transaction in which the shares of MyTheresa were transferred in 2018 to bankruptcy-remote affiliates of PE owners Ares and CPPIB. Under U.S. bankruptcy law, transferring assets from an insolvent company is a fraudulent transaction.During 2017, Neiman Marcus publicly declared the subsidiaries that held the shares were “unrestricted subsidiaries.” Once the distribution occurred in September 2018, creditors litigated the transaction. All but one (Marble Ridge) settled in 2019 as part of the previously described debt restructuring.Since the bankruptcy filing occurred, the unsecured creditors commissioned a valuation expert to review the transaction to determine whether Neiman Marcus was solvent as of the declaration date, immediately prior to the distribution and after the distribution. As shown in Figure 5, the creditors’ expert derived a negative equity value on all dates. If the court accepted the position, then presumably Ares and CPPIB would be liable for fraudulent conveyance.At the time the distribution occurred, Neiman Marcus put forth an enterprise valuation of $7 billion and relied upon the opinion of two national law firms that it was within its rights to execute the transaction. Since filing, the PE owners have commissioned one or more valuation experts whose opinion has not been disclosed.
On July 31, 2020, the committee of unsecured creditors and the Company reached a settlement related to the fraudulent conveyance claims arising from the MyTheresa transaction. Ares and CPPIB agreed to contribute 140 million MyTheresa Series B preferred shares, which represent 56% of the B class shares, to a trust for the benefit of the unsecured creditors. The Company also agreed to contribute $10 million cash to the trust. A range of value for the series B shares of $0 to $275 million was assigned in a revised disclosure statement filed with the bankruptcy court.
Marble Ridge, which served on the committee, did not view the settlement as sufficient as was the case in 2019 when it did not participate in the note exchange as part of the 2018 litigation settlement.
During August, it became known that Marble Ridge founder Dan Kamensky pressured investment bank Jeffrey’s not to make a bid for the shares that were to be placed in a trust because it planned to bid, too (reportedly 20 cents per share compared to 30 cents or higher by Jeffrey’s). The anti-competitive action was alleged to have cost creditors upwards of $50 million. Marble Ridge subsequently resigned from the creditors committee and announced plans to close the fund. Kamensky was arrested on September 7th and charged with securities fraud, extortion, wire fraud, extortion, and obstruction of justice, according to the U.S. Attorney’s Office for the Southern District of New York.
Best Interest TestA best interest test must show that the reorganization value is higher than the liquidation value of the company, to ensure that the creditors in Chapter 11 receive at least as much under the restructuring plan as they would in a Chapter 7 liquidation.
In the case of Neiman Marcus, the liquidation vs. reorganization valuation analysis was a formality because most unsecured creditors and the Company agreed to a prepackaged plan subject to resolution of such items as the MyTheresa shares. Nonetheless, we summarize both for illustration purposes.
Liquidation AnalysisA rough calculation of Neiman Marcus’ liquidation value is included below, based on balance sheet data from April 2019 as these are the most current figures available.
Substantial value in a liquidation analysis depends upon what an investor would be willing to pay for the rights to the Neiman Marcus name as well as its customer lists and proprietary IP code. The recovery ratio applied to Neiman Marcus’ inventory is higher than expected recovery ratios across the broader apparel industry since much of Neiman’s inventory is designer goods. Nonetheless, the analysis implies creditors would face a significant haircut in a Chapter 7 liquidation scenario.
Reorganization (Going Concern) AnalysisThe reorganization value represents the value of the company once it has emerged as a going concern from Chapter 11 bankruptcy. Typically, the analysis will develop a range of value based upon (i) Discounted Cash Flow (“DCF”) Method; (ii) Guideline Public Company Method; and (iii) Guideline Transaction Method.Both guideline methods develop public company and M&A “comps” to derive representative multiples to apply to the subject company’s earnings and cash flow. Market participants tend to focus on enterprise value (market value of equity and debt net of cash) in relation to EBITDA. Secondary multiples include enterprise value in relation to EBIT, EBIT less ongoing Capex, and revenues.As it relates to Neiman Marcus, we note that Lazard Freres & Co. (“Lazard”) as financial advisor focused on adjusted EBITDA for the LTM period ended February 1, 2020 and the projected 12 months ended February 1, 2022. In doing so, Lazard looked past 2020 and 2021 as excessively abnormal years due to the COVID19 induced recession. Our observation is that this treatment (for now) is largely consistent with how many market participants are treating various earning power measures in industries that were severely impacted by the downturn.A DCF analysis for Neiman Marcus that assumes the Company emerges from bankruptcy in the fall of 2020 will incorporate the impact of the adverse economy as reflected in presumably subpar operating performance in the first year or two of the projections. More generally, the DCF method involves three key inputs: the forecast of expected future cash flows, terminal value, and discount rate.Forecast of Expected Future Cash Flows: Valuation practitioners typically develop cash flow forecasts for specific periods of time, ranging anywhere from three to ten years, or as many periods as necessary until a stable cash flow stream can be realized. Key elements of the forecast include projected revenue growth, gross margins, operating costs, and working capital and capital expenditure requirements. Data from other publicly traded companies within similar lines of business can serve as good reference points for the evaluation of each element in the forecast.Terminal Value: The terminal value represents all cash flow values outside of the discrete forecast period. This value is calculated through capitalizing cash-flow at the end of the forecast period, based on expectations of long-term cash flow growth rate and discount rate. Alternatively, a terminal value can be determined through the application of projected or current market multiples.Discount Rate: The discount rate is essential in estimating the present value of forecasted cash flows. A proper discount rate is developed from assumptions about costs of equity and debt capital, and capital structure of the new entity. For costs of equity capital, a build-up method is used with long-term risk-free rate, equity premia, and other industry/company-specific factors as inputs. Cost of debt capital and new capital structure can be based on benchmark rates or comparable corporations. The discount rate should reflect the financial risks that come with the projected cash flows of the restructured entity.
The sum of the present values of all forecasted cash flows indicates the enterprise value of the emerging company for a set of forecast assumptions. Reorganization value is the total sum of expected business enterprise value and proceeds from the sale or disposal of assets during the reorganization.Cash Flow TestThe second valuation hurdle Neiman Marcus will have to jump is a cash flow test. The cash flow test determines the feasibility of the reorganization plan and the solvency of future operations. Since a discounted cash flow analysis is typically used to determine reorganization value, the projected cash flows from this analysis are compared to future interest and principal payments due.Additionally, the cash flow test details the impact of cash flows on the balance sheet of the restructured entity, entailing modeling changes in the asset base and in the debt obligations of and equity interests in the company. Therefore, the DCF valuation and cash flow tests go together because the amount of debt that is converted to equity creates cash flow capacity to service the remaining debt. If the cash flow model suggests solvent operations for the foreseeable future, the reorganization plan is typically considered viable.Fresh-Start AccountingWhen emerging from bankruptcy in the case of going concern, fresh-start accounting could be required to allot a portion of the reorganization value to specific intangible assets. The fair value measurement of these assets requires the use of multi-period excess earnings method or other techniques of purchase price allocations.ConclusionNeiman Marcus plans to eliminate about $4 billion of over $5 billion of debt and $200 million of annual interest expense in a reorganization plan that was approved by U.S. bankruptcy judge David Jones in early September. The plan will transfer the bulk of ownership to the first lien creditors, including PIMCO, Davidson Kempner Capital Management and Sixth Street Partners. PIMCO will be the largest shareholder with three of seven board seats.Other creditors will receive, in effect, a few pennies to upwards of one-third of what they were owed depending in part on the value of MyTheresa Class B preferred shares that were contributed to a trust for the benefit of unsecured creditors. Also, the Company’s term loan lenders, second lien and third lien note holders waived their right to assert deficiency claims and thereby eliminated upwards of $3.3 billion of additional claims in the general unsecured claims pool (now limited to $340 to $435 million).Lazard estimated the value of the reorganized Company upon exit from bankruptcy to approximate $2.0 billion to $2.5 billion on an enterprise basis with the equity valued at $800 million to $1.3 billion.Creditors and the Company negotiated a plan that has presumably maximized (or nearly so) value to each creditor class based upon the priority of their claims. We are not privy to the analysis each class produced and how their views of the analyses, relative negotiating strength and the like drove the settlement.Ultimately, the performance of the reorganized Neiman Marcus will determine the eventual amount recovered by creditors to the extent shares are not sold immediately. Some creditors would be expected to sell the shares immediately, while others who have flexibility to hold equity interests and have a favorable view of the reorganized company’s prospects may wait to potentially realize a greater recovery.In Figure 9 we have constructed a waterfall analysis which we compare with the actual settlement. We assume a range of enterprise values based upon multiples of projected FY22 EBITDA, or $342 million, and compare the residual equity after each claimant class is settled to provide perspective on the creditors’ recovery.This waterfall implies that class 5 through 7 debt, which for our purposes here is more or less pari passu, should receive the bulk if not all of the equity given $2.4 billion of debt owed to the three classes. Because ~10% of the equity was allocated to subordinated creditors, the senior lenders may have been willing to cede some ownership in order to reach a settlement more quickly.Per the settlement, ~90% of the equity was allocated to the 2019 senior secured term loan (~$2.3 billion; 87.5%), 2013 residual senior secured loan ($13 million) and first lien debentures ($129 million; 2.8%).Recovery for the 2019 senior secured creditors was estimated in the Disclosure Statement to approximate 33% compared to about 19% for the first lien debentures.Interests in MyTheresa also impacted projected recoveries for the junior and unsecured creditors, a byproduct of the litigation to settle the fraudulent conveyance claims related to the 2018 transaction.The second lien noteholders ($606 million) would obtain (i) 1.0% equity interest; (ii) seven-year warrants to purchase up to 25% of the reorganized equity at an agreed upon strike price; (iii) participation rights in the exit loan and associated fees; and (iv) an economic interest in MyTheresa in the form of $200 million of 7.5% PIK notes.The disclosure statement indicates the recovery equates to less than 2% of what is owed to the second lien note holders, which appears to exclude whatever value is attributable to the PIK notes because 1% of the Newco equity would equate to $800 thousand to $1.3 million of value based upon a range of equity value of $800 million to $1.3 billion.1The third lien noteholders ($1.3 billion) would obtain (i) 8.5% equity interest; (ii) participation rights in the exit loan and associated fees; and (iii) a 50% economic and 49.9% voting interest in the common equity of MyTheresa.The disclosure statement indicates the recovery to be 5.6% of the claim, which also appears to exclude the value of the MyTheresa common shares if the equity interest is equal to $68 million to $110 million based upon an aggregate equity value of $800 million to $1.3 billion.The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors.The final wrinkle in the disputed MyTheresa saga involved an agreement reached in late July 2020 in which Ares and CPPIB agreed to allocate 140 million (56%) MyTheresa Series B preferred shares to a trust established for unsecured creditors. Neiman Marcus as debtor also agreed to contribute $10 million cash to the trust.At the time the settlement was announced in late July, the value attributed to the preferred shares was $162 million; however, the August 3 Disclosure Statement assigned a range of value of $0 to $275 million. Marble Ridge reportedly had planned to bid 20 cents per share to provide certain unsecured creditors (e.g. unpaid vendors) immediate liquidity before the fracas with Jeffrey’s occurred.
Neiman Marcus emerged from Chapter 11 by September 30, 2020 in a streamlined process via the prepackaged negotiations that will leave the Company with significantly less debt in its capital structure. As outlined in this article, valuation is an important factor in the bankruptcy process.
1 The issuance of $200 million of PIK notes and transfer of 50% of the common equity interest in MyTheresa to the second and third lien noteholders appears to be a result of the 2019 debt restructuring and settlement of the 2018 litigation surrounding the 2018 transfer of MyTheresa to the parent company and out of the reach of creditors.
2 The projected 1.4% recovery rate for the second lien notes apparently excludes the MyTheresa PIK notes, while the projected 5.6% recovery rate for the third lien notes likewise appears to exclude the 50% common equity interest in MyTheresa.
Bakken Production Has Rebounded, But Operating Challenges Remain Acute
The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production declined approximately 16% year-over-year through September, in line with the Eagle Ford, though worse than production declines seen in the Permian (down approximately 5%) and Appalachia (essentially flat). However, the Bakken has rebounded strongly from production lows observed in May following April’s historic rout in crude oil prices. The Bakken was particularly impacted by production curtailments, driven in part by higher pricing differentials given the basin’s location, higher breakeven prices, and the fact that most operators in the basin have diverse operations, giving them optionality as to where to curtail production while being able to maintain cash flow necessary for near-term obligations (unlike pure-play counterparts).
The rig count in the Bakken stood at 10 as of September 18, down over 80% from the prior year. Only the Eagle Ford has seen a more severe drop in rigs, with the rig count declining by more than 86% during the same period. While swift, the decline has stabilized. The Bakken’s rig count has ranged between 9 and 11 rigs during the third quarter. However, a meaningful increase in rigs is unlikely given reduced capex budgets.
Commodity Prices Stabilize, Though Uncertain Demand Dynamics RemainThe third quarter of 2020 was relatively quiet for commodity prices, with near-term WTI futures prices oscillating around $40/bbl. Natural gas prices, which avoided crude oil’s steep declines in April, have generally been trending higher. Part of that relates to a reduction of associated gas production driven by lower oil production activity, as well as some regular seasonality as winter approaches.
We note that CapitalIQ has revised the default futures contracts utilized for historical commodity pricing in order to make the output more reasonable. (Hence the lack of negative prices shown in the preceding chart.) As such, the information shown may not tie to previous analyses.
However, there is still considerable uncertainty around future demand, both near-term and long-run. While resuming economic activity has spurred an increase in consumption, changing travel habits and concerns around a potential surge of COVID-19 cases during the upcoming traditional flu season have clouded experts’ ability to make projections. In the longer-run, BP’s 2020 Energy Outlook expects global liquid fuels consumption to peak by 2030 under a “business as usual” scenario. Under scenarios assuming more aggressive policy measures to reduce carbon emission, BP’s analysis suggests that liquid fuels consumption peaked in 2019 and will continue to trend downward.
Financial PerformanceWith Whiting’s restructuring (discussed in a subsequent section), the Bakken-focused peer group with meaningful historical trading activity has become quite small. Continental Resources is down approximately 57% year-over-year, though that isn’t much worse than the overall exploration & production sector (as proxied by XOP, which is down 51% over the same period). Oasis Petroleum’s stock price has declined by approximately 88% over the past year and the company has warned of a potential bankruptcy filing.
We note that neither company is pure-play Bakken, as Continental has a sizeable acreage position in Oklahoma’s SCOOP/STACK, and Oasis has operations in the Permian as well. Other publicly traded Bakken operators, including ExxonMobil, Marathon Oil, Hess, EOG, Ovintiv, ConocoPhillips, and QEP, also have diverse operations outside the basin. Northern Oil & Gas, which has traditionally focused on owning non-operating working interests in the Bakken, has expanded outside the basin with acquisitions in the Permian.
Equinor, which entered the Bakken with its $4.7 billion acquisition of Brigham Exploration, announced that it is halting all U.S. shale drilling and well completion activity.
The lack of a pure-play Bakken peer set makes it difficult to draw conclusions specific to the basin, but is also a telling fact about the difficult operating conditions in the area.
Whiting Emerges, Oasis Potentially to Enter BankruptcyWhiting Petroleum, which announced its Chapter 11 reorganization process in April, emerged from bankruptcy in September. The reorganization process allowed Whiting to reduce its debt load by more than $3 billion, from over $3.4 billion to just $425 million. While shareholders were able to avoid being completely wiped out, the restructuring was extremely dilutive. Legacy shareholders now own approximately 3% of the equity of the new entity.Oasis Petroleum announced it skipped an interest payment due September 15. That puts the company in a 30-day grace period in which it can continue to negotiate with lenders regarding a restructuring. Oasis has been reviewing strategic alternatives with advisors, including “a recapitalization transaction with a third-party capital provider; restructuring of the Company’s existing debt either through an out-of-court process or under Chapter 11 of the Bankruptcy Code; or other strategic transaction.”Dakota Access Pipeline Under Siege AgainEnergy Transfer’s Dakota Access Pipeline (“DAPL”), which was the subject of protests in 2016 and 2017, is under renewed legal action. The pipeline, which was instrumental in helping minimize pricing differentials in the land-locked Bakken relative to other basins, has the capacity to transport 570 mbbl/d of crude oil from the Bakken to a hub in Illinois, with connections to pipelines serving refining markets in the Midwest and Gulf Coast.In July, a judge ruled that DAPL must be shut down and emptied by August 5, pending an environmental review by the Army Corps of Engineers. A U.S. appeals court reversed the shutdown order in August, though the requirement for the environmental review is still under appeal. Based on the current trial schedule, DAPL’s should be able to continue operating through at least late December before a federal court could mandate another shutdown.Despite the renewed legal scrutiny, Energy Transfer is pushing forward with an expansion plan which would roughly double DAPL’s capacity. The additional capacity is expected to come online in the third quarter of 2021.ConclusionThe Bakken was hit the hardest by curtailments driven by low commodity prices, but has also seen the sharpest rebound in production. Whiting’s successful restructuring should add stability to the basin, but Oasis may take its place shortly in the bankruptcy courts. While operating conditions are difficult across the U.S., the stress appears quite acute in the Bakken.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
How Growing RIAs Should Structure Their Income Statement (Part I)
Compensation Conundrums
Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves). We’ll devote the next two posts to discussing best practices from an outsider’s perspective.The Scope of Compensation Costs for RIA FirmsAccording to Schwab’s 2020 Compensation Report, median compensation costs are 70% of revenue for firms with over $100 million in assets under management. We were a bit surprised by these findings since most publicly traded RIAs are in the 40% to 50% range, and our clients are typically in the 50% to 60% category, but these firms are usually larger than the median RIA in the Schwab study. There is also significant variation in these measures depending on the location, type of RIA, and how the owners choose to compensate themselves.The study reported that 76% of RIAs are planning to hire in the next twelve months, and 42% of firms recruited from other RIAs in the last year. The report also noted that 73% of these acquiring firms share equity with non-founders, suggesting that stock incentives are also part of the overall compensation package for the senior management group.
[caption id="attachment_33740" align="alignnone" width="910"]Source: Schwab’s 2020 Compensation Report[/caption]
The Compensation Conundrum for Newly Formed RIAsThis data illustrates the importance of a compelling compensation strategy for growing RIAs looking to recruit from other firms and retain talent. Newly formed RIAs don’t typically have the resources to offer higher base salaries and will often consider filling the void with stronger equity or equity-like incentives. While equity participation is especially lucrative for high growth firms with greater upside potential, partners of newly formed RIAs are generally hesitant to dilute their ownership.Equity offerings can be problematic for growing or newly formed RIAs whose principals do not take a salary or bonus from the business. While this structure makes sense in states with high income taxes, it overstates profitability and, if not remedied, would overstate income distributions to current (and prospective) owners.Over the next two posts we will delve into these two common compensation conundrums for RIAs:How to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner.
In this post, we address the first problem.Income (Not Equity) Partners Compensation is always a tricky issue, but the situation is especially complicated for RIAs as employees are typically able to estimate the profits of the company and compare their compensation to overall firm profits.Consider an RIA with two owners and two employees. The two employees know that the firm manages $250 million and estimate that the firm’s effective fees are 85 basis points, so they calculate that the firm likely generates $2,125,000 in annual revenue. By estimating overhead expenses and subtracting their own salaries, they surmise that the two owners/employees take home around $1.5 million, in aggregate.
The two employees know they are paid well but also feel they should be rewarded for their part in the success of the company. The two owners, on the other hand, took a lot of risk starting their own business and feel they deserve to be compensated for their investment. They also want their employees to feel that they are being treated fairly.
What do the owners do?
When principals at RIAs are not ready to dilute their ownership in the business, they can structure compensation such that their employees are income-partners (but not actual equity partners). If you structure employee compensation to include a base salary and a bonus that is determined as a percent of company profits then your employees have the opportunity to participate directly in the upside of your business, without diluting your ownership positions.
As shown in the adjusted model below, the owner’s take home pay did not change significantly; however, the employees are now directly compensated based on the profitability of the firm.
Tying a new hires’ compensation to firm profitability is usually good practice but may be too costly if the shareholders aren’t paying themselves a salary and bonus. In the proposed model above, the partners increase their base salary to better align company profits with industry norms.
We will dig deeper into this idea next week.
Family Business Director's Planning for Estate Taxes To-Do List
Family business leaders cannot afford to ignore estate taxes. While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay estate taxes without some action on the part of the company. The required actions may range from a shareholder loan to a special dividend to sale of the business. As we’ve noted numerous times in the past few months, there are good reasons to focus on estate planning right now.The fair market value of many family business ownership interests is depressed because of the negative impact of the pandemic.Applicable federal rates are quite low, which increases the effectiveness of many of the more sophisticated estate planning techniques.Political uncertainty is high, and the Biden campaign has indicated that estate tax reform would be a priority if elected.
In this week’s post, we provide a to-do list of important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises resulting from the estate tax.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry. Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability? Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers. If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here). You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support. You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value. If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest. Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value. In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public. Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest. In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business. If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest. Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post.
We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better. This belief is short-sighted and potentially costly. For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable. Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions. The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory. While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseWith the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved. Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations? If so, does the family business have the financial capacity to support such activities? The most advantageous time to secure financing commitments from lenders is before you need the money. What is the risk that an estate tax liability could force the sale of the business as a whole? If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business. If there was no estate tax, what evolution in share ownership would be most desirable for your family and business? The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions. Give one of our professionals a call to help you get started on knocking out your to-do list today.
M&A in the Bakken
Immense Drop in Deal Activity Due to COVID Concerns
Over the past several years, the Bakken has generally had much lighter acquisition and divestiture activity than other major basins in the United States. Given that deal activity across the energy sector has dropped an immense 42.7% over the past year, acquisition and divestiture activity has dropped even further in this basin over the past year.Observed deal activity has largely been the result of Northern Oil and Gas growing its production base in the area during the past several years.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Northern Oil and Gas Continues Core Acreage BuildoutNorthern Oil has constituted approximately two-thirds of the observed deal activity (based on disclosed deal value) in the basin, including its bolt on acquisitions in June and August 2020 for several hundred acres. This activity furthers Northern Oil’s mission of building out its core position in non-operating interests through consistent, strategic acquisitions.Although production is down across the country, wells are slowly beginning to come back online, and Northern Oil believes increasing inventory while pricing is advantageous should drive returns in the future.According to Northern COO Adam Dirlam, “We continue to add to our core inventory. Record levels of wells-in-process should drive strong volumes, and improve upon our return on capital employed metrics in 2021 and beyond.”Since the start of 2018, the company has made six large publicly announced transactions totaling more than $820 million, including its large acquisition of private equity-backed Flywheel Energy LLC in April 2019.Below is a map of Northern Oil’s acreage to show its overall footprint in the basin.[caption id="attachment_33656" align="aligncenter" width="489"]Source: Northern Oil & Gas September 2020 Investor Presentation[/caption]
ConclusionThe energy industry in Q1 and Q2 2020 has seen extreme volatility that has had investors and operators alike remaining cautious and waiting to see what happens next. As a result, acquisition and divestiture activity has been put on the back burner as companies struggle to plan ahead while remaining solvent.As we have moved from the second quarter to the third quarter, fundamentals in the Bakken have steadily improved as crude oil pipeline and storage limitations were alleviated. Stabilization of WTI pricing and well differentials in the region over the past couple of months have also aided as well. Companies like Northern Oil look towards the future as demand begins to creep upward from its mid-year lows, and the company has taken advantage of lower pricing to accrete acreage to its core position.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Does Personal Goodwill Apply to Auto Dealerships?
Observations from Recent Litigation Engagements
The concept of personal goodwill was a common topic in several recent auto dealer litigation cases. Not only is the presence (or not) of personal goodwill in a business, no matter the industry, hotly debated, but so is the quantification of that personal goodwill. However, I think the most important question to ask is “does it exist?” Often with ambiguous concepts like personal goodwill, the adage “you know it when you see it” is the most appropriate answer.What Is Personal Goodwill?Personal goodwill is value stemming from an individual’s personal service to a business and is an asset that tends to be owned by the individual, not the business itself. Personal goodwill is part of the larger bucket of an intangible asset known as goodwill. The other portion of goodwill, referred to as enterprise or business goodwill, relates to the intangible asset involved and owned by the business itself.[1]Commercial and family law litigation cases aren’t typically governed by case law resulting from Tax Court matters and can differ by jurisdiction, but Tax Court decisions offer more insight into defining the conditions and questions that should be asked in an evaluation of personal goodwill. One seminal Tax Court case on Personal Goodwill is Martin Ice Cream vs. Commissioner.[2] Among the Court’s discussions and questions to review were the following:Do personal relationships exist between customers/suppliers and the owner of a business?Do these relationships persist in the absence of formal contractual relationships?Does an owner’s personal reputation and/or perception in the industry provide intangible benefit to the business?Are practices of the owner innovative or distinguishable in his or her industry, such as the owner having added value to the particular industry?
Another angle with which to evaluate the presence of personal goodwill, specifically to professional practices, is provided in Lopez v. Lopez.[3] Lopez suggests several factors that should be considered in the valuation of professional (personal) goodwill as:The age and health of the individual;The individual’s demonstrated earning power;The individual’s reputation in the community for judgment, skill, and knowledge;The individual’s comparative professional successThe nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.Why Is Personal Goodwill Important?Many states identify and distinguish between personal goodwill and enterprise goodwill. Further, numerous states do NOT consider personal goodwill of a business to be a marital asset for family law cases. For example, a business could have a value of $1 million, but a certain portion of the value is attributable and allocated to personal goodwill. In this example, the value of the business would be reduced for personal goodwill for family law cases and the marital value of the business would be considered at something less than the $1 million value.How Applicable/Prevalent Is Personal Goodwill in the Auto Dealer Industry?Readers of this space know that in any writing pertaining to litigation matters, we always try to avoid the absolutes: always and never. The concept of personal goodwill is easier identified and more prevalent in service industries such as law practices, accounting firms, and smaller physician practices. Does that mean it doesn’t apply to more traditional retail and manufacturing industries? In each case, I think the fundamental question that should be first answered is “Is this an industry or company where personal goodwill could be present?”For the auto dealer industry, the principal product, outside of the service department, is a tangible product – new and used vehicles. In order for personal goodwill to be present in this industry, the owner/dealer principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business.Name of Owner/Dealer in the Name of the BusinessWe are all familiar with regional dealerships possessing the name of the owner/dealer principal in the name of the business. However, just having the owner's name as part of the business name does not signify the presence of personal goodwill. An examination of the customer base would be needed to justify personal goodwill.It would be more difficult to argue that customers are purchasing vehicles from a particular dealership only for the name on the door, rather than the more obvious factors of brands offered, availability of inventory, convenience, etc. An extreme example might be having a recognized celebrity as the name/face of the dealership, but even then, it would be debated how that materially affects sales and success."... just having the owner's name as part of the business name does not signify the presence of personal goodwill."Auto dealers attempt to track performance and customer satisfaction through surveys, which could provide an avenue to determine this value (if for example factors that influenced the decision to buy listed Joe Dealer as being their primary motivation) though this is still unlikely and would be subject to debate.Another consideration of the impact of a dealer’s name on the success/value of the business would be how actively involved is the owner/dealer principal and how directly have they been involved with the customer in the selling process. Simply put, there should be higher bars to clear than just having the name in the dealership for personal goodwill to be present.In more obvious examples of personal goodwill in professional practices, the customer usually interacts directly with the owner/professional such as with the attorney or doctor in our previous examples. How often does the customer of an auto dealership come into contact or deal directly with the owner/dealer principal, or do they generally engage with the Salespeople, Service Manager, or General Manager?Presence of an Employment AgreementAnother factor that often helps identify the existence of personal goodwill is the presence of an employment agreement and/or non-compete agreement.The prevailing thought is that an owner of a business without these items would theoretically be able to exit the business and open a similar business and compete directly with the prior business. Neither of these items typically exist with an owner of an auto dealership. However, owners of auto dealerships must be approved as dealer principals by the manufacturer."Another factor that helps identify the existence of personal goodwill is an employment agreement and/or non-compete agreement."The transferability of a dealer principal relationship is not guaranteed, and certainly, an existing dealer principal would not be able to obtain an additional franchise to directly compete with an existing franchise location of the same manufacturer for obvious Area of Responsibility (AOR) constraints.So, does the fact that most dealer principals don’t have an employment or non-compete agreement signify that personal goodwill must be present? Not necessarily. Again it relates back to the central questions of whether an owner/dealer principal is directly involved in the business, has a unique set of skills that contributed to a heightened success of the business, and does that owner/dealer principal have a direct impact on attracting customers to their particular dealership that could not be replicated by another individual.ConclusionsPersonal goodwill in an auto dealership can become a contested item in a litigation case because it can reduce the value consideration. As much as the allocation, quantification, and methodology used to determine the amount of personal goodwill will come into question, several central questions should be examined and answered before simply jumping to the conclusion that personal goodwill exists.The difference in valuation conclusions between experts in litigation matters generally falls within the examination and support of the assumptions that lead to differences in conclusions. If present, personal goodwill for an auto dealership must exist beyond just having the owner’s name in the title of the business or the existence of an employment agreement.The existence and determination of personal goodwill can be a complicated topic. For more information or to discuss an issue in confidence, please don't hesitate to contact me.[1] In the Auto Dealer industry, goodwill and other intangible assets are referred to as Blue Sky value.[2]Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).[3] In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).
The Evolving Landscape for Family Capital
Two Developments That Will Affect Family Businesses
One of the hallmarks of family business has been the deliberate accumulation of capital over many years. Two recent developments indicate that the landscape for family capital may be evolving, albeit slowly.Who Now Qualifies as an Accredited Investor?On August 26, 2020, the Securities and Exchange Commission relaxed long-standing rules defining who qualifies as an accredited investor. This is significant because only accredited investors can invest in privately placed securities. Since private issuers are not subject to the same disclosure requirements as public issuers, the SEC limits such issues to investors who are presumed to have a degree of financial sophistication and the ability to bear the financial risks that accompany illiquid investments with potentially long holding periods.One of the stated purposes of the rule change is to promote capital formation for smaller businesses. The practical minimum size threshold for a public securities offering is well out of reach for most family businesses.By loosening the requirements for accredited investors, the rule change increases the number of investors eligible to participate in private offerings.What remains to be seen is whether the larger pool of accredited investors will encourage more family businesses to raise equity capital through private placements. We suspect that only family businesses not having a long-standing aversion to non-family investors will be affected by the rule change.Over the longer-term, however, we will not be surprised if the taboo against non-family capital wanes, and the distinction between private and public companies diminishes.The Long-Term Stock Exchange DebutsThe Long-Term Stock Exchange (“LTSE”) debuted on September 9, 2020. Issuers qualify for listing on the LTSE under a principles-based approach that would appear to align pretty well with family business culture. The LTSE requires listed companies to publish policies around five core principles:Long-term focused companies should consider a broader group of stakeholders and the critical role they play in one another’s success.Long-term focused companies should measure success in years and decades and prioritize long-term decision-making.Long-term focused companies should align executive compensation and board compensation with long-term performance.Boards of directors of long-term focused companies should be engaged in and have explicit oversight of long-term strategy.Long-term focused companies should engage with their long-term shareholders.
As with the change in the accredited investor definition, we suspect that the presence of the LTSE will have little in the way of immediate impact on family businesses.What Do These Two Developments Mean for Family Businesses?If the near-term impact of these two developments is likely to be limited, why bring them up? Because both developments illustrate how attitudes toward family capital are changing, and family business directors need to be thinking about this shift in perspective."... capital markets for family businesses will, over time, look more like public capital markets."In the past, family business leaders could assume that they would enjoy continued access to family capital. In other words, family businesses didn’t always feel the competition for investment capital that other businesses face. Since the business had created the family’s capital, one could safely assume that the business would always have access to that family’s capital to fund operations and new investments.In our view, the loosening of the accredited investor definition and the formation of the LTSE are manifestations of a broader trend, which is that capital markets for family businesses will, over time, look more like public capital markets.The rise of the family office as a source of investment capital for other businesses is the best evidence that families are comfortable looking outside the family business to generate returns on family capital.Just as liquid naturally flows to the lowest point, capital naturally flows to its highest and best use. The viscosity of family capital is high, so it may take longer to move, but it eventually will.3 Things for Family Business Directors to Begin Thinking AboutIn the context of this broader trend, we propose three things for family business directors to begin thinking about.Are there growth opportunities available to your family business for which it would be worth obtaining non-family equity capital? Regulators seem to be focused on making such capital more readily available.Does your family business provide a compelling case for maintaining its allocation of the family’s capital? In other words, does your legacy business generate sufficient returns to prevent family capital from flowing to competing alternatives?What is your family’s overall capital allocation? Does that allocation meet the characteristics, needs, and risk preferences of your family? If you have a family office, does it have a process for identifying and screening potential investments?
These are not simple questions to answer, but it is important to begin thinking about them now.
Themes from Q2 2020 Earnings Calls
Part 2: E&P Operators
As discussed in our quarterly E&P newsletter, the oil & gas industry experienced a volatile path to price stability as COVID-19 and the Saudi-Russia price war took a toll on supply and demand. The road to recovery was apparent late in the quarter and was driven by supply cuts from OPEC+, curtailments by U.S. producers, and an increase in demand. In this post, we capture the key takeaways from E&P operator second quarter 2020 earnings calls.Theme 1: Cost Reductions Expected to PersistOne recurring theme among E&P operators in our prior E&P operator earnings calls quarterly overview included a continued focus on capital discipline. The six E&P operators we track typically characterize this concept as the reduction of operational costs and capital expenditures in the pursuit of increased operational and capital efficiencies. To that effect, all six operators pursued this goal in the second quarter, with most indicating the expectation that a substantial portion of these cost reductions will persist beyond the current environment of suppressed crude oil prices and uncertain projected economic activity.We expect capital efficiencies to increase across both the Bakken and the South in 2020. In the Bakken, we have achieved a 12% reduction to completed well costs. In the South, we've achieved a 10% reduction to our overall South completed well cost. 70% of these reductions are structural in the Bakken, and 80% of these reductions are structural in the South, driven by all aspects of our operations. – William Berry, CEO, Continental Resources, Inc.This flexibility, combined with mature production base and the structural well cost savings we have delivered, underpins our outlook for durable cash flow generation, as we were able to reduce our reinvestment rate, while maintaining production levels in a low-price environment. – Joseph Gatto, President & CEO, Callon Petroleum CompanyDiamondback has further adjusted downward our already low-cost structure and is prepared to operate successfully in a lower-for-longer oil price environment. A lot of the efficiency and cost gains made during this downturn will become permanent and will benefit Diamondback shareholders in a recovery. – Travis Stice, CEO, Diamondback Energy, Inc.When you look at these efficiency gains combined with service cost deflation and a consistent development strategy, we continue to drive down our well costs and drastically improve capital efficiency. As you can see […] we have reduced our well cost by approximately $1.8 million or 20% in the first two quarters of 2020. We believe that approximately 60% of these cost reductions are sustainable. – Joey Hall, Executive Vice President – Permian Operations, Pioneer Natural Resources CompanyTheme 2: Emphasis on Free Cash Flow to Reduce Debt and Reinforce DividendsIn our prior quarterly analysis, we noted that the operators seemed inclined to comment on their priorities moving forward. This was a recurring theme in the Q2 earnings calls. Short of referring to any such commentary as official guidance, most operators still discussed three to five year strategic goals, driven primarily by the growth of free cash flow projected to result from the cost reductions outlined previously. Among the priorities set forth by the operators, the two primary goals cited included debt reduction and providing for attractive dividends to shareholders.As I think about the first half of this year, we've made real progress on several priorities that will position us for the future: maximizing our cash flow by adjusting our spend rate, production and cost structure; increasing the strength of our balance sheet; continuing to return capital to shareholders through our dividend; and managing the oil price volatility with capital discipline, while also preserving our operational capacity. – Tim Leach, Chairman & CEO, Concho Resources Inc.With our reduction in forward capital spending, and expectation for true free cash flow generation at current commodity prices in the second half of 2020 and 2021, we will look to reduce both gross and net debt while continuing to return capital to our shareholders through our base dividend. – Travis Stice, CEO, Diamondback Energy, Inc.Initially we'd be looking to prioritize a bit of debt reduction as we then look to ease back into a base dividend structure. And then, in excess of that, there are a lot of other vehicles that we could consider the variable dividend is one, but certainly even share repurchases is another. I mean, nothing would be off the table. – Lee Tillman, President & CEO, Marathon Oil CompanyTheme 3: Expectation of Little to No Production Growth… MostlyRemarkably, the pursuit of production growth was not presented as an immediate priority by most operators at this time.We were saying essentially that – and early on – that we should not be, as an industry, overproducing into an oversupplied market. – William Berry, CEO, Continental Resources, Inc.Certainly, we're not seeing any signals that growth is needed from Diamondback or from our industry in general. So, growth in today's world is pretty much off the table. – Travis Stice, CEO, Diamondback Energy, Inc.Today, the world simply does not need more of our product. – Lee Tillman, President & CEO, Marathon Oil Company
The exception was Pioneer Natural Resources, which was the only operator that specifically cited a positive production growth rate estimate:We say 5% plus on production growth, some years it maybe 6%, some years it maybe 7%, but we don’t want to just tie to one number based on rig activity, DUC activity, frac fleet activity. We can’t hit 5% every year, so we want the flexibility, some years it maybe 7%, 8%, some years it maybe 4%, some years it maybe 5%, and so we’re just saying 5% plus on production growth over the next several years. – Scott Sheffield, CEO, Pioneer Natural Resources CompanyOn the HorizonThe E&P operator earnings calls broadly paint the picture of a mature industry in uncertain times. The name of the game at this juncture is to shore up the balance sheet, increase efficiencies through capital discipline, and signal resilience by way of free cash flow growth and reinforced dividends to shareholders.However, as these companies stand relatively still as they fortify their positions for sustaining operations over the long-haul, changes and evolution are on the horizon. Most prominently, the U.S. presidential election looms around the corner. There is no indication of a consensus among the E&P operators regarding the likelihood of a regime change, or what changes would likely affect the industry if faced with a Democratic Biden administration.It should also be noted that the majority of the E&P operators have forthcoming formal ESG reports, with most slated to come out later this year. We expect these topics will be featured in our next quarterly review of the E&P operator earnings calls.
Why Your Family Business Has More Than One Value
Due to the popularity of this post, we feature it again this week. In this post, we explore why the "value" of a family business can be a matter of perspective. The value of the business to a strategic buyer is different from the value to the family, and different yet from the value of a single share in the business.
It is understandably frustrating for family business directors when the simple question – what is our family business worth? – elicits a complicated answer. While we would certainly prefer to give a simple answer, the reality a valuation is attempting to describe is not simple.
The answer depends on why the question is being asked. We know that sounds suspect, but in this post, we will demonstrate why it’s not. Let’s consider three potential scenarios that require three different answers.What Is Our Family Business Worth to Our Family?This is the most basic question about value, and the answer revolves around the expected cash flows, growth prospects, and risk of the family business on a stand-alone basis. This does not mean that the status quo is assumed to prevail indefinitely, only that a combination with a strategic buyer's business is not anticipated. The family business may have plans for significant changes to operations or strategy, and if it does, the value should reflect such changes.The value of the family business to the family depends on three principal factors: expected cash flows, growth prospects, and risk.This perspective on value is especially important to family business directors weighing long-term decisions regarding dividend policy, capital structure, and capital budgeting. The value of the family business to the family depends on three principal factors:Expected Cash FlowsIdentifying the expected cash flows of the business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business. Revenue and earnings are important, but future cash flows also depend on how much the business will need to spend on capital expenditures and working capital to execute on the business plan.Growth ProspectsAll else equal, the faster a business is expected to grow, the more valuable it is. Cash flows can grow because of increasing market share, a growing market, or improving profitability. The assessment of growth prospects should take into account each of these potential factors and the sustainability of each.RiskThe value of a business is inversely related to the risk. Investors crave certainty, and risk is just another word for not knowing what the future holds. The wider the range of potential outcomes for your family business, the riskier it is, and the less enthusiastic investors will be about committing capital to the business. When investing in riskier businesses, investors pay less. Risk is evaluated relative to comparable investments or businesses.Whether using a discounted cash flow method or using methods under the income approach, the value of the family business to the family is a function of these three attributes of the business itself. This measure of value is often likened to the perspective of stock market investors or private equity buyers that look to the operations of the business to drive return apart from a strategic combination with another business.If this first question deals with the value of the family business assuming it continues being a family business, the second question addresses the value of the business once it stops being a family business. In other words, what is the value of the family business to a strategic buyer?What Is Our Family Business Worth to a Strategic Buyer?Families occasionally decide they don’t want to own the family business anymore. Families can reach this decision for different reasons. Sometimes, the family friction associated with managing the family business has reached an unsustainable level. In other cases, the family may be approached by a buyer of capacity with what appears to be a very enticing offer. Or, perhaps, an enterprising family decides that a “fresh start” with proceeds from the sale of the legacy business could unlock new opportunities for the family. In any event, when the decision to sell, or at least consider selling, has been made, directors naturally turn their attention to maximizing the sales price.A strategic buyer is one that will combine the operations of the target company with their existing operations.A strategic buyer is one that will combine the operations of the target company with their existing operations in a bid to increase the earnings and cash flow of the target and/or the newly combined entity as a whole. Strategic buyers are most commonly competitors of the target, but they could also be suppliers or customers. The essential attribute is that a strategic buyer has the ability to change how the target operates, resulting in either higher earnings, better growth prospects, or reduced risk (or some combination thereof).Exhibit 1 illustrates potential earnings enhancements available to a strategic buyer (in this case a competitor).
By combining the target with their existing operations, the larger strategic buyer will be able to achieve purchasing efficiencies, which will contribute to a higher gross margin. In addition, there are redundant general and administrative expenses, which can be eliminated by the buyer. As a result, the strategic buyer anticipates generating an EBITDA margin of 22%, compared to the 16% EBITDA margin available to the target company on a stand-alone basis. Stated alternatively, the strategic buyer anticipates EBITDA that is 38% higher.
Does that mean that the target company is worth 38% more to the strategic buyer? Not necessarily. The amount that a strategic buyer will, in fact, pay for the target company depends on how many other strategic buyers they are likely bidding against and how unique the target company opportunity is.
The magnitude of strategic benefits available and the likely negotiating dynamics for a family business tend to be very fact-specific. So, assessing the value of your family business to a strategic buyer will require that you and your fellow directors consider the following questions:
Who are the competitors, suppliers, or customers with whom our family business would provide the most compelling strategic “fit”?What opportunities would such buyers have for increasing earnings and cash flow, improving growth prospects, or reducing the risk of the family business?How unique is our family business? Are there other similarly situated businesses that can provide comparable strategic benefits to buyers?
A potential strategic sale is not the only context in which family business directors need to think about the value of the family business. We’ll consider the final variation on the question of value in the next section.What Is a Share of Stock in Our Family Business Worth to an Investor?The final question relates to the value of an interest in the family business, rather than the family business itself. Minority shares in a family business are often considered unattractive from an investment perspective for a number of reasons. As a minority shareholder, one has no direct influence or control over business strategy or other long-term business and financial decisions: one is simply along for the ride and subject to decisions made by others. Furthermore, since it is a family business, there is likely no ready market for the shares. As a result, one is effectively stuck, and, potentially, for a long time.So, from this perspective we need to think about all the things that influence what the family business is worth to the family plus some additional considerations that relate to the unique position of being a minority shareholder in a private company. This perspective is critical for gift and estate tax planning.Are There Any Dividends?Regular cash flow dulls the pain of illiquidity. If there is a reasonable expectation that investors will receive dividends while owning the shares, that helps to mitigate the burden of being unable to sell the shares. Since many family businesses are set up as S corporations, it is important to clarify that the dividends that matter are those in excess of any tax liabilities that are passed through to shareholders.What are the Prospects for Liquidity?Even though there is no ready market in which to sell minority shares in a family business, there are still opportunities to sell the shares from time to time. For example, the family business could be sold, the company may repurchase shares from select shareholders, or other family members may be willing to acquire the shares at a favorable price. While future liquidity opportunities cannot be predicted with precision, it is possible to establish a range of likely holding periods by analyzing relevant factors. The longer the period until a liquidity event can be anticipated, the less attractive the investment.What are the Growth Prospects for the Investment?When liquidity does come, what proceeds can be reasonably expected? In other words, at what rate would one anticipate the value of the business to the family to grow from the current level? If the family business has a track record of reinvesting earnings in attractive capital projects, investors will view the growth prospects more favorably than if management has a propensity to accumulate large unproductive stockpiles of cash or other assets in the business.What are the Relevant Risks?As with the business itself, the value of a minority share is inversely related to the attendant risks.As with the business itself, the value of a minority share is inversely related to the attendant risks. The risks of a minority share include all the risks associated with the family business plus those associated with the illiquidity of a minority interest. In other words, the focus is on identifying those risks (including, potentially, lack of access to financial statements, uncertainty as to the ultimate duration of illiquidity, uncertainty regarding future distribution decisions, and the like) that are incremental to the risks of the family business itself.The combination of expected dividends, holding period, expected growth, and risk factors determine the value of a share in the family business relative to the corresponding pro rata portion of the value of the business as a whole to the family.ConclusionThere is no simple answer to “What’s our family business worth?” because the question is never quite as simple as that. The answer depends on exactly how and why the question is being asked. From transaction advisory services to gift and estate tax compliance to corporate finance decisions, our valuation professionals have the experience and expertise to help you ask the right questions about the value of your family business and get the right answers. Call us today.
Standard of Value in Bankruptcy
The determination of the appropriate “standard of value” when performing business valuations and other valuation related analyses for bankruptcy purposes is critical. While a standard of value is often specified, it is frequently the case that the specific standard of value is not well defined in either the Bankruptcy Code, applicable state statutes, or in judicial guidance. Further, the standard of value terminology used in valuations for bankruptcy purposes often differs from the terminology used for other (non-bankruptcy) purposes.General Standards of ValueTraditional business valuations (those for purposes other than bankruptcy) are typically performed using one of the three basic standards of value: (1): fair market value, (2): fair value, or (3): investment value. While some might argue that a fourth standard of value – intrinsic value – is available to business appraisers and should be included among the typical, standards of value, use of this standard of value is rarely mandated by valuation guidance, statues, or law. Furthermore, intrinsic value (also referred to as fundamental value) is not as well defined as the other standards of value, and while mentioned in certain case law, such references rarely provide a specific definition of the standard. As such, intrinsic value is not addressed in this article.Fair Market ValueThe most recognized and accepted standard of value in relation to business and securities valuation in the U.S. is fair market value. Fair market value applies to nearly all federal and state income and corporate tax matters and is either the specified legal standard or guidepost of value for many other valuation purposes. Additionally, alternative standards of value are also frequently equated to their functional equivalents under fair market value. Although multiple definitions of fair market value exist, they are quite consistent and functionally almost identical.The definition established for fair market value in tax regulations by Treasury Regulation Section 20.2031-1(b) is as follows:The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.A second definition of fair market value is available from the International Glossary of Business Valuation Terms as:[T]he price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.Yet a third definition of fair market value is provided within Section 3(18) (B) of the Employee Retirement Income Security Act wherein adequate consideration in the case of an asset for which there is no generally recognized market (e.g., stock of a closely held corporation) is defined as the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with the regulations promulgated by the Secretary of Labor. The term "fair market value" is defined in proposed section 2510.3-18(b) (2) (i) as follows:The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset.It is widely recognized that these definitions are in general agreement, particularly in regard to their common references to (i) willing buyers and sellers, (ii) lack of compulsion, and (iii) reasonable knowledge of relevant facts. While International Glossary of Business Valuation Terms definition includes reference to (i) the hypothetical nature of the parties to the exchange, (ii) the arm’s length nature of the exchange, and (iii) an open and unrestricted market, it is widely held that these differences in the definitions are immaterial in most situations. As such, while three commonly used definitions exist, fair market value is the most well and consistently understood of the standards of value.Fair ValueThe fair value standard of value is also commonly used by business appraisers. Unlike fair market value, however, fair value’s different definitions are intentionally fashioned for different purposes. Within one purpose (financial reporting), the application of fair value is quite consistent due to now well-established standards codifications issued by the Financial Accounting Standards Board (“FASB”). In the broader legal and financial environment, the definition and or application of fair value can vary significantly from one state to another.Within the American Institute of Certified Public Accountants’ (AICPA) Statements on Standards for Valuation Services (SSVS), fair value is described as having two commonly used, albeit distinctly different definitions.Financial ReportingFor financial reporting purposes, fair value is defined under the FASB’s Accounting Standards Codification (ASC) glossary as:the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.This definition is further discussed in ASC 820 as the price being based upon a hypothetical transaction for the subject asset or liability at the measurement date, considered from the perspective of a market participant. According to ASC 820, a market participant is: (i) an unrelated party, (ii) knowledgeable of the subject asset or liability, (iii) able to transact, and (iv) motivated but not compelled to transact.This standard of value and the definition for this standard of value is universally used for financial accounting purposes within the U.S. Although quite similar to the definitions for fair market value in many respects, the definition of fair value for financial reporting purposes has distinct differences from the definitions for fair market value – particularly in the application of the market participant perspective.State Legal Matters (Non-Bankruptcy)In many states, fair value is the standard of value applicable by statute in regard to cases involving dissenting shareholder rights and is frequently used state minority oppression cases.[1] However, in these settings there may be no single definition or understanding of the fair value standard of value. Alternatively, or as an adjunct to ambiguous state statues, legal precedent may provide the primary guidance for defining fair value.Investment ValueInvestment value is much less commonly utilized by valuation practitioners than fair market value, or fair value. Unlike fair market value and fair value, investment value is rarely a required standard of value. It is most often used to support merger and acquisitions, or other business transaction related matters.While there is more than one definition of investment value, they are generally considered to be materially similar in meaning, albeit in part due to the definitions’ intentional lack of specificity.The International Glossary of Business Valuation Terms defines investment value as:[T]he value to a particular investor based on individual investment requirements and expectations.Note the intentional generalities and lack of constraints relative to the definitions of fair market value and the definition of fair value in regard to financial reporting matters.Similarly, albeit somewhat longer, in real estate terminology investment value is defined as:The specific value of an investment to a particular investor or class of investors based on individual investment requirement; distinguished from market value, which is impersonal and detached.[2]These two definitions of investment value are generally considered to be equivalent.Standards of Value in BankruptcyAs with fair value, the legal terminology describing the applicable standard of value for bankruptcy is not clearly defined in the U. S. Bankruptcy Code, or in applicable state statutes.[3] Unlike standards of value outside of bankruptcy, standards of value within bankruptcy are numerous, lacking in clarity, and inconsistent. Among the standards of value for bankruptcy purposes referenced in the Forensic & Valuation Services Practice Aid - Providing Bankruptcy and Reorganization Services, 2nd Edition Volume 2 — Valuation in Bankruptcy (F&VSPA) are:[4]Fair valuationReasonably equivalent valueIndubitable equivalentPresent fair salable valueFair consideration
The sources for these standards of value include the U.S. Bankruptcy Code, The Uniform Fraudulent Transfer Act (UFTA), and The Uniform Fraudulent Conveyance Act (UFCA). Guidance as to the definitions for these terms, or the application of the terms, are minimal, and often nonexistent, within the Code, the UFTA, or the UFCA. Guidance as available within the Code, the UFTA, or the UFCA is as follows:[5]Fair ValuationBankruptcy Code — Fair ValuationSection 101(32) of the U.S. Bankruptcy Code defines insolvency as a:...financial condition such that the sum of such entity’s debt is greater than all of such property, at a fair valuation...Fair valuation in this context is generally interpreted by bankruptcy case law, albeit not specifically defined, as fair market value.[6]UFTA — Fair ValuationWithin the UFTA, Section 2(a) indicates, "A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at a fair valuation." The UFTA provides no definition of fair valuation, however, fair valuation is frequently analyzed similarly to fair market value when evaluating solvency.[7]Reasonably Equivalent ValueBankruptcy Code — Reasonably Equivalent ValueSection 548 of the U.S. Bankruptcy Code explains that a fraudulent transfer has occurred if a debtor has "received less than a reasonably equivalent value in exchange for such transfer or obligation." No definition of reasonably equivalent value is provided, although the Code does define value to mean "property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor."[8]The F&VSPA indicates that the courts have historically considered fair market value exchanged when evaluating reasonably equivalent value.[9] However, the U.S. Supreme Court has noted that, reasonably equivalent value is not always evaluated against a fair market value benchmark.[10]UFTA — Reasonably Equivalent ValueWhen evaluating whether a transfer was fraudulent to present and future creditors the UFTA considers whether "a reasonably equivalent value [was] exchange[d] for the transfer or obligation."[11] The fair market value of the assets or debt exchanged is commonly considered. However, as previously referenced in regard to the U.S. Supreme Court, reasonably equivalent value is not always evaluated against a fair market value benchmark.[12]Indubitable EquivalentBankruptcy Code — Indubitable EquivalentThe U.S. Bankruptcy Code mandates that a Chapter 11 plan must be fair and equitable to all holders of secured claims. In circumstances where the debtor’s reorganization plan is accepted over the objections of a secured creditor, the court must ensure the plan provides that secured creditors receive the indubitable equivalent of their respective claims.[13]Fair Saleable ValueUFCA — Present Fair Saleable ValueSection 2(1) of the UFCA includes a reference to the present fair saleable value of assets in considering insolvency. Some jurisdictions have interpreted present fair saleable value to be similar to fair market value, although other jurisdictions have taken a position whereby the present fair saleable value standard imposes a reduced marketing period.[14]Fair ConsiderationUFCA — Fair ConsiderationUFCA’s Section 3 indicates that fair consideration is given for property or an obligationWhen in exchange for such property, or obligation, as a fair equivalent therefore, and in good faith, property is conveyed or an antecedent debt is satisfied, orWhen such property or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property or obligation obtained.
Therefore, fair consideration is characterized as a good faith transfer whereby the debtor receives reasonably equivalent value.[15] The fair market values exchanged are commonly used when evaluating fair consideration in states that have adopted the UFCA, as they are under the Bankruptcy Code.[16]SummaryThere is simply no clear standard of value that can be universally relied upon in the context of bankruptcy proceedings. Standard of value terminology, definitions, and guidance within the bankruptcy realm are significantly lacking in comparison to that available to business appraisers engaged in tax and financial reporting related matters. In the absence of clear standard of value definitions and guidance, precedent must often be relied upon. It is therefore crucial in bankruptcy endeavors that a business appraiser have knowledge of these standard of value considerations and work closely with experienced bankruptcy attorneys in order to apply the correct standard of value to best serve their client.[1] Valuing a Business, 5th edition (Pratt, Reilly, Schweihs), p. 45 [2] The Appraisal of Real Estate, 11th edition (Chicago Appraisal Institute, 1996), p. 638. [3] Forensic & Valuation Services Practice Aid - Providing Bankruptcy and Reorganization Services, 2nd Edition Volume 2 — Valuation in Bankruptcy [4]Ibid. [5]Ibid.[6] See Andrew Johnson Properties, Inc., CCD Dec. ¶ 65, 254 (D.C. Tenn. 1974); Briden v. Foley, 776 F.2d 379, 382 (1st Cir. 1985) [7] F&VSPA [8] F&VSPA [9] Barber v. Golden Seed Co., 129 F.3d 382, 387 (7th Cir. 1997) [10] BFP v. Resolution Trust Corp., 511 U.S. 531, 548 (1994). [11] UFTA Sections 4(a)(2) and 5(a). [12] BFP v. Resolution Trust Corp., 511 U.S. 531, 548 (1994). [13] USC 1129(b)(2)(A). [14] F&VSPA [15] HBE Leasing Corp. v. Frank, 48 F.3d 623, 633 (2d Cir. 1994). [16] F&VSPA
SEC Expands Accredited Investor Definition: What Does It Mean for RIAs?
Last Wednesday, the SEC announced an expansion to the definition of “accredited investor” to include individuals based on professional certifications and those with certain inside knowledge of private investments, among others. “Accredited investors” are deemed by the SEC to be sophisticated enough to bear the risks of often opaque private investments, which lack the disclosure requirements and some of the investor protections of their public counterparts. Under the accredited investor rule, private companies are limited to soliciting capital from accredited investors.Before the recent change, accredited investor status required net worth (excluding primary residence) over $1.0 million or an annual income of at least $200,000 ($300,000 for married couples) over at least the last two years and the current year.The old standard has been criticized over the years.While intended to protect smaller investors, the old standard has been criticized over the years as it effectively limits investment opportunities for unaccredited investors and potentially adversely impacts capital formation for small companies. Additionally, the wealth and income standards have been criticized as a poor proxy for financial sophistication and ability to bear risk.Another concern has been that the wealth and income standards have not changed since the rule was established in 1982. After 38 years of inflation, the real purchasing power of $1.0 million today has been significantly eroded. The wealth and income standards also do not consider geography or cost of living, which vary widely throughout the country.In the updated guidance, the SEC declined to revise the wealth and income thresholds for inflation or geography, saying that doing so would disrupt existing investments and add complexity and administrative costs. However, in an attempt to more effectively identify investors that have sufficient knowledge and expertise to participate in private investment opportunities, the SEC did add new ways to meet the accredited investor definition. The new guidance adds the following persons and entities to the accredited investor definition:Natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. Initially, the list of applicable professional certifications includes the FINRA Series 7 (General Securities Representative license), Series 82 (Private Securities Offerings Representative license), and Series 65 (Licensed Investment Adviser Representative). Additional professional certifications may be added from time to time by the SEC;Natural persons who are “knowledgeable employees,” as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, of the private-fund issuer of the securities being offered or sold;LLCs with $5.0 million in assets and SEC- and state-registered investment advisers, exempt reporting advisers and rural business investment companies (RBICs); and,Family offices with assets in excess of $5.0 million and their clients.
Additionally, “spousal equivalents” is added to the accredited investor definition, allowing spousal equivalents to pool their assets for purposes of meeting the net worth threshold.
Will Wealth Managers Need to Vet Private Equity Investments?For most RIAs, the new guidance probably won’t change much. Under the new definition, RIAs themselves are now considered accredited investors, but RIA clients are not likely to be affected. Notably, although it was considered, the SEC did not expand the definition to include discretionary clients of fiduciary investment advisors.For most RIAs, the new guidance probably won’t change much.Since discretionary clients are not automatically accredited investors, the impact on RIA clients is limited to those individuals with the applicable professional certifications or who are “knowledgeable employees” of the issuer who were not already accredited investors under the old rule. The SEC estimates that just over 700,000 individuals hold the professional certifications listed above. Of these, many would have already qualified as accredited investors under the old wealth and income standard. For most RIAs who work predominately with high net worth (HNW) and ultra-HNW clients (who were already accredited investors), the incremental number of clients who now meet the accredited investor definition is likely to be quite small.For those that are newly-minted accredited investors, there is still the question of whether the types of private investments available to accredited investors would be an appropriate portfolio addition. Financial sophistication and the ability to understand the investment opportunity are just one part of the equation. Private investments often have long expected holding periods, low liquidity, and relatively high probability of permanent capital loss. While these features are often accompanied by higher expected returns, the high risk and low liquidity often make these investments inappropriate for investors who don’t have the capital base to endure substantial losses.Also, despite the SEC now allowing it, there is still the practical limitation of investment minimums and sourcing investment opportunities that will likely limit the ability of those newly endowed with accredited investor status to participate in private offerings. For now, the impact of the rule on capital formation is likely to be quite small, although the SEC has indicated the potential for continued expansion of the definition into the rank and file of retail investors.
Oil Frackers Are Breaking Records Again - In Bankruptcy Court
This year has beaten down America’s oil producers. It started bad, with the Russian-Saudi battle for market share, then cascaded into terrible as the COVID pandemic gutted petroleum demand and sent oil prices down to an unheard of -$38 (negative!) per barrel.Those with the weakest hands have taken shelter in bankruptcy court, where it has been a busy six months. With the announcement of offshore producer Arena Energy’s bankruptcy late last week the count of North American bankruptcy filings for producers stood at 36 (31 of those have been in the second and third quarter so far this year). In terms of aggregate debt, the industry is near $53 billion for 2020 so far. That puts the upstream segment on the precipice of having the most debt dollars exposed to bankruptcy protection in U.S. history and we still have four months to go.Some industry insiders are hearing that around 60-70 additional producers may file before year-end, meaning that a wave of companies are on this precipice. If that is the case, then Chapter 11 records will be left in the dust very shortly. That appears to be a monumental shift for six months of depressed prices, but it is important to remember that at around $50 per barrel (where oil had been most of the year prior) some upstream producers are barely breaking even. So when prices dropped even 15-20%, there wasn’t much margin left to work with.[caption id="attachment_33393" align="alignnone" width="640"]Source: Haynes & Boone Oil Patch Bankruptcy Tracker and Mercer Capital Research [/caption]
As the industry heads down this road there will be some differences this time around compared to the surge in 2016, but with familiar signposts as well.
What’s Different This Time?In 2016 a lot was different as far as the maturity and costs of drilling in the U.S. The Permian Basin was still getting its bearings on horizontal drilling in its bountiful stacked geologic formations in the Delaware and Midland sub-basins. Optimism and asset values were higher also as supply and demand balances were flipped in the U.S. at the time. While prices for 2016 averaged $43 per barrel, which is surprisingly close to today’s WTI prices of $42, asset values were far different and future drilling inventory (otherwise known as acreage) is currently valued significantly lower. The chart below gives us a glimpse of that.[caption id="attachment_33394" align="alignnone" width="640"]Source: Bloomberg[/caption]
Rig counts and production declines are a hot topic right now as rigs and production are becoming scarcer items. This is different from last time because a higher percentage of U.S. production is tied to horizontal shale wells which decline much faster than conventional wells. According to the latest Dallas Fed Energy Survey, 82% of respondents shut-in or curtailed production in the second quarter 2020. Most of those producers expect minor or even significant costs to put those wells back online. This devalues reserves and limits recoveries for unsecured creditors. In contrast, few if any were shutting in wells in 2016.
Another difference may be in how Chapter 11 reorganization plans consider future drilling plans and commitments. Let us not forget that an exploration and production company’s primary assets are essentially two things: (i) existing production and (ii) a drilling plan for future production. In the past, companies could effectively drill their way out of bankruptcy to generate cash flow, but as we’ve shown before, that may not be an option for some filers at $42 per barrel. Others that have hedged their production may have more latitude. That is a case by case situation. Drilling commitments and even force majeure are sometimes a significant negotiating point in bankruptcy cases.
What’s Not Different This Time?For starters, this is some producers’ second or even third time that they have been in a restructuring situation in the past few years. This is sometimes known as the proverbial “Chapter 22” bankruptcy. Chaparral is one of those companies. In fact, Chaparral is an example of what else might not be different this time around –equitizing debt. Chaparral announced last week it will be equitizing all $300 million of its unsecured debt. Whiting’s bankruptcy will do this as well as their unsecured holders are estimated to recover around 39% of $2.6 billion in claims, but will end up owning 97% of the new company going forward, leaving 3% for the existing shareholders.Speaking of unsecured debt, the magnitude of unsecured debt will set records. However, the mix of secured vs. unsecured debt, overall, is similar to 2016. Asset values on the other hand are in different places, particularly PUD’s. This creates some uncertainty as to exactly where in the debt stack that creditors may recover their capital or otherwise must restructure their interest, often referred to by insiders as the “fulcrum security.” In a Chapter 11 bankruptcy scenario, there is typically a tier of creditors that is only partially “in the money.” For example, if a debtor’s secured debt will be paid in full, but unsecured debt will receive say 20 cents on the dollar, the unsecured debt is what is known as the fulcrum security. This could also change during the bankruptcy especially if commodity prices change during the process and before plans of reorganization are approved. As challenging as this year has been so far, it is far from over and there may be a glimmer of hope that prices could rise before the end of the year.There are some bullish signs for oil. Drawdowns on inventories exceeding projections and have been coming down since mid-July. They now stand at levels similar to where they were in early April and are much closer to equilibrium than thought even 45 days ago. Fuel demand (except for jet fuel) is likely to recover before the end of the year, thus bringing upward pressure on prices according to ExxonMobil’s (XOM) latest investor presentation.[caption id="attachment_33395" align="alignnone" width="940"]Source: ExxonMobil Investor Presentation and the International Energy Agency (IEA)[/caption]
If this happens, it will improve creditor recoveries, and lubricate gears of the bankruptcy process. It would also bring relief to those who are not planning to file and are looking to weather this year’s storm. Nonetheless, it is unlikely that even a precipitous rise in prices could stop this year from breaking bankruptcy records. That is the unfortunate reality that makes 2020 a frustrating year for many.
Originally appeared on Forbes.com on August 25, 2020.
Acquisition Strategies for Family Businesses
Casting a Wider Net May Reveal Attractive Opportunities in the Downturn
Is it time for your family business to make an acquisition?Growing through acquisition has a bad reputation because countless studies have shown that buyers tend to overpay for businesses. In other words, the real winners in many corporate transactions are the sellers, not the buyers.That said, there is some evidence that acquisitions during a recession are more likely to be accretive. A recent study by Brian Salsberg of global accounting firm EY indicates that companies making acquisitions in the depths of the 2008 financial crisis generated superior returns for shareholders than peer companies that waited until the storm passed before making acquisitions. Not surprisingly, the study attributes the superior returns to the ability of buyers to pay bargain prices during the crisis. Motivated sellers and fewer competing bidders tip the negotiating scales in favor of eventual buyers. As our colleague Jeff Davis is fond of saying: “Bought right, half right.”In our experience, many family businesses are reluctant acquirers. In addition to the fear of overpayment, family businesses are wary of the cultural challenges that can arise in the integration phase. Since families often avoid having non-family shareholders, traditional equity financing is assumed not to be available, so if the family is debt-averse, significant acquisitions may not be financially feasible. However, these concerns need not be absolute obstacles for your family business making an opportunistic acquisition while others sit on the sidelines to wait out the pandemic.We recommend that directors cast a wide net when evaluating potential acquisitions. As we noted in last week’s post, directors should take this opportunity to think more broadly about the portfolio of assets owned by their family business. Are any pieces extraneous? Are there any pieces that are missing? For family businesses that have hesitated to make acquisitions in the past, the missing pieces do not have to be big, nor do they have to be existing competitors. It may be helpful to expand your list of potential acquisition opportunities to include five categories of targets (with an obvious nod to Michael Porter’s five forces framework).Competitors. Competing firms are the most obvious acquisition candidates. Competitors offer the opportunity both to cut costs and enhance revenue through improved pricing power. The downside is that because the potential benefits are transparent, a competitor may be able to extract a larger purchase price.Suppliers. All of us who have shopped in vain for toilet paper or Lysol during the past six months have a new appreciation of the importance of having a reliable supply chain for critical inputs. Are there risks to your supply chain that can be mitigated by an acquisition?Customers. Where does your family business sit in the value chain from raw material to the end user? Would an acquisition of a customer allow one of your business segments to capture a greater proportion of the overall value created in your industry?Substitute Products/Services. Your family business competes against both other companies that provide the same product or service you do, and companies that offer products or services that your customers could reasonably substitute for what you offer. Acquiring such a company can help to round out your product line/service offering and reduce the risk of your family business.Innovators. This requires a higher degree of risk tolerance, but are there companies developing a product or service that could disrupt your business in three or five years? If you can’t beat ‘em, you may want to buy ‘em. While the unicorn tales populate the headlines, they are rare. Many innovators are intrigued by the opportunity to sell now rather waiting years for a unicorn-type event that, statistically speaking, will likely never materialize. Especially during a downturn, you may be able to reap the benefits of someone else’s development efforts at a reasonable price.
Of course, it is possible to make a bad acquisition, even during an economic downturn. Your family shareholders may not have the appetite for a “transformative” deal, but a smaller acquisition that enhances your overall portfolio may well be doable. The main thing is to be deliberate. Even if you are not ready to cut a check today, you and your fellow directors should be thinking about your acquisition strategy. Call one of our experienced professionals for some outside perspective.
Is the Hype Sustainable?
How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market
As we mentioned in a previous blog post, the electric vehicle (EV) market has been all the rage lately, driven primarily by Tesla’s success in creating main stream electric vehicles. We’ve discussed the “Tesla Story” extensively in previous posts, and their stock has continued to rise. It was sitting around $2,200 last Friday (August 28), up from $216 last year, or an astounding 918%. Tesla split its stock 5-1 Monday and was hovering around $450 at the time of writing this post.As expected, other companies want to capitalize on the hype that Tesla has created in the industry, with EV start-ups trying to capture a slice of the pie. This summer has been a huge one for the industry, with electric vehicle startups Nikola, Fisker, Hyiilon, Lordstown, and Canoo all either going public or announcing plans to go public. Notably, however, they are not relying on the typical, lengthy IPO route to achieve this. Instead, they are using special purpose acquisition companies (or SPACs) to hit public markets quicker. In this post, we will walk through the companies going public, the deals, pros and cons of the SPAC, and what this could mean for your dealership.The EV Start-up ContendersNikola was the first of these EV start-ups to go public, announcing an IPO merger with VectoIQ Acquisition, a special purpose acquisition company, on March 3rd. After the merger was completed, the combined company was estimated to be worth $3.3 billion. Nikola was founded in 2015 and now is the global leader in zero-emission heavy duty trucks and hydrogen infrastructure. They hope to use the money raised from the public offering on the development of their electric semi trucks, of which they had around 14,000 preorders. This represents about $10 billion of potential revenue and three years of production. While the stock peaked 5 days after the offering at $79.73, the hype hasn’t lasted as its stock price has steadily declined back down to about $42 as of Monday. Despite the recent lackluster performance, future success is most likely hinging on if Nikola can deliver when they start rolling out vehicles.Hyiilon is seeking to follow in Nikola’s footsteps; on June 19th the company announced it would merge with Tortoise Acquisition, also a SPAC. At the time of the announcement, Nikola stock was up 80% from its IPO price, an encouraging sign for Hyiilon, who differentiates itself from Nikola and Tesla by offering a hybrid solution that works with existing diesel trucks. The company plans to introduce the first carbon-negative solution that will recycle natural gas. This, paired with a lighter design, could result in greater payloads that will lead to more profitable truck routes without having to invest in a totally new fleet. According to internal metrics, the company also outperforms Tesla and Nikola in range and payload capacity. The deal is expected to close in Q3 and once this happens, the ticker symbol will change from SHLL to HYLN, and Hyiilon will officially be a publicly traded company. Hyiilon has indicated that it will use the funds from the public offering for commercialization, production, and operations growth.While the Nikola and Hyiilon deals are in the heavy-duty truck space, Fisker, Lordstown Motors, and Canoo are EV start-ups in the standard light weight vehicle market. They announced their plans to go public through SPACs on July 13th, August 3rd, and August 18th, respectively. Fisker and Canoo both deal with traditional vehicles, though the designs are completely different. The founder of Fisker is best known for designing luxury vehicles for companies such as Ford, BMW, and Aston Martin. Looking to bring the same style to the electric vehicle market, Fisker and Spartan Energy Acquisition, a special purpose acquisition corporation backed by Apollo Global Management is expected to close in the fourth quarter, valuing the company at $2.9 billion. In a similar fashion, Canoo announced a merger with Hennessy Capital Acquisition Corp IV, another SPAC, valuing the company at $2.4 million. Canoo’s spin on the electric vehicle is a VW microbus-style van. Finally, Lordstown Motors entered the public space as well, trying to get more traction for their electric pickup truck, Endurance. Lordstown listed on its site some impressive features of the vehicle including 250-plus miles EV range, 7,500-pound towing capacity, and an 80 mph top speed. They are planning a merger with DiamondPeak that will give the company a pro forma equity value of $1.6 billion. Suffice it to say, there is a lot going on in the EV space right now.SPACsDespite some of these companies not even having a viable product yet, through the use of a SPAC rather than the traditional IPO route, these companies are all able to raise large funds from public market investors that are more averse to risk than private investors to back public development. Having mentioned the SPAC extensively above, it’s important to consider what it is specifically and why it could be considered so favorably by companies such as those in the EV industry. A special acquisition company (or SPAC) is a special type of company that goes public for the sole reason of buying another company regardless of how much it raises through an IPO. It’s for this reason that a SPAC is also known as a “blank-check” company. SPACs have become increasingly popular over the past few years, with 28 SPACs having IPO’d this year raising $8.9 billion. This is on track to reach $16.5 billion by the end of the year, a 21% increase from the prior year.
What is prompting this SPAC boom? Some theorize that it has to do with the COVID-19 pandemic. IPO roadshows have become difficult to do in the current climate and don’t work as well remotely. Furthermore, there has been a shift toward one-on-one deals rather than one-to-many capital raises. However, while these circumstances can explain the increase in 2020, they fail to account for the increase over the past decade. Another favorable attribute includes risk mitigation for the selling company. The reasoning for this is because, with a SPAC, the company negotiates the price and then signs the deal. With a traditional IPO, it is the other way around, and there is no guarantee that it will be successful. Despite all of these factors, the most compelling argument for the SPAC boom doesn’t have to do anything with the cost (the SPAC is more expensive) or risk-mitigating factors, but instead primarily has to do with its timeline. With companies in “hyped-up” industries such as the EV market or the space tourism market (looking at you, Virgin Galactic), it makes sense for them to get to market as quickly as possible in order to extract gains in the market from this hype factor. Hence, the appeal of the SPAC.
Despite all of the positives for companies, SPACs do have their drawbacks. One of these drawbacks is no reverse break fees, meaning that the potential to receive deal protection in the form of a reverse-breakup fee from the SPAC can be limited because of an inability to access the trust account cash other than post-business combination. Furthermore, since the SPAC structure is less risky for the company than an IPO, the SPAC should be compensated for this risk protection with an even bigger discount than regular IPO investors. Finally, there can be an uncertain amount of cash availability with SPACs due to a SPAC’s public stockholders having the option to elect to have their shares redeemed for cash in connection with the business combination. More investors redeeming their shares for cash means less cash for the company going public.
How Long Can the Hype be Maintained?While in the 21st-century fads can catch on quickly and explode, they also have the potential to die out just as fast with “the next big thing” always around the corner. This seems to be the problem with companies that use SPACs to go public. Of the 222 SPAC IPOs since the start of 2015, 89 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -18.8% and a median return of -36.1% since 2015. This is a stark contrast to traditional IPO returns which have averaged 37.2% since 2015. Behind these numbers is a common trend of an initial pop when the company is announced followed by a further jump if it is priced right when it begins trading. However, declines tend to follow these initial bursts. Only 26 SPACs in the group have had positive returns as of the end of July. It seems that while SPACs could be useful for helping a company ride the interest-wave in order to raise funding, they have to have a product that isn’t just hype-worthy but can sustain consumer interest over the years.Key TakeawaysThough these public offerings may not initially impact dealerships directly, the surge of electric vehicle start-ups capitalizing on SPACs could mean there may be more electric vehicle alternatives to Tesla in the near future. Traditional manufacturers could ultimately try to acquire these start-ups in order to bolster their own electric vehicle offerings. For example, General Motors has invested $75 million in the Lordstown deal. If large traditional manufacturers pivot to larger EV offerings through the investment in these companies, dealerships could ultimately benefit from the larger selection being offered to consumers. Furthermore, as the use of SPACs to reach the public market increases in prominence, it is not out of the question that we see dealerships using this vehicle in the near future as well. With the main public dealers all reaching the market around the same time and there not being any new entrants in a while, the industry is overdue for some new players. While ultimately these thoughts are speculative, observing what is going on in the space can help companies prepare for what might be ahead.
Is the Hype Sustainable?
How EV Start-Ups Are Taking Advantage of SPACs to Enter the Public Market
As we mentioned in a previous blog post, the electric vehicle (EV) market has been all the rage lately, driven primarily by Tesla’s success in creating main stream electric vehicles. We’ve discussed the “Tesla Story” extensively in previous posts, and their stock has continued to rise. It was sitting around $2,200 last Friday (August 28), up from $216 last year, or an astounding 918%. Tesla split its stock 5-1 Monday and was hovering around $450 at the time of writing this post.As expected, other companies want to capitalize on the hype that Tesla has created in the industry, with EV start-ups trying to capture a slice of the pie. This summer has been a huge one for the industry, with electric vehicle startups Nikola, Fisker, Hyiilon, Lordstown, and Canoo all either going public or announcing plans to go public. Notably, however, they are not relying on the typical, lengthy IPO route to achieve this. Instead, they are using special purpose acquisition companies (or SPACs) to hit public markets quicker. In this post, we will walk through the companies going public, the deals, pros and cons of the SPAC, and what this could mean for your dealership.The EV Start-up ContendersNikola was the first of these EV start-ups to go public, announcing an IPO merger with VectoIQ Acquisition, a special purpose acquisition company, on March 3rd. After the merger was completed, the combined company was estimated to be worth $3.3 billion. Nikola was founded in 2015 and now is the global leader in zero-emission heavy duty trucks and hydrogen infrastructure. They hope to use the money raised from the public offering on the development of their electric semi trucks, of which they had around 14,000 preorders. This represents about $10 billion of potential revenue and three years of production. While the stock peaked 5 days after the offering at $79.73, the hype hasn’t lasted as its stock price has steadily declined back down to about $42 as of Monday. Despite the recent lackluster performance, future success is most likely hinging on if Nikola can deliver when they start rolling out vehicles.Hyiilon is seeking to follow in Nikola’s footsteps; on June 19th the company announced it would merge with Tortoise Acquisition, also a SPAC. At the time of the announcement, Nikola stock was up 80% from its IPO price, an encouraging sign for Hyiilon, who differentiates itself from Nikola and Tesla by offering a hybrid solution that works with existing diesel trucks. The company plans to introduce the first carbon-negative solution that will recycle natural gas. This, paired with a lighter design, could result in greater payloads that will lead to more profitable truck routes without having to invest in a totally new fleet. According to internal metrics, the company also outperforms Tesla and Nikola in range and payload capacity. The deal is expected to close in Q3 and once this happens, the ticker symbol will change from SHLL to HYLN, and Hyiilon will officially be a publicly traded company. Hyiilon has indicated that it will use the funds from the public offering for commercialization, production, and operations growth.While the Nikola and Hyiilon deals are in the heavy-duty truck space, Fisker, Lordstown Motors, and Canoo are EV start-ups in the standard light weight vehicle market. They announced their plans to go public through SPACs on July 13th, August 3rd, and August 18th, respectively. Fisker and Canoo both deal with traditional vehicles, though the designs are completely different. The founder of Fisker is best known for designing luxury vehicles for companies such as Ford, BMW, and Aston Martin. Looking to bring the same style to the electric vehicle market, Fisker and Spartan Energy Acquisition, a special purpose acquisition corporation backed by Apollo Global Management is expected to close in the fourth quarter, valuing the company at $2.9 billion. In a similar fashion, Canoo announced a merger with Hennessy Capital Acquisition Corp IV, another SPAC, valuing the company at $2.4 million. Canoo’s spin on the electric vehicle is a VW microbus-style van. Finally, Lordstown Motors entered the public space as well, trying to get more traction for their electric pickup truck, Endurance. Lordstown listed on its site some impressive features of the vehicle including 250-plus miles EV range, 7,500-pound towing capacity, and an 80 mph top speed. They are planning a merger with DiamondPeak that will give the company a pro forma equity value of $1.6 billion. Suffice it to say, there is a lot going on in the EV space right now.SPACsDespite some of these companies not even having a viable product yet, through the use of a SPAC rather than the traditional IPO route, these companies are all able to raise large funds from public market investors that are more averse to risk than private investors to back public development. Having mentioned the SPAC extensively above, it’s important to consider what it is specifically and why it could be considered so favorably by companies such as those in the EV industry. A special acquisition company (or SPAC) is a special type of company that goes public for the sole reason of buying another company regardless of how much it raises through an IPO. It’s for this reason that a SPAC is also known as a “blank-check” company. SPACs have become increasingly popular over the past few years, with 28 SPACs having IPO’d this year raising $8.9 billion. This is on track to reach $16.5 billion by the end of the year, a 21% increase from the prior year.
What is prompting this SPAC boom? Some theorize that it has to do with the COVID-19 pandemic. IPO roadshows have become difficult to do in the current climate and don’t work as well remotely. Furthermore, there has been a shift toward one-on-one deals rather than one-to-many capital raises. However, while these circumstances can explain the increase in 2020, they fail to account for the increase over the past decade. Another favorable attribute includes risk mitigation for the selling company. The reasoning for this is because, with a SPAC, the company negotiates the price and then signs the deal. With a traditional IPO, it is the other way around, and there is no guarantee that it will be successful. Despite all of these factors, the most compelling argument for the SPAC boom doesn’t have to do anything with the cost (the SPAC is more expensive) or risk-mitigating factors, but instead primarily has to do with its timeline. With companies in “hyped-up” industries such as the EV market or the space tourism market (looking at you, Virgin Galactic), it makes sense for them to get to market as quickly as possible in order to extract gains in the market from this hype factor. Hence, the appeal of the SPAC.
Despite all of the positives for companies, SPACs do have their drawbacks. One of these drawbacks is no reverse break fees, meaning that the potential to receive deal protection in the form of a reverse-breakup fee from the SPAC can be limited because of an inability to access the trust account cash other than post-business combination. Furthermore, since the SPAC structure is less risky for the company than an IPO, the SPAC should be compensated for this risk protection with an even bigger discount than regular IPO investors. Finally, there can be an uncertain amount of cash availability with SPACs due to a SPAC’s public stockholders having the option to elect to have their shares redeemed for cash in connection with the business combination. More investors redeeming their shares for cash means less cash for the company going public.
How Long Can the Hype be Maintained?While in the 21st-century fads can catch on quickly and explode, they also have the potential to die out just as fast with “the next big thing” always around the corner. This seems to be the problem with companies that use SPACs to go public. Of the 222 SPAC IPOs since the start of 2015, 89 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -18.8% and a median return of -36.1% since 2015. This is a stark contrast to traditional IPO returns which have averaged 37.2% since 2015. Behind these numbers is a common trend of an initial pop when the company is announced followed by a further jump if it is priced right when it begins trading. However, declines tend to follow these initial bursts. Only 26 SPACs in the group have had positive returns as of the end of July. It seems that while SPACs could be useful for helping a company ride the interest-wave in order to raise funding, they have to have a product that isn’t just hype-worthy but can sustain consumer interest over the years.Key TakeawaysThough these public offerings may not initially impact dealerships directly, the surge of electric vehicle start-ups capitalizing on SPACs could mean there may be more electric vehicle alternatives to Tesla in the near future. Traditional manufacturers could ultimately try to acquire these start-ups in order to bolster their own electric vehicle offerings. For example, General Motors has invested $75 million in the Lordstown deal. If large traditional manufacturers pivot to larger EV offerings through the investment in these companies, dealerships could ultimately benefit from the larger selection being offered to consumers. Furthermore, as the use of SPACs to reach the public market increases in prominence, it is not out of the question that we see dealerships using this vehicle in the near future as well. With the main public dealers all reaching the market around the same time and there not being any new entrants in a while, the industry is overdue for some new players. While ultimately these thoughts are speculative, observing what is going on in the space can help companies prepare for what might be ahead.
Themes from Q2 2020 Earnings Calls
Part 1: Mineral Aggregators
As discussed in our quarterly overview, the oil & gas industry experienced a volatile path to price stability as COVID-19 and the Saudi-Russia price war took a toll on supply and demand. The road to recovery was apparent late in the quarter and was driven by supply cuts from OPEC+, curtailments by U.S. producers, and an increase in demand. Mercer Capital has aimed to focus on the mineral aggregator space, most recently with the release of the second quarter mineral aggregator valuation multiples analysis. In this post, we capture the key takeaways from mineral aggregator second quarter 2020 earnings calls.Theme 1: M&A Activity Is Momentarily Taking a Back SeatAlthough mineral aggregators have the reputation to seek acquisitions through reinvesting strategies, they seem hesitant to pull the trigger as the current environment is providing many challenges.The world’s greatest deal would have to present itself, and that’s always possible. But the world’s greatest deal would have to present itself, given where we’re currently trading. – Daniel Herz, President & CEO, Falcon MineralsI think it’s fair to say that it’s always more difficult to get deals done when the bid ask spread is just so severe. I mean, the volatility in oil prices kills deals. I mean, it just makes it really hard to get things done. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersThe balance sheet is most important, holding us back from M&A. I mean, if we saw the best deal in the history of minerals, we’d have to think hard about it, but unfortunately those deals just aren’t out there. – Kaes Van’t Hof, President, Viper Energy PartnersTheme 2: Consolidation and Operators’ Stability Is Affecting AggregatorsAs the difficult environment plays out, a number of operators will be forced to liquidate or consolidate, leading to opportunities for aggregators to work with new, and often financially improved, partners. In Brigham Minerals’ second quarter earnings call, Ben Brigham expressed his excitement to have their assets migrate into the hands of Chevron, subsequent to the closing of Chevron’s acquisition of Noble Energy (expected in the fourth quarter of 2020). As times are tough, aggregators assess the stability of their operators, and may be fortunate, like Brigham, to land a major partner.We expect financially challenged operators to liquidate or consolidate with larger entities and those surviving operators will focus on drilling our highest remaining rate of return wells. So I think that’s going to continue to play out – where you have a weak operator with the weak balance sheet, they’re going to get taken out by a stronger operator with a better balance sheet, and that’s going to benefit our asset base. – Ben Brigham, Founder & Executive Chairman, Brigham MineralsDorchester Minerals states that during the challenging environment they are observing the "Financial stability of our operators and lessees and paying increased attention to operator credit risk and revenue recovery." – Dorchester Minerals Annual Meeting Presentation held May 18, 2020What we have found to be very successful in times like this is that you need to be more of a partner with your operators now than maybe you do in really good times where capital is more available. – Jeff Wood, President and CFO, Black Stone MineralsTheme 3: Natural Gas Optimism Is IncreasingIt is pretty ironic that the industry is shifting its focus to natural gas, as it was viewed as a secondary asset not too long ago. Although at a historically low price, it has shown consistency and resiliency during the first half of the year as opposed to greater volatility in oil prices. Aggregators have not ignored this trend and seem optimistic about the future for natural gas.We're seeing increased deal flow in gas. A lot of Marcellus stuff is coming to market. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersWhile it’s been challenging to find many silver linings lately, one of them is a more constructive outlook for natural gas prices with several of our major equity research firms calling for gas prices well above the strip for 2021. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsFurthermore, combining this competitive advantage with our robust hedge book and significant natural gas production, which has an increasingly positive macro outlook, provides even more enhanced cash flow stability into the coming quarters, as we emerge from this volatile period. And I think some of our gas positions have been remarkably resilient. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty PartnersTheme 4: Balance Sheet Priorities: Preparing for the Worst, Hoping for the BestIt is no surprise that aggregators are paying close attention to their balance sheet positions. Participants on the calls gauged their company’s balance sheet flexibility. The aggregators remained confident that their ability to pay down debt and appease investors continues to be a priority. This may come at a cost to some companies such as Black Stone Minerals, as they sold two asset packages in the Permian in June to strengthen their liquidity position.In early June, we announced the sale of two asset packages in the Permian. Both of those transactions closed in July and brought in net cash proceeds of $150 million. That cash, together with the retained free cash flow from our operations, enabled us to reduce total debt by over $230 million or 60% from the end of the first quarter of this year. – Tom Carter, CEO & Chairman of the Board, Black Stone MineralsWe purposely reduced our acquisition activity in the latter half of the first quarter and largely through the entirety of the second quarter in order to preserve liquidity and maintain optimal balance sheet flexibility and thus position ourselves to capitalize on more attractive opportunities we expected in the second half of the year, that's playing out well for us now. – Robert Roosa, Founder & CEO, Brigham MineralsWe will use the retained amount to strengthen the balance sheet by paying down debt of $2.5 million in the coming days. We continue to manage the Company in a conservative and prudent manner, especially given the risks and uncertainties in the energy sector and the broader economy so far this year. – Davis Ravnaas, President, CFO & VP of Business Development, Kimbell Royalty Partners
Q2 2020 Earnings Calls
Constrained Inventories and Improved SG&A Margins Expected to Normalize While the Future of Omnichannel Initiatives Stays Top of Mind
As expected, the COVID-19 pandemic has thrust many dealerships into relying on their digital and omnichannel offerings due to complications arising from stay-at-home orders. Further government restrictions have curbed new vehicle supply as manufacturers have struggled to ramp up supply. Many dealers noted inventory shortages. However, with sales volumes significantly below the 17 million seen over the last several years, both the numerator and denominator of the days of supply statistic are declining. Lower sales mean lower inventory isn’t a deal breaker; in the short term, limited supply has led to some gross margin improvement. However, total gross profit is still significantly down due to the lower sales (combination of lower inventory and lower demand). While sales have improved sequentially as restrictions have eased, parts and service (particularly collision) have trailed in their recovery as fewer miles driven has translated into reduced demand. Analysts inquired about the potential for stay-at-home orders to be ramped back up, particularly in large states such as Texas, California, and New York, though executives largely downplayed the likelihood and the impact it would have on their businesses.On Q1 calls, public auto dealer executives played down incremental costs related to digital initiatives and highlighted the reduction in SG&A related to online sales. Specifically, advertising and personnel costs are much lower for digital. In Q2, public auto dealers saw these initiatives come to fruition, and earnings largely beat estimates despite year-over-year revenue declines of 15-35%. Despite the successful cost cutting, executives were quick to point out not all of these cost savings were sustainable.Theme 1: Manufacturer plant closures have caused inventory shortages, but lower sales levels require less inventory. Some dealers noted higher gross margins due to their limited supply, while others highlighted issues sourcing their most popular models.Our second quarter new vehicle volumes declined 28%, and used vehicle volumes were down 14%, the latter of which was caused by inventory shortages. However, gross margin was extremely strong. New vehicle gross profit per unit was up 40% in the quarter. […] we are seeing a bit of an inventory strain in new and used and especially on the new side with some hot models that are typically our volume sellers. -Daryl Kennigham, President of U.S. and Brazilian Operations, Group 1 AutomotiveIt's going to be a tough road for July August September although we are seeing inventories improve. They're just not going to improve rapidly. I would look for October November time frame to get some normalized inventory levels. And the great news is this low supply equals high margin. -Jeff Dyke, President, Sonic AutomotiveWe are clearly constrained in inventory, and that means that for any given customer that comes to the site, the odds of them seeing the car they're looking for is lower, and therefore, your conversion rates will be lower. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaOur day supply was 52, down 34 days from the prior year. These levels are low, because of temporary OEM factory shutdowns. However, we expect the day supply to increase gradually through the summer selling season. -Dan Clara, SVP Operations, Asbury Automotive GroupTheme 2: Service & parts (primarily collision) fared better in April than vehicle sales. As the pandemic persisted, less mileage driven led to decreased demand due to less wear and tear.Collision is really what's taken the big hit for us […] when April really shut down for sales and service, collision was actually okay and then collusion took their hit in May forward. With less people driving on the road there's been less accidents. So collision has been a little bit further behind. -David Hult, CEO, Asbury Automotive GroupThere's just been people driving less mileage. And so our collision business, which isn't a massive part of our business overall. But it's probably the weakest when you look at it year-over-year. -Earl Hesterberg, President & CEO, Group 1 AutomotiveTheme 3: SG&A declined to lows as a percentage of growth for many of the public auto dealers. However, analysts and executives noted these results were unsustainable in the long-term.Store leaders continue to take prudent and decisive cost savings measures and personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions lead to significant sequential improvements throughout the quarter. Same store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. […] for the month of June, our company [SG&A] to gross profit improved to 57.4%, […] significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs. […] Our stores are well aware that their largest SG&A item is personnel. The next one is advertising. […] As we move forward, the target in SG&A gross percentage is 65% which we’ve talked about for years, I think it seems a lot more attainable in the near term. -Chris Holzshu, EVP & COO, Lithia MotorsWe were 64% which I would never [have] thought we'd be in the 60s with SG&A when looking at July 77% last year. […] We see less salespeople necessary to drive the business. The same thing on the fixed side. We're seeing better utilization of our people. […] I think advertising is moving from traditional to obviously online which obviously is less costly. -Roger Penske, Chairman & CEO, Penske Automotive GroupWe drove significant SG&A leverage through extensive cost reduction efforts, including leveraging our digital capabilities to reduce expenses across labor, advertising and discretionary spend. As Mike stated we will continue to maintain a discipline in our cost structure going forward, targeting to continue to operate SG&A as a percentage of gross profit below 69%. […] We were down about 40% in advertising year-over-year. Really driven by the environment and our digital capabilities and being far more efficient. -Joe Lower, CFO, AutoNationTheme 4: Digital innovation requirements loom large for smaller players who lack the scale to make the necessary investments. However, online used vehicle retailers do not have the same issues inherent to new vehicle retailing for traditional franchised players.Suddenly, buying cars online is becoming normalized. This is a big deal. We have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -Ernest Garcia, Founder, President, CEO & Chairman, CarvanaI think there is a yearning in the pre-owned market for a brand that can be trusted. And scale also brings in the consumers' mind an idea of trust. And if you really have a good experience and you stand behind the product I think that's where the business is going to consolidate around and whether that's Carvana, CarMax, AutoNation, Vroom, I think the big players that are branded are clearly going to take share. It's a share consolidation in a very big ocean. That's how I see it developing. -Mike Jackson, Chairman & CEO, AutoNationIt's getting tougher and tougher for smaller independent dealers to be competitive in a world where the omnichannel and scale really matters so much. -John Rickel, SVP & CFO, Group 1 AutomotiveI know there's a lot of vibe in the market about growth and how big people can get over the years in consolidation in national branding. We have to remember that this is a franchise business. And that there's dealer agreement with every single one of these brands and then there's framework agreements on that. So until those documents materially change, I don't see the massive consolidation […] Once you start having multiple rooftops of any brand beyond your dealer agreement that exists, you have a framework agreement. And within those framework agreements there are limitations and how many you can acquire in an annual season […] And for a company A to buy company B of 40-plus stores overnight would take a significant amount of work with the manufacturers to make that happen and it would be a true test of some documentations that are out there. […] We all have restrictions on where we can market our new vehicle sales service to some degree in CPO where there are no restrictions or out and out pre-owned sales. -David Hult, CEO, Asbury Automotive GroupConclusionDespite public auto dealership's excitement surrounding the addition of online sales and lower SG&A expenses, key questions still remain. First, are the true costs being measured? “Omnichannel” requires both an online and in person presence. Quoting GPUs or SGA as % of gross may become muddled when trying to apportion which line item expenses are stuck in. What’s important to remember is these costs still exist, even if they seem small relative to the potential sales pickup. Digital may be more cost effective, but a full-on shift into digital for auto dealers likely sheds less cost than expected. Unless dealers plan to significantly shift their real estate strategy, it appears there are limits to how much cost can be taken out of overhead, even if advertising and personnel can be more efficient.How long dealerships can keep advertising and personnel costs low also remains to be seen. In a period of high unemployment, people may be happy to have their jobs. If we forecast out a few years, will people remain as jubilant to continue to do the work previously assigned to more people? Technology should help reduce personnel costs, but we’re simply pointing out there are limits. And on advertising, digital is the cheaper option – for now. Digital advertising is less established but gives more insight into the successful conversion of customers. For example, how are you supposed to know if someone decided to buy because they saw your billboard? In the long-term, this could lead to higher pricing power for digital advertising platforms.Finally, while large auto dealers have the scale to invest in digital platforms, smaller dealerships do not have such luxury. Their digital platforms may be limited to only when consumers looking to buy a specific make or model Google the closest location and head to the dealership or their website for an omnichannel experience. While these platforms may pale in comparison to larger players, it works for now. The question may become whether smaller players are forced to make commensurate digital investments. In the bear case, dealers would look to exit when deal multiples recover. For those with a more bullish view, we tend to agree with comments made by Asbury’s CEO (worth noting Asbury has the fewest dealerships of the publics). Dealerships may not want to overburden themselves with overinvesting in digital initiatives that aren’t being pushed by their OEMs. While dealers can be prisoners of the moment or attempt to “Keep up with the Joneses”, to use two puns in one sentence, we also caution it could be a risky play for dealers that step out of their lane and look to materially shift their operations online to compete with the well capitalized players in the nascent space.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.
Planning for Post-Pandemic Life for Family Businesses
We are not about to predict when the pandemic will end. However, we are confident that it will end. And we do know that it is closer to being over today than it has ever been.Two recent articles have reminded us that it is not too early to begin thinking about what the eventual end of the pandemic will mean for your family business.The first, entitled “More Wealthy Families Are Throwing a Lifeline to Distressed Businesses,” appeared in the New York Times a few weeks ago. Direct investment in businesses has been an emerging theme in the family office space since the end of the last recession, and according to the article, the trend is only accelerating in the current financial crisis. With public markets back at – or even above – pre-pandemic levels, patient families are seeking out the potential for more attractive long-term returns by providing capital to private companies that need a financial lifeline through the recession. Since many enterprising families possess unique industry expertise and insight, they may be better equipped to separate the wheat from the chaff when evaluating investment opportunities.The second, from the global accounting firm PWC, summarizes the results of a survey of 18 family offices: “Gauging the Deals Outlook for Family Offices.” According to PWC, nearly all family offices they spoke with are planning to make a strategic acquisition over the coming year, while only one-third plan to be sellers during that period. Of note in the article is the emphasis on proper and thorough due diligence processes for acquisitive families.
Surviving the pandemic has been the top priority for many family business leaders for the past six months. Is it time for you and your fellow family business directors to switch from a reactive to a more proactive footing? Here are four potential agenda items to consider for your next board meeting:1) Positioning OwnershipOwnership is the ultimate “given” in family businesses. When did you as a board last review your family business’s shareholder list? If you were starting from scratch, which shareholders would promote your family business thriving over the next 10-20 years? If there is a difference between your “actual” and “ideal” shareholder lists? This is a uniquely favorable time to engage in intra-family transactions to get closer to the ideal ownership structure. The fair market value of ownership interests is depressed for many businesses, interest rates are at historical lows, and lifetime exemption levels and gift tax rates are relatively favorable. In short, this is a great time to ensure that the ownership of your family business is oriented toward tomorrow, not yesterday. Don’t miss it.See our posts on the topic:Opportunity Times Two?Now Is a Great time to Transfer Stock to Heirs2) Evaluating Capital Needs and SourcesFamily businesses have been very diligent in short-term cash and working capital management through the pandemic. But what about the longer-term? How much availability do you have on existing credit facilities? Are existing facilities sufficient for likely post-pandemic needs? Are family shareholders willing to provide additional equity capital to the business, either through direct contributions or temporary distribution cuts? Are there non-traditional financing sources that could be advantageous, such as joint ventures or similar structures? As noted in the two articles linked at the beginning of this post, disillusionment with the public markets could begin to open up new sources of competitively priced long-term capital for family businesses. The sources and structures may not be traditional, but as more investors look to put capital to work, opportunities for favorable access to long-term capital are likely to emerge for families that have a plan for how to put it to work.3) Rebalancing Your PortfolioIf you were unburdened by your family business’s existing portfolio of operating assets, what would you want to own today? Are there legacy assets that are no longer a good “fit” with your family business? Are there other investors to whom such assets are more valuable? If so, do you have a plan for monetizing that incremental value? Conversely, is your family business puzzle missing some pieces that would make for a prettier picture? Like the family offices discussed above, are you evaluating investment opportunities that are either currently available, or likely to become available over the next 6 to 12 months? The dislocations triggered by the pandemic will result in attractive investment opportunities for family businesses that have their eyes open. Having a clearly defined hurdle rate, investment criteria, and due diligence processes in place is essential to ensuring that such acquisitions are productive uses of family capital.4) Selecting a New DestinationOur GPS navigation systems are amazing. But when you get in the car, it can still be a bit cumbersome to input the address for a new destination; it is much easier to scroll through the list of previous destinations. But if you’ve never been where you want to go before, selecting one of the previous destinations saved to your system won’t cut it. The Great Disruption of 2020 provides a natural opportunity for you and your fellow directors to re-evaluate just where it is your family business needs to be going. What will the long-term ramifications of the pandemic be for your segment of the market? How will you need to change your interactions with suppliers, customers, competitors, and regulators? Are there secular trends that you can get in front of, and use to enhance the long-term sustainability of your family business? This is not the time to default to previous destinations. Selecting a new destination may be just what your family business needs for it to continue serving the needs of your family for generations to come.Family directors have rightly been focused on keeping their people safe and healthy, and taking the steps necessary to help their businesses survive the pandemic. It will eventually be time to look ahead, however. When that time comes for your family business, what will you be thinking about? Contact one of our family business professionals today to help kick-start that conversation.
Gin, Business Valuation, and Ryan Reynolds
Earn-Outs in RIA M&A
Typically, my love of business valuation and gin and tonics do not go hand-in-hand, and, unfortunately, Ryan Reynolds has never been thrown into this mix. But last week, three of my favorite things collided in Reynolds’ viral out of office reply.On Monday, Diageo, a European beverage company, announced it would be acquiring Aviation American Gin, owned by Ryan Reynolds (among others), for total consideration of $610 million, and, on Tuesday, Reynolds had a stark realization...Thanks for your email. I am currently out of the office but will still be very hard at work selling Aviation Gin. For quite a long time, it seems.In related news, I just learned what an ‘earn out’ is... And I'd like to take this opportunity to apologize to everyone I told to go f**k themselves in the last 24 hours. My lawyers just explained how long it takes to achieve an 'earn out'... so... turns out I'm not as George Clooney as I thought. The point is, to those listed below, I'm sorry... and I'll indeed be needing your help in the coming months and years. Thanks in advance!Mom, Blake, Peter, Diageo CEO, The Rock, George Clooney, Southern Glazer's, Betty White, TGI Friday's, Baxter, Calisthenics, AMC Theaters, Total Wine, The Number 8, Don Saladino, Darden, The Head of Alfredo Garcia, Soothing Lavender Eye Pillows.Ryan Reynolds
Owner ?
Aviation American GinApparently, the $610 million advertised transaction price is made up of an initial payment of $335 million and contingent payments of $275 million, based on the performance of Aviation American Gin over a 10-year period.Gin, Business Valuation, Ryan Reynolds, and your RIA Earn-outs are commonly used in RIA deals, and we expect contingent payments to make up an even larger percent of deal consideration for the next few months, quarters, or years depending on how long the current economic uncertainty lasts. And while we hope most of our clients would be thrilled by the prospect of $335 million in upfront cash payments, we don’t want you to end up feeling as Ryan Reynolds did last week. In this post, we explain what an earn-out is, why they are commonly used in RIA transactions, and how earn-outs may be used as a saving grace for deal activity in the current economic environment.What Is an Earn-Out? An earn-out is an agreement between a buyer and a seller to defer a portion of the purchase price. The amount of consideration ultimately paid is determined based on either some measure of post-closing financial performance such as AUM or EBITDA, or a specific milestone that occurs post-closing such as the renewal of a large contract.Contingent consideration allows for risk-sharing between the buyer and the seller. Deferral of the purchase price functions as a hedge for the buyer against poor future performance, while sometimes simultaneously providing the prospect of additional upside for the seller if they outperform buyer expectations. Importantly, contingent consideration influences post-transaction behavior. When it is necessary for the seller to continue operating the business following the sale (for RIAs, this is almost always the case), the presence of contingent consideration can incentivize the freshly-endowed sellers not to “call in rich” (like Reynolds thought George Clooney did in his sale of Casamigos tequila for $1 billion - actually 30% of the total consideration was subject to a 10 year earn-out like in Reynolds’ case), but continue to promote the success of the business.Why are Earn-Outs Commonly Used in RIA Transactions? Earn-outs are commonly used in RIA transactions, as the purchase price is not based on the value of hard assets acquired but expected future cash flows. Future cash flows of an RIA can vary dramatically as they depend on a large number of variables, including:The performance of financial markets;The skill of the investment management staff;The sustainability of the acquired firm’s fee schedule;The retention of key staff at the acquired firm;The motivation of key staff; andThe retention of client assets.
As an example, we consider just one of these variables - market performance - and how an earn-out can be used as insurance to the buyer in case of a market downturn. While the market has almost recovered back to February highs, thanks mostly to the FANG stocks, some still think that this V-shaped recovery could turn into a W.
Assume that RIA Capital buys ABC Investment Management, with $4.2 billion in assets, for a total price of $100 million. The transaction is structured such that two-thirds of the proceeds are paid up front and the remainder of the purchase price is paid over three years if ABC’s AUM grows by at least 5% per year.
In Scenario A, ABC Investment Management’s AUM grows by 7.5% per year, and given the operating leverage inherent in most RIAs, EBITDA increases from $12.5 million to $15.8 million over the earn-out period. In this scenario, the entire earn-out is paid. The total consideration paid by the buyer is $100 million, which represents 6.8x average EBITDA in years 1-3.In Scenario B, ABC’s AUM falls by 15% in year one and slowly begins to recover, but, due to the operating leverage, EBITDA falls by almost 40% in the first year (a decline in revenue with little or no decline in expenses results in a larger drop in profitability). In Scenario B, the seller does not receive any contingent payments. The total consideration paid by the buyer is $67 million (the amount of the closing payment), which represents 6.6x average EBITDA in years 1-3.While the financial results in Scenario A and Scenario B differ quite drastically, the deal economics (from the buyer’s perspective) are similar. In both scenarios outlined above, the buyer paid roughly the same multiple of forward average EBITDA despite the difference in ABC’s EBITDA trajectory.Expect a Larger Portion of RIA Deal Proceeds to be Paid as Contingent ConsiderationRIA transaction activity has slowed during COVID-19. Most deals that were already in motion when COVID-19 hit, were finalized. However, new deal activity has been minimal. While a lot of due diligence can be performed virtually, buying an RIA in the middle of so much uncertainty is hard to swallow. However, the need for succession planning in the RIA space has not halted because of the pandemic. Rather, during COVID-19, many RIA principles have realized that succession planning is something that can no longer be delayed.So, how do you get buyers and sellers to execute a transaction during COVID-19 when the economic environment is so uncertain and when buyers likely have never set foot in the office they are buying or met management face-to-face? Part of the answer may be to bridge the gap between seller and buyer expectations by structuring the deal in a way that defers payment of a substantial portion of the purchase price in the form of contingent consideration.If you’re contemplating an offer for your firm that includes an earn-out, talk with an independent expert so you can better understand the value of the payments. And, Ryan Reynolds, if you are reading this, we would be happy to advise you on your next business deal.
Mineral Aggregator Valuation Multiples Analysis
Market Data as of August 14, 2020
As shown in the report, mineral aggregators’ stock prices have declined substantially over the past twelve months, but have rebounded from lows seen earlier in the year. The perfect storm of reduced asset values, record-low IRS rates, and the prospect of significant tax law changes early next year make this the ideal time to think about estate planning and tax-efficient ways to transfer assets to the next generation. With asset values trending upwards, vaccine candidates progressing rapidly, and political polling suggesting a high probability of a regime change in November, this perfect storm may not last long. Take advantage by taking action. In the current environment, there is little to gain by procrastinating, but potentially a lot to lose. We’re here to help with any valuation needs you have in this unique environment. Download our report below.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Mineral Aggregator Valuation MultiplesDownload Analysis
July 2020 SAAR
SAAR Increased to 14.5 Million in July, and Declines in Public Transportation and Ride-Sharing Usage Could be Creating Opportunities for Dealerships
SAAR has continued its upward trend coming in at 14.5 million, an encouraging 11% increase from June. However, sales continue to trail pre-COVID numbers with July 2020 14% below the same time last year.With demand picking up as customers can return to brick-and-mortar locations, dealerships aren’t feeling the need to offer as strong of incentives as they did at the start of the pandemic. According to JD Power, preliminary estimates put incentive spending for the month at $4,236 per unit, down from June 2020, but up by $166 compared to July 2019.As we mentioned in our previous SAAR post, inventory problems continue to be a difficult hurdle for dealerships to contend with as demand returns. JD Power reported that 41% of all vehicles sold in July spent fewer than 20 days on dealer’s lots, up from 35% a year ago.2020 is also proving to be an interesting year for new and used vehicles, as thin margins on cheap, new vehicles have manufacturers abandoning the investment. According to data from KBB, vehicles between $20K and $30K have declined from 44% of the market share in 2015 to 22% of the market share in 2020. Cars under $20,000 make up only 1.3% of new car sales so far this year. With the average price paid for a new vehicle around $39,000, this is way above many buyers’ budgets. As a result, entry-level buyers have been looking to the used car market instead. With the used car market getting bumps from new technologies, this has proven to be a viable and cost efficient option for new buyers.Pandemic Silver Linings for Auto DealershipsWhile the reopening of the country is bringing people back to dealerships, many places still aren’t being frequented like they had been in the past. Included in this list are bars, concert halls, and public transportation means. With fewer events going on, demand for ride shares has decreased significantly according to the Q2 earnings calls (stay tuned for next week’s blog post for a full rundown on those calls).The empty subways and buses should be on the radar of dealerships and could prove to be an ultimate silver lining among all of the negatives that the Covid-19 pandemic has created for auto sales. With social distancing difficult to achieve in a closed space environment like public transportation, there seems to have been a shift in consumer sentiment in favor of car ownership.The empty subways and buses should be on the radar of dealerships and could prove to be a ultimate silver lining to the struggles caused by the pandemic.A survey released in mid-July from CarGurus tracked customers’ views around buying a vehicle, and the results were striking! 39% of people planning to buy cars are looking to avoid ride-sharing, and 44% of them say they want to decrease or stop public transit use. Furthermore, as people start returning to the office, this number could increase, with 44% of people who take public transit to work citing that this is their top concern in returning to the office.As more data has been released noting the potential risks of using public transportation, the data surrounding people’s comfort level with public transport in the current climate is understandable. Even the government has become somewhat of a proponent of car ownership over public transportation during this time, as the CDC has encouraged companies to offer incentives for employees to use their own cars to ride to work, rather than public transportation or ride sharing.The Current State of Public Transportation and RidesharingWhen you look at the data behind public transportation usage since the pandemic began, it paints a clear picture of consumer preference during this time. Public transit ridership is measured by “unlinked passenger trips” with trips defined as whenever a person boards a transit vehicle, including transfers.Despite local governments pouring billions into public transit infrastructure, public transit ridership has been declining since at least 2014, with unlinked passenger trips falling 7.5%. The COVID-19 pandemic has escalated this decline significantly, with public transit unlinked trips dropping 85% from January to April at its lowest levels in more than a century. While this decline in usage could be attributed to overall declines in travel from stay at home orders, the graph below tells a different story. Vehicle miles did experience a decline as well, but it was strikingly smaller than that of public transit at 42%.
Ridesharing services are facing a similar problem, as consumers are feeling uncomfortable sharing an enclosed space with a stranger.
Uber has reported gross bookings on rides being down 75% in Q2. While Lyft declined to comment to the Washington Post on the impact of the pandemic on its business, the company has previously said its April ridership was down 75% in Q2.
Recovery in this space as the country reopens has varied widely by city and state depending on which are reopening, recovering, or reimposing restrictions. For example, ridership recovery has been prominent in cities like New York that have recently been recovering after facing the brunt of Covid cases earlier this year. In San Francisco and Los Angeles, however, it has been depressed as California continues to struggle with its caseload. California’s gig worker legislation also poses an existential threat, particularly for Lyft where it derived 16% of its business.
Manufacturers are encouraged by the changing sentiment surrounding car purchases, with Scott Keogh, Volkswagen’s U.S CEO noting that “We definitely do see a return to what I’ll call personal transportation and trust” and predicts a shift in consumer mindset to: “I know where this car has been; I know it’s mine.”
What Increased Private Car Ownership Might Mean for the EnvironmentWith many cities having heavily invested in public transportation infrastructure, this Covid-induced fear of public transportation has many city officials nervous. New York City Mayor Bill de Blasio this past week issued statements against purchasing a car during the pandemic, as he told reporters “My advice to New Yorkers is do not buy a car. Cars are the past, the future is going to be mass transit – biking, walking – and there’s so many options right now and there’ll be more and more as we go forward.”The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions.While currently it may be safer to purchase a car to avoid unnecessary encounters with other individuals on public transit, ultimately this pandemic has an expiration date. More notable are worries that all of the efforts made to dissuade car usage for the sake of the environment could be unraveled through the emphasis on private car ownership.The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions if people turn to cars to avoid exposing themselves to the virus. University of British Columbia urban planning and public health professor Lawrence Frank notes that “promoting private vehicle use as a public health strategy is like prescribing sugar to reduce tooth decay.”However, both optimism from auto dealers on the prospect of new sales and concerns from public transportation advocates may be premature. With a vaccine predicted in 2021, consumer sentiments toward public transportation could easily revert back. Rebecca Lindland, an auto industry analyst, shares this viewpoint having seen previous trends come and go. For example, in 2008 when people started buying small fuel-efficient cars, she notes that “That only lasted two to three months, and then people went back to buying a vehicle that suited their wants and needs.” If people feel safer riding public transit with the development of COVID-19 vaccines and treatments, and parking and traffic once again become headaches, consumer preferences could shift off private car ownership.Looking ForwardWhile pandemic-related car sales stemming from public transportation avoidance may not be long-term, in the short run it could help boost dealership sales while they are trying to recover.However, many Americans are still hesitant to purchase a vehicle. This is despite a third of consumers saying they value having their own car more now than they did before Covid, and 93% were using cars more in the era of social distancing.The NADA expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle.This hesitation stems not from opinions on transportation, but rather on the state of the economy. As unemployment remains high and there are uncertainties surrounding future government stimulus, consumers could be waiting for a more stable environment to make large purchases such as vehicles.Nonetheless, the National Auto Dealer Association expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle. Inventory constraints may continue to plague the industry, but barring more production shutdowns, supply should ultimately be able to reach demand levels by end of the summer further supporting SAAR’s upward trajectory.
Estate Tax Planning May Be the Next Surprise for RIA Community
2020 Chicanery Never Ends
Road racecourses were originally built with at least one very long straightaway that allowed cars to reach maximum speed before braking for the turn. As cars became more powerful, the maximum speed attainable on the straights was dangerously fast. Racecourses added serpentine curves, known as chicanes, to the straights that require cars to slow down and maneuver before resuming a straightaway. 2020 has been a year of one chicane after another, and at this point, I don’t think anybody expects a direct path to 2021.RIAs Outran Two Challenges in 2020…After a decade of gaining speed, the outlook for the investment management industry suddenly turned fairly grim in March. With workforces on lockdown and equities falling, the pricing of publicly traded RIAs unsurprisingly trended downward. But running an investment advisory practice remotely turned out to be much less impossible than many imagined, and AUM rebounded rapidly with the markets. As such, Q2 did not turn out to be the industry bloodbath that many imagined, especially in the wealth management space.2020, however, is full of surprises, and the third quarter is bringing more. The persistence of the pandemic and the consequent economic strain on many has shifted political winds in favor of the minority party. If these trendlines don’t roll over between now and November 3, we’ll have a new executive and legislative regime and, with it, a redirection of tax policy. It’s not too early to start thinking about what impact certain legislative changes will have on the RIA industry, especially with regard to estate tax law.Estate Planning Rising in ProminenceInvestment advisors are not estate planners per se, but estate planning is a necessary part of financial planning for very wealthy clients. If political winds shift, more of your clients could be subject to estate taxes and, therefore, would benefit from estate planning. When my career started in the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple. The unified credit wasn’t indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were more or less legislated away over the following decade. Over the past decade, the law has changed several times but mostly to the benefit of wealthier estates. That $650 thousand exemption from estate taxes is now $11,580,000. A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of RIA clients (not to mention RIA owners) need heavy duty tax planning.That may all be about to change. Joe Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Biden’s Proposed Tax PoliciesBasis step-up is a subtle but important feature of tax law. Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date). Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death. Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis. Further, he prefers taxing the embedded capital gain at death. Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Capital gains tax rates are generally lower than ordinary income taxes, of course, but Biden has also suggested that he would raise capital gains taxes for high earning households to equal ordinary income tax rates, which he also plans to increase. Imagine a $10.0 million portfolio with a tax basis of $2.0 million. If your client passed today, it might go to heirs free of estate taxes and with a new tax basis of $10.0 million. If your client pays the maximum capital gains tax rate of 20%, the unified credit and basis step-up would save them $1.6 million (20% of the $8 million gain). The entire $10.0 million portfolio would pass to an heir tax free. If, instead, the unified credit is significantly reduced and capital gains rates rise to, say, 40%, the change will cost your client’s estate $3.2 million, and the bequest would be diminished to $6.8 million. If an estate tax is levied on top of that, the impact will be much greater.For those who want to minimize exposure to changes in tax law, estate planning can leverage the very low interest rate environment in conjunction with trusts and asset holding entities to transfer wealth efficiently and outside of the reach of the U.S. Treasury. The problem that may well present itself is the overwhelming demand for these services in late 2020 if the election is decisively in favor of the Democratic Party. If success in investing is “anticipating the anticipations of others,” this is a good time to think seriously about estate planning before tax planners become as scarce as toilet paper was in April.What is the Next Chicane?Where were you when you first realized that the Coronavirus pandemic was a big deal? I was in, of all places, New York with my family during the second week of March, and I’ll never forget how every day of the week it became more apparent that COVID-19 was going to change the trajectory of this year, if not beyond. First, the NBA suspended the season, then Tom Hanks – who was in Australia – tested positive, and then – also in Australia – the Formula 1 racing season was suspended about two hours before it was scheduled to start.F1 resumed on July 5 with the Austrian Grand Prix, and the motorsport, which is essentially a giant logistical exercise anyway, has successfully pivoted schedules, business practices, and financial models to adapt to operating in an environment with plenty of at-home viewers but nobody in the stands. Even for a business that thrives on making order out of chaos, Formula 1 is going better than expected, and the same could be said of the RIA industry. But now that you’ve successfully protected, and maybe even enhanced, your clients’ financial well-being and the earnings of your firm, the challenges that loom from political change are coming in fast. The chicanery of 2020 never ends.
How Is Your Family Business Performing in the COVID-19 Pandemic?
One thing in short supply thus far in the pandemic has been perspective. We know that GDP fell by more than 30% during the second quarter, but how does that translate into the actual financial performance of businesses? Family business directors have been flying blind over the past few months, with no reliable way to benchmark the performance of their businesses.Earnings season for the second quarter of 2020 gives us the first opportunity to see how the COVID-19 pandemic is affecting businesses. We normally don’t get too concerned about reported results for a particular quarter, but this is an obvious exception. By the time the second quarter started on April 1, many regions of the country were already in quarantine, with the rest to follow shortly thereafter. While the pandemic started to weigh on results in 1Q20, it was hard to get an accurate feel for the impact, since January and February were essentially “normal.”In this post, we elaborate on four themes that emerge from the data.Theme #1 – Smaller companies have been more adversely affected than larger companies.Revenue and earnings for smaller companies fell more sharply than for larger companies. In the aggregate, revenue for the companies in the Russell 1000 fell 12% relative to 2Q19, compared to a 23% shortfall for the companies in the Russell 2000. The size effect is most pronounced for companies in the communication services and health care industries.It is not possible to tease out from the data precisely why larger companies fared better during the pandemic. However, investors did successfully predict the phenomenon, as returns for the small cap index have lagged those of large cap names since the pandemic struck.Questions for Family Business DirectorsHow does your performance compare to that of the public companies in your industry?In your specific industry niche, do the larger players have a natural advantage? If so, what steps can you take to turn your smaller size into a competitive advantage? Can you be more responsive, nimbler, than larger competitors?How will your family business preserve profitability if the pandemic-induced recession persists?Theme #2 – Smaller companies are prioritizing cash flow.In the aggregate, the Russell 2000 companies in our sample reported a net loss of $17.8 billion during 2Q20, compared to net income of $3.6 billion during the prior year period. The negative effects of the 23% revenue shortfall experienced by those firms cascaded down the income statement, growing to a 58% reduction in EBITDA, and triggering net accounting losses after taking into account impairment charges, depreciation and amortization, and interest expense.However, when we turn to the statement of cash flows, operating cash flow increased in 2Q20 compared to 2Q19, in large measure to the cash freed up from lower working capital balances. While not a sustainable source of cash flow, careful management of working capital levels is an important source of precious cash flow during a downturn, and the public companies in our sample have been diligent in maximizing cash from working capital.Questions for Family Business DirectorsHow have your cash collections been holding up through the downturn? Are there any problematic accounts lurking in your receivables list? Do you have a strategy for dealing with customers that encounter financial distress of their own?How are you managing inventory? Are there specific portions of inventory that have a heightened risk of becoming obsolete?What is your strategy for managing payables? Are any vendors offering discounts for prompt payment?Theme #3 – Smaller companies are building cash.The pandemic has featured a recurring cycle of positive developments followed by setbacks. As a result, no one has a good handle on how long these conditions will persist. Facing this uncertainty, managers and directors of the public companies in our sample have been accumulating cash as a hedge against a potentially extended period of underperformance. If the downturn persists into 2021, financial flexibility will be critical. As one of our long-time family business clients once observed: “You make better decisions when you don’t need the money.”As shown below, the companies in our sample added to cash balances, in part, by becoming much more selective investors. Cash outlays for M&A activity evaporated, and capital expenditures were cut by 40%. In fact, capital expenditures represented just 75% of depreciation and amortization charges, which are a good proxy for the “maintenance” level of spending. This is not a sustainable practice for family businesses, but deferring non-essential capital expenditures can be a prudent move in the short-term when the outlook for the future is especially cloudy. Questions for Family Business DirectorsHow has the downturn affected the size of your capital budget? Are you using a higher hurdle rate on potential investments, taking a haircut to pre-COVID cash flow projections, or using some other mechanism to ration capital?Have you been deferring “maintenance” capital expenditures? If so, it is important to carefully monitor what has been deferred, and identify what the priorities for catching up will be when more normal conditions return.Are there any idle assets on the balance sheet that don’t have a strategic role to play in your family business and can be converted to cash?Theme #4 – Shareholders are being patient (for now).Finally, we can see that the shareholders of the smaller companies in our sample are doing their part as companies seek to conserve cash. Combining dividend payments and amounts spent on share buybacks, total payments to shareholders fell by more than 60% from $5.3 billion in 2Q19 to $1.9 billion in 2Q20. Repurchases fell by more than 80%, while aggregate dividend payments were cut by 33%. Of the 224 small cap companies in our sample paying dividends at this time last year, 44 (20%) have suspended their dividends entirely.Questions for Family Business DirectorsHow have you communicated the business impact of the pandemic to your family shareholders?What adjustments to dividends are appropriate/necessary considering the performance of your family business? How can you prepare shareholders for those changes?If you have a share redemption program, is the valuation up-to-date? If it is not, the remaining shareholders may end up inadvertently subsidizing the shareholders that elect to cash out.Is there consensus within your family regarding what the family business “means”? In other words, do family members view the business as an economic growth engine for future generations, a source of wealth accumulation, a store of value, or a source of lifestyle? How does the prevalent “meaning” of the business influence your dividend deliberations?ConclusionIt’s a horrible cliché, but these really are pretty unprecedented times. Up to now, family business directors have had little context for evaluating how their companies are performing, and how their strategic decisions are stacking up against those made by others. Give one of our professionals a call today to discuss the benefits of a customized benchmarking analysis for your family business or how the value of your family business has likely changed as a result of the pandemic. For many successful multi-generation family businesses, this a uniquely opportune time for tax-efficient estate planning. Don’t let it pass by without taking advantage – the future generations will thank you.For a deeper dive, download our COVID Benchmarking Update (August 2020) below.August 2020COVID Benchmarking
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Whitepaper Release: Understand the Value of Your Auto Dealership
If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper
The Importance of the Valuation Date in Divorce
During the divorce process, a listing of assets and liabilities, often referred to as a marital balance sheet or marital estate, is established for the purpose of dividing assets between the divorcing parties. Some assets are easily valued, such as a brokerage account or retirement, which hold marketable securities with readily available prices. Other assets, such as a business or ownership interest in a business, are not as easily valued and require the expertise of a business appraiser. Upon retaining a valuation or financial expert, together with the family law attorney, it is important to understand and agree upon certain factors that set forth a baseline for the valuation. These may be state specific, such as case precedent and state statute. One of these considerations is the valuation date, which differs from state to state.Valuation Date DefinedThe valuation date represents the point in time at which the business, or business interest(s), is being valued. The majority of states have adopted the use of a current date, usually as close as possible to mediation or trial date. Other states use date of separation or the date the divorce complaint/petition was filed. See the map on page 2 for a preferred valuation date summary by state (note that the summary may be modifiable for recent updates in state precedent).Those states that use date of separation or date of complaint/ petition as the valuation date face a bit of “noise” and complexity when the divorce process becomes lengthy and/or when there are significant impacts to the economy and/or industry in which that business operates.As an example, consider the timeframe from December 31, 2019 to now, Summer 2020, and the economic reverberation of COVID-19. A valuation as of these two dates will look quite different due to changes in actual business performance as well as shifts in future expectations/outlooks for the business and its industry. However, this is not only a consideration for those states which use date of separation or date of petition. This is also an important consideration for matters which have extended over a prolonged period. It is also critical for current matters – we are all aware that much has transpired since December 31, 2019 – as that valuation date may no longer accurately reflect the overall picture of the business, necessitating a secondary valuation, or alternatively, an update to the prior valuation.Let’s take a deeper dive at understanding the importance of valuation date as it relates to the divorce process.Why Does the Valuation Date Matter?Laws differ state to state regarding valuation date and standard of value (generally fair market value or fair value). There are other nuances related to the business valuation for divorce process, such as premise of value which is often a going-concern value as opposed to a liquidation value. After the standard of value, premise of value, and the valuation date have been established, the business appraiser must then incorporate relevant known and knowable facts and circumstances at the date of valuation when determining a valuation conclusion. These facts and trends are reflected in historical financial performance, anticipated future operations, and industry/economic conditions and can fluctuate depending on the date of valuation.
Using our prior example, the conditions of Summer 2020 are vastly different than year-end 2019 due to COVID-19. For many businesses, actual performance financial performance in 2020 has been materially different than what was expected for 2020 during December 2019 budgeting processes. The current environment has made the facts and circumstances in anticipated future budget(s), both short-term and long-term, even more meaningful. The income approach reflects the present value of all future cash flows. So, even if a business is performing at lower levels today, that may not necessarily be a permanent impact, particularly if rebound is anticipated. Thus, that value today may be impacted by a short-term decrease in earnings; however, an anticipated future rebound will also impact the valuation today.
It must be pointed out that it would be incorrect to consider the impact of COVID-19 for a valuation date prior to approximately March 2020, as the economic impact of the pandemic was not reasonably known or knowable prior to that date. Therefore, the valuation date is meaningful and a significant consideration in any valuation process, and especially in current conditions. A state that typically requires a date of separation may consider consensus among parties to update to a more recent date as much has changed between then and now.
How Have Valuations Been Affected by COVID-19?Valuations of any privately held company involve the understanding and consideration of many factors. We try to avoid absolutes in valuations such as always and never. The true answer to the question of how have valuations of privately held companies been affected by the coronavirus is “It Depends.”It depends on what industry the business operates in and how that industry has been impacted (whether negatively or positively) by COVID-19 conditions.It depends on where the subject company is geographically as we are seeing timing impacts from openings/closures differ throughout the country and globally.It depends on what markets the subject company serves. As we have seen and are continuing to see across the country, the stay-at-home restrictions have varied greatly from state to state and certain areas have been more severely affected than other. Certain industries, such as airlines, hospitality, retail, and restaurants, have been far more impacted than other industries.
As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a guide. The stock market has been volatile since the March global impact from COVID-19 began to unfold. Specific indicators of each subject company, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.Valuation Date Considerations for Lengthy ProcessesThe valuation date for purposes of business valuation for marital dissolution is an important issue, even in times without the current COVID-19 conditions. Consider matters that extend into multiple years from time of separation to time of divorce decree. Has the value of the business changed during this time? If the answer is yes, or maybe, another consideration for some clients may be related to the cost of another valuation. However, the importance of an accurate and timely valuation should far outweigh the concerns of additional expense to update a conclusion.It is important to discuss these elements with your expert as the process may depend on the length of time which has transpired since the original valuation and the facts and circumstances of the business/economy/industry. Your expert will be able to determine if an acceptable update may be simply updating prior calculations; however, if much has changed, such as expectations for the future performance of the business, the approach may involve a secondary valuation using a current date of valuation.Another consideration to keep in mind: depending on jurisdiction, state law may deem the value of the business after separation but before divorce as separate property. If this is the case, two valuation dates are necessary.Concluding ThoughtsThe litigation environment is complex and already rife with doom and gloom expectations. We have previously written about the phenomenon referred to as divorce recession in family law engagements. Understanding the valuation date of an asset valuation, such as a privately held business, for marital dissolution is an important consideration, especially for matters which have extended over a lengthy time and those that may be impacted by significant global events such as COVID-19. Speak to your valuation expert when these matters arise. The already complex process of business valuation becomes even more complex with the passing of time and also in the midst of economic uncertainty.
The Importance of the Valuation Date in Divorce
During the divorce process, a listing of assets and liabilities, often referred to as a marital balance sheet or marital estate, is established for the purpose of dividing assets between the divorcing parties.
Bridging Valuation Gaps With Options
How Option Pricing Can Be Used to Understand the Future Potential of Assets Most Affected by Low Prices, PUDs and Unproven Reserves
Due to the precipitous drop in oil prices in 2020, oil E&P companies in the U.S. have struggled to pay their debts, and in many cases already have had to file for bankruptcy. In this post, we re-examine how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. Whether companies are looking to sell these reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market. The Struggle: Valuation in Distressed MarketsThe petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and meaningful appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, such as in today’s low price environment, the DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.The DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 & P3) categories. The DCF’s use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project’s upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to consider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the future price deck, many, if not most, PUDs appear to have a negative DCF value.What does this mean for the E&P companies looking to reorganize under a Chapter 11 Bankruptcy? There are five key concepts for management teams and their advisors to be familiar with to understand how reserve valuation impacts Chapter 11 reorganization.Liquidation vs. Reorganization. The proposed reorganization plan must establish a “reorganization value” that provides superior outcomes for shareholders relative to a Chapter 7 liquidation proceeding.Liquidation Value. This premise of value assumes the sale of all of the company’s assets within a short period of time. Different types of assets might be assigned different levels of discounts (or haircuts) based upon their ease of disposal.Reorganization Value. As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” Reorganization values are typically based on DCF analyses.Cash-Flow Test. A cash-flow test examines the viability of a reorganization plan, and should be performed in order to determine the solvency of future operations. In practice, this test involves projecting future payments to creditors and other cash flow requirements including investments in working capital and capital expenditures.Fresh-Start Accounting. Upon emergence from bankruptcy, fresh-start accounting may be required to allocate a portion of the reorganization value to specific identifiable intangible assets. Fair value measurement of these assets typically requires use of the multi-period excess earnings method or other techniques often used in purchase price allocations following a business combination.
If recent market transactions are utilized to establish a liquidation value, then it stands to reason that very little, if any, value will be given to the PUD reserves. For a company trying to avoid liquidation in a distressed market where sale prices do not indicate the true value, there may still be a way to demonstrate significant value if reserves are retained in reorganization. However, that reorganization value has typically been based on a DCF. It is possible that the DCF may capture significant value in PUD reserves because in reorganization debt levels are adjusted. When debt levels are adjusted the cash flow PUD reserves need to generate to be viable is much lower. This will provide two significant benefits: more time and possibly more cash. More time may allow global and regional oil and gas prices to increase while the additional cash flow from lower interest payments may allow investment in future PUD wells.
Unfortunately, it is still the case that the present value calculation is strongly tied to current market conditions, and thus even for companies with reasonable leverage, many PUD and unproven reserves show negative cash flow. The presence of some sizable transactions made without significant PDPs shows that there are buyers who disagree with this assessment and see value in these reserves. The issue is demonstrating that value in either a sale or bankruptcy scenario. An option pricing model is one solution that could account for the value of the increased time provided by restructuring the debt.Option Pricing Providing A Potential SolutionOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As previously discussed, if one relied solely on the market approach many of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of potentially multiple forces come into play: either the PUDs potential for development can be altered by fluctuations in the price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is typically most pronounced in unconventional resource or when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed shorter and/or contractual timeframe.Current Pricing Environment:As oil prices have dropped and temporarily stabilized around $40 PUD values may drop precipitously.
After the last recession, some PUDs faced a similar, yet more modest, decline in prices. In fact, nearly half the companies surveyed this spring by the Federal Reserve Bank of Dallas reported only being able to be solvent for 2-3 years at the most under these values. We have already seen some declare bankruptcy.
Valuation would be made easier if we could determine when oil prices would rise again. Valuations vary as to producers’ sensitivity to this price. The Dallas Fed’s latest survey suggests that $40 is about the tipping point to restart shut-in wells, but not necessarily to drill new ones:
Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists many times vary widely from actual results. So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? In many cases, they are following a real option conceptual framework.
Real Options: Valuation FrameworkPUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF, or a haircut. Historically, in a similar oil price environment, as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves.An option pricing model can guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the natural gas commodity currently. This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. It is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below.
When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the currently out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by some buyers of this optionality upside.
All that said, there are some challenges and dangers in applying the options model to reserves such as observable markets, risk quantification, assumption sensitivity, service and drilling availability, and time to expiration to name several.
Utilization of the modified option theory is not in the conventional vocabulary of many oil patch dealmakers, but the concept is considered among E&P executives as well during transactions in non-distressed markets. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), the time value of the out-of-the-money drilling opportunities can have significant worth in the marketplace. Careful application is important, but given today’s conditions, the benefit can outweigh the challenges.
Now Is a Great Time to Transfer Stock to Heirs
Depressed Market Values Provide an Opportunity for Tax-Efficient Transfers of Family Wealth for Estate Planning Purposes
The economic effects of the COVID-19 pandemic are dire, and family businesses are not immune to the economic fallout from the virus. Yet we are confident that family businesses are best positioned to survive and lead in the post-pandemic economic recovery.For family shareholders who are optimistic about the resilience of their family businesses and focused on the long view, this is an ideal time to execute intrafamily transfers in pursuit of estate planning objectives.Coronavirus and Fair Market ValueThe precipitous decline in public equity markets has been well documented. From its Feb. 19 peak, the S&P 500 index lost nearly 24% of its value by the end of the first quarter. Small-cap stocks in the S&P 600 index suffered even more, falling approximately 33% over the same period.What caused the significant drop in public stock prices? Stock prices reflect three factors.Cash Flow. Stock prices are based on the future, not the past. Historical earnings and cash flows can provide important perspective, but investors are much more focused on what’s visible through the windshield than what is in the rearview mirror. For most public companies, the pandemic has caused investors to reassess the amount of cash flow those companies will generate in the coming year. Lower expected cash flows result in lower stock prices.Risk. When fog or other conditions reduce visibility, smart drivers slow down. Investors do the same thing. The pandemic has caused the range of potential cash flow outcomes for the coming year to be much wider than normal. In other words, stock investors are facing more risk than normal. When risk goes up, stock prices come down.Growth. The growth component describes how fast cash flows are forecast to increase in subsequent years. Theories abound as to whether the economic recovery curve from the pandemic will look a “V” or a “U” or a “W” (or some other letter). To the extent investors expect the negative effect of the pandemic to weigh on cash flows for a prolonged period, stock prices will be cut.
It is impossible to dissect the observed change in stock prices to discern how much of the decrease is attributable to expected cash flow, risk, or growth. What matters is that the three factors, in combination, have caused the reduction in public stock prices.
What does all this have to do with the fair market value of illiquid minority interests in private companies? The value of such interests depends on the same three factors.
Business appraisers determine the fair market value of shares for gifting or other intrafamily transfers using a two-step process.First, appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them on the stock market. In doing so, they develop expectations regarding the cash flow, risks, and growth prospects of the family business. If a particular family business is better positioned to weather the COVID-19 storm than its peers, the negative impact on value may be muted. For many family businesses, however, an assessment of these three factors in the midst of the pandemic will likely result in a materially lower value than would have been the case in mid-February.Next, appraisers consider the appropriate discount, or reduction in value, to account for the fact that the shares in the family business are not publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on the specific attributes of the shares, including the likely holding period until a favorable opportunity for liquidity is expected, the amount of expected interim distributions from owning the shares, the expected capital appreciation over the holding period, and the incremental risk associated with illiquidity. The impact of the pandemic on the magnitude of the marketability discount is more ambiguous than the effect on the as-if-freely-traded value. Some of the factors are likely to be neutral relative to the pre-pandemic environment, while others may be negatively or positively affected.
In short, the fair market value of minority shares in family businesses is likely lower today than it was just a couple months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Case Study: Decisive vs. Hesitant PlanningWe can illustrate the significance of the current opportunity with an example. Consider a family business having a pre-pandemic value on an as-if-freely-traded basis of $25 million. Although the long-term prospects of the business remain unchanged, the dislocations caused by coronavirus have triggered a temporary reduction in fair market value of 25%. The founder has yet to do any estate planning and continues to own 100% of the shares.Exhibit 1 depicts the expected value trajectory for the family business both before and after the pandemic.Because of the resilience of the family business, the value trajectory resumes its pre-pandemic path after three years. The founder’s tax advisers suggest that – since the long-term prospects of the business are unimpaired – the current depressed fair market value provides an excellent opportunity to begin a program of regular gifts. The current lifetime gift tax exclusion is approximately $12 million, and the founder and his advisers devise a strategy of making an initial gift of $6 million, followed by annual gifts of $1 million in each of the following six years.We’ll examine two scenarios. In the first, the founder begins the gifting program immediately (the “Decisive” scenario). In the second, the founder defers the gifting program until the uncertainty associated with the pandemic has passed (the “Hesitant” scenario). In both cases, the shares gifted represent illiquid minority interests, so a 25% marketability discount is applied to derive fair market value.Since the annual gifts are for fixed dollar amounts, lower per-share values result in more shares being transferred, which reduces the amount of shares in the future taxable estate, all else equal. Exhibit 2 summarizes the shares that are transferred under the gifting program for the Decisive and Hesitant scenarios.Because the gifts under the Decisive scenario were made while share prices were depressed because of the coronavirus, a larger portion of the shares were transferred than in the Hesitant scenario. As a result, the founder retained just 33% of the total shares after using the $12 million lifetime exclusion, compared with 58% under the Hesitant scenario. As shown in Exhibit 3, the effect on the resulting taxable estate is compounded because, under the Hesitant scenario, the 58% retained interest represents a controlling position in the shares and the value is not reduced for the marketability discount. In fact, although not shown in Exhibit 3, a control premium to the as-if-freely traded could be applicable, which would exacerbate the disparity.
In our example, failing to take advantage of the estate planning opportunity presented by the depressed asset prices added $7.2 million to the eventual estate tax bill. Procrastination can be costly.
Estate Planning and ControlOur preceding example was relatively simple. Estate planners often use a variety of strategies involving trusts and other vehicles to accomplish estate planning and other goals. However, our simple example illustrates what is often perceived as a “cost” to aggressive estate planning: the senior generation’s loss of voting control.In the Decisive scenario, the founder’s ownership percentage fell below 50% in 2022. So, from that point on, the founder could no longer unilaterally make significant corporate decisions. We have seen a variety of strategies used to mitigate this outcome, such as establishing voting and non-voting share classes. These techniques can delay the eventual loss of control, but every business leader will eventually relinquish voting control of their company, whether through estate planning, death, or sale of the business.In our experience, deferring estate planning to accommodate a desire to maintain voting control is rarely worthwhile. When the desire to maintain control is especially strong, that is often a clue that there are other underlying family issues that need to be addressed. If, as the controlling owner advances in age, the loss of voting control remains unpalatable, that could signal that the family dynamics are such that selling the business might be the best outcome for everyone.Strike While the Iron Is HotFamily business leaders are currently facing many pressing issues. Amid the uncertainty, however, family shareholders should know that the estate planning opportunities triggered by lower valuations may not last. Schedule a quick call with your estate planning advisers to see if there are steps you can take to help reduce the burden of future estate taxes on your family and business.This article originally appeared in Family Business Magazine (April 2020) and was republished with permission.
Electric-Vehicle Industry Is Heating Up
Policy and Oil Price Implications for EV Sales
I remember watching the movie Cars when it first came out in 2006. I was seven years old and can easily recall the infamous line Lightning McQueen would say before a race, “I am speed.” His determination on the racetrack was unrivaled as he went on to win many races and championships. However, Lightning’s winning tradition came to a halt in the third movie. He had lost his competitive edge as cars with new technology began to dominate the racetrack.Unlike Cars, however, the current focus for new auto technologies is less focused on speed, and more on sustainability, as there appears to be a shift in focus away from developing the century-old gasoline-powered vehicle to electric. The electric-vehicle (EV) industry has shown to be an attractive long-term alternative for manufacturers. In this post, we’ll survey the landscape including the beginnings of EVs, major players in the industry, and the future outlook.Origins of the Electric-Vehicle IndustryThe first electric-vehicle in the U.S. was introduced in 1890 with a top speed of 14 miles per hour. According to the American Census, by 1900, 28% of all cars produced in the U.S. were electric. However, Henry Ford’s mass production of gasoline-powered vehicles reduced the cost of this vehicle significantly. In 1912, a gas-powered car averaged $650 while an EV averaged $1,750, and as a result of this price disparity, EV’s lost a great degree of popularity.Fast forward nearly 100 years, and EV’s continue to trail their counterparts. For example, GM’s EV1 was produced in 1996 and contained 137 horsepower with a 0-60 mph acceleration time of about nine seconds. Moreover, charge time and range proved problematic with a 15-hour charge time and only a 90-mile maximum cruising range not drawing much consumer demand. As a result, this model was discontinued only after a couple of years of production. Charge time and range problems continued to plague the industry as manufacturers struggled to compete with traditional vehicles. However, in 2008, the EV industry revealed a glimpse of hope when Tesla Inc. released the all-electric Roadster. This vehicle had a range of almost 250 miles on a single battery with a 0-60 mph acceleration time of four seconds. These metrics were unrivaled in the EV industry, and Tesla ascended quickly as competitors could not compete with this level of technology in their batteries.Tesla’s Emergence as Market LeaderWhile Tesla dominates the industry, CEO Elon Musk revealed his intentions of offering a helping hand to its competitors. He recently tweeted the following: “Tesla is open to licensing software and supplying powertrains & batteries. We’re just trying to accelerate sustainable energy, not crush competitors!” Major automotive manufacturers have recognized Tesla’s dominance in the industry. Volkswagen (VW) CEO, Herbert Diess, reflects on Tesla’s technological achievements: “What worries me the most is the capabilities in the assistance systems. 500,000 Teslas function as a neural network that continuously collects data and provides the customer a new driving experience every 14 days with improved properties. No other automobile manufacturer can do that today.” Furthermore, Audi CEO, Markus Duesemann, recognizes the magnitude of Tesla’s accomplishments: “Currently, Tesla has larger batteries because their cars are built around the batteries. Tesla is two years ahead in terms of computing and software architecture, and in autonomous driving as well.” Tesla’s dominance in the EV industry is reciprocated by investor enthusiasm, though as we’ve noted, plenty of other factors are at play.Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales.As Tesla continues to expand its EV line and invest in new technologies such as autonomous vehicles, other automotive manufacturers have set their sights on expansion of their electric vehicle fleet to try and keep up. GM Chief Executive, Mary Barra is optimistic regarding the trajectory of GM’s influence in the EV industry. She states, “We believe in an all-electric future, and we’re moving aggressively to have vehicles that people want.” GM revealed plans to expand its EV fleet through 2023 with 20 new vehicles including a $20 billion investment towards electric and autonomous technologies. Similarly, Ford plans to invest over $11.5 billion through 2022 and plans to use aspects of its E-Mustang in future EV’s.While other companies are investing in this space, Tesla continued to be the market leader in 2019 with its Model 3 alone accounting for 14% of total global EV sales. Other global models with a presence in U.S. markets that finished strong in sales for the year included the Nissan Leaf (#3), BMW 530e/LE (#6), Mitsubishi Outlander PHEV (#7), Hyundai Kona EV (#9), and the BMW i3 (#10). To put things in perspective, the combined sales of these other models still fell short of Tesla’s sales for its Model 3 alone.The Road to EV Success Paved by Government SubsidiesConsumers and manufacturers are increasingly showing interest in electric vehicles for their ability to reduce one’s carbon footprint. However, costs and infrastructure are proving to be difficult hurdles for them to catch up to petrol or diesel alternatives. The battery costs of an electric vehicle are showing to be the most acute, taking up 30% of the total costs of an EV. To help automakers past this hurdle, the government has provided subsidies to encourage electric vehicle sales. Each automaker is eligible for $7,500 in credits for each electric vehicle sold, up to $200,000 sales. Credit gets halved to $3,750 for six months after hitting that target, and then halved again to $1,875 for another six months. After that, the credit goes to zero. From 2014-2018, U.S. buyers claimed credits for 239,422 vehicles, worth $1.4 billion. So far, Tesla and GM have been the only manufacturers to hit the thresholds. Still, there have been proponents of the government extending incentives or increasing them to further support electric vehicle sales. With just over 2% of American vehicles sold last year being electric, losing federal tax credits could make the expansion of electric vehicles more troublesome.Costs and infrastructure are proving to be difficult hurdles to catch up to petrol or diesel alternatives.Beyond cost, electric vehicle manufacturers must improve poor supporting infrastructure. In March 2020, the U.S. had approximately 78,500 charging outlets and almost 25,000 stations for plug-in electric vehicles. While this number has been increasing over the years, it still pales in comparison to the approximately 115,000 gas stations in the U.S (which has sharply declined from much higher levels). Furthermore, a large portion of the total charging stations are in California.While daily commutes can be supported by overnight charging, consumers need to be confident that they can go on road trips and reliably find a charging station for EV’s to really take off. Electric vehicles have historically had an inferior range to their gas-powered counterparts. While the gap has narrowed over time, miles covered on one tank isn’t the only hurdle. Gassing up your car takes a fraction of the time required to fully recharge EVs, lengthening consumers’ ETA. California currently has 25% of charging stations and 35% of charging outlets. For EVs to become mainstream, access will have to be increased. So far, the government has been willing to subsidize purchases and incentivize production. There are also federal grants for cities and states looking to invest in the necessary charging infrastructure, but it will be interesting to see who foots most of the bill if EVs achieve the scale desired. More accessibility to charging stations should improve consumers’ interest in electric vehicles, though it won’t fully solve the problems of longer road trips.State and federal governments aren’t just using subsidies to power this shift, as there have been more regulations and requirements for more fuel-efficient vehicles. For example, the National Highway Traffic Safety Administration (NHTSA) and the Environmental Protection Agency (EPA) passed The Safer Affordable Fuel-Efficient Vehicles Rule (SAFE) which went into effect in March of this year. This rule tightens the fuel economy and carbon dioxide standards progressively by 1.5% each year from 2021 to 2026. Passenger cars and light trucks are subjected to this rule. This rule could undoubtedly act as a catalyst for manufacturers shifting additional focus towards EV production.Further, the Zero Emissions Vehicle (ZEV) program mandates a certain proportion of EV sales to non-electric sales in California and ten other states. Under this rule, plug-in hybrids, battery EV’s, and hydrogen fuel cell vehicles qualify as a ZEV. The 2020 ZEV production requirement is 9.5%, but it will rise to 22% by 2025.Tesla continues to capitalize on the benefits of producing strictly EV’s, as their 10-Q report indicated massive profits from the sales of regulatory credits totaling to $428 million in Q2 (about 7% of revenue). In order to dodge emission fines, other automotive manufacturers will purchase credits to make up for their own deficits in EV sales. For example, last year, Fiat Chrysler Automobiles (FCA) closed a deal with Tesla for about $1.3B in credits to stay in compliance with heightened European environmental regulations taking effect in 2021.
Oil Price OutlookIn the past, high oil prices have increased the incentive to shift to electric. However, the pandemic’s disruption to global supply and demand of oil has significantly decreased the urgency in the near term. According to the U.S. Energy Information Administration (EIA), in March and April, consumption fell significantly for liquid fuels largely due to travel declines from stay-at-home orders. During this period, the consumption levels matched those of the early 1980s, hovering at an average of 14.7 mb/d (million barrels per day). As states reopened following the lockdown, liquid fuel consumption levels began to recover. However, amid coronavirus infections surging, another dip in liquid fuel consumption levels may be on the horizon.
While low oil prices are the current reality, the ultimate resurgence of travel post-COVID-19 is expected to bring back higher oil prices. Volkswagen’s chief strategist, Michael Jost, does not view this year’s slump in oil prices as a barricade to the company’s transition for expanding its EV fleet. Jost does not see oil getting any cheaper in the long run, as he states, “We have a clear commitment to become C02 neutral by 2050, and there is no alternative to our electric-car strategy to achieve this.”
While oil prices are expected to rebound, the International Energy Agency (IEA) projects a decline in North American oil demand through 2040, which is contingent upon the implementation of policy initiatives to curb greenhouse gas emissions. While the Stated Policies Scenario suggests only a fall in demand of 4 mb/d, the IEA projects a decline of 11 mb/d under the Sustainable Development Scenario, which the IEA views as a feasible solution for mitigating the potential impacts of air pollution and climate change.
EVs through the Eyes of the ConsumerClearly, governments have both rewarded early adopters and outlined penalties for manufacturers that don’t increase compliance in the future. However, EVs still make up a relatively small size of the overall car market. Despite the aforementioned subsidies, the price mark-up of these vehicles to its gasoline counterparts continues to be a concern. For example, in June 2019, the average retail selling price of new cars was about $36,600 compared to $55,600 for EV’s. This is one of the big reasons why consumers are hesitant to purchase an EV. Subaru of America CEO, Tom Doll reflects on the public’s unwillingness to accept EV’s, as “people don’t seem to accept the (EV) price up. They sit at their kitchen table and consider their budget. They’re doing the price up for an EV and most say, ‘It’s just not worth it at this point, with gas prices being so low.” Still, Subaru is expected to roll out their first EV model in 2021.If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Rising fuel prices may renew interest in EVs, but upfront costs will likely be more important. Lithium-ion battery prices have decreased significantly since 2010, and it is believed that low battery prices will outweigh the benefits of low oil prices, thus propelling EV sales. Tesla’s move to develop a new cobalt-free battery could be a game-changer in decreasing over EV prices. The 30% reduction in wholesale battery prices expected in 2023/4 could mean a drop of 10% in car prices. As noted above, EV’s on average were about $19k pricier but had opposite trajectories. Where ASP’s increased about 2% annually, EV’s declined 13.5%. If upfront costs are comparable, lower expenses over the life of the car may make EVs more worthwhile despite road trip drawbacks.Concluding ThoughtsIt is safe to say that Lightning McQueen would be no match against Ford Motor Company’s new Mustang Mach-E 1400. It is expected to debut on the NASCAR track soon. As described by Mark Rushbrook, motorsports director of Ford Performance, the all-electric Mustang is “an all-around athlete” with an impressive 1400 horsepower.Technological innovation plays a vital role in the future of EV’s, as we have seen Tesla emerge as the industry leader through its technological advancements in software and battery capabilities. The future of the EV industry seems bright in the long-run as falling battery prices paired with heightened emission standards serve as pillars for sustaining the expansion of this sub-industry, even if consumers are less motivated to make the switch. However, manufacturers with significantly more scale than Tesla shouldn’t be too far behind and may ultimately eclipse them. The main concern for auto dealers lies in whether their manufacturer can develop models that are desirable to consumers and meet emissions regulations. Whether or not there is a meaningful shift towards EVs over the coming years, dealers will likely continue to adapt to consumer preferences as they always have.Our thanks to our summer analyst, Will Pesto, who drafted this post in collaboration with our Auto Dealer Group.
Cautionary Tales of Valuation Adjustments in Litigation
Valuations of a closely held business in the context of litigation such as in a contentious divorce, shareholder dispute, damages matter or other litigated corporate matter can be multifaceted and may require additional forensic investigative scrutiny. As such, it is important to consider the potential forensic implications of valuation adjustments as they may lead to other analyses. For example, in a divorce business appraisal, a valuation adjustment for discretionary (personal) expenses may, in turn, provide an implied “true income” and pay ability of a spouse. This is but one example - this session addresses other examples you will likely face.Presented at the NACVA 2020 Business Valuation and Financial Litigation Virtual Super Conference.
Stress Testing and Capital Planning for Banks and Credit Unions During the COVID-19 Pandemic
A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline, adverse, and severe scenario).The concept of stress testing for banks and credit unions is akin to the human experience of going in for a check up and running on a treadmill so your cardiologist can measure how your heart performs under stress. Similar to stress tests performed by doctors, stress tests for financial institutions can ultimately improve the health of the bank or credit union (“CU”). The benefits of stress testing for financial institutions include: Enhancing strategic/capital planningImproving risk managementEnhancing the value and earning power of the bank or credit unionAs many public companies in other industries have pulled earnings guidance due to the uncertainty surrounding the economic outlook amid the coronavirus pandemic, community banks and CUs do not have that luxury.Key stakeholders, boards, and regulators will desire a better understanding of the ability of the bank or CU to withstand the severe economic shock of the pandemic. Fortunately, stress testing has been a part of the banking lexicon since the last global financial crisis began in 2008. We can leverage many lessons learned from the last decade or so of this annual exercise.Conducting a Stress Test It can be easy to get overwhelmed when faced with scenario and capital planning amidst the backdrop of a global pandemic with a virus whose path and duration is ultimately uncertain.However, it is important to stay grounded in established stress testing steps and techniques. Below we discuss the four primary steps that we take to help clients conduct a stress test in light of the current economic environment.Step 1: Determine the Economic Scenarios to ConsiderIt is important to determine the appropriate stress event to consider.Unfortunately, the Federal Reserve’s original 2020 scenarios published in 1Q2020 seem less relevant today since they forecast peak unemployment at 10%, versus the recent peak national unemployment rate of 14.7% (April 2020).However, the Federal Reserve supplemented the original scenario with a sensitivity analysis for the 2020 stress testing round related to coronavirus scenarios in late 2Q20, which provides helpful insights. The Federal Reserve’s sensitivity analysis had three alternative downside
scenarios: A rapid V-shaped recovery that regains much of the output and employment lost by year-end 2020A slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020A W-shaped double dip recession with a short-lived recovery followed by a severe drop in late 2020 due to a second wave of COVIDSome of the key macroeconomic variables in these scenarios are found in Table 1.In our view, these scenarios provide community banks and credit unions with economic scenarios from which to begin a sound stress testing and capital planning framework.Step 2: Segment the Loan Portfolio and Estimate Loan Portfolio Stress LossesWhile determining potential loan losses due to the uncertainty from a pandemic can be particularly daunting, we can take clues from the Federal Reserve’s release of results in late 2Q20 from some of the largest banks.While the specific loss rates for specific banks weren’t disclosed, the Fed’s U, V, and W sensitivity analysis noted that aggregate loss rates were higher than both the Global Financial Crisis (“GFC”) and the Supervisory Capital Assessment Program (“SCAP”) assumptions from the prior downturn. We note that many community banks and CUs may feel that their portfolios in aggregate will weather the COVID storm better than their larger counterparts (data provided in Table 2).We have previously notedthat community bank loan portfolios are more diverse now than during the prior downturn and cumulative charge-offs were lower for community banks as a whole than the larger banks during the GFC.For example, cumulative charge-offs for community banks over a longer distressed time period during the GFC (four years, or sixteen quarters, from June 2008 - June 2012) were 5.1%, implying an annual charge-off rate during a stressed period of 1.28% (which is ~42% of what larger banks experienced during the GFC).However, we also note that this community bank loss history is likely understated by the survivorship bias arising from community banks that failed during the GFC.Each community bank or CU’s loan portfolio is unique, and it will be important for community banks and CUs to document the composition of their portfolio and segment the portfolio appropriately. Segmentation of the loan portfolio will be particularly important.The Fed noted that certain sectors will behave differently during the COVID downturn. The leisure, hospitality, tourism, retail, and food sectors are likely to have higher credit risk during the pandemic. Proper loan segmentation should include segmentation for higher risk industry sectors during the current pandemic as well as COVID-modified/restructured loans.Once the portfolio is segmented, loss history over an extended period and a full business cycle (likely 10-12 years of history) will be important to assess. While the current pandemic is a different event, this historical loss experience can be leveraged to provide insights into future prospects and underwriting strength during a downturn and relative to peer loss experience. In certain situations, it may also be relevant to consider the correlation between those historical losses and certain economic factors such as the unemployment rate in the institution’s market areas. For example, a regression analysis can determine which variables were most significant statistically in driving historical losses during prior downturns and help determine which variables may be most relevant in the current pandemic. For those variables deemed statistically significant, the regression analysis can also provide a forecasting tool to estimate and/or test the reasonableness of future loss rates based on assumed changes in those variables that may be above and beyond historical experience. Lastly, higher risk loan portfolio segments (such as those in more economically exposed sectors) and larger loans that were modified during the pandemic may need to be supplemented by some “bottom-up” analysis of certain loans to determine how these credits may fare in the different economic scenarios previously described.To the extent losses can be modeled for each individual loan, these losses can be used to estimate losses for those particular loans and also leveraged to support assumptions for other loan portfolio segments.Step 3: Estimate the Impact of Stress on EarningsStep 3 expands the focus beyond just the loan portfolio and potential credit losses from the pandemic modeled in Step 2 and focuses on the institution’s “core” earning power and sensitivity of that over the economic scenarios modeled in Step 1. When assessing “core” earning power, it is important to consider the potential impact of the economic scenarios on the interest rate outlook and net interest margins (“NIM”). While the outlook is uncertain, Federal Reserve rate cuts have already started to crimp margins. Beyond the headwinds brought about by the pandemic, it is also important to consider any potential tailwinds in certain countercyclical areas like mortgage banking, PPP loan income, and/or efficiency brought about by greater adoption of digital technology and cost savings from branch closures.Ultimately, the earnings model over the stressed period relies on key assumptions that need to be researched, explained, and supported related to NIM, earning assets, non-interest income, expenses/efficiency, and provision expense in light of the credit losses modeled in Step 2.Step 4: Estimate the Impact of Stress on CapitalStep 4 combines all the work done in Steps 1, 2, and 3 and ultimately models capital levels and ratios over the entirety of the forecast periods (which is normally nine quarters) in the different economic scenarios. Capital at the end of the forecast period is ultimately a function of capital and reserve levels immediately prior to the stressed period plus earnings or losses generated over the stressed period (inclusive of credit losses and provisions estimated).When assessing capital ratios during the pandemic period, it is important to also consider the impact of any strategic decisions that may help to alleviate stress on capital during this period, such as raising sub-debt, eliminating distributions or share repurchases, and slowing balance sheet growth.For perspective, the results released from the Federal Reserve suggested that under the V, U, and W shaped alternative downside scenarios, the aggregate CET1 capital ratios were 9.5%, 8.1%, and 7.7%, respectively.What Should Your Bank or Credit Union Do with the Results?What your bank or credit union should do with the results depends on the institution’s specific situation.For example, assume that your stress test reveals a lower exposure to certain economically exposed sectors during the pandemic and some countercyclical strengths such as mortgage banking/asset management/
PPP revenues.This helps your bank or CU maintain relatively strong and healthy performance over the stressed period in terms of capital, asset quality, and earnings performance. This performance could allow for and support a strategic/capital plan involving the continuation of dividends and/or share repurchases, accessing capital and/or sub-debt for growth opportunities, and proactively looking at ways to grow market share both organically and through potential acquisitions during and after the pandemic-induced downturn.For those banks and CUs that include M&A in the strategic/capital plan over the next two years, improved stress testing capabilities at your institution should assist with stress testing the target’s loan portfolio during the due diligence process. Alternatively, consider a bank that is in a relatively weaker position.In this case, the results may provide key insight that leads to quantifying the potential capital shortfall, if any, relative to either regulatory minimums or internal targets.After estimating the shortfall, management can develop an action plan, which could entail seeking additional common equity,accessing sub-debt, selling branches or higher-risk loan portfolios to shrink the balance sheet, or considering potential merger partners.Integrating the stress test results with identifiable action plans to remediate any capital shortfall can demonstrate that the bank’s existing capital, including any capital enhancement actions taken, is adequate in stressed economic scenarios. How Mercer Capital Can Help A well-reasoned and documented stress test can provide regulators, directors, and management the comfort of knowing that capital levels are adequate, at a minimum, to withstand the pandemic and maintain the dividend.A stress test can also support other strategies to enhance shareholder value, such as a share buyback plan, higher dividends, a strategic acquisition, or other actions to take advantage of the disruption caused by the pandemic.The results of the stress test should also enhance your bank or credit union’s decision-making process and be incorporated into strategic planning and the management of credit risk, interest rate risk, and capital.Having successfully completed thousands of engagements for financial institutions over the last 35 years, Mercer Capital has the experience to solve complex financial issues impacting community banks and credit unions during the ups and downs of economic cycles. Mercer Capital can help scale and improve your institution’s stress testing in a variety of ways. We can provide advice and support for assumptions within your bank or credit union’s pre-existing stress test. We can also develop a unique, custom stress test that incorporates your institution’s desired level of complexity and adequately captures the unique risks you face. Regardless of the approach, the desired outcome is a stress test and capital plan that can be used by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. For more information on Mercer Capital’s Stress Testing and Capital Planning solutions, contact Jay Wilson at wilsonj@mercercapital.com.
Originally appeared in Mercer Capital's Bank Watch, July 2020.
Independent RIAs Drive M&A During Downturn
RIA M&A Amid COVID-19 (Part II)
The outlook for RIA M&A at the end of the first quarter was murky. While we did not expect deals already in motion to be canceled, we did expect deal activity to temporarily slow. We theorized that this slowdown could actually benefit the industry if RIA principals used the downtime to think about succession planning. DeVoe & Company summarized similar expectations for RIA M&A in a "Four-Phase Outlook for M&A Post COVID-19" published in its Q1 RIA Deal Book: Live transactions get completed.A lull in activity as owners respond to the COVID-19 pandemic rather than seek out new dealsA surge in activity caused by delayed deals coming to the marketReturn to normalcy where the trends of increased M&A continue with an aging ownership base and a need for succession planning
So, were these expectations on track?Review of M&A in Q2 2020As anticipated, previously announced deals in the final stages of negotiations did close but new deal activity slowed some in the second quarter. According to Fidelity’s Wealth Management M&A Report, M&A activity in January and February kept pace with 2019 levels but fell off in March, April, and May. There were 24 transactions involving RIAs with over $100 million but less than $20 billion in AUM announced in Q2 2020 (and many of these deals were announced in June 2020). Still, this represents a decline in M&A activity compared with last year, as shown in the chart below.[caption id="attachment_32836" align="aligncenter" width="675"]Source: Fidelity Wealth Management M&A Transaction Report; Complied by Mercer Capital[/caption]
Interestingly, in the second quarter of 2020, independent RIAs, rather than consolidators, drove much of the deal activity. Over the last few years, we have written about RIA consolidators time after time:
Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017 (January 2018)Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators (January 2019)RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing (January 2020)
In the second quarter, two independent RIAs—The Mather Group (TMG) and Creative Planning—accounted for approximately 21% of the total transactions announced, while consolidators accounted for only 17% of the deals.
The Mather Group (an independent wealth management firm with seven offices around the U.S.) announced its sixth acquisition in the last 18 months on June 16, 2020, only one week after announcing a previous acquisition. The acquisition of Knoxville-based Resource Advisory Services, with $116 million in AUM, will bring TMG’s AUM to over $3.9 billion. TMG’s acquisition of Resource Advisory Services is indicative of a few M&A trends.
First, in a relationship-driven business such as wealth management, the fastest way to expand a firm’s footprint is often through acquisitions. TMG has been working to expand its footprint into the Southeast and this acquisition is a sensible addition to their recent acquisition of Atlanta-based Barnett Financial. Additionally, this acquisition highlights a struggle many RIA owners face: a need for scale but a hesitation to partner with PE-backed firms who have a reputation for pushing growth at all costs. Many RIA principals need a succession plan, and private equity capital isn’t always the right answer. Resource Advisory Services’ founder David Lewis said, “I’m thrilled to partner with a next-generation founder who isn’t private-equity backed, and feel very confident TMG’s long-term vision will support my advisors into the future.”
Creative Planning, based in Overland Park, Kansas, is one of the nation’s largest independent RIAs, announced three deals in the second quarter. Its most recent acquisition of Starfire Investment Advisers ($560 million AUM) was Creative Planning’s eighth deal in 2020 and its twelfth deal since it started on its acquisition spree last year. Creative Planning organically grew its AUM to $48 billion and since February 2019, has added another $5 billion in AUM through acquisitions. We expect to see more acquisitions from Creative Planning as it strives to reach $100 billion in AUM and become more of a household name. While Creative Planning is a driver in the trend of consolidation, it differentiates itself from traditional RIA consolidators by acquiring 100% of target companies and integrating them into the Creative Planning brand and investment philosophy. Additionally, while it is PE-backed, NY based General Atlantic holds a non-controlling minority share.
Creative Planning’s M&A activity and investment from General Atlantic makes us ask: When does an RIA shift from being an independent wealth manager to an acquirer of independent wealth managers? Mercer Advisors (no relation) seemed to make this transition when it first started buying RIAs in 2016. Since then, it has acquired around 30 advisory firms and has financed its acquisition activity by selling a sizeable stake in the company to PE firm Oak Hill Capital Partners while maintaining an investment from Genstar Capital.
The line between independent wealth manager and consolidator can be murky, but the trend this quarter was clear. Established consolidators, who primarily rely on debt financing or capital from PE firms, slowed acquisition activity in the second quarter. Dynasty Financial announced two deals in Q2, Focus Financial and Mercer Advisors each announced one deal, and Wealth Enhancement Group and HighTower Advisors did not report any deal activity in the second quarter – while strategic acquisitions by independent RIAs continued.
RIA consolidators who use leverage to buy RIAs were much more vulnerable to the decline in the market at the end of March. Most RIA consolidators have never been through a market downturn and their balance sheets may have not been as well-capitalized as needed to handle what many expected to be a few bad quarters and potentially years. With leverage on the balance sheet, interest coverage ratios became a concern for consolidators and the downturn in March likely served as a warning for aggregators to reevaluate their balance sheets. Most independent RIAs, on the other hand, have lived through market downturns previously and had capital built up to slug through a few bad quarters. Some even had the capital to acquire firms when competition from other buyers temporarily eased.Outlook for RIA M&AWhile RIA M&A did slow some in Q2, we don’t expect that this slowdown will continue as M&A activity picked up in June. We have been contacted by several RIA principals who are using this time to reconsider their buy-sell agreements and their plans for their firms. These conversations often prompt strategic discussions which can pique some firms’ interest in making acquisitions, can guide others down a path of internal succession planning as they prepare for retirement, and can serve as a wakeup call to others who are tired of dealing with the volatility inherent in many RIA practices. We also hope that the recent downturn and lack of activity from RIA consolidators will lead buyers to proceed with more caution when partnering with leveraged consolidators. Amid a market downturn, when RIA principals should be focused on servicing client assets, the charge to save margin to meet interest coverage ratios will trickle down to the principal of those RIAs.
A 2020 Estate Planning Reader
Amid a Global Pandemic, It's Easy to Lose Track of Some Big Things That are Going On
In the depths of the stock market pullback, we wrote about the opportunity to take advantage of depressed share values. When the Applicable Federal Rate fell to historic lows, we wrote about the “double opportunity” afforded by low values coupled with low interest rates.Which leads us to last week. During our webinar on the estate planning opportunities in the current environment, fellow panelist Brook Lester reminded us that – in addition to all the other fun stuff going on in 2020 – there’s a presidential election in November.We possess no political clairvoyance. However, if a Biden administration were to assume power in January 2021, we know that adverse changes to the current estate tax regime would be likely. As November draws near, advisors are urging family shareholders to mitigate the political risk by implementing significant transactions now.In this week’s post, we have assembled some helpful resources we have come across that provide helpful insight on the estate planning opportunities and strategies available to family business owners during 2020.Written in a pre-COVID world, the 2020 Wealth Planning Outlook from Northern Trust still offers valuable perspective for family business leaders.Published in June 2020, this whitepaper from our friends at Diversified Trust provides timely insights for family shareholders evaluating their planning needs in the wake of COVID-19.This article sheds some light on how wealthy families are pursuing estate planning goals with renewed vigor under the shadow of COVID-19.Attorney and Forbes.com columnist Matthew Erskine offers a compelling case for using one’s unified credit sooner rather than later.Finally, this article from CNBC’s website digs deeper into the Biden campaign’s tax proposals, including the elimination of the “step-up” in basis currently available to heirs. It is generally a bad idea to let the tax tail wag the dog. However, the combination of depressed asset values, low interest rates, and political risk means that family shareholders should accelerate work on the business and family issues that pave the way for effective estate planning. If your family has avoided having those conversations, it’s not too late, but the time to start really is now. A well-reasoned and supported business valuation is fundamental to any estate planning strategy. Call one of our professionals today to started on a valuation of your family business.
Fiat Chrysler & Peugeot (PSA) Merge into “Stellantis”
Analyzing the Timeline and Twists and Turns of a Transatlantic Merger During a Pandemic
Last week, we analyzed Asbury Automotive Group’s acquisition of Park Place, a deal scuttled by COVID-19 that came back to life under revised terms. This week, we are moving upstream to look at the merger between Fiat Chrysler (FCA) and Group PSA (manufacturer of Peugeot and Citroen) and observe the new name of the entity, the merits and hurdles of the ongoing deal, and some potential impacts on auto dealers.What’s in a Name?A fresh start with a new name feels reasonable.On July 15th, the name Stellantis was announced, which drew jokes from various people within the industry. The press release indicated the name comes from the Latin verb “stello," meaning to "brighten with stars.” The name will be used exclusively at the Group level, as a corporate brand, with the names and the logos of its constituent brands remaining unchanged. While the change drew some attention, we think it’s largely much ado about nothing. Sure, the press release was filled with a litany of corporate platitudes about how the name “draws inspiration from this new and ambitious alignment of storied automotive brands and strong company cultures …” but overall we think it might be more of a practical choice considering FCA-PSA doesn’t really roll off the tongue. Also considering its 18 brands on a combined basis, the sheer size of the transaction, and many previous corporate name changes, a fresh start with a new name feels reasonable.While Stellantis won’t appear on any of the cars, it’s not the only industry participant to not have one of its brands in the corporate name. GM and Daimler are the other exceptions in the industry whose names go back a lot longer. Every manufacturer besides Tesla makes cars under a brand other than the corporate name (Toyota makes Lexus, Volkswagen makes Audis, etc.).The company includes manufacturers in Detroit, Paris, Turin, Charlton, Russelsheim, and more. A full list of these brands are included in the graphic below.[caption id="attachment_32791" align="aligncenter" width="642"]*Parts manufacturer[/caption]
Merits of the DealHaving exhausted the new name, let’s look at the deal. The deal was announced in October 2019, and in December, Group PSA and FCA released a joint press release highlighting:Benefits of scale in developing more sustainable, tech-savvy (including autonomous) modelsCombined company to be 4th largest global OEM by volume (8.7 million units in 2018) and 3rd largest by revenue (170 billion euros in 2018)Diversification across markets in Europe, North America, and Latin AmericaAnnual run-rate synergies of 3.7 billion euros with no plant closures50/50 merger expected to lead to investment-grade credit rating with high level of liquidity
The company indicated 40% of its synergies would come from its combined technology, product, and platform. Stellantis expects another 40% of its synergies to come from sourcing its suppliers at a discounted price due to its bargaining power, or as the company called it, “enhanc[ing] its purchasing performance.” Savings on marketing, IT, G&A, and logistics round out the last 20% of anticipated savings.
Mergers frequently try to cut duplicative costs and add to pricing power, both from suppliers and customers. However, since the combining legacy companies largely operate on different continents, minimal enhancements to market share are unlikely to drive higher selling prices to dealers and consumers. This could help enhance blue sky values for FCA dealers, which have lagged other brands. Enhancements to technology and tweaks to its platform could also help improve the brands’ SSI ratings, which were generally below their respective averages in 2019.Pandemic Impact on the Deal Regulatory HurdlesThe initial press release indicated the deal was expected to take 12-15 months subject to “customary closing conditions, […] and satisfaction of anti-trust and other regulatory requirements.” While the COVID-19 pandemic was certainly not anticipated, the reasons for the deal are “stronger than ever,” according to FCA Chairman John Elkann. Last month, PSA CEO Carlos Tavares also expressed confidence that the $50 billion merger will proceed as planned, noting “the merger with FCA is the best among the solutions to cope with the crisis and its uncertainties.”The deal structure of the Stellantis merger shields it from some inherent issues in acquisitions.While many auto dealers are seeing transactions being placed on pause, the deal structure of the Stellantis merger shields it from some inherent issues in acquisitions. During the pandemic, acquirors are looking to either use a reduced Blue Sky multiple on 2019 earnings or an old multiple on reduced 2020 earnings. This has widened the bid-ask spread, as dealers don’t want to sell at depressed values. With this stock swap merger of equals (“MoE”), each side has to provide equal value to the deal, and pandemic related concerns may cancel each other out. According to Elkann, “both parties in FCA-PSA deal are committed to get parity in the merger deal.” PSA shares are set to be exchanged at a rate of 1.742 shares of the new combined company for each share contributed by FCA. However, it is possible the pandemic has disproportionate impacts on the two companies, requiring a change in the exchange ratio based on adjustments to their relative contributions.There are other issues at play besides the exchange ratio before this deal can be finalized. Both sides have already announced they no longer intend to pay their planned ordinary dividends of 2.2 billion euros for 2019 results which was included in the initial deal. While this is sensible to preserve liquidity in this environment, ordinary dividends aren’t expected to be a sticking point. It’s FCA’s 5.5 billion euros special dividend that may cause problems. According to Tavares, the “time has not come to discuss this issue,” though it is widely speculated that it could be revised downwards in light of the downturn in the global auto industry. This may be a point of contention for FCA shareholders. Peugeot shareholders were also supposed to get PSA’s 46% interest in Faurecia SE in order to help achieve a merger of equals status. This interest was worth approximately 3 billion euros at announcement when the French auto parts company’s shares traded at 50 euros. Shares have declined to about 37 euros (as of July 27th), meaning PSA’s interest is closer to about 2.2 billion euros due to the pandemic.Regulatory HurdlesHaggling between the two companies over the appropriate compensation of this interest and the special dividend isn’t the only hang-up. FCA’s Italian unit had been in talks with Rome over a 6.3 billion euro state-backed loan from Intesa Sanpaolo (Italy’s largest retail bank) to combat the coronavirus crisis. Optically, a special dividend approaching this amount did not sit well, but the loan was ultimately approved. This was the largest crisis loan to a European carmaker. The state support should “preserve and strengthen the Italian automotive supply chain,” according to Economy Minster Roberto Gaultieri. FCA’s COO for Europe said “100% of the money this facility provides will be directed to our Italian business,” though neither side indicated whether any conditions surrounding the special dividend had been imposed.Europe is expected to be the main regulatory roadblock (or maybe more of a speed bump).While the deal has received the green light in the U.S., China, Japan, and Russia, Europe is expected to be the main regulatory roadblock, though executives have categorized it as more of a speed bump. In addition to earlier concerns in Italy about the special dividend, EU antitrust regulators began its investigation into the deal in June, citing potential to harm competition in small vans in 14 EU countries and Britain. So far, Stellantis has not offered any concessions. According to the European Commission, commercial vans are an “increasingly important market in a digital economy where private consumers rely more than ever on delivery services.” Through a joint venture, FCA and PSA already hold 34% of the van market in Europe. On July 22nd, the European Commission announced its probe had been suspended as the parties failed to provide requested information. The EU was originally supposed to offer its decision in mid-November, which has now been delayed.Will the Deal Happen?Though both sides are confident that the merger will go through as planned, there are clearly some details that will need to be tweaked throughout this process. Merger arbitrage traders usually provide a pretty good real-time view as to the likelihood of a transaction. For example, if a company is to be purchased at $50/share in cash, but shares are trading at $35, that means the market doesn’t think the deal will go through on those terms. However, the market’s view on the success of the FCA-PSA merger is nuanced. Arbitrage traders typically need to be able to short one side of the deal to execute their trade, but France has temporarily banned short-selling. Also, as an MoE, swapping stock certificates means both sides retain equity in the combined company, so share prices give different insight than an acquisition anyway. This means the share prices likely have more to do with the operating environment of the pandemic than the likelihood of the merger, though it may offer hints to what adjustments to the exchange ratio, special dividend, or Faurecia stock may be looming. Because the synergies are centered around cost-cutting measures, and regulatory hurdles don’t appear to be a deal backer, Stellantis will likely come into being if the two sides can hammer out the details.
A “Grievous” Valuation Error: Tax Court Protects Boundaries of Fair Market Value in Grieve Decision
All fair market determinations involve assumptions regarding how buyers and sellers would behave in a transaction involving the subject asset. In a recent Tax Court case, the IRS appraiser applied a novel valuation rationale predicated on transactions that would occur involving assets other than the subject interests being valued. In its ruling, the Court concluded that this approach transgressed the boundaries of what may be assumed in a valuation.BackgroundAt issue in Grieve was the fair market value of non-voting Class B interests in two family LLCs.The first, Rabbit, owned a portfolio of marketable securities having a net asset value of approximately $9 million.The second, Angus, owned a portfolio of cash, private equity investments, and promissory notes having a net asset value of approximately $32 million.
Both Rabbit and Angus were capitalized with Class A voting and Class B non-voting interests. The Class A voting interests comprised 0.2% of the total economic interest in each entity. The Class A voting interests were owned by the taxpayer’s daughter, who exercised control over the investments and operations of the entities.Valuation Conclusion – TaxpayerThe taxpayer measured the fair market value of the Class B non-voting interests using commonly accepted methods for family LLCs. The net asset value of each LLC was deemed to represent the value on a controlling interest basis.Since the subject Class B non-voting interests did not possess control over either entity, the net asset value was reduced by a minority interest discount. The taxpayer estimated the magnitude of the minority interest discount with reference to studies of minority shares in closed end funds.Unlike the minority shares in closed end funds, there was no active market for the Class B non-voting interests in Rabbit and Angus. As a result, the taxpayer applied a marketability discount to the marketable minority indication of value. The taxpayer estimated the marketability discount with reference to restricted stock studies.
The combined valuation discount applied to the Class B nonvoting interests was on the order of 35% for both Rabbit and Angus, as shown in Exhibit 1.
Valuation Conclusion – IRSThe IRS adopted a novel approach for determining the fair market value of the Class B non-voting interests.Noting the disparity in economic interests between the Class A voting (0.2%) and Class B non-voting interests (99.8%), the IRS concluded that a hypothetical willing seller of the Class B non-voting interest would sell the subject interest only after having first acquired the Class A voting interest. Having done so, the owner of the class B non-voting interest could then sell both the Class A voting and Class B nonvoting interests in a single transaction, presumably for net asset value.If the dollar amount paid of the premium paid for the Class A voting interest is less than the aggregate valuation discount applicable to the Class B non-voting interest, the hypothesized series of transactions would yield more net proceeds than simply selling the Class B non-voting interest by itself. The sequence of transactions assumed in the IRS determination of fair market value is summarized in Exhibit 2.Tax Court ConclusionIt is certainly true that – if the Class A voting interests could, in fact, be acquired at the proposed prices – the sequence of transactions assumed by the IRS yield greater net proceeds for the owner of the subject Class B non-voting interests than a direct sale of those interests. However, is the assumed sequence of transactions proposed by the IRS consistent with fair market value?The Tax Court concluded that the IRS valuation over-stepped the bounds of fair market value. The crux of the Court’s reasoning is summarized in a single sentence from the opinion: “We are looking at the value of the Class B Units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units.” Citing a 1934 Supreme Court decision (Olson), the Tax Court notes that “[e]lements affecting the value that depend upon events within the realm of possibility should not be considered if the events are not shown to be reasonably probable.” In view of the fact that (1) the owner of the Class A voting interests expressly denied any willingness to sell the units, (2) the speculative nature of the assumed premiums associated with purchase of those interests, and (3) the absence of any peer review or caselaw support for the IRS valuation methodology, the Tax Court concluded that the sequence of transactions proposed by the IRS were not reasonably probable. As a result, the Tax Court rejected the IRS valuations.The Grieve decision is a positive outcome for taxpayers. In addition to affirming the propriety of traditional valuation approaches for minority interests in family LLCs, the decision clarified the boundaries of fair market value, rejecting a novel valuation approach that assumes specific attributes of the subject interest of the valuation that do not, in fact, exist. As the Court concluded, fair market value is determined by considering the motivations of willing buyers and sellers of the subject asset, and not the willing buyers and sellers of other assets.Originally appeared in Value Matters™, Issue No. 3, 2020
Valuation Considerations in Bankruptcy Proceedings
An Overview for Oil & Gas Companies
The outbreak of the COVID-19 pandemic in the United States has caused a severe public health crisis and an unprecedented level of economic disruption. While some economic activity is beginning to come back, predictions for longer-term negative economic impacts have also become more prevalent. The initial thoughts of a quick V-shaped economic recovery have been replaced with a more nuanced consideration of how this situation will impact businesses within different industries and geographic areas over the next several years. In some of the most hard-hit industries, we are already seeing what is expected to be a prolonged surge in corporate restructurings and bankruptcy filings.While some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.In the first half of 2020, the U.S. oil and gas industry suffered what was arguably its worst six-month period ever. The combined impact of the Saudi/Russian price war and the drop in energy demand due to the onslaught of the COVID-19 pandemic was unprecedented. Brent crude prices that had begun the year near $67 per barrel had dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the quarter when the Saudi/Russia spat was in full force, but while the impact of the pandemic was still materializing. Since the start of the pandemic, liquid fuel consumption has dropped by 15% with production levels falling 10%. Drilling activity has been even harder hit with rig counts (active rotary rigs) now at a mere 30% of early first quarter levels. Despite oil prices having partially recovered, oilfield activity remains anemic with the OFS industry having shed nearly 90,000 jobs through May. While in a few areas oil and gas can be produced profitably at mid-year 2020 prices (WTI at 38.31 and Henry Hub at $1.63), most areas cannot. Thus, while some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.For oil & gas companies, the decision to file for bankruptcy does not necessarily signal the demise of the business. If executed properly, Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge from the proceedings as a viable going concern. Along with a bankruptcy filing (more typically before and/or in preparation for the filing), the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of business. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that both specifies a reorganization value and reflects the agreed upon strategic direction and capital structure of the emerging entity.In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:11. The plan should demonstrate that the economic outcomes for any consenting stakeholders are superior under Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for more direct relief through a liquidation of the business. This is generally referred to as the “best interests test.”2. The plan should demonstrate that, upon confirmation by the bankruptcy court, it will not likely result in liquidation or further reorganization of the business. This is generally referred to as the “cash flow test.”Finally, upon emerging from bankruptcy, companies are required to apply “fresh start” accounting, under which all assets of the company, including identifiable intangible assets, are recorded on the balance sheet at fair value.Best Interests TestWithin this context of a best interests test, valuation specialists can provide useful financial advice to:Establish the value of the business under a Chapter 7 liquidation premise.Measure the reorganization value of a business, which, absent liquidation, represents the economic “pie” from which stakeholder claims can be satisfied. A plan confirmed by a bankruptcy court should establish a reorganization value that exceeds the value of the company under a liquidation premise.A Floor Value: Liquidation ValueIf a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. The law generally mandates that Chapter 11 restructuring only be approved if it provides a company’s creditors with their highest level of expected repayment. The Chapter 11 restructuring plan must be in the best interest of the creditors (relative to Chapter 7 liquidation) in order for it to be approved. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise generally contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value. Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. Experience tells us that the underlying “marketing period” assumptions made in a liquidation analysis can have a material impact on the valuation conclusion.Liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation.From a technical perspective, liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation. As implied, these are asset-based approaches to valuation that differ in their assumptions surrounding the marketing period and manner in which the assets are disposed. There are no strict guidelines in the bankruptcy process related to these three sub-sets; bankruptcy courts generally determine the applicable premise of value on a case by case basis. The determination (and support) of the appropriate premise can be an important component of the best interests test.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would typically be applied to cash and equivalents, while less liquid assets (such as accounts receivable or inventory) would likely incur potentially significant discounts. For some assets categories, the appropriate level of discount can be estimated by analyzing the prices commanded in the sale of comparable assets under a similarly distressed sale scenario. Within the oil & gas industry, the operating assets come in many varieties, from oil & gas reserves, industry-specific well-site equipment and midstream assets, and less industry-specific equipment utilized by oilfield service providers.Reorganization ValueOnce an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s stakeholders than discounted asset sales.ASC 852 defines reorganization value as:2The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.Typically, the “value attributable to the reconstituted entity” (i.e., the new enterprise value for the restructured business) is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is valued based on the return that would be generated by the future operations of the emerging, restructured entity and not what one would be paid for selling individual assets. The intangible elements of going concern value result from factors such as having a trained workforce, a loyal customer base, an operational plant, and the necessary licenses, systems, and procedures in place. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash flow (DCF) method. The DCF method estimates the net present value of future cash flows that the emerging entity is expected to generate. Implementing the discounted cash flow methodology requires three basic elements:1. Forecast of Expected Future Cash Flows. Guidance from management can be critical in developing a supportable cash flow forecast. Generally, valuation specialists develop cash flow forecasts for discrete periods that may range from three to ten years, or in the case of upstream companies, the economic life of the company’s reserves. Conceptually, one would forecast discrete cash flows for as many periods as necessary until a stabilized cash flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. The historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business, can provide reference points to evaluate each element of the cash flow forecast.2. Terminal Value. The terminal value captures the value of all cash flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash flow growth rate and the discount rate to capitalize cash flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases, the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date. For upstream oil & gas companies, a terminal value is typically not utilized given the finite nature of the underlying resource. Instead, the discrete cash flows are projected for the entire economic life of the reserves.3. Discount Rate. The discount rate is used to estimate the present value of the forecasted cash flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the operational and market risks associated with the expected cash flows of the emerging entity.The sum of the present values of all the forecasted cash flows, including discrete period cash flows and the terminal value (if appropriate), provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization. Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigation. The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate.In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan. If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared: a cash flow test. This is an examination of whether the restructuring creates a company that will be viable for the long term—that is not likely to be back in bankruptcy court in a few years.Cash Flow TestFor a company that passes the best interest test, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Within the context of a cash flow test, valuation specialists can demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash flows that can be reasonably expected from the business. The cash flow test essentially represents a test of the company’s current and projected future financial solvency.The cash flow test essentially represents a test of the company’s current and projected future financial solvency.Even if a company shows that the restructuring plan will benefit stakeholders relative to liquidation, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash flow test can be broken into three parts.The first step in conducting the cash flow test is to identify the cash flows that the restructured company will generate. These cash flows are available to service all the obligations of the emerging entity. A stream of cash flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash flows for the cash flow test is often a straightforward matter of using these projected cash flows in the new model.Once the fundamental cash flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash flows of the company will not be used only to pay debts, and so the third and final step in the cash flow test is documenting the impact of the net cash flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash flows are invested in working capital and capital equipment, and modeling changes in the debt obligations of and equity interests in the company as the remaining cash flows are disbursed to the capital providers.A reorganization plan is generally considered viable if such a detailed cash flow model indicates solvent operations for the foreseeable future. The answer, however, is typically not so simple as assessing a single cash flow forecast. It is a rare occurrence when management’s base case forecast does not pass the cash flow test. The underpinnings of the entire reorganization plan are based on this forecast, so it is almost certain that the cash flow projections have been produced with an eye toward meeting this requirement. Viability is proven not only by passing the cash flow test on a base case scenario, but also maintaining financial viability under some set of reasonable projections in which the company (or industry, or general economy) underperforms the base level of expectations. This “stress-testing” of the company’s financial projection is a critical component of a meaningful cash flow test.“Fresh Start” AccountingCompanies emerging from Chapter 11 bankruptcy are required to re-state their balance sheets to conform to the reorganization value and plan.On the left side of the balance sheet, emerging companies need to allocate the reorganization value to the various tangible and identifiable intangible assets the post-bankruptcy company owns. To the extent the reorganization value exceeds the sum of the fair value of individual identifiable assets, the balance is recorded as goodwill.On the right side of the balance sheet, the claims of creditors are re-stated to conform to the terms of the reorganization plan.
Implementing “fresh start” accounting requires valuation expertise to develop reasonably accurate fair value measurements.
ConclusionAlthough the Chapter 11 process can seem burdensome, a rigorous assessment of cash flows, and a company’s capital structure can help the company as it develops a plan for years of future success. We hope that this explanation of the key valuation-related steps of a Chapter 11 restructuring helps managers realize this potential.However, we also understand that executives of oil & gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success.With years of experience in both oil & gas and in advising companies through the bankruptcy process, Mercer Capital’s professionals are well-positioned to help in both of these roles. For a confidential conversation about your company’s current financial position and how we might assist in your bankruptcy-related analyses, please contact a Mercer Capital professional.1 Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.2 ASC 852-10-20.
Valuation Considerations in Bankruptcy Proceedings
An Overview for Oil & Gas Companies
The outbreak of the COVID-19 pandemic in the United States has caused a severe public health crisis and an unprecedented level of economic disruption. While some economic activity is beginning to come back, predictions for longer-term negative economic impacts have also become more prevalent. The initial thoughts of a quick V-shaped economic recovery have been replaced with a more nuanced consideration of how this situation will impact businesses within different industries and geographic areas over the next several years. In some of the most hard-hit industries, we are already seeing what is expected to be a prolonged surge in corporate restructurings and bankruptcy filings.While some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.In the first half of 2020, the U.S. oil and gas industry suffered what was arguably its worst six-month period ever. The combined impact of the Saudi/Russian price war and the drop in energy demand due to the onslaught of the COVID-19 pandemic was unprecedented. Brent crude prices that had begun the year near $67 per barrel had dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the quarter when the Saudi/Russia spat was in full force, but while the impact of the pandemic was still materializing. Since the start of the pandemic, liquid fuel consumption has dropped by 15% with production levels falling 10%. Drilling activity has been even harder hit with rig counts (active rotary rigs) now at a mere 30% of early first quarter levels. Despite oil prices having partially recovered, oilfield activity remains anemic with the OFS industry having shed nearly 90,000 jobs through May. While in a few areas oil and gas can be produced profitably at mid-year 2020 prices (WTI at 38.31 and Henry Hub at $1.63), most areas cannot. Thus, while some oil & gas industry bankruptcies have already occurred, expectations for many more to come are widely held.For oil & gas companies, the decision to file for bankruptcy does not necessarily signal the demise of the business. If executed properly, Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge from the proceedings as a viable going concern. Along with a bankruptcy filing (more typically before and/or in preparation for the filing), the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of business. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan that both specifies a reorganization value and reflects the agreed upon strategic direction and capital structure of the emerging entity.In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:11. The plan should demonstrate that the economic outcomes for any consenting stakeholders are superior under Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for more direct relief through a liquidation of the business. This is generally referred to as the “best interests test.”2. The plan should demonstrate that, upon confirmation by the bankruptcy court, it will not likely result in liquidation or further reorganization of the business. This is generally referred to as the “cash flow test.”Finally, upon emerging from bankruptcy, companies are required to apply “fresh start” accounting, under which all assets of the company, including identifiable intangible assets, are recorded on the balance sheet at fair value.Best Interests TestWithin this context of a best interests test, valuation specialists can provide useful financial advice to:Establish the value of the business under a Chapter 7 liquidation premise.Measure the reorganization value of a business, which, absent liquidation, represents the economic “pie” from which stakeholder claims can be satisfied. A plan confirmed by a bankruptcy court should establish a reorganization value that exceeds the value of the company under a liquidation premise.A Floor Value: Liquidation ValueIf a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. The law generally mandates that Chapter 11 restructuring only be approved if it provides a company’s creditors with their highest level of expected repayment. The Chapter 11 restructuring plan must be in the best interest of the creditors (relative to Chapter 7 liquidation) in order for it to be approved. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise generally contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value. Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window. Experience tells us that the underlying “marketing period” assumptions made in a liquidation analysis can have a material impact on the valuation conclusion.Liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation.From a technical perspective, liquidation value can occur under three sub-sets: assemblage of assets, orderly liquidation, and forced liquidation. As implied, these are asset-based approaches to valuation that differ in their assumptions surrounding the marketing period and manner in which the assets are disposed. There are no strict guidelines in the bankruptcy process related to these three sub-sets; bankruptcy courts generally determine the applicable premise of value on a case by case basis. The determination (and support) of the appropriate premise can be an important component of the best interests test.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would typically be applied to cash and equivalents, while less liquid assets (such as accounts receivable or inventory) would likely incur potentially significant discounts. For some assets categories, the appropriate level of discount can be estimated by analyzing the prices commanded in the sale of comparable assets under a similarly distressed sale scenario. Within the oil & gas industry, the operating assets come in many varieties, from oil & gas reserves, industry-specific well-site equipment and midstream assets, and less industry-specific equipment utilized by oilfield service providers.Reorganization ValueOnce an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s stakeholders than discounted asset sales.ASC 852 defines reorganization value as:2The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.Typically, the “value attributable to the reconstituted entity” (i.e., the new enterprise value for the restructured business) is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is valued based on the return that would be generated by the future operations of the emerging, restructured entity and not what one would be paid for selling individual assets. The intangible elements of going concern value result from factors such as having a trained workforce, a loyal customer base, an operational plant, and the necessary licenses, systems, and procedures in place. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash flow (DCF) method. The DCF method estimates the net present value of future cash flows that the emerging entity is expected to generate. Implementing the discounted cash flow methodology requires three basic elements:1. Forecast of Expected Future Cash Flows. Guidance from management can be critical in developing a supportable cash flow forecast. Generally, valuation specialists develop cash flow forecasts for discrete periods that may range from three to ten years, or in the case of upstream companies, the economic life of the company’s reserves. Conceptually, one would forecast discrete cash flows for as many periods as necessary until a stabilized cash flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. The historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business, can provide reference points to evaluate each element of the cash flow forecast.2. Terminal Value. The terminal value captures the value of all cash flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash flow growth rate and the discount rate to capitalize cash flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases, the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date. For upstream oil & gas companies, a terminal value is typically not utilized given the finite nature of the underlying resource. Instead, the discrete cash flows are projected for the entire economic life of the reserves.3. Discount Rate. The discount rate is used to estimate the present value of the forecasted cash flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the operational and market risks associated with the expected cash flows of the emerging entity.The sum of the present values of all the forecasted cash flows, including discrete period cash flows and the terminal value (if appropriate), provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization. Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigation. The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate.In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan. If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared: a cash flow test. This is an examination of whether the restructuring creates a company that will be viable for the long term—that is not likely to be back in bankruptcy court in a few years.Cash Flow TestFor a company that passes the best interest test, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Within the context of a cash flow test, valuation specialists can demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash flows that can be reasonably expected from the business. The cash flow test essentially represents a test of the company’s current and projected future financial solvency.The cash flow test essentially represents a test of the company’s current and projected future financial solvency.Even if a company shows that the restructuring plan will benefit stakeholders relative to liquidation, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash flow test can be broken into three parts.The first step in conducting the cash flow test is to identify the cash flows that the restructured company will generate. These cash flows are available to service all the obligations of the emerging entity. A stream of cash flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash flows for the cash flow test is often a straightforward matter of using these projected cash flows in the new model.Once the fundamental cash flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash flows of the company will not be used only to pay debts, and so the third and final step in the cash flow test is documenting the impact of the net cash flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash flows are invested in working capital and capital equipment, and modeling changes in the debt obligations of and equity interests in the company as the remaining cash flows are disbursed to the capital providers.A reorganization plan is generally considered viable if such a detailed cash flow model indicates solvent operations for the foreseeable future. The answer, however, is typically not so simple as assessing a single cash flow forecast. It is a rare occurrence when management’s base case forecast does not pass the cash flow test. The underpinnings of the entire reorganization plan are based on this forecast, so it is almost certain that the cash flow projections have been produced with an eye toward meeting this requirement. Viability is proven not only by passing the cash flow test on a base case scenario, but also maintaining financial viability under some set of reasonable projections in which the company (or industry, or general economy) underperforms the base level of expectations. This “stress-testing” of the company’s financial projection is a critical component of a meaningful cash flow test.“Fresh Start” AccountingCompanies emerging from Chapter 11 bankruptcy are required to re-state their balance sheets to conform to the reorganization value and plan.On the left side of the balance sheet, emerging companies need to allocate the reorganization value to the various tangible and identifiable intangible assets the post-bankruptcy company owns. To the extent the reorganization value exceeds the sum of the fair value of individual identifiable assets, the balance is recorded as goodwill.On the right side of the balance sheet, the claims of creditors are re-stated to conform to the terms of the reorganization plan.
Implementing “fresh start” accounting requires valuation expertise to develop reasonably accurate fair value measurements.
ConclusionAlthough the Chapter 11 process can seem burdensome, a rigorous assessment of cash flows, and a company’s capital structure can help the company as it develops a plan for years of future success. We hope that this explanation of the key valuation-related steps of a Chapter 11 restructuring helps managers realize this potential.However, we also understand that executives of oil & gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success.With years of experience in both oil & gas and in advising companies through the bankruptcy process, Mercer Capital’s professionals are well-positioned to help in both of these roles. For a confidential conversation about your company’s current financial position and how we might assist in your bankruptcy-related analyses, please contact a Mercer Capital professional.1 Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.2 ASC 852-10-20.
Asbury-Park Place Acquisition as Seen Through a Monday Night Football Commercial
You Make the Call!
One of my favorite memories as a kid was watching Monday Night Football. Three things, in particular, stood out: the iconic introduction theme music, the “Game of the Week” feeling, and the IBM: You Make the Call commercial segment. Invariably at some point during the hotly contested game, the IBM commercial would be inserted. The announcer would narrate a controversial play and the highlight would run to a critical juncture, only to be paused and allow for the viewer to play armchair referee and guess the outcome or “make the call.” These commercials basically pre-dated instant replay review and the official’s ability to “go under the hood” to review the play and determine the proper outcome.With the revival and announcement of Asbury Automotive Group’s acquisition of the Park Place dealerships in Texas earlier this month, I was once again reminded of the IBM commercial.In this week's post, we review a timeline of the transaction, along with an analysis of Asbury’s stock price against the rest of its public competitors and also examine the operational strategy of Asbury over the years to explain aspects of the Park Place acquisition.As with any merger or acquisition, the true success or failure of the deal may not be known for years. Investors and industry professionals can try and play armchair quarterback and try to predict the outcome. This blog post aims to provide ample information so that you can “make the call” on the transaction.Transaction TimelineThe original transaction was announced in December 2019 and would include 19 franchise locations, one open point, two collision centers, and an auction business all located in the Dallas and Austin markets. Franchises included: Mercedes-Benz, Lexus, Jaguar, Land Rover, Porsche, Volvo, Sprinter, and five ultra-luxury (Bentley, Rolls-Royce, McLaren, Maserati, and Karma). At the date of the announced transaction, Asbury’s common stock traded at $122.67/share.
On March 18, 2020, Asbury secured additional borrowings on its existing lines of credit and used vehicle floor plans. Recall that the first two weeks of March saw COVID-19 cases and the impact of shelter-in-place orders and other economic interruptions in the United States. At this point in the timeline, it still appeared that the transaction would continue, although Asbury’s stock price had already declined by a whopping 64% to $44.62/share.
Just one short week later, Asbury terminated the Park Place transaction on March 25, 2020, citing the uncertain market conditions related to the COVID-19 pandemic. Interestingly, Asbury’s stock had rebounded slightly from the week before to trade at $58.67/share.
Earlier this month, news broke that the Asbury-Park Place transaction was moving forward again on July 6. The auto industry had experienced some modest gains in the monthly SAARs for May and June, and this news was a shot in the arm for the auto M&A market. As more information has been released, the revised transaction with Park Place is scaled slightly lower from the original proposed transaction in December 2019. Terms of the revised transaction include the acquisition of 12 franchises, no open point, two collision centers, and the auction business. Pricing terms include total consideration paid of $735 million, excluding vehicles, reflecting $685 million of Blue Sky value on $95 million of EBITDA with $20 million in run-rate synergies. As I reviewed Asbury’s Q1 earnings call from earlier in the Spring, there were hints that this transaction might have still been in the works. At the time of the re-announcement, Asbury’s share price had increased to $78.41/share.
In the two weeks following the announcement, Asbury’s share price increased by 25%. It appears that investors are excited by the revived transaction in the short run. We analyzed the historical trading prices of the other auto public competitors to determine how Asbury’s trends compared to the overall public auto market. While other public competitors (Lithia Motors and Sonic Automotive) have experienced larger rebounds than Asbury, the boost provided by Asbury’s transaction announcement has exceeded the gains by any other public competitor in that short time. It remains to be seen if investors will continue to show this level of enthusiasm in the months to come.
Asbury’s Operational Strategy In its presentation to investors and explanation for the transaction, Asbury executives cited the following objectives: 1) conscious effort to acquire more luxury franchises, and 2) move out of less desirable markets and move into more favorable markets. Asbury management further postulated that luxury dealerships are more resilient than other franchises during market downturns, provide more stable margins, have less competition due to fewer dealers across the country, and maintain a higher portion of their gross profits from parts and service than other franchises such as import, domestic or mid-market.Let’s examine these objectives and play armchair quarterback with Asbury’s executive management. Since a large focus of the proposed transaction centers around luxury dealerships and their performance during economic downturns, we analyzed Asbury’s franchise platform from 2008 to present day. As much has been written in this space and in numerous industry pieces, perhaps the closest comparison to the present unstable economic conditions is the Great Recession in 2008 and 2009.Since 2008, Asbury has operated approximately 93 to 115 franchise locations in any given year. While the overall number of franchise locations hasn’t shifted too dramatically, the shift in dealership types can definitely be viewed following the additions from the Park Place transaction. As early as 2008, Asbury operated with only one-third of its franchises as luxury brands. Post-Park Place, Asbury’s brand mix will now be almost 50/50 luxury vs non-luxury.
In addition to the brand shift, Asbury has also vacated several markets and entered into more favorable new markets. Specifically, Asbury has vacated Arkansas, California, and New Jersey. In recent months, Asbury has also divested of its Mississippi locations and one of its Atlanta Nissan locations, but has made an acquisition in the Denver, Colorado market. With the additional platform provided by the Park Place locations, Asbury’s focus will be on Florida and Texas as the two main sources of total revenue.
Resiliency of Luxury BrandsIn order to test Asbury’s theories regarding the resiliency of luxury franchises against others during a downturn, we examined various financial indicators from public manufacturers’ from 2005 through 2012. For purposes of our analysis, we categorized the following as luxury brands: Audi AG, Bayerische Motoren Werke, Tata Motors Limited, Daimler AG, and Porsche Automobil Holding SE. We also compiled a sample group for other dealership classifications including import, mass market, and domestic. The results will be slightly skewed as several public companies overlap into multiple categories. Nevertheless, we indexed and measured the performance of the luxury brands to the other dealership groups by median revenue, gross profit, earnings before tax (“EBT”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”).Our study provided the following analysis of each financial metric indexed against a baseline median from 2005 data:
[caption id="attachment_32683" align="alignnone" width="782"]Source: Capital IQ[/caption]
For these indicators, luxury brands fared better than most other dealership groups but seemed to lag slightly behind import dealerships. Asbury executives will be banking on similar success and performance of their luxury brands as the auto industry continues to try and recover from the turbulent economic conditions caused by the pandemic.ConclusionsSo how will Asbury perform and will the revived acquisition of the Park Place dealerships prove to be successful? Only time will tell in the coming months and years.But for now, investors and industry professionals can hit the pause button and evaluate it just as viewers did with IBM's iconic commercials from Monday Night Football in the 1980s and “YOU MAKE THE CALL!”
How Much Money Do Family Businesses Like Ours Invest?
The old bromide assures us that “You’ve got to spend money to make money.” Although obviously true at some level, how much should you spend, and what should you spend it on?Investment DecisionsWe tend to think of family business investments in terms of a series of three decisions.What investments do we need to make to maintain our productive capacity?How much capital should we allocate to growth investments?Should we grow by building or buying?#1 – What investments do we need to make to maintain our productive capacity?Maintenance capital expenditures are rarely exciting. But they are important. Successful families resist the urge to defer the unglamorous expenditures needed to maintain and enhance the productivity of their businesses. Companies that failed to make the necessary investments to keep their information technology infrastructure up-to-date and compatible with the latest remote work applications experienced a rude awakening when the pandemic sent their employees home.Companies are not required to disclose which of their investments are for maintenance purposes rather than for growth. However, depreciation expense is probably a decent proxy for maintenance capital expenditures. In the 2020 Benchmarking Guide for Family Business Directors, we examined maintenance capital expenditures for the companies in our sample. Over the period analyzed, maintenance investments accounted for nearly 20% of EBITDA (a proxy for cash from operations) and approximately 2.5% of revenue.#2 – How much capital should we allocate to growth investments?The investment decisions get progressively harder. After setting aside funds for maintenance capital expenditures, family business directors must allocate capital to incremental growth investments. Answering this question well requires directors to balance a variety of concerns, which include:Can we identify growth investments that align with our broader business strategy?Do the growth investments we identify present an attractive relationship between risk and reward?Do we have access to the capital required for the investments we identify?How do our family shareholders prioritize growth relative to current income?
Risk influences the willingness of directors to commit capital to growth investments. The companies in our sample reduced spending on growth investments by more than 10% in 2019 compared to 2018. This may reflect some wariness on the part of directors regarding the durability of the economic expansion which was entering its second decade. Growth investments also fell in 2016, perhaps reflecting uncertainty regarding that year’s presidential election.
#3 – Should we grow by building or buying?Growth investments come in two varieties: organic (building additional capacity from scratch) and acquisitions (buying existing capacity from someone else).As growth strategies, building and buying present their own set of risks and potential benefits.Companies opting to build avoid the risk of overpaying for someone else’s goodwill and are assured that the default culture will be that of the family business. On the risk side of the ledger, builders should be concerned about whether the market really needs the additional capacity they are building. Builders also bear the opportunity costs of what are often extended investment periods during which more nimble competitors may be able to seize the first-mover advantage.Acquirers, on the other hand, often overpay for target companies and struggle to integrate the culture of the acquired entity. However, acquisitions can present opportunities for cost savings and revenue synergies that are not available with organic growth investments. Further, acquirers can begin capitalizing on the perceived market opportunity immediately.
The public companies in our sample tend to allocate more of their growth capital to acquisitions than organic capital expenditures. Across all industries, acquisitions outpaced growth capital expenditures by a more than 2-to-1 margin during 2019. However, this relationship varied significantly by industry, as shown below.
Companies in the consumer staples, health care, and information technology sectors rely much more heavily on acquisitions than capital expenditures for growth.
We suspect that family businesses are, in general, less acquisitive than their publicly traded counterparts. While we have plenty of clients that grow by acquisition, our sense is that the cultural hurdles associated with acquisition cause other family businesses to prefer organic growth strategies.
ConclusionTo be sustainable, family businesses need to invest capital wisely. As directors, the answers you give to the investment questions today will help define what the family business looks like for future generations. Before making a significant investment decision that will be hard to reverse, it is a good idea to evaluate how other companies in your industry are answering the investment questions for themselves. If your answers are different, articulating why they are different and testing those reasons can help directors gain comfort that they are on the right path.2020 Benchmarking Guide for Family Business DirectorsDownload Guide
RIAs Rally After Worst Quarter in Eleven Years
The Industry Is Now in a Bull Market Following March’s Sell-Off
It probably doesn’t feel like it, but most RIA stocks are up over the last year. Over this time, we’ve had two bull markets and one bear market in one of the most volatile twelve-month periods that I can remember. This volatility has been especially beneficial to alternative asset managers since hedge funds are usually well-positioned to take advantage of variability in security prices. The aggregators are the only segment of RIAs that are down over the last year since their models rely on debt financing, which exacerbated their losses during March’s sell-off.Last quarter showed the positive side to leverage as aggregators bested all other classes of RIAs during generally favorable market conditions in April and May. Other investment managers also fared well since collective AUM and ongoing revenue recovered with the market over the quarter. The primary driver behind the increase was the increase in the market itself, as most of these businesses are primarily invested in equities, and the S&P gained about 20% over the quarter.The recent uptick is promising, but it should be evaluated in the proper context. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt in March before rallying again in April and May.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value. These multiples show a similar rise in Q2 after a sharp decline in the first quarter.
There are a number of explanations for this variation. Earnings multiples are primarily a function of risk and growth, and risk has waned since March’s run-up and growth prospects have recovered. Specifically, future earnings are likely to increase with the recent rally, so the multiple has picked up as well since March’s bottom. Conversely, the decline in Q1 reflected the market’s anticipation of lower earnings with falling AUM and management fees. The multiple usually follows ongoing revenue, which is simply a funtion of current AUM and effective fee percentages, as discussed in a recent post.
Implications for Your RIADuring such volatile market conditions, the value of your RIA largely depends on the valuation date or date of measurement. In all likelihood, the value declined with the market in the first quarter before recovering most of that loss in the second. We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down 20% in the first quarter (see chart above) before gaining just as much in the second to end up back in the same spot as year-end. The P/E multiple is another reference point, which has followed a similar path. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last appraisal, while being careful not to count good or bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter. We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last couple of months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well though year-end is still a high water mark for many RIAs. July has been kind so far, but who knows where the back half of 2020 will take us in a wild year for RIA valuations and overall market conditions.
June 2020 SAAR
A Lackluster Month, But a Move in the Right Direction
After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry. Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains. Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry. Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically, franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions.
As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work.
With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant. Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk. The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken. At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19 cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage. Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.
June 2020 SAAR
A Lackluster Month, But a Move in the Right Direction
After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry. Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains. Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry. Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically, franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions.
As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work.
With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant. Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk. The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken. At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19 cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage. Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.
Middle Market Transaction Update First Quarter 2020
The deteriorating economic situation in the U.S. as a result of the ongoing COVID-19 pandemic, which began at the end of the first quarter, is expected to hamper deal activity through the remainder of 2020 and into 2021.
Current Environment Challenges America’s Most Prolific Basin
Permian Basin Update
The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian Basin.Production and Activity LevelsPermian production grew approximately 3% year-over-year through June, in line with Appalachia and avoiding the declines observed in the Bakken and Eagle Ford (down 28% and 10%, respectively). The Permian is still one of the focus areas of supermajors Exxon and Chevron, and also relatively well-capitalized independents such as Concho, Diamondback, Parsley, and Pioneer. As such, it has been more resilient than other oil-focused basins and experts expect to see production growth.
Rig count in the Permian at June 26th stood at 131, down 70% from the prior year. While significant, this decline is less severe than reductions seen in the Bakken and Eagle Ford of 82% and 85%, respectively. Appalachia rig counts declined by a more modest 52%, though the gas-focused basin had fewer rigs to drop and faced a more benign commodity price environment. With companies beginning to bring production back online, this may be the nadir, though significantly lower E&P capex budgets will likely keep a lid on rig counts in the near term.
The Permian is also seeing gains in new-well production per rig. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New-well production per rig in the Permian increased 2% on a year-over-year basis through June, compared to changes of -42%, 12%, and 6% in the Bakken, Eagle Ford, and Appalachia, respectively. (Note that the decline in Bakken production is an artifact of the significant production curtailments in the basin. The EIA forecasts a normalization in July.)
Commodity Prices Rebound After Unprecedented DeclineWTI front-month futures prices increased over 90% during the second quarter of 2020, though it was a bumpy road getting there. Prices at the beginning of the quarter were ~$20/bbl, still depressed in the wake of the Saudi/Russian price war, and demand destruction caused by COVID-19. In early April, prices generally increased, approaching nearly $30/bbl by the middle of the month. However, on April 20, WTI futures prices collapsed, falling below $0 to settle at negative $37/bbl. While there are numerous technical reasons for the collapse, there was significant concern regarding crude storage capacity as production had not declined in tandem with demand.
However, crude futures prices generally increased thereafter, driven by supply cuts from OPEC+, curtailments by US producers, and a recovery in demand. WTI front-month futures prices ended the quarter at $39.34/bbl.
Financial PerformanceAll Permian E&P operators analyzed have had year-over-year stock price declines. Pioneer and Parsley were the best performers in the Permian group, only down 37% and 44%, respectively. Concho also outperformed the broader E&P index (XOP), down 50% compared to the XOP’s 52% decline. Centennial was the worst performer in the group, down 88% year-over-year, though it has rebounded significantly since its lows in early April.
While the Permian has been less affected by the most recent batch of E&P bankruptcies, it has not been immune. At the end of June, two Permian operators filed for bankruptcy. Sable Permian filed for bankruptcy on June 25 with approximately $1.3 billion of interest-bearing debt. The company previously underwent debt restructurings in 2017 and 2019. On June 29, Lilis Energy filed for Chapter 11. The company entered proceedings with a Restructuring Support Agreement with certain investors. Under the terms of the agreement, common equity holders will not receive any consideration in the restructured entity.
Though commodity prices have recovered from recent lows, they remain below levels at which certain operators can cover operating expenses on existing wells (and well below prices required to drill new wells), according to a Dallas Fed survey. As such, more Permian bankruptcies are likely coming.
Texas Railroad Commission Decides Against ProrationOn April 14, the Texas Railroad Commission (which, despite its name, regulates oil & gas activities in the state of Texas) held a meeting to discuss prorating production in the state in light of significant demand destruction and concerns regarding oversupply. Proponents of proportion, led by Scott Sheffield of Pioneer and Matt Gallagher of Parsley, argued that proration was needed to save American jobs and ensure that the energy industry is able to respond once demand returns. Opponents argue that government mandates were unnecessary and that operators should adjust production in response to market prices. Some, specifically midstream operators, were concerned that such a mandate would allow E&P companies to eschew contractual commitments.On May 5, two of the three Texas Railroad commissioners voted against proration.ConclusionWhile commodity prices have recovered from recent lows, they remain below levels at which certain E&P companies can operate sustainably. Two Permian operators have filed for bankruptcy, and more are likely coming. However, the Permian’s economics remain superior relative to most basins, so it will likely fare better than other areas in this difficult environment.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Middle Market Transaction Update Second Half 2020
U.S. M&A activity slowly rebounded in the third quarter of 2020 from the pandemic-shocked levels seen in the second quarter and reached pre-pandemic levels of activity in the fourth quarter.
Whitepaper Release: Valuing Independent Trust Companies
If you’ve never had your trust company valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your firm’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of independent trust companies given the typical independent trust company’s ownership structure, where a majority interest is held by the firm’s founders or senior partners, with younger, more junior partners holding smaller stakes. Such an ownership dynamic—with its (relatively) frequent arms-length transactions and potential for ownership disputes—heightens the need to understand the value of your ownership interest. In our experience working with independent trust companies on valuation issues, the need for a valuation is typically driven by one of three reasons: shareholder agreements, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your firm might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in independent trust companies.In the whitepaper, we describe the situations that may lead to a valuation of your firm, provide an overview of what to expect during the valuation engagement, introduce some of the key valuation parameters that define the context in which a firm is valued, and describe the valuation methods and approaches typically used to value independent trust companies. If you own an interest in an independent trust company, we encourage you to take a look. While the value of your firm may not be top of mind today, chances are one day it will be. Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your firm and the situations—good and bad—that may give rise to the need for a valuation. WHITEPAPERValuation of Independent Trust CompaniesDownload Whitepaper
Vroom, Zoom, and Stock Market Boom
As we teased last month, Vroom filed an S-1 with the SEC in May enabling its initial public offering (IPO) on June 9th. The online automotive retailer priced the 21,250,000 shares at $22/share. By the end of the trading day, Vroom’s stock had increased 118% to $47.90. For perspective, the NASDAQ as a whole rose only 0.3% that day.The company positions itself as “an innovative, end-to-end platform designed to offer a better way to buy and a better way to sell used vehicles.” A press release also touted its “contact-free” nature, apparently seeking to distinguish Vroom from traditional, franchised, brick-and-mortar dealers as COVID-proof.In this post, we consider Vroom’s business model compared to other online dealers, the company’s investment thesis that may have driven their spike, and see what the filing could tell us about the broader industry and the IPO market more generally.Drafting Behind CarvanaLeading up to an IPO, companies must put their best foot forward and offer plenty of promise. While being a futuristic company that uses buzz words like “data science” and “machine learning” sounds nice, will the benefit of an ecommerce boom ultimately be conferred on Vroom? We’ve previously noted this with Tesla. Despite being the buzz-worthy poster child, Tesla isn’t the only company with online retailing or electric vehicles. Carvana, Vroom’s most direct comparable in terms of online car retailing, IPO’d in 2017 and has about triple the revenue and gross profit margin. Carvana’s public life began with a rather inauspicious start; it opened trading at a 10% discount to its $15 IPO price and finished the day at $11.1 for a 26% decline. However, just over three years later, the stock is now trading 683% above its IPO price (as of June 26th). Carvana rode triple-digit quarterly revenue growth for 23 consecutive quarters, a feat unlikely to be duplicated by Vroom. However, Vroom is hoping their business model differences will be persuasive to investors.Vroom CFO Dave Jones acknowledges the similarities between the companies from the consumer perspective, but he emphasized their asset-light approach as something that materially distinguishes the two from an investment perspective. This approach has been taken in other industries, and such companies benefit from staying out of the fray when difficult operating environments depress margins. It remains to be seen whether Vroom will be able to navigate this effectively.Investment Thesis from the S-1Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles.While their asset-light approach helps distinguish them from Carvana, Vroom used its S-1 to make the case for the growth of ecommerce in the auto space, particularly for used vehicles. Vroom highlights industry fragmentation (42,000 dealers), millions of peer-to-peer transactions, and dissatisfaction with the status quo as reasons its ecommerce platform can continue to grow. The Company calculates the Used Auto market as the largest consumer product category with $841 billion sales on approximately 40 million units in 2019. This surpasses both Grocery and New Auto sales, which are $683 billion and $636 billion, respectively. Vroom pitches the current used vehicle business model is broken, with “limited selection, lack of transparency, high pressure sales tactics, and inconvenient hours.”Vroom also highlights the gross profit advantages inherent in used vehicles. From 2007 to 2009, the S-1 notes gross margins for new vehicles fell from 6.9% to 6.7%. Not only were gross margins higher for used vehicles, but they actually increased during these troubling times from 8.9% to 9.4%. While careful to explicitly make this forecast, Vroom heavily implies its ability to capitalize on COVID, a story that investors seem to be buying, at least for now.Financial Realities of VroomUnder “Use of Proceeds,” Vroom intends to use the $468 million in fresh capital (excluding certain underwriting costs) for general corporate purposes, including advertising and marketing, technology development, working capital, operating expenses, and capital expenditures. This should help fuel future growth as the company burns cash. Like many companies going public in recent years, Vroom is not turning a profit as it intends to “invest in growth to scale our company responsibility and drive towards profitability.” Advertising expense in 2019 was $72.5 million, which is 6.1% of revenue and more alarmingly, 125% of gross. With advertising consuming only about 40% of its SG&A expense in 2019, Vroom is spending about 3 times gross on SG&A. The company will be hoping that scale will eventually allow them to throttle back advertising spend without giving price concessions on its gross.A red flag for Vroom and its ability to draw future investors is its gross margin. In 2019, gross margin declined to 4.85%, down from 7.11% in 2018. While the company would likely point to its superior ecommerce margins of 6.1%-6.4% over the past two calendar years, it is notable Vroom’s gross margins are well below average margins (11.3%-11.4%) for used vehicle for these years. The asset light approach, one they have used to differentiate, may become a cause for concern as well due to the cost of outsourcing much of its critical operations.Future for Vroom, and Other Auto RetailersWill Vroom be able to carve out a place in the market? There are plenty of examples of duopolies such as Pepsi and Coke, Lyft and Uber, and Republican and Democrat. Uber and Lyft are hot auto-adjacent tech companies, but their service has been commoditized as many of its gig drivers opt to drive for both companies to increase their opportunities for trips and tips. The gig economy has spawned other fast-growing tech companies with many competitors in the food delivery space (DoorDash, Grubhub, Uber Eats, Postmates, etc.). Again, these companies have been forced to compete heavily on price despite not offering all of the same restaurants (not a complete commodity if you want a specific pizza only carried by DoorDash). Consolidation talks have already taken place in this industry, and it begs the question of how online auto-retailing will shake out. There are plenty of examples of tech subsectors having one giant player that is the go-to option for consumers (Amazon for online retail, Google for search engines, etc). Vroom, and the industry more generally, will be hoping that there are many seats at the table. For now, no single party owns more than 2% of the market.How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The S-1 highlighted ecommerce penetration in the industry sitting at just under 1%, compared to about 16% for total retail (thanks, Amazon). Vroom’s long-term value proposition likely hinges on your view of the future of car buying and the Internet’s role in the market. Consumers were forced online during recent stay-at-home orders, but will these necessary precautions breed long-term shifts? How will younger consumers who grew up with iPhones and tablets in their hands prefer to shop?The ability to seamlessly browse across brands seems appealing, but traditional franchised dealership executives have voiced concerns over how much of the transaction can really take place fully online. Analysts have also frequently questioned the incremental costs associated with delivering cars and whether or not they are covered by the cost savings on retail. With its asset-lite approach, Vroom will provide a good case study.State of the IPO MarketAfter high-profile IPO flops in 2019, including Uber, Lyft, and WeWork (who couldn’t even make it to IPO), the tides appear to have turned in 2020 as exemplified by Vroom and to a lesser extent, Warner Music. Companies such as DoorDash, Lemonade, Airbnb, and others are looking at potential virtual IPOs, which may shed more light on whether Vroom was the anomaly or the precedent.Stock Market VolatilityCOVID-19 has led to significant market volatility with certain industries hammered (cruise lines, restaurants, and airlines to name a few) and others soaring (consumer durables such as cleaning supplies and virtual communication like Slack and Zoom). Speaking of the latter, a case of mistaken identity sent Zoom Technologies (ticker: ZOOM), a thinly traded Chinese wireless communications company, stock up 47,000%. Investors meant to be investing in the popular Zoom Video Communications (ZM), which has overtaken other platforms such as Skype as the dominant player during stay-at-home orders. Trading was halted to fix this issue, but this has not been the only curious case in the market over the past few months.COVID-19 has led to significant market volatility with certain industries hammered and others soaring.As a further example of the fluid, volatile nature of the current stock market, consider Hertz, the established rental car company. On the same day Vroom was publicly listed, Hertz saw its share price jump to $5.53. Yes, the same Hertz that filed for bankruptcy protection on May 22nd. The pandemic-induced demand shock on car rentals and air travel, that begets more rental cars, compounded years of problems including competition from ride-hailing services. The share price increase represented a nearly 900% rise from a May 27th low and an even more astonishing 80% higher than the day before it filed for bankruptcy protection. The sharp increase prompted Hertz to consider tapping the equity markets for one last bite at the apple. Despite the stock being theoretically worthless, the company was seeking to take advantage of the market’s exuberance after gaining bankruptcy court approval on June 12th. However, Hertz ultimately scuttled these plans as the SEC balked at the company’s filing which included a statement that the company’s shares could “ultimately be worthless.”There are theories abound as to what caused Hertz’ unfathomable increase. Central bank liquidity has no doubt fueled the risk-off mindset as the S&P index has increased nearly 35% since a March 23rd low (as of June 26th). The broader market reversal began when the Fed announced it would be buying individual corporate bonds, a promise they only started to make good on nearly 3 months later. Specific to Hertz, they appear to have benefitted, at least in part, from retail investors bidding up the price. As of June 15, data from Robintrack indicated more than 170 thousand Robinhood users held shares in the company. It was the #1 traded stock on the popular retail investor app that doesn’t charge commissions on trades. Some have taken it a step further to connect it to the dearth of gambling options with professional sports on hold. A more nuanced view might be that strategic investors are seeking to exploit the structure of the company’s debt. In the past, equity holders threatened to hold up the process, pressuring credit holders to pass on some of the value during bankruptcy proceedings. Hertz’ debt is largely held in asset-back-securities which fragments the voice of creditors and may ultimately weaken their bargaining power. While Hertz and Vroom are on the opposite ends of their time as a public company, each exhibit reasons to be wary of what the market might or might be telling private business owners.ConclusionSo, what does the stock price of Vroom mean for the value of my private dealership? Virtually nothing. While dealerships, like all businesses, require careful analysis in order to determine a reasonable indication of value, the value of your dealership probably did not double in a day. However, the public market does offer the opportunity to gain valuable insights from companies that operate all over the country. Vroom’s S-1 and successful IPO should signal what many dealership owners already know: digital platforms will become increasingly important, inherent margin advantages in used vehicle retailers are attractive, and growth captures the eye of investors.Contact a Mercer Capital professional to discuss the effect the dynamic auto dealership industry is having on your business today.
Five Things to Keep in Mind When Evaluating the Dividend Policy of Your Family Business
Dividend Misunderstandings?
In a recent Wall Street Journal article, Professor Alex Edmans of the London Business School offers an impassioned plea for public companies to stop prioritizing dividend payments. In “Why Many People Misunderstand Dividends, and the Damage This Does,” Dr. Edmans contends that investor aversion to dividend cuts causes public companies to make irrational investment and expense management decisions. Furthermore, Dr. Edmans postulates that over-reliance on dividends encourages an unhealthy degree of investor passivity.Is dropping the regular dividend a viable option for closely held family businesses?Rather than paying a stout, maintain-at-all-costs regular dividend, the author suggests that companies rely on share buybacks and non-recurring “special” dividends to provide returns to shareholders. Perhaps this is the proper prescription for public companies – after all, shareholders can readily “replace” the lost dividend income by simply selling a portion of their holdings. Doing so is really no different than receiving a dividend, which reduces the value of the shares owned. But is dropping the regular dividend a viable option for closely held family businesses?Unlike public company investors, family shareholders do not have access to ready liquidity for their shares. This can have profound implications for dividend policy. Family shareholders cannot easily create their own “synthetic” dividend by simply selling a portion of their holdings. Opportunities to sell shares in the family business may come only sporadically and may be on disadvantageous terms. For example, family shareholder liquidity programs – when they exist – often allow for transactions just once per year, have hard caps on the total repurchase budget, may occur at a discounted price, or may provide consideration in the form of a multi-year note. In short, despite being an important part of the shareholder engagement toolbox, family shareholder liquidity programs are no substitute for the freely traded shares of a public company.Five Things to Keep in MindSo how should family businesses think about dividend policy? Here’s a non-exhaustive list of five things to keep in mind while evaluating your family business’s dividend policy.1. Dividends Are Not a Substitute for Freely Traded Shares, But They Do HelpA predictable dividend stream does not provide the near-instantaneous liquidity that public shareholders enjoy, but it does provide access to liquidity over time. Since family shareholders cannot easily sell small portions of their holdings to fund major life purchases, they instead rely on dividend income to supplement other sources of cash flow as personal needs arise.2. Dividends Help Reduce the Risk Faced by Family ShareholdersA long-time client of ours endured a significant business crisis several years ago. In order to survive, the company had to raise capital from outside investors, which diluted the ownership position of the family. In short, the wealth of the family – as represented by the value of the family business – fell materially. However, prior to the crisis, the family business had a long history of paying regular and substantial dividends to shareholders, which provided many of them the opportunity to diversify their overall personal balance sheets. As a result, the sharp drop in the value of the family business’s shares, while certainly unpleasant, was not as devastating as it would have been in the absence of the outside wealth accumulation permitted by the prior dividend payments.3. Dividends Provide a Signal Regarding the Health of the Business That All Shareholders Can UnderstandPositive shareholder engagement is critical to the sustainability of any family business. We are firm believers in the benefits of clearly communicating financial results to family shareholders. Yet, the surest way to communicate with shareholders is through the dividend. Financial reports and management letters may or may not get read, but dividend checks always get cashed.A regular dividend that fluctuates in response to the performance of the business may be the most effective communication tool available.Public companies allocate about twice as much to share buybacks as dividend payments each year. They do so, in part, to uncouple the dividend from the inevitable year-to-year fluctuations in business performance; during boom years they simply repurchase more shares, and during lean years, they cut the repurchase budget.For many family businesses, share redemptions cannot provide a comparable release valve on shareholder distributions. As a result, family business directors should consider “training” their shareholders to anticipate year-to-year fluctuations in dividend payments that track the underlying health of the family business.4. Dividends Can Help Managers Be More Selective in Making Capital InvestmentsThe natural tendency of corporate managers toward “kingdom building” is well-documented. We suspect that family business managers are not immune to this urge. Forcing corporate investments to compete with dividend payments for scarce capital can be a very helpful antidote to the tendency of corporate managers to over-invest. In fact, some researchers have concluded that the investment discipline associated with paying dividends actually contributes to better returns on capital and higher earnings growth.5. Dividends Help Bring the Trade-Off Between Future Growth and Current Income Out Into the OpenWhen asked if they want to maximize cash flow for current shareholders or growth for future generations, many shareholders respond with an emphatic “Both!” But in the economic world that we live in, that’s not really a feasible posture.Dividends are the most tangible manifestation of what the family business really means to the family. Identifying and – if needed – adapting the meaning the family business to the family is one of the most important tasks for senior leaders of the family.ConclusionProfessor Edmans makes some provocative suggestions in his Wall Street Journal article. While they may have some merit for public companies (which were, in all fairness, the professor’s intended audience), his suggestions do not translate well to most family businesses.Give one of our family business professionals a call to discuss the challenges you face in setting a dividend policy for your family business.
M&A in the Permian Basin
The Road Ahead: Deal Count and Deal Motives Changing in Challenging Times
Transaction activity in the Permian Basin, and frankly elsewhere as well, is in a unique, and potentially critical situation as companies are facing unpredictable consequences and uncertain futures.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2018-2019, deal count decreased by ten and median deal size declined by roughly $60 million year-over-year. Although this table looks busy with a number of deals, the transactions that occurred before March are most likely not indicative of the road ahead. Industry participants are much more concerned with deals that have been announced following the dramatic fall in oil price due to COVID-19 and the Russian-Saudi price war, which in this case was determined to be after March 1, 2020. Looking at the table, only four deals have been announced post-March. Although the sample is small, they could be the best indication of what is to come, assuming prices remain depressed.Black Stone Minerals Letting Go of Core Permian AcreageIn early June, Black Stone Minerals announced that they were selling a total of $155 million of royalty interest assets in two separate transactions to strengthen their balance sheet and liquidity position. This appeared to be core acreage in the Permian as the price per flowing barrel was a premium compared to average private transactions of $40,000 per flowing barrel in March and April. The deal with Pegasus Resources included a 57% undivided interest across parts of the company’s Delaware Basin position and a 32% undivided interest across parts of the company’s Midland Basin position. Black Stone noted that proceeds from the sale will be used to reduce the balance outstanding on the company’s revolving credit facility. Black Stone expects its total debt levels to be under $200 million after closing the two transactions.HighPeak Energy & Pure Acquisition Combine Forces After Early ComplicationsPure Acquisition, a blank-check company, announced in early May that it was acquiring Howard county focused HighPeak Energy in a deal worth $845 million. The original deal, which was terminated due to the crash in oil prices and market uncertainty, included a three-way merger agreement with private-equity-backed Grenadier Energy Partners. The new business combination between HighPeak Energy and Pure Acquisition will hold a pure-play 51,000-net-acre position in the northern Midland Basin. Jack Hightower, HighPeak Energy’s Chairman and CEO, commented, “With the decline of energy prices over the last few months, several energy companies are struggling. However, due to our low drilling and completion costs and our low operating costs, our breakeven prices are much lower than our competitors which enables us to operate profitably at lower price levels.” Time will tell whether the merger will be able to capitalize. The transaction is expected to close in the third quarter of 2020, with the combined company trading on the NASDAQ.Ring Energy Taking a Conservative Approach Moving ForwardIn mid-April, Ring Energy agreed to sell its Delaware Basin asset located in Culberson and Reeves Counties, Texas for $31.5 million to an undisclosed buyer. The asset included a 20,000 net-acre position with current production of 908 boepd (63% oil) at the time of the deal. Kelly Hoffman, CEO of Ring Energy stated, “The proceeds from this transaction will be used to reduce the current balance on the company’s senior credit facility. The current environment mandates a cautious, conservative approach going forward, and strengthening our balance sheet is a step in the right direction.” Ring Energy continues to hold positions in the Permian and Ventral Basin Platform and the Northwest Shelf. The company recently completed a redetermination of its senior credit facility and expects the transaction to close before the end of July.ConclusionM&A transaction activity in the Permian was skewed, in terms of deal count, as most activity during the last twelve months occurred in the second half of 2019. Deal motives moving forward will be interesting to monitor as companies may be forced to let go of premium acreage, notably in the Permian Basin, to improve their liquidity positions. It does not appear to be a seller’s market, as sellers realize the intrinsic value associated with acreage. If companies have the luxury and are not forced to sell, they seem to be holding on tight searching for the light at the end of the tunnel.
What Market Volatility Means for your RIA
Is Volatility the New Normal?
By the middle of March, most RIA owners were hunkering down for what looked to be the next recession. By the end of March, the S&P 500 had fallen approximately 24% from its all-time high of 3,386 on February 19, 2020 to 2,585 on March 31, 2020. By the middle of June, however, the stock market and most RIAs’ assets under management have recovered to where they were about a year ago. While we gave up the gains of the final year of an 11-year market run up, the market and income statements of most RIAs look much the same as they did 18 months ago. Despite this, most RIA principals feel they are in a very different position than they were a year ago.Due to the COVID-19 global pandemic, the future of the economy has become more uncertain. The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16th of 82.69, which was higher than the peak during the financial crisis in 2008. The recent VIX measure is especially noteworthy given the comparatively sleepy decade which preceded it.If one thing has become more clear, it’s that market volatility is here to stay – at least for a while. In this post, we explore what this volatility means for you and for your RIA.AUM, aka Revenue Base, is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2020 will be significantly lower than the fees charged as of June 30 (barring any significant decline in the market over the next 7 days – which is not out of the question). Many RIAs have quickly adjusted to this new normal. Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis.Active Managers May be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients. This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined. A lack of liquidity in market structure is associated with increased risk. In a less liquid market, it is more likely that you could get stuck in a losing position. Additionally, in less liquid markets, prices tend to overreact, making market moves less informative. While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers are Missing OutMost of the recovery in the market since the March decline is attributable to the resilience of tech stocks. Investors are willing to bet that tech companies, such as Microsoft and Apple, will emerge from the COVID-19 pandemic stronger than before. Just five stocks - Microsoft, Apple, Amazon, Google parent Alphabet, and Facebook - account for more than 20% of the market cap of the entire S&P 500 index, according to BofA Global Research. This means that asset managers without exposure to the tech industry are likely lagging the broader market, as measured by the S&P 500.Internal Transactions Have Been CanceledMost sellers of RIAs are currently unwilling to sell at the pricing implied by valuations as of March 31, 2020, which likely did not forecast the quick recovery in equity markets in April. Additionally, the next generation of leadership is likely not currently in the financial position to take on additional risk. Rather, many households are decreasing risk as they prepare for the possibility of another global recession.External Transactions are on PauseUnlike the slowdown in M&A in many other industries, the stall in deal activity in the RIA space is not due to a lack of financing. Rather many deals have been put on hold as the due diligence process is impeded by travel restrictions meant to limit the spread of COVID-19. While most business and due diligence can be conducted over Zoom calls, it’s hard to actually sign an eight-figure check without having ever stepped foot in the main office of the company you are buying. And most sellers don’t want to hand their businesses over to someone they haven’t actually met.Planning is More Important Than EverDuring this time when the outlook for global markets, the economy, and one’s own health and financial well-being is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership. RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms. As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.
Impairment Testing of Oil & Gas Reserves
2020 Global Events Causing Significant Reserve Write-Downs
Oil & gas producers have been forced to take steps to improve their liquidity and make production cuts as prices have fallen to the lowest in decades, primarily due to a price war between Saudi Arabia and Russia as well as a demand slump amid the coronavirus pandemic. Weakness in the equity markets at the end of Q1 and through Q2 in 2020, due to the virus outbreak and substantial decline in commodity prices, have forced public oil & gas companies to take large impairment charges in recent quarterly reports (See table below for a non-exhaustive list of companies that have taken Q1 impairment charges).
Even before prices started to collapse, energy companies were cutting outlooks and planning major asset write-downs. Last fall, Schlumberger planned to take a $12.7 billion charge as shale drilling slowed, and Chevron Corp. announced a $10 billion charge related to offshore assets in the Gulf of Mexico and its Appalachia shale assets.
This post is aimed at discerning whether an oil & gas company may need to make interim impairment assessments in light of recent major global events and discuss the impairment testing process.
The Basics of Impairment TestingIn an earlier post from Mercer Capital titled Goodwill Impairment Testing in Uncertain Times, we cover the basics of impairments, namely when it is appropriate to assess and how to perform tests of impairment with the most notable item for testing relating to goodwill on a company’s balance sheet.In short, under ASC Topic 360 impairment tests for long-lived assets should follow a two-or three-step process:Assess Impairment IndicatorsTest for RecoverabilityMeasure the Impairment
In addition to the listed indicators in the accounting guidance, an entity may identify other indicators or “triggering events” that are particular to its business or industry. Once an indicator is identified, a company then tests for recoverability.
For oil & gas companies, conditions such as extreme volatility of supply, demand, and sustained periods of low commodity prices brought on by international commodity price wars, adverse global politicking, and the novel coronavirus pandemic can constitute as triggering events to necessitate interim impairment testing.Oil & Gas Reserves – Accounting MethodologyAs opposed to the vast majority of companies outside of the energy sector, oil & gas companies have reserves that are considered long-lived assets for accounting purposes. These reserves are subject to the same impairment testing rules outlined above such that they are required to be tested on a periodic basis or when triggering events occur.Before performing any impairment testing, however, the accounting methods used to account for these oil & gas reserves need to be considered. Under ASC Topic 932, companies can use one of two methods to account for their oil and gas operations: the successful efforts method or the full cost method.Under the successful efforts method, the cost of drilling an oil well cannot be capitalized unless the well is successful. Costs for unsuccessful wells (dry holes) must be charged as an expense against revenue in the matching period.Under the full cost method, companies may capitalize all operating expenses relating to searching for and producing new oil reserves. Costs are then totaled and grouped into cost pools.Impairment Considerations Related to Oil & Gas Reserves In Statement of Financial Accounting Standards No. 19, the FASB requires that oil & gas companies use the successful efforts method. However, the SEC allows companies to use the full cost method. Guidance for impairment testing of reserves under both methods differ but are available to valuation and other practitioners conducting the tests.Successful Efforts MethodOil & gas companies that use the successful efforts method apply the guidance in ASC 932-360-35 and ASC 360-10-35 to account for the impairment of their reserve assets.Timing of Impairment Testing and Impairment IndicatorsUnder the successful efforts method, an oil & gas company generally performs a traditional two-step impairment analysis in accordance with ASC 360 when assessing reserves for indications of impairment. As mentioned above, impairment assessment for reserves may be determined on an annual basis or in the case of a triggering event. To begin, we bifurcate the total reserve assets into two major groups: proved properties and unproved properties.Proved properties in an asset group should be tested for recoverability whenever triggering events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable. Generally, companies that apply the successful efforts method will perform an annual impairment assessment upon receiving their annual reserve report by preparing a cash flow analysis. Companies can consider proved (P1), probable (P2), and possible (P3) reserves and other resources since these are all included in the value of the assets. Typically, the impairment evaluation of proved properties are performed on a field-by-field basis. Property groupings may differ due to specific circumstances like shared platform infrastructure or other logical reasons.Oil & gas companies should also assess unproved properties periodically to determine whether they have been impaired. The assessment of these properties is based mostly on qualitative factors and are generally assessed on a property-by-property basis.Measurement of Impairment LossA company that applies the successful efforts method then evaluates each asset group for impairment using the two-step approach under ASC Topic 360. In step one, the company will perform a cash flow recoverability test by comparing the summation of an asset group’s undiscounted cash flows with the asset group’s carrying value. If the undiscounted cash flows are less than the asset group's carrying value, the assets are likely impaired. The company would then proceed to step two of the impairment test to compare the asset group’s determined fair value with its carrying amount. An impairment loss would be recorded and measured as the amount by which the asset group’s carrying amount exceeds this determined fair value.Recognition of Impairment LossAn impairment loss for a proved property asset group will reduce only the carrying amounts of the group’s long-lived assets. The loss should be allocated to the long-lived assets of the group on a pro rata basis by using the relative carrying amounts of those assets. However, the loss allocated to an individual long-lived asset of the group should not reduce the asset’s carrying amount to less than its fair value if that fair value is determinable without undue cost and effort.For unproved properties, if the results of the assessment indicate impairment, a loss should be recognized by providing a valuation allowance. Under the successful efforts method and consistent with U.S. GAAP, companies are prohibited from reversing write-downs.In most cases, write-downs occur when oil & gas reserves cannot be extracted economically, such as on properties where drilling has not started or where properties were expected to be developed based on higher oil prices than are currently estimated. As evidenced in recent market events, if oil prices drop too low, the cost to develop the properties may outweigh the net revenues associated with production.Full Cost MethodAlthough less common in U.S financial reporting, companies that use the full-cost method of accounting should apply the guidance in Regulation S-X, Rule 4-10; SAB Topic 12.D; and FRC Section 406.01.c.Timing of Impairment Testing and Impairment IndicatorsUnder the full-cost method, a full-cost ceiling test must be performed on proved properties each reporting period. This “ceiling” is a formulaic limitation on the net book value of capitalized costs prescribed by SEC guidance listed above. This ceiling formula is equal to:
+ The present value of estimated future net revenues, minus any estimated future expenditures to develop and produce proved reserves, using a discount rate of 10%
+ The cost of any properties not being amortized
+ The lower of cost or the estimated fair value of unproved properties that are included in the amortized costs
- Any income tax effects associated with differences between the book and tax basis of the excluded properties and the unproven properties being amortized
Similar to the successful efforts method, unproved properties must be assessed periodically for inclusion in the full-cost pool, subject to amortization.Measurement and Recognition of Impairment LossIf a full cost pool ceiling is exceeded, the excess amount must be recorded as an expense. If the cost center ceiling later increases, like the successful efforts method, write-downs may not be reversed and the amount written off may not be reinstated.Determination of Fair Value of Oil & Gas ReservesIn the event that a step two analysis needs to be performed, the determination of fair value of the reserve assets can be performed under three approaches:Income approach — Under this approach, valuation techniques are used to convert future cash flows to a single present amount using a discount rate. The measurement is based on the value indicated by current market expectations about those future amounts.Market approach — This approach requires entities to consider prices and other relevant information in market prices and transactions that involve identical or comparable assets or companies. Valuation techniques commonly used under the market approach include the guideline public company and guideline transaction methods.Asset approach —Also known as the cost approach, the value of a business, business ownership interest, or tangible or intangible asset is estimated by determining the sum of total costs required to replace the investment or asset with similar utility.
When determining the fair value of oil & gas reserves, companies use various methods and approaches. The vast majority utilize a discounted cash flow (DCF) model to estimate the fair value of reserves. Depending on circumstances other approaches or a mix of approaches may be appropriate for determining fair value of a company’s reserves.Concluding ThoughtsThe oil & gas market and the energy sector as a whole have taken a beating and experienced unprecedented events due to the global impacts from the pandemic and international price wars. While the scale of the full economic effects from these events has yet to be seen, companies are having to question and consider the need for interim impairment testing on reserves.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim oil & gas reserve impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Energy Group.
Family-Owned Real Estate in the Aftermath of COVID-19
For many enterprising families, owning real estate is a cornerstone of family wealth.Here is a story that is common to many families:Once upon a time, the family business had grown to the point that it needed a new facility from which to operate. Rather than leasing the needed real estate, the first-generation shareholders cobbled together a down payment and took out a mortgage for the rest to buy the property.
The owners then leased the property to the family business. The rent payments received from the family business were sufficient to service the mortgage debt and maintain the property.
Decades passed, and steady capital appreciation in the real estate along with the debt retirement funded by rental payments from the family business resulted in the owners owning an attractive parcel of commercial real estate with no debt.
Rinsing and repeating as necessary over the life of the family business, the value of the accumulated real estate portfolio became a significant portion of the family’s total wealth. Once the real estate holding was sufficiently deleveraged, the family elected to reinvest cash flow from the real estate portfolio in yet more real estate.Accumulating real estate seems to be a natural strategy for many family business owners. After all, real estate is generally assumed to be less risky than the operating business of the family. Further, so long as the real estate has a reasonable range of alternative future uses, the returns to the real estate portfolio often have a low correlation to the returns from the operating business.If the observable returns on publicly traded real estate investment trusts (REITs) are any indication, the current coronavirus-induced economic downturn may put those beliefs to the test. While, through the end of mid-June, broader market indices have regained much of the value lost during late February and March, REIT shares have lagged, as shown in Exhibit 1.
To the extent public market behavior is a guide to broader valuation trends for family businesses, the data presented in Exhibit 1 suggests that – rather than providing stability to family wealth – real estate holdings may have actually contributed to overall volatility. We were intrigued by this, so we decided to take a closer look at the data.
As summarized in Exhibit 2, we examined share price data for the 167 REITs in the Russell 3000 index for which comprehensive data was available through Capital IQ.The overall average price change was -22% over the period. Receipt of distributions during the first five months of the year would enhance the total return for most REITs by about 2%, give or take.Performance was driven by property type. Unsurprisingly, hospitality and retail REITs underperformed, falling 47% and 38%, respectively, while industrial REITs led the way with an average price increase of 3%.Apart from the hospitality and retail sectors, REITs announcing dividend increases outnumbered those instituting cuts by a nearly 2-to-1 margin (33 increases to 16 decreases). On a combined basis, the hospitality and retail sectors saw 28 dividend reductions, compared to just 4 increases. Of those announcing dividend cuts, over half (19) were REITs that totally suspended dividends.REIT share prices are closely tied to dividend expectations. As shown in Exhibit 2, the average price change for the 44 REITs cutting dividends was -43%, compared to -19% for those with no announced changes and -4% for the 37 REITs which increased dividends.TakeawaysWhat should family business leaders think about with respect to their current (and future) real estate holdings considering the performance we have reviewed in this post?The pandemic may have fundamentally changed the demand for real estate in our economy. Consider the office sector: even though only one REIT announced a dividend cut, the share price for the average office REIT fell 24% from the end of 2019. This occurred despite a decrease in interest rates, as the 10-year treasury yield fell from 1.92% to 0.75% over the same period. This suggests that the market is concerned about longer-term trends in demand for space and lease rates following a lengthy mandatory “work from home” experiment. In contrast, the (relatively) strong performance of industrial REITs suggest that the market may perceive a future trend toward more domestic manufacturing, as well as the increased need for warehouse space to meet the fulfillment demands of web-based retail.Correlations between real estate and the performance of your operating business may be higher than previously assumed. For example, the move toward on-line shopping has been such a pervasive trend that owning a portfolio of commercial real estate zoned for retail is probably not much of a hedge for struggling family businesses in the retail space. For families contemplating additional real estate investments, it may be worthwhile to balance the temptation to “invest in what you know” against opportunities to better diversify the family balance sheet by looking outside your industry for real estate investments. For example, a family in the manufacturing business may look to reinvest cash flow in health care or residential properties rather than taking on more exposure to the industrial economy.Perhaps even more than politics, all real estate is local. We have not attempted to discern any geographic trends in the data we analyzed for this post. Family business leaders should carefully evaluate the local market dynamics that are influencing the value of real estate portfolios.For families with real estate held outside the family business, this may be a fortuitous time for estate planning strategies involving real estate holdings. Consult your tax advisor to see if real estate transfers could make sense for you.How do rents paid by the family business compare to the current market? If there are significant differences from market rents, that can introduce distortions among family members that own differing proportions of the family business and the family’s real estate holdings.Finally, it may be a good time to evaluate your overall real estate strategy. Do you have one? What economic role does real estate play in your family’s overall balance sheet? What role should it play? More broadly, what does your family business “mean” to your family? Is there alignment among your family shareholders regarding that meaning? How well do your family’s real estate holdings align with that meaning?
Of course, markets move every day, and the market signals regarding commercial real estate may be quite different a month or a year from now. We are not recommending knee-jerk reactions, but we do think real estate strategy would be a worthwhile addition to your next board meeting agenda.
Valuation and M&A Trends in the Auto Dealer Industry
Shifting Out of Neutral
For this week’s blog post, we sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the recent release of their First Quarter 2020 Haig Report. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for each of the auto manufacturers based on their observations and data from participating in transactions in this industry.It’s still early on, but how does the economic disruption due to COVID-19 compare to the Great Recession in 2008/2009 on the auto dealer industry?KN: 2008 provided a great recipe for how to manage dealerships in a time of financial stress. But COVID-19 hit so quickly and with unprecedented shutdowns and associated reductions in sales volume and service revenue. The financial disruption was far more harsh in 2020 but there were some tailwinds that dealers didn’t have during the Great Recession. For example, almost 100% of lenders offered interest, principal and curtailment deferments immediately. PPP funds were available to most dealers and provided some necessary working capital. Interest rates were lowered to almost 0% immediately. And most OEMs got aggressive quickly with 0% deals for 72 and 84 months.
SW: As Kevin alludes to, the biggest difference between 2008 and 2020 in navigating these troubling times is the assistance from OEMs. Industry bailouts were widely debated, and these manufacturers have been conscientious about being part of the solution this time around.What impact has the COVID-19 pandemic had on a) Blue Sky multiples, b) deal flow, and c) overall dealership value?KN: The pandemic has clearly impacted dealership operating performance and instilled some uncertainty around future earnings for the remainder of 2020 and even into 2021. In general, valuations have tended to recede approximately 10% but there are some dealerships that continue to attract pre-COVID 19 value due to franchise attractiveness and/or geographic demand. Buyers appear to be taking 2 different approaches – 1) they are utilizing 2019 and pre-COVID 19 2020 YTD results (i.e. historic performance) and then applying a slightly lower historic multiple to arrive at a moderately discounted value; or 2) they are utilizing unadjusted pre-COVID 19 multiples but against a forecasted 2020 and 21 earnings base that reflects a slightly lower expectation for income. Either way, it typically works out to about a 10% lower valuation. But again, some stores remain as or more valuable than before the pandemic.
New transaction deal flow has been impacted in the short term simply because potential sellers have been fully engaged and focused internally on operating their dealerships during an unprecedented period of stress. They’ve been working on getting their PPP money, furloughing and rehiring associates, building a process to sell and deliver vehicles remotely, managing inventory, etc. We expect when the proverbial dust settles, there will be some motivated sellers who have experienced the Great Recession of 2008 and now the pandemic and will raise their hands and say enough’s enough. Additionally, the pandemic has further set in motion the need to have scale to compete in the new digital age of automotive retailing and some owners are recognizing it’s time to get big or get out.
SW: Our valuation approach considers a broader analysis of historical earnings to estimate ongoing earnings. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year if neither are sustainable. Typically, forecasted earnings approaches were only utilized on start-up locations or early-stage dealerships where historical financials could not be produced. The economic impacts of the pandemic to the current year’s earnings will present a challenge to all valuation professionals. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Has any segment/classification of franchise (luxury, domestic, import, high-line) type been hit harder with regards to the impact of their implied Blue Sky multiples than others?KN: Higher value dealerships – luxury, very large dealerships or very high performing dealerships might experience moderately lower interest in the near term. This is strictly a function of capital availability as we wonder how many lenders are prepared to extend large amounts of credit on an expensive dealership. These types of stores generally have less risk and yield attractive valuations and will still be in demand but it may take several months of normalcy before buyers and lenders are ready to step up for an expensive BMW or Mercedes-Benz dealership as an example.Have you seen different effects on value in different areas of the country? If so, what are those differences?KN: The quantity and severity of COVID-19 cases and the related state shutdowns is partially correlated to valuations and demand for dealerships. Businesses in the northeast and California, where the pandemic hit hard and governors reacted with severe operating restrictions, have suffered far more than dealerships in the southeast and TX. The latter areas were able to operate, albeit with some restrictions, and sell and service vehicles more effectively. As a result, we’ve spoken with a number of dealers who’ve enjoyed record performance in May as states reopened and consumers took advantage of good weather, stimulus checks, and big OEM incentives.
SW: In our discussions with clients, the severity of the impact on operations/earnings is also widespread. In addition to the pockets of the country mentioned by Kevin, we have noted dealers in Arkansas and Utah seem to have suffered less than other areas.Are there buying opportunities for larger auto groups, public companies, and those poised to be in the auto dealer market for the long-term?KN: Auto retail remains a highly attractive investment despite the inherent cyclicality of the industry. Dealerships can be very profitable and generate significant cash, further supplemented by the offshore and captive insurance companies many owners operate. Public companies, outside investment groups including PEFOs (private equity and family office investors), and well-capitalized private dealers have access to low-cost capital and are able to enjoy significant operational synergies. As the industry continues to consolidate and as the need for technical proficiency to master and innovate within the digital retailing sphere accelerates, buyers are going to continue to find opportunities to invest with strong returns.What is the profile of buyers and sellers that you’re seeing on current M&A deals?KN: For sure, a majority of buyers, particularly for the more attractive and valuable dealership assets are the consolidators, both private and public. They are pursuing opportunities to broaden their geographic footprint and franchise representation. Growth becomes a way to leverage both their cost structure over more stores but also to take market share through their improved processes, customer acquisition and retention strategies, and digital strength.
Of course, smaller stores remain attractive to local buyers who want to expand their portfolio in their “backyard” or extend into nearby markets.
Lastly, outside investor capital or PEFOs are again evaluating opportunities in this sector as they believe stores have some newfound upside with the recent reductions in performance.
SW: Family office investors tend to have longer-term investment horizons than public/private consolidators. Additionally, family office investors present additional challenges as they often require more education, due diligence, and they also must bring a dealer principal/operator to the transaction or retain an existing person from the acquired company to assume this role. Once such a person is in the fold, bolt-on acquisitions become smoother and a platform can be created.What are your predictions for the auto M&A market for the remainder of 2020 and 2021?KN: We think 2Q 20 will again be slow as deals that were “inked” before or right at the beginning of the pandemic have been slow-walked to allow time for stability to return to operations. However, judging by the strong progress within our pipeline and conversations with other dealers and professional service providers, the back half of 2020 and 2021 should see some pretty strong transaction volume. Further, we anticipate some dealers will re-evaluate their future once they’ve had the chance to catch their breath from the shutdown and restart of business. This could include a full exit or a partial disposition of certain stores either to raise capital or eliminate some problem stores.What impact has the pandemic had on digital retailing vs. facilities/image requirements?KN: The concept of executing the purchase of a vehicle remotely had begun to gain some smaller degrees of traction before the start of the pandemic. However, a fully digital solution has received far more interest since consumers were forced or chose to transact as much of the vehicle purchase over their phone, tablet, or computer during the shutdown. Even home delivery has ramped up for both sales and service. Various surveys seem to indicate a digital end to end solution is becoming more desirable but a vast majority of consumers still want to come to the dealership for a test drive and thus complete the sale on site.
We see those dealerships and groups who have the capital and sufficient intellectual horsepower to invest in digital solutions to be the winners over time. This is one more reason consolidation will continue.
We are also hearing that OEMs are recognizing this trend and may soften their stance around upgrades of facilities, larger buildings, more acreage, etc. It’s a tough balance for dealers to have the best online solution and also invest millions of dollars to have the most extravagant and new building when fewer customers want to come to the store for both sales and service.
SW: We tend to agree that these improvements appear to be declining as a value driver. We expect there to be more pressing needs for capital than facility upgrades, both from acquirors and dealer principals. These funds will go to consolidation efforts and shoring up finances coming out of the pandemic.What impact will the bankrupt rental car companies have on mitigating the sluggish used vehicle supply market?KN: It appears the bankruptcies of a couple of the large rental companies will restructure debt and equity, not necessarily eliminate operations. It allows the weaker operators time to weather the storm until rental activity ramps up. However, if the recovery goes slowly and business and vacation travel doesn’t pick up, you could see some permanent reductions in rental volume. That could impact nearly new used vehicles from supply in the coming years which are good sources of inventory for dealers and generally produce strong gross margins.
What effect will the slowing down of new vehicle production supply from factory shutdowns have on auto dealer valuations and M&A activity?
We believe tight inventories will be a short-term disruption that gets resolved over the next few months as production returns to normal. If you couple a big ramp up in production with lower new volume sales, dealer lots should get back to a steady state inventory level well before most current and any new transactions close.
SW: Near-term supply will continue to remain a question as manufacturers cope with COVID outbreaks and the need to shut plants down for a day to sanitize. The stop-start nature may play a significant role in how quickly supply can ramp up.Do you anticipate that we will see a V, U, W-shaped recovery, or something else?KN: We are by no means economists and read the same data you and your clients see around the recovery expectations. It seems the consensus lies in the U or W recovery as it’s highly unlikely we immediately return to the low levels of unemployment pre COVID-19. Regrettably, too many businesses won’t reopen and certain industries that are large employers will be slow to recover. Think hospitality, transportation, entertainment, energy, etc. The near term improvement will occur far more quickly than the Great Recession comeback but it’s probably wishful thinking to believe we bounce back to past levels in just a couple of months. The good news is we have low rates, stimulus, OEM incentives and a strong banking sector to accelerate growth this time around.
We thank Kevin Nill and Haig Partners for their interesting perspectives on the auto dealer industry. Industry participants are cautiously optimistic that retail sales, earnings performance and deal flow are trending in the right direction, but not without additional challenges. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.
Mercer Capital's Mineral Aggregator Valuation Multiples Analysis
Market Data as of June 2, 2020
Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis. Download our report below.Mineral Aggregator Valuation MultiplesDownload Analysis
Hedging And Bank Retreats Complicate Royalty Aggregators’ Valuation
As the clouds begin to clear from the oil patch storm that began three months ago, management, analysts and investors are wondering what is going to happen next. Has the proverbial storm system passed? Is it time to venture out and rebuild, or are we still in the eye of the hurricane, with the back wall on its way? Both are possibilities.As for management teams of royalty aggregators and MLPs, they have mostly given up on gambling on a specific outcome for now. The ones who have initiated new policies are battening down the hatches for another wave to come through. Of the six publicly traded upstream royalty aggregators (VNOM, MNRL, FLMN, KRP, BSM and DMLP) most either suspended guidance or locked down their hedging positions over the last few months so they don’t have to extend their risk profiles. “We really only have today what we have in front of us, which is a strip, and we had to make the tough decision based on the first quarter being one of the biggest cash inflows that we’re going to have over the next five quarters or six quarters, based on where the strip is today,” explained Travis Stice of Viper Energy Partners, LP. This rationale makes sense considering the motives of various stakeholders, particularly bankers.Just about every public aggregator has had their borrowing bases shrunk by their bankers, typically in the range of 20%-25%. This is not a big problem per se for most as they did not have much debt leverage anyway, but it is indicative of the recoil mentality going on. Another indicator of this mentality is the cut in distributions. Kimbell and Viper dropped payout ratios substantially for the short-term. Thus, changing yields significantly. The charts below show this before/after effect of reduced payouts as of last week.
[caption id="attachment_32106" align="aligncenter" width="800"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption]
Dorchester is the outlier here, but it is paying out 140% of its earnings right now which is unsustainable. It will have to pull back its payout ratio sometime, perhaps sooner rather than later. In fact, one of the most dramatic examples of this pullback was Blackstone Mineral’s recent announcement that they were selling $155 million of choice Permian royalty interests for an average of $86,111 per flowing barrel. This does not appear to be non-core acreage they sold either. In fact, it is a significant premium compared to what they are trading at as of early June and is on par with Viper whose assets are almost entirely Permian based. It’s also a big premium to average private transaction ranges of $40,000 per flowing barrel that was cited in my last column.
[caption id="attachment_32109" align="aligncenter" width="374"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption]
Considering values have fallen significantly, it might be fertile ground for more acquisitions, but management teams generally don’t seem to think so (Kimbell’s Springbok acquisition did happen in late April as an exception). Sellers’ mindsets are stickier and although prices are low, bid ask spreads remain wide. “From our perspective though, the seller’s expectations remain robust, and rightfully so. This is an asset class that’s highly valuable, where if it’s in the best areas, there will be activity over time. There will be production over them and likely growth over time. And so sellers’ expectations will remain, I think, relatively high and they’ll be patient,” said Daniel Herz of Falcon Minerals. This mentality was consistent across analyst calls.
Where does that leave aggregators from a valuation perspective? That is more complicated. The change in prices and the mixed bag of hedgers vs. non-hedgers makes it more challenging. A more specifically constructed discounted cash flow analysis will become as relevant as ever as opposed to benchmarking metrics against guidelines or an index. Why? Hedging is just that – hedging. It boxes in commodity price ranges and limits downside, which banks want. It also limits upside, which shareholders do not want. Several aggregators are hedged in varying degrees through 2020 and into 2021 as well. This makes comparison trickier. Prices have already risen to nearly $40 per barrel in West Texas which is faster than many expected. It may bob up and down this year, but what if the supply shock sends prices on a march upward? It could leave hedged aggregators behind and either undervalued or overvalued. It also de-links several of these entities as a more direct proxy to commodity prices and makes it a more fluid exercise in which to attempt to intrinsically value this aggregator group or any royalty company or asset.
Commodity mix matters too. Oil has been on the downside of a roller coaster, while gas has been stuck at the bottom for a while now, but has been more stable, local and predictable. As such, gas is becoming more popular than it was even six months ago. Chatter on analyst calls affirm this.
[caption id="attachment_32110" align="aligncenter" width="388"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption]
Lastly, shut ins and production drops are potentially looming as well. Most management teams believed it would impact them, but not significantly. In fact, it was portrayed as a good thing because it could preserve value for down the road as opposed to realizing little value today. Better to put food in the refrigerator for later than letting it rot on the table now, was the idea. (Not a bad idea by the way). However, if shut ins become more permanent, there will be no food for later. The proverbial fridge will go unplugged.
Valuations appear to have reset a bit, and from an EBITDA perspective, earnings are going to slide, but the market appears to think this will be temporary. How temporary will be the question. The recent OPEC+ meeting was an indicator that prices could rebound sooner rather than later, but that remains to be seen.
[caption id="attachment_32109" align="aligncenter" width="331"]Source: Company Filings, Capital IQ and Mercer Capital Analysis[/caption]
Whatever may happen going forward, it has been a turbulent ride the past few months. It is also a signal that things are strange when public aggregators stop aggregating and even go so far as to sell premium assets. It likely will not happen for very long, but it has turned some things upside down. That is both a risk and an opportunity.
Originally appeared on Forbes.com on June 9, 2020.
How Proper Normalization Adjustments Contribute to a Better Finished Product
Trusting the Process
"Head chef" in my family is a title and role that I not only enjoy but take very seriously. Like most folks, the last few months have created many more opportunities to refine my home cooking skills and sample different recipes and cuisines. My kitchen cooking repertoire has always exceeded my grilling capabilities. With the extra time at home, I decided to tackle the holy grail of grilling challenges: smoking a beef brisket. For those that have never tried, the brisket is one of the most intimidating cuts of meat to tackle. In addition to a million different temperature/time/technique recommendations, the brisket starts as a very tough piece of meat. It’s not uncommon to labor for 10+ hours smoking a brisket and still have it turn out like a leather shoe.After spending some time researching, I honed in on my process. This included preparing the brisket by trimming excess fat and cooking the meat at a higher temperature for a period of 4 hours or until the meat reached a certain internal temperature. The next step involved lowering the cooking temperature for another set of hours until the internal temperature of the meat reached an ideal 203 degrees. Not 200, not 205……203! The final step involved foiling or tenting the brisket in a dark, damp, confined space for a period of several hours, allowing it to rest and come to its final temperature. How’d it turn out? I’ll revisit that topic at the end of the post.Much like smoking a brisket, the valuation of an auto dealership is a process, and the client or intended audience for the valuation must trust the process (apologies to any Philadelphia 76ers fans that lived through the rebuilding years under Sam Hinkie).In previous posts, we discussed the valuation methodologies and the value drivers of an auto dealership valuation. The next step in the process is to normalize the financial statements.Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Adjustments are often interrelated; a change to the balance sheet frequently will affect the income statement as we’ll discuss. Some typical areas of potential normalization adjustments in the automobile dealership industry include, but are not limited, to the following.Balance SheetInventoriesMost automobile dealerships report the value of their new and used vehicle inventories on a Last-In, First-Out (“LIFO”) basis. LIFO accounting allows the dealership to reduce the value of their inventories and pay fewer taxes. General valuation theory calls for inventories to be restated at First-In, First-Out (“FIFO”) basis. The FIFO adjustment affects both the balance sheet and the income statement. On the asset side of the balance sheet, we add the LIFO reserve amount to the reported LIFO inventory, raising the value of the inventory. Liabilities also increase due to the additional taxes that would be paid on a FIFO-equivalent inventory, calculated as the LIFO Reserve multiplied by the corporate tax rate. We will discuss the income statement impact later.
Fixed AssetsFrequently, dealers own everything in two separate, but related entities. One entity owns the operations of the dealership and other owns the underlying real estate. In those cases, most dealerships still report some cost value of land or leasehold improvements on their factory dealer financial statements. The business valuation expert must determine who owns the real estate, and if not owned by the dealership, the value of the land and leasehold improvements needs to be adjusted/removed. This adjustment reflects the true value of the tangible assets of the dealership. Failure to properly assess and make this adjustment will skew the implied Blue Sky multiple on the concluded value for the dealership.
Working CapitalMost factory dealer financial statements list the dealership’s actual working capital, along with the requirements from the factory on the face of the dealer financial statement, as seen in the graphic to the right. It’s important for the business valuation expert to assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital are not always rigid. An understanding of the auto dealer’s historical operating philosophy can help determine whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of the factory requirements.
Goodwill/Intangible/Non-Operating AssetsOften auto dealers might have intangible and non-operating assets such as goodwill from a prior acquisition, cash surrender value of life insurance, personal seat licenses ("PSLs"), excess/non-operating land, airplanes, etc. These assets do not contribute to the cash flow from operations and/or are not included in the tangible assets of the business. Blue Sky multiples inherently capture the intangible value of a dealership’s expected future earnings. The appraiser must remove goodwill and intangibles on the balance sheet to establish the tangible asset base of the dealership before any application of a Blue Sky multiple.
Owner Accounts Receivable Occasionally, auto dealers loan money into the dealership with no intention of ever repaying those funds, and dealers sometimes misplace or disguise items on the dealer financial statement to overstate working capital. Valuation analysts have to ask about these items specifically during their management interviews with the dealer principal or controller to know if adjustments to the dealer financial statement are warranted.
Income StatementInventoriesAs discussed earlier, the use of LIFO inventory systems creates normalization adjustments on both the balance sheet and the income statement. On the income statement, the inventory adjustment affects the cost of goods sold (“COGS”), and ultimately, the gross profit margin. The shortcut method to the adjustment analyzes the change in the LIFO reserve year-over-year. If the LIFO reserve increases, the resulting normalization adjustment decreases COGS and increases profits. Conversely, if the LIFO reserve decreases, the resulting normalization adjustment increases COGS and decreases profits.
Officers’/Dealer CompensationLike all valuations, the compensation of the officers’/dealer principal must be considered for potential adjustment. Typically, a business valuation expert will review actual compensation paid and determine a replacement or market equivalent compensation level; experienced business valuators in the auto dealer industry have techniques and benchmarks to determine a reasonable replacement cost. In addition, some auto dealers have non-active employees or family members on the payroll. The salaries of non-active employees also must be normalized by adding back those expenses as they would not be included for a public equivalent.RentAs noted previously, the underlying real estate utilized by the auto dealer is frequently owned in a separate, related entity. As such, the dealership pays rent to the related party entity. The business valuation expert needs to determine if the rental rate paid is equivalent to a market rental rate. Often, this rental rate creates additional profitability at either the dealership entity or the real estate entity. Experienced business valuators in the auto dealer industry have several techniques and benchmarks to determine a fair market rental rate for the facilities.Other Income Items Most factory dealer financial statements have a line item on the income statement for other income items/additions. This category can be sizeable for a dealership depending on its sales volume and level of profitability. It’s important for a business valuator to determine the items that comprise this category and how likely they are to continue at historical levels. Some common items that appear in this category include factory dealer incentives on sales volume levels for vehicles, factory dealer incentives for service performance, document/preparation fees on the sale of new and used vehicles, and additional costs for financing and other services sold as a part of the vehicle transaction ("PACKs").Discretionary/Non-Recurring/Personal Expenses Like all valuations of privately-held companies, auto dealership valuations should normalize all expenses that are discretionary, non-recurring, or personal in nature. Often, these expenses can be determined during the management interview phase of the business valuation.Expected Industry Profitability vs. Actual Profitability The valuations of auto dealerships are also unique in that underperforming stores can often be more “valuable” than stores performing at or above the market from a multiple perspective. One reason for this phenomenon is that hypothetical buyers recognize the improvements they can make to profitability for underperforming stores. Experienced business valuators in the auto dealer industry know to consult expected industry profitability levels depending on the manufacturer, geographic region, and competition. Expected profitability levels can be an added benchmark to the totality of the other normalization adjustments determined in the valuation process.ConclusionsJust like the cooking technique with the brisket, the process of normalization adjustments and the overall valuation is a roadmap for advancing from the start of the engagement to a finished conclusion. Skipping any steps along the way in the process will lead to a flawed/incomplete valuation conclusion, or a leather shoe of a brisket. I’m happy to report that trusting the process with smoking the brisket resulted in a happy family and a tasty/tender dinner!We have highlighted many of the typical normalization adjustments that must be considered in the valuation of an auto dealership. With the many nuances that must be considered, hiring a business valuation expert that specializes in this industry rather than a generalist business appraiser can make all the difference in providing a reasonable valuation conclusion.
The Evolution of Rule-Based Valuation Metrics and Why They Still Don’t Work
One of our first blog posts addressed the fallacies of rule-based valuation measures in RIA transactions. Our position hasn’t changed, but these so-called rules of thumb have certainly evolved over time.In a recent podcast with Michael Kitces, industry transaction specialist Elizabeth Nesvold of Raymond James explains the history and rationale behind these changes. For this week’s post, we’ll discuss this evolution and why such measures are usually more misleading than meaningful.Ten to twenty years ago, it was just assumed that all RIAs were worth 1-2% of AUM. At that time, many RIAs were able to charge 1% of AUM for their services, so a valuation of 1-2% of AUM equated to a 1-2x multiple of revenue, which was also thought to be a reasonable estimate of value. Over the last decade, AUM-based valuations have broken down with fee compression and the proliferation of non-asset-based sources of revenue. The example below illustrates how AUM multiples break down for firms with different fee structures and revenue sources.
Firm A charges higher fees and has other sources of income. Its revenue yield (total revenue as a percentage of AUM) is therefore much higher at 1.1% (versus 0.3% for firm B), so a 2% of AUM valuation translates into a 1.8x revenue multiple, which is within a range often observed for investment management firms. Firm B, on the other hand, charges lower fees and has no alternate source of revenue, so a 2% of AUM valuation would be nearly 7x revenue, well above a reasonable valuation estimate for most RIAs. Mathematically, the AUM multiple is the product of the revenue multiple and the revenue yield (e.g. 2% = 1.1% of 1.8x for Firm A), so this measure varies directly with realized fees.
As fee schedules changed, many RIA owners began valuing their businesses with revenue multiples. This approach isn’t much better as it ignores how efficiently the business is managing its costs. Firms with similar levels of revenue can have drastically different EBITDA margins, so blindly applying the same revenue multiple to all of them can lead to nonsensical valuations.
Applying a 2x revenue multiple to a low margin RIA like Firm D would likely overvalue the subject company since it would imply an unrealistically high multiple of earnings or cash flow. Just like AUM multiples vary with realized fees, revenue multiples are directly proportional to profit margins since these cap factors are the product of EBITDA multiples and profit margins (2x revenue multiple= 40% EBITDA margin times a 5x EBITDA multiple for firm C).
Because of these shortcomings, many industry analysts now use earnings multiples to value RIAs. We consider cash flow metrics superior to AUM and revenue measures since earnings multiples take into account realized fees and profit margins. Earnings multiples are directly related to growth prospects and inversely related to risk, so valuing all RIAs with the same profitability multiple can be problematic as well. Investment management firms can have radically different risk profiles due to varying customer concentrations, manager dependencies, and regulatory pressures. Growth prospects also vary with scalability, capacity limitations, and new business development. Applying a one-size-fits-all earnings multiple to businesses with varying risk profiles and growth prospects will lead to inaccurate valuations.
The appropriate multiple also changes over time. This is true for all industries but is especially true for RIAs, whose business is tied to market conditions, which have been highly volatile in recent years. The EBITDA multiple for publicly traded RIAs with under $100 billion in AUM has been cut in half in the last two years, so if your firm was worth 8x in 2018, all else equal, that’s probably no longer the case, as depicted in the graph below.
Even though the multiple has changed, the methodologies for valuing investment management firms remain the same.Most RIA appraisals include a discounted cash flow (DCF) analysis and a market methodology involving publicly traded investment managers or industry transactions if there are sufficiently similar companies with reported financial metrics. Rules of thumb are overly simplistic and often lead to nonsensical appraisals.The reality is that there is no magic formula for valuing RIAs, so try not to fall into that trap. Any reasonable appraisal of your business will include a careful study of trends in asset flows, realized fees, profit margins, client retention, investment performance, stock transactions, shareholder agreements, and budgeted financial performance, among other things. It’s a lot to keep up with, but we’re happy to walk you through it.
Themes from Q1 2020 Earnings Calls
Part 2: Mineral Aggregators
As discussed in our quarterly overview, the oil & gas industry took arguably its worst beating in history due to Saudi Arabia-Russia price war and demand destruction caused by COVID-19. Rather than restating the events and underlying economics behind the drastic downturn in the market, it would be more beneficial to read Part One of this series and cut to the chase with Part Two of the Q1 2020 earnings calls, which focuses on mineral aggregators.Theme 1: Dividend Policies Varying Moving ForwardParticipants and investors seemed to question aggregators’ current and future distribution plans, as this asset class is primarily a yield investment vehicle.“The $0.025 dividend payment reflects a payout ratio of 23% of pro forma free cash flow. It really is simply about getting back to a more stable economic and energy environment. I would expect that we’ll see our payout ratio return to its traditional level of 90% plus.” – Daniel Herz, President & CEO, Falcon Minerals“We committed to a 100% payout ratio through the first quarter, and we want investors to know that our word is important, and we remain committed to following through and doing what we said we were going to do.” – Robert Roosa, CEO & Director, Brigham Minerals“That resulted in us cutting the distribution to 25% of available cash. And I think it’s going to be a very fluid process. I can only really use the baseline of 25% for now.” – Travis Stice, CEO, Viper Energy PartnersTheme 2: Hedging: Defensive Strategies Leading to Limited Upside ExposureAlthough mineral aggregators enjoy certain advantages relative to operators, their performance remains tied to commodity prices. As a result of the uncertain and volatile pricing environment, there have been difficult decisions made in regard to hedging. Some aggregators are hedged through 2021, limiting the potential upside of these investments if prices continue to increase.“We currently have a substantial portion of our oil and natural gas production hedged in the form of swaps going out two years with prices for oil averaging in the low $40s and natural gas averaging around $2.49 per MMBTU.” – Robert Ravnaas, CEO & Chairman, Kimbell Royalty Partners“Because of this market uncertainty and our concern that it may persist for some time, we have put in place substantial hedges for 2021 for both oil and has to further our already robust 2020 hedge positions.” – Jeff Wood, President & CFO, Black Stone MineralsTheme 3: Aggregator Advantages Muted for the MomentUnlike traditional royalty trusts, mineral aggregators reap the benefit of reinvesting capital to acquire new acreage. This advantage, however, has been paused as the M&A market is in a standstill due to the wide bid-ask spread between buyers and sellers. It will be interesting to monitor the performance of the aggregators closely if they are unable to benefit from their acquisition strategies.“Right now, our acquisition machine is silent for the foreseeable future. Now, mineral owners tend to be stickier with respect to perception of value, and there’s often less leverage in the mineral space. So, I think it’s going to be pretty quiet here for the next couple quarters.” – Travis Stice, CEO, Viper Energy Partners“The A&D market, as you might imagine, is pretty slow currently, but we expect it to pick up in the next, let’s call it, 2 to 6 months. From an M&A perspective, we plan to continue to fund our micro acquisition strategy at current depressed commodity prices and continue to be well positioned as a consolidator in the highly fragmented minerals industry.” – Robert Ravnaas, CEO & Chairman, Kimbell Royalty Partners“There will be production over time and likely growth over time. And so sellers’ expectations will remain, I think, relatively high and they’ll be patient. – Daniel Herz, President & CEO, Falcon Minerals
May 2020 SAAR
May Vehicle Sales Supported Optimistic Predictions, But a Slow Manufacturing Rebound is Threatening to Hinder This Growth
May ReopeningsMay brought some hope of a return to normalcy with most states easing lockdown restrictions and stay-at-home orders. With this easing of orders, businesses were optimistic that their economic struggles may be alleviated as their customers could finally return. However, the effects of shutting down an entire global economy do not go away as soon as lockdowns end with major supply chain disruptions contributing to bottlenecking and inconsistent inventories. This issue will be prevalent across many industries and auto dealers won't be exempt. The industry will be impacted by manufacturing slowdown problems.May SAAR UpdateAfter a devastating April SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks), predictions for a rebound in May proved to be correct. Vehicle sales in the month jumped with SAAR increasing 38.6% to 12.2 million. Though this was a 29.7% decline from May 2019, the uptick from April and March numbers point to a recovery. Dealers are hopeful that April was the lowest the SAAR would reach, and with this new data, feel greater confidence in their predictions.May vehicle sales jumped with SAAR increasing 38.6% to 12.2 million.As we mentioned in our April SAAR post, many of these sales reflected dealers embracing online technologies and incentive programs to get cars out the door. Recently released data for May from Edmunds.com showed that the annual percentage rate (APR) on new financed vehicles averaged 4% last month. This was a drop compared to the April average of 4.3%. More strikingly, however, was the difference from the year-ago average of 6.1%. May’s 4% rate is the lowest average interest rate since August 2013.While auto dealers were able to use different methods to increase sales, factories that supply auto parts and cars did not have such flexibility. The reopening of plants for General Motors, Ford Motor, in mid-May came after an almost 2-month production hiatus. Furthermore, though plants have begun reopening, they are not running at full capacity. Jamie Butters, Chief Content Officer of Automotive News, noted that disruptions in both Mexico and the U.S. manufacturing industries from the virus and social distancing measures threatens to cut the flow of vehicles and vehicle parts. According to a report from industry research firm LMC Automotive, fewer than 9 million vehicles are expected to be produced in 2020, the lowest since 2011 when an earthquake in Japan disrupted the global supply chain. If volumes are going to snap back like some have forecast, this will either require a pivot to used vehicles, or an increase in the expectations for vehicle production.Dealership Inventory HeadwindsEven if auto dealers wanted to reopen their dealerships at 100% capacity, they need the pipeline of inventory to do so. Dealers who liquidated inventory (sometimes at fire sale prices) may have trouble sourcing popular models if production can’t ramp back up quickly enough. As the Lansing State Journal notes, “Every vehicle that is sold is a catch-22 for the industry. Every sale depleted inventory but with manufacturing all but frozen those inventories could not be replenished.”According to data from the BEA, April saw an inventory-to-sales ratio of 3.6, its highest level since February 2009. This likely says more about severely depressed sales than any excess in inventory. Prior to the pandemic, this ratio was actually below 2.0 for four consecutive months, a figure that has only occurred twelve times since 2000. Although BEA data for May inventory has not been released yet, according to Motor Intelligence, new-vehicle U.S. inventory fell 32% in May, to about 2.6 million, the lowest in recent years. Among the vehicles in the shortest supply are large pickup trucks. In a research note Monday, Barclays warned of a “critical risk of supply shortages” of large pickups, estimating dealers had only 44 days of inventory before running out of models such as the Ford F-150 and GM’s Chevrolet Silverado. The truck stock is half of what it was earlier in the year.Barclays isn’t the only bank focused on inventory. John Murphy of Bank of America asked all of the public auto dealers about the potential for short inventory in the summer months, and many acknowledged the potential for shortages. Below are some select quotes regarding the topic from the earnings call:“At the end of March, our total new vehicle inventory was $861 million, and our day supply was 105, up 18 days from the prior year. In April, we were able to drop our new car inventory approximately $120 million from March 2020. While these levels may seem high, because the OEM factories have been shut down, we believe we could run into a low day supply for the summer selling season. […] in some of our luxury and some of our domestic specifically, we could run into a lower day supply of some of the models.” –Dan Clara, SVP Operations Asbury Automotive Group“But I think we're going to have a big issue on incoming inventory from all the manufacturers. You've seen the German manufacturers starting and then stopping from the standpoint of a new production. I know from Daimler's perspective in Mexico. They pushed off heavy duty trucks like two months. It's not the fact that they don't want to open or not meeting the protocols in the plant is the fact that the supplier base -- in the old days, maybe back in '08 and '09 at least OEMs are more vertical from the standpoint of the supplier their parts for their vehicles. That's not the case today. So, they have to rely on many, many suppliers and I think that's going to be key.”
– Roger PenskeRental Company DeclineRental car bankruptcies could result in a high number of used cars diluting an already crowded used car market.A decline in the rental car industry may compound the problem. In late May, Hertz and the parent company of Advantage Rent A Car filed Chapter 11 bankruptcy due to debt and global travel being wiped out from the COVID-19 pandemic. New vehicle sales to rental car companies accounted for about 10% or 1.7 million vehicles last year. That demand came to a screeching halt due to the COVID-19 pandemic, and some analysts expect no more than 250,000 such sales in 2020. While the disruption in the rental car industry most directly impacts automakers, used car dealerships could find themselves in trouble as well. With downsizing expected among restructuring efforts, the rental car bankruptcies could result in a high number of used cars diluting an already crowded used car market and impacting overall used car prices. Although this may mean a good deal on a vehicle purchase for consumers, trade-in values would decrease and lower values could damage auto brands and impact newer model pricing.Despite the prospects of inventory shortages and used vehicle surpluses later in the summer, as long as there is not another major disruption to the supply chain and travel, these issues may not be long lasting. As Chris Holzshu of Lithia Motors noted in their earnings call, “Once the ramp up starts, it takes about 30 days for a vehicle to get completed on the production line and make it to one of our stores.” Though a month of disruption is not ideal, it can be managed. Dealers will hope to get through short supply by nudging customers towards less in-demand models. As travel picks up in the future, rental car companies can expect to see increased activity and thus, less saturation of the used car market.ConclusionWhile the rest of the country began to try to start fresh after months indoors, I decided that I needed a change in my own household as well in the form of an Australian Shepherd puppy. As you can see, Bobby loves Mercer Capital and the auto dealer industry team just as much as I do. We follow SAAR and other key industry trends to gain insight into the private dealership market. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to us.
What Is a “Level” of Value, and Why Does it Matter? (Part 3)
In last week’s post, we demonstrated how critical getting the level of value right is for family businesses for estate planning, acquisitions, and divestitures. We conclude our series on the levels of value this week, by turning our attention to shareholder redemption transactions.Shareholder RedemptionsA shareholder redemption is a purchase by the family business of shares from a family shareholder. As with our corporate development and divestiture examples from last week’s post, shareholder redemptions reflect an inherent tension between buyers and sellers, as illustrated in Exhibit 1.In a shareholder redemption transaction, the buyer and seller do not share the same perspective.The selling shareholder owns an illiquid minority interest in a private business. As a result, the fair market value – the amount that a hypothetical willing buyer would pay – reflects a marketability discount. In other words, the nonmarketable minority level is relevant.However, in a shareholder redemption transaction, the buyer is not a hypothetical party, but the company that issued the shares in the first place. The family business is not burdened by the illiquidity of the shares in the same way a shareholder is. As a result, the value of the shares to the family business is consistent with the marketable minority level of value.
It strikes us as a bit perverse to evaluate transactions between family shareholders and family businesses in terms of relative negotiating leverage. Instead, we prefer to frame the decision in terms of family business objectives: What is the purpose of the redemption?
The “correct” price at which to conduct a shareholder redemption transaction is always a bit ambiguous. Consider the alternatives:Nonmarketable Minority Level. This seems straightforward – after all, that is the fair market value of what the shareholder owns. Why should the family business pay any more than that?Marketable Minority Level. On the other hand, this is the value of what the redeeming company is acquiring. Why should the family business pay any less than that?
From an economic perspective, a redemption at the nonmarketable minority level is accretive to the non-selling shareholders. Redeeming at the marketable minority level provides a windfall to the selling shareholder relative to the fair market value of their shares. There is no simple escape from this dilemma.If the family business wants to discourage redemption requests, the nonmarketable minority level of value may be preferable.If the family business is designing a shareholder liquidity program with a view to promoting positive shareholder engagement, it may be desirable to conduct redemptions at the marketable minority level of value. However, in such cases it is essential to set limits on the amount of redemption requests the family business will honor in a given period; otherwise, the liquidity program could trigger a “run on the bank,” crowding out corporate investments critical to the long-term sustainability of the family business.If the objective of the redemption is to “prune” the family tree of unwanted branches, it may be necessary to pay a redemption price at the marketable minority / financial control level of value. Depending on state statute, it may be a legal necessity. In any event, the departing shareholders are likely to demand such pricing to exit the family business.ConclusionIn this series of posts, we have explained what the levels of value mean. Your family business has a different value at each level of value because of differences in expected cash flows and risk factors. Considering four common corporate transactions, we have illustrated why the level of value matters to family businesses:When transferring minority interests among family members in furtherance of estate planning objectives, the fair market value of the interests transferred is properly measured at the nonmarketable minority level.When considering a potential acquisition, family businesses should evaluate both the marketable minority / financial control level of value (what the target is worth to the existing owners) and the potential strategic control level of value (what the target is worth to the family business). These two values for the target define the relevant range for negotiating a transaction price.When divesting a business, the dynamics are reversed. The relevant negotiating range is set by the difference between the marketable minority / financial control level of value (in this case, what the business is worth to the family) and the strategic control level of value (what the business is potentially worth to the buyer). The family can improve its negotiating leverage in these situations by differentiating the business from other available targets and exposing the business to multiple motivated buyers.Finally, shareholder redemptions can occur at either the nonmarketable minority or marketable / minority financial control levels of value. The appropriate level for a given transaction should be selected with a view to the objectives of the redemption for the family business.
These transactions can have profound and long-lasting economic implications for the family business and its shareholders. When the stakes are high, it’s a good idea to measure twice and cut once. When your family business is preparing for any of these transactions, give one of our valuation professionals a call.
See Part 1 of this series here.
See Part 2 of this series here.
What Is a “Level” of Value, and Why Does it Matter? (Part 3)
We conclude our series on the levels of value this week, by turning our attention to shareholder redemption transactions.
Themes from Q1 2020 Earnings Calls
Part 1: E&P Companies
In the first quarter of 2020, oil benchmarks ended arguably their worst quarter in history with a thud. The concurrent overlapping impact of (i) discord created by the OPEC / Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic. Brent crude prices began the quarter around $67 per barrel and dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of the month. WTI pricing behaved similarly although it continued to trail Brent pricing by a narrowing margin (about $5 per barrel) at the end of the quarter. For context, WTI recovered to a range of roughly $25 per barrel to $30 per barrel relative to when the earnings calls occurred in late April and early/mid-May. As of yesterday, WTI closed at $37.29 per barrel. Natural gas has trended downward but has been more stable in the U.S. as its pricing is generally more tied to region-specific factors.This week, we examine some of the most discussed items and trends from E&P companies’ Q1 earnings calls. We will turn our attention to those in the mineral aggregator space in a subsequent post.E&P CompaniesOperators experienced mixed earnings in the first quarter. Although operators started the year with a positive outlook, the events that occurred in March quickly forced them to reconsider their forecasts. Investors and participants were far less concerned with earnings figures for the quarter than future implications of current events.Theme 1: Setting Priorities During Uncertain TimesOperators seemed inclined to comment on their priorities moving forward. Making cuts to capital expenditures was predicted and unanimous among the group; however, the operators discussed other measures that they are implementing to combat the current depressed environment.“Paying our interest expense, retaining our people and paying our dividend remain our priorities through these uncertain times.” – Travis Stice, CEO, Diamondback Energy“First, optimizing our cash flow by adjusting our spend rate, production and cost structure. Second, maintaining a strong balance sheet. Third, continuing to return capital to shareholders through our dividend. And finally, maintaining flexibility to cut further while also preserving our operational capacity.” – Timothy Leach, Chairman & CEO, Concho Resources“Our capital allocation priorities are balance sheet, dividend and capital spending.” – Scott Sheffield, Chairman & CEO, Pioneer Natural ResourcesTheme 2: Maintaining Bank Relationships in Times of NeedBanks will continue to play a substantial role as many of the operators relied on tapping into their credit lines and/or other debt instruments to satisfy liquidity needs.“Our banks are very strong. Our credit facility is strong. We don’t have covenants really in there, debt-to-capital covenants, only one we have, and we’re well south below that and we’re not in any realm of even approaching that. Our debt would have to go up by $8 billion to hit that covenant level. So, I told you we’ve got a lot of cushion.” – John Hart, CFO & Treasurer, Continental Resources“As of today, the undrawn capacity on our credit facilities total $6.75 billion. We believe a strong balance sheet is essential to succeeding in this industry and we are committed to maintain our investment grade credit rating.” – Don Templin, CFO, Marathon Petroleum CorporationTheme 3: Prepared for the Worst While Hoping for the BestMany operators focused on their individual advantages to convey their resilience during the difficult pricing environment.“Diamondback is prepared to operate in a lower oil price environment and our cost structure will prove to be a differentiator through this downturn. Low interest expense, low leverage, industry leading low cash G&A, a full hedge book, strong midstream contracts and benefit of Viper and Rattler will allow them to operate effectively through these uncertain times.” – Travis Stice, CEO, Diamondback Energy“Just as Pioneer entered this downturn as one of the best positioned companies, we will emerge just as strong. The key points here, obviously, is maintaining our top-tier balance sheet through capital discipline, combined with significant cost reductions in 2020.” – Scott Sheffield, Chairman & CEO, Pioneer Natural Resources“We still have levers we can pull if conditions deteriorate further, and we will maintain flexibility to make additional cuts to our spending.” – Timothy Leach, Chairman & CEO, Concho ResourcesTheme 4: Providing Flexibility with LiquidityE&P companies are attempting to maximize liquidity to allow financial flexibility.“Just to be on the safe side, we did increase our liquidity position in early April by adding a 364-day credit facility, a little over $900 million that get our liquidity up to $2.4 billion.” – Scott Sheffield, Chairman & CEO, Pioneer Natural Resources“We’ve taken steps to maintain our financial flexibility. We’ve secured $3.5 billion of additional liquidity, including a new $1 billion 364-day revolver, and issued $2.5 billion of senior notes.” – Mike Hennigan, CEO, Marathon Petroleum Corporation“With our reduction in spending, current hedge protection and suspensions of our buyback program, we expect to maximize liquidity and retain cash to pay down debt.” – Travis Stice, CEO, Diamondback Energy
There is no question that E&P companies were forced to react quickly during the first quarter of 2020. Macroeconomic events mixed with a global pandemic slashed demand and caused prices to plummet. The operators tried to convey their confidence and resilience with their strategies moving forward. Time will tell whether they come out of this situation as stronger companies.
Top Three Valuation Considerations for Credit Unions When Contemplating a Bank Acquisition
After five or six years of strong bank M&A activity, 2020 slowed drastically following the onset of COVID-19.Eventually, we expect M&A activity will rebound once buyers have more confidence in the economy and the COVID-19 medical outlook. In that case, there will be greater certainty around seller’s earnings outlook and credit quality, particularly for those loan segments more exposed in the post-COVID-19 economic environment. The factors that drive consolidation such as buyers’ needs to obtain scale,
improve profitability, and support growth will remain as will seller desires to exit due to shareholder needs for liquidity and management succession among others. Credit Unions as Bank AcquirersOne emerging trend prior to the bank M&A slowdown in March 2020 was credit unions (“CUs”) acquiring small community banks.Since January 1, 2015, there have been 36 acquisitions of banks by CUs of which 15 were announced in 2019. In addition to the factors favoring consolidation noted above, credit unions can benefit from diversifying their loan portfolio away from a heavy reliance on consumers and into new geographic markets.In addition to diversification benefits, bank acquisitions can also enhance the growth profile of the acquiring CU. From the first quarter of 2015 through the second quarter of 2019, CU bank buyers grew their membership by ~23% compared to ~15% for other CUs according to S&P Global Market Intelligence.A positive for community bank sellers is that CUs pay cash and often acquire small community banks located in small communities or even rural areas, that do not interest most large community and regional bank acquirers.Valuation Issues to Consider When a Credit Union Acquires a Commercial BankThere are, of course, unique valuation issues to consider when a credit union buys (or is bidding for) a commercial bank.Transaction Form and Consideration. Transactions are often structured as an asset purchase whereby the CU pays cash consideration to acquire the assets and assume the liabilities of the underlying bank.Taxes (CU Perspective). CUs do not pay corporate income taxes, and this precludes them from acquiring certain tax-related assets and liabilities on the bank’s balance sheet, such as a deferred tax asset.Taxes (Bank Perspective). If a holding company owns a bank that is sold to a CU, then any gain will likely be subject to taxation prior to the holding company satisfying any liabilities and paying a liquidating distribution to shareholders.Expense Synergies. CUs often extract less cost savings than a bank buyer because bank acquisitions are often viewed as part of their membership growth strategy whereby the transaction expands their geographic/membership footprint and there will be no or fewer branch closures.Capital Considerations. CUs must maintain a net worth ratio of at least 7.0% to be deemed “well capitalized” by regulators. The net worth ratio is akin to a bank’s leverage ratio and the pro-forma impact from the acquisition on the net worth ratio should be estimated as the increase in assets from the acquisition can reduce the post-close net worth ratio of the CU. Some CUs may be able to issue sub debt and count it as capital but CUs often rely primarily upon retained earnings to increase capital.Other. CU acquisitions can often take longer to close than traditional bank acquisitions and, thus, an interim forecast of earnings/distributions may need to be considered for both the bank and CU to better estimate the pro forma balance sheet at closing.Valuation Considerations for Credit Unions When Contemplating Acquiring a BankBased upon our experience of working as the financial advisor to credit unions that are contemplating an acquisition of a bank, we see three broad factors CUs should consider.Developing a Reasonable Valuation Range for the Bank TargetDeveloping a reasonable valuation for a bank target is important in any economic environment but particularly so in the post-COVID-19 environment.Generally, the guideline M&A comparable transactions and discounted cash flow (“DCF”) valuation methods are relied upon.In the pre-COVID-19 environment, transaction data was more readily available so that one could tailor one or more M&A comp groups that closely reflected the target’s geographic location, asset size, financial performance, and the like.Until sufficient M&A activity resumes, timely and relevant market data is limited.Even when M&A activity resumes, inferences from historical data for CU deals should be made with caution because it is a small sample set of ~35 pre-COVID-19 deals where only 75% of announced deals since 2015 included pricing data with a wide P/TBV range of ~0.5x to ~1.7x (with a median of ~1.3x).While deal values are often reported and compared based upon multiples of tangible book value, CU acquirers are like most bank acquirers in which value is a function of projected cash flow estimates that they believe the bank target can produce in the future once merged with their CU. A key question to consider is: What factors drive the cash flow forecast and ultimately value?No two valuations or cash flow estimates are alike and determining the value for a bank or its branches requires evaluating both qualitative and quantitative factors bearing on the target bank’s current performance, outlook, growth potential, and risk attributes. The primary factors driving value in our experience include considering both qualitative and quantitative factors. In a post-COVID-19 valuation, a CU may have a high degree of confidence in expense savings, but less so in other aspects of the forecast—especially related to growth potential, credit losses, and the net interest margin (“NIM”). Developing Accurate Fair Value Estimates of the Loan Portfolio and Core Deposit Intangible It is important for CUs to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma net worth of the CU at closing as well as their future earnings and net worth.In the initial accounting for a bank acquisition by a CU, acquired assets and liabilities are marked to their fair values, with the most significant marks typically for the loan portfolio followed by depositor customer relationship (core deposit) intangible assets. Loan Valuation.The loan valuation process can be complex before factoring in the COVID-19 effect on interest rates and credit loss assumptions.Our loan valuation process begins with due diligence discussions with management of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio.We also typically factor in the CU acquirer’s loan review personnel to obtain their perspective.The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates.Problem credits above a certain threshold are typically evaluated on an individual basis.Core Deposit Intangible Valuation.Core deposit intangible asset values are driven by both market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.We also assess market data regarding the costs of alternative funding sources, the forward rate curves, and the sensitivity of the acquired deposit base to changes in market interest rates.Simultaneously, we analyze the cost of the acquired deposits relative to the market environment, looking at current interest rates paid on the deposits as well as other expenses required to service the accounts and fee income that may be generated by the accounts.We analyze historical retention characteristics of the acquired deposits and the outlook for future account retention to develop a detailed forecast of the future cost of the acquired deposits relative to an alternative cost of funds.Evaluating Key Deal Metrics to Model Strength or Weakness of TransactionOnce a valuation range is determined and the pro forma balance sheet is prepared, the CU can then begin to model certain deal metrics to assess the strength and weaknesses of the transaction.Many of the traditional metrics that banks utilize when assessing bank targets are also commonplace for CUs to evaluate and consider, including net worth (or book value) dilution and the earnback period, earnings accretion/dilution, and an IRR analysis. These and other measures usually are meaningfully impacted by the opportunity cost of cash allocated to the purchase and retention estimates for accounts and lines of business that may have an uncertain future as part of a CU.One deal metric that often gets a lot of focus from CUs is the estimated internal rate of return (“IRR”) for the transaction based upon the following key items: the cash price for the acquisitions, the opportunity cost of the cash, and the forecast cash flows/valuation for the target inclusive of any expense savings and growth/attrition over time in lines of business.This IRR estimate can then be compared to the CU’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the CU and its members.In our experience, an IRR estimate 200-500 basis points (2-5%) above the CUs historical return on equity (net worth) implies an attractive acquisition candidate. ConclusionMercer Capital has significant experience providing valuation, due diligence, and advisory services to credit unions and community banks across each phase of a potential transaction.Our services for CUs include providing initial valuation ranges to CUs for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the CU’s management and/or Board, and providing valuations for fair value estimates of loans and core deposit prior to or at closing. We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit by including a credit union in the transaction process.Feel free to reach out to us to discuss your community bank or credit union’s unique situation in confidence.
Originally published in Bank Watch, May 2020.
Driving Value: Key Components of an Auto Dealership Valuation
As a lifelong, avid sports fan, the lack of live sports over the past few months has created a huge void. In their absence, I have enjoyed watching the replays of several classic, iconic games from my childhood and teenage years: the 1986 World Series Game 6 aka the “Bill Buckner game,” the 1992 Elite 8 matchup between Kentucky and Duke aka the “Laettner Shot,” and the 1992 NLCS Game 7 between my beloved Atlanta Braves and the Pittsburgh Pirates aka the “Sid Bream Slide game” among others. The replays have been fascinating for the memories and emotions that they evoke, but it’s also interesting to see the finer details that had been lost or blurred from my memory over time. And yes, Buckner still missed the ball, Laettner still hit that miraculous shot (unfortunately), and Sid Bream was still safe! But what made these games iconic and have the classic value over time that they still do today?The appreciation and ultimate value of an auto dealership is impacted by several key value drivers.All of them had certain ingredients that were “controllable.” An Elite 8 or playoff game will always have greater stakes than a regular season game, and playoffs tend to have greater talent at a higher level of competition. It also just means more when it’s your team. And rivalries will always up the ante. These situations increase the likelihood of a game becoming a classic, but I also realized the games I rewatched had other uncontrollable components that contributed to their value – pressure moments, unlikely heroes like role players stepping up, and the never-ending spirit to keep competing until the final out or buzzer.Just like these classic sporting events, the appreciation and ultimate value of an auto dealership is impacted by several key value drivers. Some of these value drivers are controllable or able to be affected by the owner, and some are outside of their control.Auto dealers, like most business owners, are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are various life events that make them need to know the value such as a transaction (including buy-sell), litigation, divorce, wealth-transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and focusing on the value drivers of their auto dealership and addressing them on a consistent basis. So, what are some of the value drivers of an auto dealership?FranchiseAn auto dealership’s franchise affiliation has a major impact on value. Each franchise has a different reputation, selling strategy, target consumer demographic, etc. Public value perception of franchises tends to be unique and are most easily illustrated through Blue Sky multiples. As the Haig Report and Kerrigan’s Blue Sky Report indicate, Blue Sky multiples vary over time even if they are frequently stagnant from period to period. Often auto dealerships and franchises are grouped into broader categories, such as: luxury franchises, mid-line franchises, domestic franchises, import franchises and/or ultra high-line franchises. Dealers may not have significant influence over the value perception of their franchise, making this value driver appear “uncontrollable.” However, dealers do have the opportunity to make bolt-on acquisitions and expand their operations to more rooftops. This will likely improve foot traffic to the various franchises in general and ultimately may improve the value of the business, particularly if they are able to appropriately decide which franchise to add.Real Estate/Quality of FacilitiesTypically, most dealership operations are held in one entity, and the underlying real estate is held by a separate, often related entity. Several issues with real estate can affect an auto dealership valuation. First, an analysis of the rental rate and terms should be performed to establish a fair market value rental rate. Since the real estate is often owned by a related entity, the rent may be set higher or lower than market for tax or other motivations that would not reflect fair market value. Second, the quality and condition of the facilities are crucial to evaluate. Most manufacturers require facility and signage upgrades on a regular basis, often offering incentives to help mitigate these costs. It’s important to assess whether the auto dealership has regularly complied with these enhancements and is current with the condition of their facilities. Owners seeking to drive value can do their part in making sure their facilities are up to date and appealing to customers.Due to the coronavirus pandemic, facility upgrades may become less of a value driver. Stay-at-home orders have forced consumers to buy automobiles through more automated means. While dealers have long touted their omnichannel offerings, the pandemic has put them to the test. The shift to digital platforms is expected to decrease foot traffic to the actual dealership. With the focus moved away from the dealer’s real estate and physical showroom, the importance of the latest and greatest signage is likely to be diminished. It’s possible that the quality of a dealer’s facilities may become less of a value driver if consumers are less dependent on those facilities.Employees/ManagementThe quality and depth of management can have a positive impact on an auto dealership valuation. Auto dealerships with greater management depth and less dependence on a few key individuals will generally be viewed as less risky by an outside buyer. Also, an auto dealership’s CSI (Customer Service Index) and SSI (Service Satisfaction Index) rating can influence incentives from the franchise and the overall perception of the consumer. A strong CSI and SSI are reflections of a strong service department and a commitment to quality customer service. While franchise customer service figures are not controllable, owners can make sure their employees provide consistent, exemplary customer service which will boost reputation and drive value.Recent Economic PerformanceLike most industries, the auto industry is dependent on the national economy. The auto industry measures and tracks sales of lightweight automobiles and trucks in a Seasonally Adjusted Annual Rate (SAAR), which is an indicator of historical economic performance in the auto industry. In addition to monitoring and understanding the current month’s SAAR, the longer-term history of the SAAR and its trends also provide insight into the auto industry and an auto dealership valuation. Below is a long-term graph of the SAAR over the past 20 calendar years:While dealerships tend to ebb and flow with the general economy, the industry can also be cyclical based upon the average age of cars owned. Consider a period with significant volumes over a number of years. Because cars are typically owned for several years, these customers are not repeat customers except to the extent they visit the parts and service departments. All else equal, periods with high volume sales tend to be followed by lower volume periods. As you might expect, dealers have minimal influence over these cycles. Like the bottom of the 9th in Game 7 of the World Series, it’s just going to mean more.Buyer DemandBuyer demand in the transaction market can illustrate the value climate for auto dealer valuations. Typically, buyer demand is measured by the deal activity in the M&A market. The Haig Report indicated that 2019 was another strong year for the buy-sell market after a sluggish beginning. They estimated 78 stores were acquired by public and private buyers in Q42019 alone. Similarly, Kerrigan’s figures also illustrate a strong buy-sell market for 2019 after a slow start. Kerrigan notes 2019 was the strongest year for transactions since 2014. Increased buyer demand leads to higher multiples and ultimately valuations for dealers. While this is not something that dealers can directly influence themselves, adhering to the other aspects noted in this piece can increase the likelihood dealers receive a favorable multiple.Buyer demand and M&A activity will be severely affected in 2020 as the buy-sell market has largely been placed on pause due to the economic conditions and stay-at-home mandates related to COVID-19. Again, this is largely out of the dealer’s control, though they can take steps to make their dealership more attractive.Location/MarketThe value of an auto dealership can be more complex than urban vs. rural or major metropolitan city vs. minor metropolitan city. Each store location is assigned a certain area or group of zip codes referred to as an area of responsibility (AoR). Particularly, how does a location’s demographic characteristics line up with a certain franchise? For example, a high-line auto dealership would perform better and seemingly be more valuable in a major metropolitan area with a high median income level, such as Beverly Hills, California, or South Beach in Miami than in a mid-western city. Conversely, a mid-line Store would probably fare better in areas with more moderate median income levels.We’ve discussed how the national economy can affect an auto dealership’s value, but in some instances, performance can also be greatly influenced by its local economy. Certain local markets are dominated by a particular trade or industry. Examples can be auto dealership locations near oil & gas refining areas, mining areas, or military bases. For example, there may be an influx in car sales as members of a particular base are deployed or return home. In such instances, a dealership is probably more dependent on local economic conditions than national economic conditions. This is where it is key for owners to recognize the environment in which they operate and tailor their operations to maximize these opportunities. Like Steve Kerr said when Michael Jordan was double-teamed in Game 6 of the NBA Finals, “I’ll be ready.”Single-Point vs. Over-Franchised MarketThe amount of competition in an auto dealership’s AoR, as well as the nearest location of a similar franchised auto dealership, can also have an impact. It’s important to make the distinction that we are talking about a single-point market and not a single-point dealership. A single-point market refers to a market where there is only one auto dealership of a particular franchise. An over-franchised market would be a larger market that may contain several auto dealerships of a particular franchise within a certain radius. Often, an auto dealership in a single-point market would be viewed as more valuable than one in an over-franchised market that would be competing with its own franchise for the same consumers. Additionally, the auto dealerships of the same franchise in the same market could be drastically different in size. One may be part of a larger auto group of dealerships, while the other may be a single-point dealership location, meaning that owner only owns that one location. A dealer with one of many Ford dealerships in a city, for example, is likely to be worth less because customers going to buy a new Ford have many convenient options. Additionally, a dealer with a single-point franchise is likely to lose out on customers that aren’t sure what make or model they want. If they only offer vehicles from one franchise at their location, they may draw less foot traffic due to less variety. We’ve already discussed how certain brands tend to receive higher Blue Sky Multiples and how that should factor into acquiring a new franchise. Owners looking to enhance the value of their dealership operations should also consider the saturation of franchises in their market. While a Lexus dealership may have a higher Blue Sky multiple than a Kia, if there are no other Kia dealerships in the market, they may be able to earn more in profits. Improving earnings are an easier way for owners to improve the valuation of a dealership as multiples tend to represent other uncontrollable market influences.Conclusions and ObservationsAs we’ve discussed, the value of an auto dealership is influenced by a variety of factors. Some of the factors are controllable, and some are external. Just like a classic sporting event, auto dealers have to focus on what they can control, hoping to create value and maintain or grow it over time.To find out the value of your auto dealership today, contact one of the automotive industry professionals at Mercer Capital. Whether or not you may have an upcoming life event that may necessitate a valuation, we can help you understand your progress and further understand our process. That way, when it comes time, you’ll be ready.
What Is a “Level” of Value, and Why Does it Matter? (Part 2)
In last week’s post, we defined the three principal levels of value and explained that the levels reflect differing perspectives on expected future cash flows and risk. This week, we turn our attention to the importance of the levels of value for family businesses.
One of the great strengths of a family business is the ability to take the long view. Unburdened by the quarterly reporting cycles of publicly traded companies, family businesses can make investing and operating decisions for long-term benefit without worrying about the effect on next quarter’s earnings. One of the foundations of this long-term perspective is the stability of ownership within the family.
With an indefinite holding period, why does the value of the family business even matter? While the family may have an indefinite holding period, the fact of mortality means that individual shareholders do not. So, even for committed families, transactions will occur, and valuation will matter. In our next two posts, we consider four potential transactions in which getting the level of value right matters a lot.Estate PlanningMany family shareholders will determine that it is advantageous to transfer wealth to heirs while still living. Regardless of the specific technique used, the value of shares in the family business is a cornerstone of estate planning. Under the IRS’ definition of fair market value, the appropriate level of value depends on the attribute of the block of shares being transferred. Since estate planning almost always involves transactions of minority interests in the family business, the nonmarketable minority interest level of value is relevant.Measuring the value of shares in the family business at the nonmarketable minority interest level of value is a two-step process. First, we consider what the shares would be worth if they were traded on an exchange (i.e., the marketable minority level of value). Second, we determine an appropriate discount to apply to that value to reflect the unfortunate side effects of owning a minority interest in a private company. The magnitude of that discount depends on factors like the expected duration of the holding period until a liquidity event, the level of interim distributions, and the expected pace of capital appreciation. When combined with an assessment of the risks facing the investor, these factors determine the marketability discount, which, in turn, defines the fair market value of the shares on a nonmarketable minority interest basis.Corporate DevelopmentFamily businesses have two basic pathways for growth: organic growth through capital expenditures (“build”) or non-organic growth through acquisitions (“buy”). The pathways are not mutually exclusive. Some families are culturally averse to acquisitions, while for others a disciplined acquisition strategy is part of the family’s business DNA.For family business acquirers, developing an appropriate valuation of the target is essential. As one of our colleagues is fond of saying: “Bought right, half right.” Regardless of the strategic merits of a proposed acquisition, overpayment will weigh on the returns available to future generations of the family. When formulating a bid price for a potential target, acquirers should seek to answer two questions.What is the business worth to the existing owners? Selling their business to you means that the existing owners will be giving up the future cash flows they expect the business to generate under their stewardship. This reflects the financial control level of value, which as we noted in last week’s post, is probably not much different from the marketable minority value.What is the business worth to us? To answer this question, acquirers need to carefully evaluate how the target “fits” with their existing business. Will the combination of the two businesses generate revenue synergies (i.e., 2 + 2 = 5)? Or are there duplicative costs that can be eliminated as a means of generating higher margins for the combined entity? Perhaps the combination will reduce the risk of the family business, or perhaps the family has access to lower cost capital than the existing owners. In any event, family business acquirers should develop forecasts for the pro forma combined entity using well-supported inputs that reflect the strategic case for the acquisition to determine what the business is worth to them.
The difference between these two values defines the “space” over which negotiations will center. The ultimate purchase price will reflect the relative bargaining power of the two parties. As illustrated in Exhibit 1, bargaining power is a function of the number of likely buyers for the target, and whether the target represents a generic or unique opportunity for buyers.To avoid overpaying, savvy family business acquirers focus not just on what the target could be worth to them, but also what the target is worth to its current owners, along with a careful assessment of the factors that influence the relative bargaining power of the parties.DivestituresAt some point, many families transition to being enterprising families. In other words, they are defined by the fact that they pursue economic opportunities together, rather than by continued ownership of the legacy family business. In pursuit of broader portfolio management objectives, enterprising families may sell businesses from time to time. In this case, the dynamics described in the preceding section are reversed.As the seller, you won’t have direct access to what your business could be worth to the buyer. However, knowing how your industry is structured and how your business operates, you should be able to estimate potential revenue synergies and cost saving opportunities available to the buyer.In order to achieve a sales price closer to the value of your business to the buyer, it is important to identify the attributes of your business that differentiate it from other potential acquisition targets available to buyers. Further, generating interest from a larger pool of buyers is essential to reaping greater proceeds from a divestiture.ConclusionIn this week’s post, we have demonstrated how critical getting the level of value right is for family businesses for estate planning, acquisitions, and divestitures. Next week, we will look at the levels of value in the context of shareholder redemption transactions. If you could benefit from an outside perspective on a pending transaction for your family business, give one of our experienced valuation professionals a call.See Part 1 of this series here.See Part 3 of this series here.
What Is a “Level” of Value, and Why Does it Matter? (Part 2)
This week, we turn our attention to the importance of the levels of value for family businesses.
Royalties And Minerals: A New Market Is Emerging
The marketplace has delivered some jarring blows over the past few months to players in the mineral and royalty space. Although this asset class enjoys certain benefits relative to oil and gas producers, its value is still connected to commodity prices. The recent swing downward has staggered market participants and quickly changed several assumptions regarding a sense of normalcy. In analyzing the sector, we pulsed EnergyNet, one of the largest private mineral transaction platforms in the market. Chris Atherton, EnergyNet’s CEO, is about as close to the royalty and mineral market as anyone. How close? Consider the following:EnergyNet has closed over 400 royalty, overriding royalty, and/or mineral transactions this year through April 2020.The platform frequently handles transactions with participants ranging from individuals all the way to integrated majors such as Chevron CVX and Shell.Geographically, they handle transactions across the contiguous United States.They regularly broker transactions across the dollar size spectrum in this market, ranging all the way from five figures to eight figures.
Therefore, it is reasonable to suggest EnergyNet represents an excellent glimpse into the royalty and mineral market at large (no – I did not get paid to say that). In the course of my correspondence with Chris Atherton, several interesting market movements began to emerge. After the March 7th launching point with the OPEC+ impasse, EnergyNet’s platform has taken several twists and turns. Both demand and supply shocks have squeezed the market and values have plummeted. The timeline below chronicles this:
[caption id="attachment_31848" align="alignnone" width="709"]Source: EnergyNet[/caption]
ObservationsThe fact that valuations have decreased is not news at this point, but what is interesting is that this environment has changed a lot of things along the way:Buyer Pool – Currently EnergyNet has 33,000 buyers vs. 7,000 sellers on its platform. Buyer registrations have skyrocketed in the past few months. New investors are seeking what they perceive as a potential good deal. At the same time, many of the larger participants on their platform (majors and independent producers) have paused much of their selling activity. Possibilities for this hiatus can vary. Changing economics are certainly a factor, but sellers also may be concerned about entering restructuring negotiations and do not want to be divesting assets in the time leading up to what may eventually be a bankruptcy filing.Liquidity and Valuations – Although typically not falling as far as upstream producers, valuations for minerals and royalties have plummeted. Deals, even in quality basins, are trading for half of what they were a few months ago. Liquidity has been a part of this. As buyers and sellers wallow in uncertainty, more and more deals are either terminating or not happening at all.
[caption id="attachment_31849" align="alignnone" width="640"]Source: EnergyNet [/caption]
Basin Preferences – During this time, a previously unexpected occurrence has happened: gas assets are considered a more “tradeable” investment. Said Atherton: “With gas in the proverbial doghouse, buyers are becoming more attracted to its relative stability. Sellers have noticed this too and are more reticent to trade. The transaction volume is still thin, but interestingly, the rationale has shifted.” This has led to an uptick in Appalachian and East Texas interest. Colorado has lost favor, as much due to its changing regulatory climate as commodity prices. The Bakken has had decreasing interest as well with its higher breakeven prices and transportation issues.
[caption id="attachment_31850" align="alignnone" width="640"]Source: EnergyNet [/caption]
Takeaways“We are going to have a different market coming out of this.” says Atherton. What exactly that market will look like is another question. Speaking of questions, what will drilling activity look like going forward? How might the relationship between the mineral owner and operator change? It is possible that litigations between royalty owners and operators will pick up?Arguably, the most pertinent question above all is this: How will horizontal wells respond to being shut-in? This is an experiment that has never been tried before. Nobody knows how the wells may or may not respond when the spigots get re-opened at some future point. This uncertainty is part of why values are so depressed right now. The answer, whenever it comes, could be the lynchpin to what royalty and mineral valuations will look like in the future.Originally appeared on Forbes.com.
What Is a “Level” of Value, and Why Does It Matter? (Part 1)
Family shareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in Exhibit 1, there are three basic “levels” of value for a family business.Each of the basic levels of value corresponds to different perspectives on the value of the business. In this post, we will explore the relevant characteristics of each level.Marketable Minority Level ValueThe marketable minority value is a proxy for the value of your family business if its shares were it publicly-traded. In other words, if your family business had a stock ticker, what price would the shares trade at? To answer this question, we need to think about expectations for future cash flows and risk.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate. In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices. There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments. Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain. As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments. When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa.
So when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk. They will estimate this value in two different ways.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business.
While these are two distinct approaches, at the heart of each is an emphasis of the cash flow-generating ability and risk of your family business.
We started with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control). Acquirers are often classified as either financial or strategic.Financially-motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded).
The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value. Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist. The name and branding may change, employees may be downsized, and production facilities may be closed.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value. All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.What factors are investors at the nonmarketable minority level of value most interested in? First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business. But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest? The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold. The longer an investor expects the holding period to be, the larger the discount to the marketable minority value.Expected capital appreciation. For most family businesses, there is an expectation that the value of the business will grow over time. Capital appreciation is ultimately a function of the investments made by the family business. Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return. Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares. All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value.Interim distributions. Does your family business pay dividends? Interim distributions can be an important source of return during the expected holding period of uncertain duration. Interim distributions mitigate the marketability discount that would otherwise be applicable.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above. As a result, they demand a premium return relative to the marketable minority level. The greater the perceived risk, the larger the marketability discount.ConclusionThe so-called “levels” of value reflect the real-world concerns of different investors in different circumstances. Having provided a brief overview of what each level of value means, we will turn our attention in next week’s post to why the levels of value matter for family shareholders.See Part 2 of this series here.See Part 3 of this series here.
Q1 2020 Earnings Calls
COVID-19 Causes Declines in Q1, but Executives Maintain Optimism Going Forward
Auto dealers stock prices declined in the first quarter of 2020 following the broader market trend. Though many dealers saw year-over-year gains in sales and earnings in the first two months of the year, earnings calls focused on the coronavirus pandemic. Volumes have fallen across the country, though executives pointed to recent positive trends. Downturns have muddied the M&A market, and some companies don’t plan to rehire everyone that has been let go. Many praised the support of OEMs including significant incentives such as 0% financing. With dealership doors shuttered, many executives touted their online presence, though there was not a consensus on digital’s long-term place in the market.CarMax (stock price -4% year-to-date May 26th) and Carvana (+48%) have performed better than traditional franchised dealers (-23% on average), pointing to the strength of this business model during this time. Vroom, Inc., another online used car seller, even filed for an IPO despite the significant macroeconomic headwinds and recent poor performance of auto-adjacent tech-company offerings. If the offering occurs as scheduled and performs well, this bodes well for AutoNation, who owns about 7% of the company after a $50 million investment in late 2018. In mid-April, AutoNation granted its CEO, Cheryl Miller, a leave of absence for health reasons. They also returned their PPP loan well before the Safe Harbor Deadline (most recently postponed to May 18th) due to shifting guidance about eligibility. It should also be pointed out that their eligibility as one of the largest auto dealers in the country drew ire from the public.AutoNation wasn’t the only public auto dealer facing its own issues amid the market turbulence. Asbury scuttled their $1 billion Park Place transaction, which included $10 million in damages, not counting other expenses incurred related to due diligence and financing. This would have been one of the largest transactions in the auto dealer space in years. Penske waited until after their earnings call to announce they were cutting their dividend, “consistent with the other measures the company has implemented the impact of COVID-19.” The S&P 500 has rallied significantly from March lows due to significant liquidity injections and optimism of a quick “V-shaped” recovery, but there may be more room for it to fall if more companies like Penske and Group 1 have to cut dividends.Theme 1: April was the worst month for national sales volumes in decades. However, recovery has been evident on a weekly basis even throughout April as companies ramp up their digital capabilities.In the U.S., our workshops have generally remained open, unlike many of our showrooms, but the flow of service customers has been down 40% to 50% since mid-March, simply because most of our customers have been living under shelter-in-place orders. The closure of most of our U.S. showrooms since mid-March has reduced new and used vehicle sales by a similar percentage. […] As April progressed, we began to see some rebound in our week-over-week sales base in the U.S. market. For the final week, retail unit sales were down approximately 25%, and service revenues were pacing about 30% lower than prior-year levels. -Earl Hesterberg, President and CEO, Group 1 AutomotiveDuring this period, our overall vehicle sales volumes fell roughly 40% compared to the prior year. […] In the past week though, the year-over-year vehicle sales declines have improved to roughly 30%, with used vehicle sales being slightly more resilient than new vehicle sales. Parts and service gross has also improved over the past week as states begin to relax their stay-at-home orders and customers begin to return for delayed repair and maintenance work. -David Bruton Smith, CEO and Director, Sonic AutomotiveTheme 2: Coronavirus has accelerated the push to digital, resulting in heavy investment which means online shopping will continue beyond the pandemic. However, some executives believe consumer preferences and their (lack of) understanding of financing options will continue to be roadblocks to fully online.I think that [digital] trend was already underway where the value of a brand and experience and a warranty/guarantee has all been expressed as a consumer of things that are valued and there’s been a movement towards companies like AutoNation with One Price, CarMax, Vroom, Carvana. […] I think for digital, this whole disruptive period with corona is an inflection point from which there’s no turning back. […] You need first-class digital capability; you need a safe environment for your customers and a safe environment for your associates. That is the Holy Grail going forward. We see no difference in profitability between the digital channel and the traditional challenge whatsoever. -Michael Jackson, Chairman and CEO, AutoNation[W]e believe that about half of the consumers today would really prefer to be able to buy cars in the comfort of their own home. We are seeing though that there is still many of the consumers and we’ve narrowed it down that we think that about 20% of the consumers have the ability to [complete the car buying process] by doing it digitally and doing it all from home without human interaction. The other 80%, we really believe even though they want to that’s the biggest impediment not the desire, but consumers just don't have the ability. -Bryan DeBoer, President and CEO, Lithia MotorsA lot of customers that come in whether they don't know what they're looking to acquire, they don’t know the kind of vehicle that they want for their family or they have some financial issues. As we’ve said before, you know, our average consumer has $5,100 of negative equity that they’re working to, you know, leverage our finance specialists to help them find the right solutions for them. -Chris Holzshu, EVP and COO, Lithia MotorsTheme 3: Auto dealers cut headcounts to manage SG&A expenses, but not all these jobs will return when markets stabilize due in part to digital. Some are optimistic they will bring everyone back, and most directly relate rehiring to the rate at which business returns.I don't know that [headcount related cost saves are] near-term, I think what we have to do is understand what will be the footprint of our business. How much will be digital? How much will be done from home? How many people we have actually working in the operations? […] As we see the number of people we have furloughed and as a business going [forward will] be decided by how business comes back. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe didn’t furlough any technicians. Because of our cash position and how we manage our expenses [the quarter could have been better] had we just cut the normal expense as you would in a typical recession. We believe that this was going to be temporary. And eventually, the business was going to come back. […] we have strong metrics that will dictate to us when we bring people back. And when we see those metrics starting to be achieved, we’ll certainly bring people back at that time. The folks that we’ve furloughed, we communicate with them consistently, and we were hopeful one day to bring them all back. -David Hult, President and CEO Asbury Automotive GroupWe’ve bought back 1,000 associates thus far, meaning that our staffing reduction is around the same as the business reduction. There is no predetermined cadence or plan as to when we bring back additional employees. […] [I]f I look back to 2008 and 2009, I would observe re-staffing trailed the improvement in business. […] And what other efficiencies and effectiveness around digital is figured out or we come to grips with, whether that leads fact that we hire everyone when we ultimately have a full recovery in our back, well, I can’t answer that today, other than I can say, rehiring will trail the growth of the business. -Michael Jackson, Chairman and CEO, AutoNationTheme 4: M&A has been delayed or canceled due to the coronavirus as buyers aren’t willing to pay what sellers want with earnings deteriorating. Executives believe consolidation will ultimately resume and companies focused on maximizing liquidity may be best positioned for such acquisitions.As we saw business decline, we acted decisively to fortify our business to prepare for the inevitable slowdown. Unfortunately, this included canceling the Park Place acquisition […] we thought the Park Place deal was going to be a transformational deal for us, and it was a heck of an acquisition, but things happen. On the other side of that coin, we’re sitting on a lot of cash and probably the lowest net leverage ratio we’ve had. […] I think we need to see the dust settle a little bit. There is some activity out there. […] I don’t want to comment on [reengaging] the Park Place transaction. But we feel like from a cash position and where we’re sitting operationally, we have the ability to be very flexible and being acquisitive when the right opportunities come. -David Hult, President and CEO Asbury Automotive GroupI think it's going to be brand-by-brand where you have your strengths and also we have scale where you can consolidate some of the fixed costs, but I think it's too soon to look at that. […] We would focus [capital allocation] today, probably investing in the used car business from the superstore perspective and also look at expanding our footprint get on commercial trucks side. -Roger Penske, Chairman and CEO, Penske Automotive GroupWe need to verify earnings quality that they’re within that 90% to 95% earnings level of what they were pre-COVID-19. So, those earnings quality verifications will determine the second half closing date or possibly even beyond that in the event that earnings quality hasn’t improved. There are chances that if earning quality doesn't improve then we would actually renegotiate the transaction in terms of the goodwill amount as well. -Bryan DeBoer, President and CEO, Lithia MotorsOur liquidity position, for us, is about as strong as it's ever been. So as we come out of this, we do believe there's going to be some M&A opportunities for us -Jeff Dyke, President, Sonic AutomotiveSummaryEarnings calls this quarter were uniquely positioned. Despite much of the financial impact occurring in Q2, the demand shock caused by the coronavirus was so severe that many dealers saw a decline in Q1 figures. While things are expected to get worse in Q2, there is optimism as numbers continue to improve on a weekly basis. Still, it should be noted that volumes are becoming less negative, not reversing to positive in most instances. Hopefully trends will continue their positive trajectory by next quarter’s calls. Tough times are ahead for public and private dealers, but current investments in digital strategies may lead to some long-term benefits as a silver lining to this difficult situation.At Mercer Capital, we follow the auto industry closely in order to understand not only recent trends, but how investors ascribe value to the public dealerships. These give insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, reach out to one of us, and we’d be happy to chat via telephone, email, Zoom, or whatever your preferred communication in this dynamic digital age.
The Family Office
Managing Family Wealth Since 27 BC
After appearing on our Family Business Director Blog earlier this month, we decided to share this post as it provides useful guidance on assessing whether a family office is right for your family.
Private investment office… Family business advisor... Single-family office… The name differs and the definition varies greatly depending on whom you ask. But the concept remains the same. Wealthy families often seek assistance to manage their accumulated wealth, organize family affairs, and preserve capital for future generations.The concept of a family office dates back as far as 27 BC.The concept of a family office dates back as far as 27 BC when Emperor Augustus Caesar, who at the time controlled approximately 25% of global GDP, employed a group of appointees to manage his estate, businesses, military, and even lifestyle. The concept continued to evolve in the sixth century when it was common for the king’s steward to manage the royal family’s wealth. However, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.A family office is different than a traditional wealth management firm. A family office typically provides a full suite of services including accounting, budgeting, family education, investment management, insurance, charitable giving, and sometimes even concierge services including travel arrangements, personal security, and miscellaneous other household services. However, it is hard to define the “typical” family office as most develop out of a family’s specific needs. Additionally, many wealthy families likely employ professionals who carry out such duties, without necessarily defining or even realizing their function is similar to a single-family office.Single-Family Office vs. Multi-Family OfficeA single-family office is tailored to meet your family’s specific needs. However, to warrant the cost of a single-family office, a family’s assets likely must exceed $100 million, and to afford a full investment practice, assets likely must exceed $250 million. As such, the multi-family office took shape to provide similar services to ultra-wealthy families (typically those with assets in excess of $25 million), while allowing for cost-sharing between multiple families. A multi-family office can be commercially owned by a group of outside investors or privately owned by a founding family with significant wealth. For example, the Rockefeller family office, which has served the Rockefeller family for almost 140 years, recently expanded its services to over 250 clients.There are key legal and regulatory differences between a single-family office and a multi-family office. Because single-family offices serve only one family, they are not registered with the SEC (the Investment Advisor Act of 1940 made single-family offices exempt from SEC registration). Multi-family offices, on the other hand, are typically structured as registered investment advisors (RIAs), which are registered with the SEC, or trust companies, which are typically regulated at the state level.Additionally, a single-family office’s main goal is to preserve and generate wealth for the family. Whereas a multi-family office also seeks to generate a profit for itself. This results in a somewhat lower return on assets for families belonging to a multi-family office as the profits are split between the families and the ownership base. We have compiled what the average income statement for a single-family office and multi-family office looks like to highlight this difference.
[caption id="attachment_31050" align="alignnone" width="784"]Charts Compiled by Mercer CapitalData per The Global Family Office Report 2019AUM = Global Average AUM for SFOs and MFOs Portfolio Return = Average Family Office Portfolio Return from Q1/Q2 2018 through Q1/Q2 2019 in N America Expenses = Average Global Expenses for SFOs and MFOs[/caption]
As shown above, the total return on assets managed by a single-family office (5.2%) is slightly higher than the return on assets managed by the multi-family office (4.9%). The return generated by the multi-family office, however, is sensitive to our assumption of fees charged for family office services. We have estimated multi-family office fees to be 1.0% of AUM. Family offices have varying fee structures but typically include a combination of fixed fees, hourly fees, and asset-based fees. While these asset-based fees typically range between 50bps to 100bps, for comparability, we have assumed a fee at the higher end of this range to provide an estimate for comprehensive services such as would be provided by a single-family office.Investment Performance At first glance, the average return for the portfolio (5.9% for the twelve months ended Q1/Q2 2019) appears rather low, given that wealthier individuals typically have a greater ability to take risk, leading to generally higher returns. However, keep in mind that family offices don’t just manage an individual’s investable assets, as does a typical wealth manager from whom you would likely expect a 7%-ish return. A family office generally manages a family’s entire portfolio, including cash.The “average” portfolio for a family office is shown below.
[caption id="attachment_31052" align="alignnone" width="851"]Source: The Global Family Office Report 2019[/caption]
Recently, family offices have started investing in more diverse and riskier products, such as private companies and distressed debt, that have typically been reserved for institutional investors. Family offices have reduced their allocation to hedge-funds over time, unable to justify such high fees for often mediocre performance and have reallocated these funds to direct investments in debt and equity. Over the last few years, family offices have become somewhat of a disruptive force in the private equity and venture capital space as they are able to offer competitive pricing and terms since their holding periods are longer than the typical private equity fund and they have more flexible investment criteria than a private equity firm who may be working to manage the expectations of hundreds of investors, instead of one family.Growing Presence of Family OfficesEducating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.In the 1980s family offices started to multiply as the number of families who were able to afford such services increased the concept. In 2018, EY estimated that there were approximately 10,000 single family offices worldwide, a ten-fold increase over less than a decade. Looking forward, the number of single and multi-family offices is expected to continue increasing as the number of wealthy families grows and investor preferences continue to shift towards having more control over one’s own wealth. While family offices are more streamlined than traditional investment firms there are some obvious drawbacks of mixing business and family. This is why family education and communication is so important. Educating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.As the family office continues to evolve and wealthy families have more options when it comes to managing their wealth, it will be increasingly important for families to ask who can help them best align the family’s interests, making it easier to operate your business, cooperate with other family members, and allow yourself more time to do what is important to you.
What Is a “Level” of Value, and Why Does It Matter? (Part 1)
Family shareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.
Why Are Small Cap RIAs Down 40% Over the Last Year?
Most Investment Managers Remain in Bear Market Territory Even as the Broader Market Recovers
Believe it or not, the S&P 500 is exactly where it was a year ago. It’s been a wild ride, but most diversified investors probably haven’t done as bad as they think during this time. Unfortunately, that’s not the case for the RIA industry, which is still reeling from the Coronavirus pandemic and numerous other industry-specific headwinds. Such a divergence is unusual for an industry tied to market conditions, so this week we analyze the driving forces behind this disparity.From a quantitative perspective, most of this deterioration is attributable to rising cap rates. Earnings multiples (the inverse of cap rates) tend to follow trends in AUM, which are leading indicators for future revenue and profitability. The market fall-out in the first quarter precipitated a sharp decline in AUM and lowered expectations for future management fees and cash flow. Trailing twelve month multiples shrank to all-time lows in anticipation of much weaker earnings reports over the next few quarters. Smaller RIAs have generally fared worse as lower margins and AUM provide less of a cushion against adverse market events.The earnings decline is a bit more intuitive. The bear market triggered declines in AUM and management fees, which combined with a bit of operating leverage has created margin pressure for most of these businesses. The cumulative effect of a 10%-15% earnings decline and a 30%-35% multiple contraction is a sharp contraction in equity prices.The recent pullback is certainly a catalyst but not the only culprit here. Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last quarter.A notable exception in the RIA space is the alt asset sector. Many of these businesses have actually thrived in the current environment as their AUM is typically not directly tied to equity market conditions. As a result, they generally did not fare as well over the last decade relative to more traditional asset managers, but recent events have made most of their asset classes more attractive than public equities.OutlookIt’s difficult to assess how long these divergent trends in pricing will hold up. We’d expect some mean reversion over time, though alt managers should continue to outperform other classes of RIAs in a bear market with elevated levels of volatility. If, on the other hand, we get more months like April, we should see a bounce in traditional asset manager multiples. Unfortunately, May hasn’t been so kind.The trends in earnings multiples are a bit more revealing. Falling cap rates suggests a more promising outlook for alt manager cash flows, though it varies by asset class. A hedge fund that thrives on volatility, for example, should fare much better than, say, an MLP or commodity investor. The sharp decline in small cap RIA multiples so far this year tells us that the market is anticipating drastically lower levels of profitability for many of these businesses. The recent bear market compounded the prevailing headwinds pertaining to asset outflows and fee pressure, and several publicly traded RIAs have lost over half their value over the last year.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much. Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions. There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter. The P/E multiple is another reference point, which has endured a similar decline. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts. We also look at how much a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on. On balance, it’s a lot to keep up with, and we’re happy to walk you through it if you’re considering a valuation.
Q&A: Five Questions with Ralph Jones
From time to time, Family Business Director will interview family business leaders or experienced advisors to get their perspective on important questions common to family businesses. In this installment, we talk with Ralph Jones, Executive Chairman of Jones Family of Companies. Ralph offers great insight that we know our readers will profit from.Brief Overview2020 starts our 84th year of manufacturing textile products and yes, textiles are still made in the United States. Our company began as a yarn spinner founded by two brothers (my grandfather and great uncle) who grew up around textiles. Their dad had been a journeyman specialist in weaving fabrics. The brothers began spinning yarns in 1936 made from recycled textile byproducts for use in string mops, and today we continue that tradition but with a long story of morphing and changing throughout our history. We continue to spin yarn domestically and source internationally, but have moved from a yarn centric company to one now led by production of nonwoven fabrics with manufacturing on both U.S. coasts. We continue to use recycled fibers from the textile and ginning sectors for much of our production as well as other globally sourced man-made fibers. Today we are led by a team of professional managers with our Executive Chairman (3G) being the sole family member involved day-to-day.1. What roles in the family business have you fulfilled over your career?I am the grandson of one of the founding brothers, and like many in a family business, I began my work while in high school working menial summer jobs in the manufacturing plants. I joined the firm immediately after graduating from college and over my 40-year career, I have led most every aspect of the business including sourcing, sales management, business development, export development, growth, rightsizing, downsizing, strategic planning, M&A, succession planning, and eventually serving as President, CEO, and now Executive Chairman. The one role I regret not having held was Plant Management. In manufacturing, this is where the rubber meets the road.2. Does the family business still operate in its original industry, or has it pivoted/diversified into another? And what is the biggest challenge your family business has ever faced? Did being a family business make it easier or harder to meet the challenge?We were fortunate to put together a string of years of significant growth in domestic yarn spinning until the Asian currency crisis of the late 1990s decimated the U.S. textile industry. This closed many U.S. textile companies and over one million domestic jobs were lost which made it difficult, if not impossible, to compete globally. This timeframe became the greatest challenge our company had faced in its history. Customers moved offshore or closed. Over the course of time, we closed 5 yarn spinning plants and attempted to develop a greenfield facility in India. We eventually learned that the distance to India was too great to manage, and we then developed strategic partnerships to source yarn products in order to maintain our competitiveness. In the late 1980s we had acquired a small nonwovens facility and found that we could compete globally due to the low labor cost component and high freight cost barrier for our type nonwovens. As our core yarn business shrank, we pivoted to nonwovens and added another acquisition, repurposed a yarn plant, added a West Coast facility and began growing this sector successfully in the 2000s. Nonwovens manufacturing has now become our core business sector while continuing to operate a much smaller yarn spinning operation. This transition was both a challenge and a blessing.3. How often does your family business communicate to family shareholders and in what form? How have your communication practices evolved over the years?Our family business ownership is now made up of 1-2G, 3-3G, and 16-4G owners and scattered across the country. Quarterly, I provide a state of the company communication to family shareholders, and we hold an annual Family Assembly. The state of the company provides a general update on operations and business conditions. It has grown in the amount of detail provided as the 4G family owners have matured and now that a 5th generation is among us. We focus our Family Assembly on business education, business updates, and family fun. We recently executed a legal reorganization and restructuring which will help the entire family better understand their ownership interests and, with intentional education, become more adept at being engaged family owners. Included in our restructuring, we set aside 5% of our ownership for use as a long-term incentive for key managers. Our current focus is on shareholder education and engagement.4. Does your family business have any independent (non-family) directors? If so, when did you first add an independent director? What are the challenges/benefits of having independent directors?In the early 2000s, as we were morphing into another type of company and our remaining 2G family member was retiring, we engaged two outside professional advisors for an advisory board. They were not friends of the family but truly two individuals with strong business acumen that had run large family and non-family businesses. They served our purpose for 15 years, but it soon became apparent that we were approaching another crossroad.As the lone 3G family member involved in the business, I began a conscious journey of succession planning. This journey led me to the place of determining that I could serve the best interest of the company and family by stepping aside but not down. My succession plan has led to the hiring of a professional CEO and instituting a full fiduciary board made up of 3 independent outside directors, our CEO, 2-4G family shareholders, and myself. This gives us 4 non-family directors and 3 family directors. My wife also sits in on board meetings as an observer.Before family members can serve on the board, they must commit to furthering their family business education at a highly acclaimed short course. In this initial case, our 2-4G members, my wife, and I spent a week at Harvard’s Families in Business program. Of our three independent directors, two have family business experience and one has industry experience while each of them currently serve on either family business boards or public boards. They are engaged and committed to seeing us succeed and are fully committed to our Judeo/Christian value system.I think we outkicked our coverage on these board members! These last two years have brought us a professional non-family CEO and a majority non-family board that have certainly pushed management to adjust and learn to accept change. Through it all, we have communicated to our associates and our family that our culture is becoming much more accountability-based but our values are sacrosanct! They are all rising to the occasion!5. What is your best advice for other family business leaders?I have a few comments here: start your succession planning sooner rather than later (I wish I had), don’t fear the use of independent directors and/or professional managers but make sure your value systems are aligned and they bring the giftedness you need (we did and I wish I had done it sooner), educate your next-generation family board members on expectations of board membership (you can’t prepare them enough), and have your children work outside the business before joining it (I wish I had and now mine are)!
April 2020 SAAR
April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR
April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders. April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May.
SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic. NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains. With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery. Kentucky and Hawaii were also among the last states to ease online restrictions. Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time. One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market. During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop. With less than a 50% decline, dealers in America are faring better than expected. How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months. With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions. A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits. To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing. Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day
We assumed a depreciation cost associated with the vehicle sitting on the lot. Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.” For illustrative purposes, we settled on a $100 a day depreciation cost.
The following charts show a summary of the results from three present value calculations.
As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments.
If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494. That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront.
May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May. Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels. Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].” Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April. Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused. It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.
April 2020 SAAR
April Showers Bring May Flowers? High Optimism Following a Historically Low April SAAR
April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders. April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May.
SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic. NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains. With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery. Kentucky and Hawaii were also among the last states to ease online restrictions. Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time. One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market. During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop. With less than a 50% decline, dealers in America are faring better than expected. How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months. With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions. A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits. To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing. Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day
We assumed a depreciation cost associated with the vehicle sitting on the lot. Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.” For illustrative purposes, we settled on a $100 a day depreciation cost.
The following charts show a summary of the results from three present value calculations.
As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments.
If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494. That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront.
May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May. Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels. Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].” Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April. Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused. It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.
Are Public RIA Dividend Yields a Mirage?
Investors Quarantine Their Positions Despite the Search for Income, Strong Fundamentals
Twenty-five years before the marketing group at General Motors rebadged a humble Yukon to create the first Cadillac SUV, the Escalade, a body shop in California called Traditional Coach Works was modifying Coupe de Villes into a car/truck configuration they dubbed the Mirage. Whether or not anybody really needed a Cadillac to haul a 4x8 sheet of plywood was beside the point; the car was aptly named for the double-take any casual observer might have upon seeing one. The Mirage was sold through Cadillac dealers at nearly twice the cost of a standard Coupe de Ville, and in spite of that premium, buyers saw enough function in the form to order over 200 of them. A few are still around.Since the Coronavirus pandemic settled into the American consciousness in mid-March, industry pundits such as myself have been actively musing about the impact of the crisis on the RIA community. Two months later, we’ve learned:Most investment management firms can work very effectively on a virtual basis (at least for months at a time), and,The Fed is not afraid of moral hazard, and is, in fact, more than willing to socialize the cost of market disruptions (remember the other Golden Rule: whoever has the gold makes the rules).
This should be calming, even inspiring, to shareholders of investment management firms. RIA operations are mostly unaffected by this pandemic, and RIA financial performance has been supported by massive central bank intervention. None of this explains the pricing of publicly traded RIAs, however; especially when you look at the impact that slumping valuations have had on RIA dividend yields.Are we really in a yield-starved environment? One would think so, with longer dated Treasuries priced more on the basis of a return OF capital than return ON capital. The broader market has shrugged off the likelihood of steep declines in earnings, leaving the dividend yield on the S&P 500 mostly unchanged from what it was before the advent of COVID-19. RIA pricing, ironically, has not enjoyed the same support.The valuation dysphoria facing the investment management industry does not make sense. RIAs are viewed by many as an ideal growth and income asset: with durable customer relationships producing revenue streams that drift upward with financial markets, and cost structures that can be leveraged to improve distributable cash flow per dollar of revenue. Despite this very supportable investment thesis and the absence of many alternatives, the market seems to have lost interest in the RIA sector. Why?A review of comments from first quarter earnings calls does not suggest that most industry participants are getting ready to cut dividends:Silvercrest Asset Management Group(6.0% yield): “Silvercrest currently pays a generous quarterly dividend of $0.16 or an annual dividend of $0.64 per Class A share of common stock. The firm anticipates that it can support the current dividend for a sustained period of time, even while continuing to invest in the business.” – Rick Hough, Chairman and CEOWaddell & Reed (7.1% yield): “…we feel pretty comfortable with respect to the level of the dividend at this point. There's quite a difference between the cash flows that we generate versus reported net income. And at this point, we feel very comfortable with the current level of dividend, [and] the sustainability of that.” – Philip Sanders, CEOBlackrock (2.9% yield): “As we’ve previously announced in late January, we increased our quarterly cash dividend by 10% to $3.63 per share and have no plans to reduce our dividend during the remainder of the year.” – Gary Shedlin, Chief Financial OfficerFranklin Resources (5.5% yield): “…just to complete the capital management with dividends. We [intend to] keep where they are, as you know we're pretty - a sacrament to us. We want to continue to pay out [the] dividend.” – Matthew Nicholls, Chief Financial Officer
The one exception to this otherwise reassuring chorus is Invesco, which has suffered greatly from asset outflows, and recently cut its dividend in half:Invesco(7.9% forward yield): “Our decision to reduce our common dividend by 50% was done certainly with an understanding that the environment could weaken from here. It wasn’t necessarily our working assumption, but certainly we’re not thinking that we’re seeing a snap back going forward. But we don’t intend, and we certainly don’t intend to make another difficult decision like this again, and we do feel confident that this was the right action at the sufficient level to give us the flexibility that we desire to manage the balance sheet, even if the environment were to deteriorate from here, and we’ve stress tested this all which ways.” – Loren Starr, Chief Financial Officer
Whether Invesco is the bellwether or uniquely challenged remains to be seen. On the whole, it’s difficult to rationalize a business leveraged off of market performance that has become priced so differently than the market. Either the RIA industry is being unfairly punished (and therefore represents a nice yield play at these prices) or broader equity markets are due for a comeuppance, or some combination of the two.
Dividend stocks haven’t gotten much love in the growth obsessed market of the past couple of decades. But with bonds priced to yield very little, talk of negative rates, and little in the way of meaningful income from shares in other industries, the coupon-with-upside opportunity represented by public RIAs won’t go unnoticed forever. The yields available from much of the public RIA community may seem like a mirage, but they may, instead, prove to be an income oasis in the investment desert of ZIRP.
What Makes a Forecast Useful for a Family Business?
“All models are wrong; some are useful.” George E.P. Box“When the facts change, I change my mind. What do you do?” Winston ChurchillFamily businesses devote time and resources to creating forecasts and budgets to guide resource allocation and strategy decisions. Yet, the forecasts and budgets for 2020 that many family businesses spent months creating are now worthless. So managers and directors face the task of revising and updating those forecasts amid a uniquely uncertain environment.The pandemic has caused businesses to reassess all sorts of practices – should your family business re-think how it makes forecasts?Granting that all models are wrong, what can family business leaders do to make their forecasts more useful? After all, anyone can put anything into an Excel spreadsheet. Useful forecasts are products of careful analysis. Our English word “analysis” derives from the compound Greek word “ana-luein” which literally means to “loosen up” something. So a useful forecast is one that “loosens” the whole into its constituent parts for better understanding. In the remainder of this post, we provide some ideas of how to “loosen up” forecasting models to make them more useful.RevenueWhat are the component parts of revenue for your family business? The most obvious place to start for many of our clients is by breaking revenue into physical volume and unit pricing.What are the economic factors that drive demand for your family business? How has historical sales volume been correlated to some broader, objective, measure of economic activity? How has the pandemic influenced that relationship?What trends do you expect in unit pricing over the forecast period? Is your family business typically a price leader or price responder in your industry? Do you propose lower pricing in order to secure more volume in the current environment? Or, are you considering increasing price to help offset the revenue impact of reduced volumes?
Some of our clients forecast revenue by constructing a sales funnel. By examining prospect activity, they develop sales forecasts that are rooted in objective measures of the business activities that lead to sales. For example, by examining historical conversion data, one can assign probabilities to revenue at various points along the sales funnel (X% of outstanding proposals turn into sales, and Y% of 2nd meetings turn into proposals, etc.).
In any event, the goal is to reduce the general (revenue) to the specific (price/volume, lead generations, etc.). By “loosening up” total revenue into its constituent parts, family business leaders can have more meaningful conversations at the appropriate level of detail to develop objective forecasts.ExpensesThere are multiple ways to “loosen up” expenses into various components.Fixed vs variable costs. While it is true that all expenses are variable in the long run, your family business is likely committed to incurring some expenses in the short-run (rent, depreciation, etc.). Classifying expenses as fixed or variable can help identify the “breakeven” level of sales volume and can provide important perspective for long-term strategic decisions in the current environment.Expenses by functional area. Sometimes it is more fruitful to segregate expenses into functional areas (manufacturing, selling, distribution, research and development, general and administrative, etc.). This perspective allows managers and directors to focus on what resources are necessary to fulfill the functions of the business, and may highlight opportunities to explore alternative models for executing certain functions.Expenses by nature. For many businesses, operating costs can be associated with either people or “stuff.” Or somewhat more elegantly, costs can be divided into compensation and non-compensation expenses. On the compensation side of the ledger, one can then isolate headcount and compensation rate factors. This perspective can help managers and directors make strategic decisions regarding the relative use of labor and capital as means of production.
Regardless of the perspective adopted, managers should also consider whether to forecast using a percentage change relative to the prior period or a zero-base. Some advocate zero-base budgeting on an annual basis. That has always struck us as a bit extreme, but the potential value from a zero-base budgeting process is probably heightened in the current operating environment.
Useful forecasts do not focus exclusively on the trees. It is important to keep the forest in view by assessing the operating margins implied by a forecast to assess the overall reasonableness of the underlying assumptions.Cash FlowCash flow is especially critical in difficult operating environments. A useful forecast will make explicit the necessary assumptions regarding working capital management, capital expenditures, and financing obligations. Doing so will highlight just where managers and directors may be able to exercise discretion to help conserve cash and preserve liquidity during the downturn.ConclusionDoes your family business generate useful forecasts? Usefulness is not the same thing as accuracy. A forecast can be very useful even if it turns out not to be accurate, just as a forecast that – by chance – turns out to be accurate may not be terribly useful. A useful forecast is one that Churchill would approve of: one that can adapt to changing facts. A useful forecast brings the key operating and strategic decisions that your family business needs to make out of the background and into the foreground, and helps frame those decisions appropriately.Over the past two months, our family business professionals have been assisting our clients in reviewing forecasts and assessing their usefulness. If you could benefit from a fresh perspective on your forecasts, give one of our professionals a call to discuss your situation in confidence.
2020 Commodity Prices Upend 2019 E&P Bankruptcies
The recent historic decline in oil prices has strained the balance sheets of E&P companies. Whiting Petroleum Corporation, the first publicly traded U.S. E&P company to declare bankruptcy in 2020, announced its Chapter 11 reorganization process on April 1. More are expected to follow.Despite a much more benign commodity price environment of ~$50-$60/bbl in 2019, a number of E&P companies declared bankruptcy last year and have seen their reorganization processes derailed in 2020 as a result of low oil prices.Sanchez Energy DIP Financing ImpairedSanchez Energy filed for bankruptcy in August 2019, citing a misalignment between the company’s capital structure and the “continued low commodity price environment.” At the time of filing, Sanchez had approximately $2.3 billion of debt outstanding, according to Haynes Boone.As part of the bankruptcy process, Sanchez secured $200 million of debtor-in-possession (DIP) financing. DIP financing is generally senior to the company’s other indebtedness, and thus usually recovered in full. However, in light of commodity price declines caused by COVID-19’s energy demand destruction, Sanchez is only worth an estimated $85 million according to the court-approved reorganization plan. This implies a substantial impairment of the DIP financing (to say nothing of the other $2.3 billion of debt).Despite the approved reorganization plan, the ultimate ownership of the company is still in question.Alta Mesa Sale Terms RevisedAlta Mesa announced its bankruptcy in September, a month after Sanchez, citing a need to “reorganize its capital structure.” According to Haynes Boone, Alta Mesa’s debt totaled $871 million.Alta Mesa received a $310 million stalking horse bid on December 31 from a joint venture between Mach Resources (an E&P company) and Bayou City Energy (a private equity firm). The joint venture won the subsequent auction in January 2020, bidding $320 million, but was unable to secure the necessary financing amid the initial stages of the Saudi/Russian price war in March. The sale ultimately went through, but at a $100 million discount.EP Energy Restructuring Plan ScrappedEP Energy, an Eagle Ford and Permian-focused producer, filed for bankruptcy in October. The company was spun out from El Paso Corp. during 2012 in a leveraged buyout (LBO) led by Apollo and subsequently taken public in 2014. The LBO left EP Energy with a massive debt balance, which stood at $7.3 billion per Haynes Boone.EP Energy’s restructuring plan was approved on March 6, the same day Saudi Arabia and Russia failed to come to terms on an OPEC+ supply cut. It soon fell apart, as Apollo and other financial backers pulled out.The company has submitted a motion requesting an extension, which would give EP Energy until October 31, 2020 to file a revised restructuring plan.Approach Resources Buyer Backs OutApproach Resources was the last U.S. public E&P to file for bankruptcy in 2019, seeking to explore strategic alternatives including “the restructuring of its balance sheet or the sale of its business” as stated in its November press release. The company received a stalking horse bid of $192.5 million from Alpine Energy Capital in February. The court approved the sale in early March. Later in the month, Alpine announced that it was terminating the agreement. The approach subsequently sought to force Alpine to complete the purchase.The matter has not yet been resolved.ConclusionRecent commodity price volatility has driven certain E&P producers to file for bankruptcy and has prevented several more from emerging. While prices have bounced back from recent lows, they remain below breakeven costs for many producers. As such, we expect to see continued bankruptcy filings and protracted restructuring processes.If you want to learn more about the valuation side of the bankruptcy process, and how we at Mercer can use our years of experience in bankruptcy and the oil & gas industry to help you emerge from Chapter 11 well-prepared for future success, contact one of our valuation analysts for a confidential discussion.
Complex Valuation Issues in Auto Dealer Litigation
Solving the Puzzle
Litigation engagements are generally very complex, consisting of many moving parts. The analogy that comes to mind is the nostalgic game of Tetris. While invented in 1984 by a Russian named Alexey Pajitnov, most of us remember the iconic version popularized through the Nintendo Gameboy in the 1990s. The game featured seven game pieces cascading down at increasing speed forcing the game player to manipulate them by rotating and placing them, trying to create a flat surface. As anyone that has played can attest, the game creates more anxiety and stress as the pieces cascade faster and begin to pile up.Like the game, many clients involved in auto dealer valuation disputes also experience anxiety and stress as problems begin to pile up. When assisting these clients in our family law and commercial litigation practices, we strive to help alleviate the pain points, or “clear the blocks.”We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes.The following topics, posed as questions, have been points of contention or common issues that have arisen in recent litigation engagements. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.We begin with seven questions to represent each of the original Tetris pieces, and we’ve added two questions to consider additional issues raised during the COVID-19 crisis.Should Your Expert Witness Be a Valuation or an Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts – one for the plaintiff and one for the defendant. In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry.
It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques. Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)1 or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples.
Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy. Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy. The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer. For example, a luxury or high-line franchise in a smaller or rural market would not be expected to fare as well as one in a market that has a larger and wealthier demographic.
In certain markets, an understanding of the local economy/industry is more important than an understanding of the overall auto dealer industry and national economy. Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the dealership.
If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon? Many of the corporate entities involved in litigation have sophisticated governance documents that include operating agreements, buy-sell agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigation, the focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value. However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers.
Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document? These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. If they’ve never been used, and don’t conform to accepted valuation methodologies for auto dealers, then how reliable can these be?
Additionally, some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney.
Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an automotive dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.
An important consideration is the motivation of the buyer and seller in these internal transactions. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.
What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing. The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, the stated value by the dealer principal on their personal financial statement provides another data point to valuation.
One view of a personal financial statement is that no formal valuation process was used; so at best, it’s a thumb in the air, blind estimate of value of the business. The opposing view would say the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in a document under penalty of perjury. Further, some would say that the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business. While they are not business appraisers, they are instrumental to a valuation expert’s understanding of risk and growth in their business.
It’s never a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The value indicated in a personal financial statement should be viewed in the light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as national and local economy to explain the difference and changes in values over time. If an expert opines the value is X, but the personal financial statements says 3X or 1/3X, an expert must be prepared to explain the difference.
Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data?
The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries. As such, any sole comparison to general industry profitability data should be avoided. If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this could be problematic. RMA’s studies are organized by the North American Industry Classification System (NAICS). Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data may do the trick in certain industries, but most dealers sell both new and used vehicles. Further, RMA does not distinguish between different franchises.
The National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data. However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships, and Mass Market Dealerships.
While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available.
Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than actual profitability of the business.
The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming.
If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000. At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified.
For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101.
What Is the Date of Valuation and Why Does It Matter? Depending on the state, family law matters might require the date of valuation to be the date of filing, the date of separation, the date of the trial (current), or some other date. Commercial litigation can require the date of valuation to be the date of a certain event, the date of trial (current), or some other date. Why does the date matter? In addition to the standard of value (generally fair market value or fair value), a business valuation contemplates a premise of value – often a going-concern business. The business appraiser must use the relevant known and knowable facts at the date of valuation to incorporate into a valuation conclusion. These facts reflected in historical financial performance, anticipated future operations, and industry/economic conditions can differ depending on the proper date of valuation.As we are all experiencing during COVID-19, the conditions of March/April 2020 are vastly different than year-end 2019. It would be incorrect, however, to consider the impact of COVID-19 for a valuation date prior to Spring 2020.How Have Auto Dealer Valuations Been Affected by COVID-19? Valuations of auto dealers involve many factors. We also try to avoid absolutes in valuation such as "always" and "never." The true answer to the question of how auto dealer valuations have been affected by COVID-19 is “It Depends.”As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a barometer. Depending on the day, the stock market has declined anywhere between 20-30% during that time from previous highs. Specific indicators of each auto dealer, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.The litigation environment is already rife with doom and gloom expectations and we’ve previously written about the phenomenon referred to as divorce recession in family law engagements. While some auto dealers may go out of business as a result of COVID-19, the valuation of most may be deflated from prior indications of value, but generally, the conclusion is not zero. As always, it depends on the specific facts and circumstances of each particular auto dealer under examination.Putting It All TogetherAs with all litigation engagements, the valuation of automobile dealerships can also be complex. A deep knowledge of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. Understanding how these components fit together is important to a successful resolution, just like the assembly and combination of pieces in a game of Tetris. If you have a valuation issue, feel free to contact us to discuss it in confidence.1 DCF methodology might have to be considered in the early stages of a Company’s lifecycle where the presence of historical financials either does not exist or are limited.Images by DevinCook via Wikimedia Commons
Middle Market Transaction Update Fourth Quarter 2019
Overall transaction value and volume in the middle market in the fourth quarter of 2019 increased slightly from levels observed in the third quarter of the year, and deal value increased to its highest level over the observed historical period.
Opportunity Times Two?
Estate Planning Opportunities Abound as a Result of Low Valuations and Low Interest Rates
If a window of opportunity appears, don’t pull down the shade.
– Management guru Tom PetersAs family business leaders tackle the many operating challenges thrust upon them by the COVID-19 pandemic, it is tempting to let tasks like estate planning fall to the bottom of the to-do list. While estate planning may appear to be less pressing than other issues, the positive impact of effective planning on the long-term health of both the family and the family business is hard to overstate. If you are confident in the long-term resilience of your family business, you should not miss the current opportunity for tax-efficient estate planning activity.We’ve discussed the impact of coronavirus on fair market value in a recent post. While the S&P 600 small cap index has gained a bit over 20% since we wrote that post, the index remains nearly 30% below its February peak. So valuations for many family businesses remain favorable for tax-efficient planning.
Normally, stock prices and interest rates are inversely related. In other words, lower stock prices are often correlated with higher interest rates. However, thus far in 2020, we have witnessed both lower stock prices and lower interest rates. As described in a recent article from law firm Baker Hostetler, low interest rates further increase the efficiency of estate planning techniques such as intra-family loans, sales to grantor trusts, grantor retained annuity trusts, and charitable lead annuity trusts.
The IRS publishes monthly tables identifying what is known as the applicable federal rate, or AFR. The AFR is significant for estate planning because it established the threshold interest rate for private loans. Exhibit 2 summarizes monthly AFR rates in 2020.
Mid-term AFR rates (applicable to loans with terms up to nine years) have fallen from 1.75% in February to 0.58% in May. A quick example will illustrate the “double opportunity” for family shareholders provided by lower valuations and lower interest rates.First, assume that a family shareholder sells shares having a fair market value of $10 million to a family member in exchange for an eight-year note at the AFR rate of 1.75%. The expected total return on the shares at that date was 8.0%. Exhibit 3 presents the net shares transferred to the family member over the life of the note, assuming that shares are used to repay the note.Since the appreciation on the family business shares exceed the AFR, the borrower is able to service the debt and repay the note at the end of the term using only a portion of the shares owned, retaining approximately $6.6 million worth of shares in the family business.Exhibit 4 assumes that a similar transaction is undertaken in May 2020, with three differences:Because the share value is lower ($75 per share, compared to $100 per share in Exhibit 3), the acquirer is able to purchase a greater number of shares for the same $10.0 million price (133,333 shares, compared to 100,000 shares in Exhibit 3).Since the family business is assumed to be resilient, the current lower share price is expected produce higher future capital appreciation (10%, versus 8% in Exhibit 3). Under this assumption, the terminal share value in Exhibit 4 ($160.77) remains approximately 13% less than the corresponding value in Exhibit 3 ($185.09). Expected annual appreciation of 12% would result in equivalent terminal share values.The lower AFR reduces annual interest expense on the note by $117,000, which reduces the drag on returns from the family business shares.The hypothetical May transfer results in an additional $4.1 million of value transferred relative to the hypothetical February transfer. Approximately 68% of this increase is attributable to the lower share value (and correspondingly higher expected returns), with the balance attributable to the reduction in the AFR.ConclusionWe are not tax advisors, and the simple example in this post is intended only to illustrate the relative contribution of lower share values and lower interest rates on potential estate planning outcomes. Consult your tax planning professionals today to discuss how best to take advantage of the “double opportunity” presented by depressed share prices and low interest rates. Many strategies will require a current valuation of your family business, and our professionals are here to help.For those families that are confident in the ability of their family business to survive and thrive in a post-COVID 19 world, the window of opportunity is clearly open. Don’t pull the shade.
Revolution or Evolution: COVID-19 Pushing Auto Dealers into the 21st Century
While making a trip to the grocery this past week, I came across a billboard that caught my eye, but not for the right reasons. An advertisement had been recently removed, exposing a much older advertisement beneath. It was a 3-videos-for-$5 ad from Blockbuster. It provoked an instant sense of nostalgia as I remembered going with my family to pick out movies on Friday nights. Unfortunately, this old ad now serves as a cautionary tale of what can happen to businesses that aren’t able to keep up with ever-evolving consumer demands.
Blockbuster had the chance to keep up by buying Netflix for $50 million in September of 2000, but the CEO thought it was a joke. Now with a market cap of $130 billion (as of May 1st), due to the influx of streaming demand, Netflix’s worth now surpasses Disney’s. The same cannot be said for Blockbuster, which shut down for good in 2014. Every industry faces the Blockbuster/Netflix dilemma at some point as they try to innovate to keep up with the changing times and stay relevant. The next big thing is always easier to see with the benefit of hindsight.
The most recent of these changes has been in the retail space with the “retail apocalypse,” as brick-and-mortar stores are closing their doors as consumers opt for the ease of online purchases. Although initially evading the switch, the current COVID-19 pandemic has auto dealers scrambling to find ways to maintain sales as stay-at-home orders are keeping customers from the dealership. To move vehicles off the lot, dealerships have been pushed into a new era of online car sales. While many auto dealers have only somewhat dipped their toe into the digital space, they have now been pushed off the deep end. As Plato once said: "Necessity is the mother of invention."
Early Modelers of Online Car SalesBefore the coronavirus outbreak, the two major players in online car sales were Carvana and Tesla. Though both engage with their customers primarily through electronic platforms, their business models differ. Founded in 2013, Carvana now boasts an inventory of over 29,950 used vehicles that can either be delivered to customers or picked up in one of their vending machines. Customers can even get approved for financing online. The company is now live in 146 markets and has doubled revenue in each quarter since its founding. Their ability to provide a larger selection of vehicles than traditional used car dealerships has helped it expand to the third-largest used-car retailer in the country. They also only sell used cars, which differentiates them from traditional dealers and may ultimately be more profitable. Gross profits for used vehicles are higher than for new vehicles. While Carvana operates as a virtual dealership for used cars, Tesla was founded in 2003 and operates as a manufacturer that eliminates the need for dealerships all together with its direct to consumer online sales strategy. Tesla has also experienced considerable revenue growth, and like Carvana, sports a lofty valuation compared to the traditional auto dealers.Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019.While not frequently employed in the valuation of auto dealerships, Tesla’s revenue multiple is 6.2x, compared to 0.5x or below for the five most traditional players. Carvana’s revenue multiple of 1.7x is also significantly higher despite negative earnings even before interest, taxes, depreciation, and amortization (EBITDA). While both of these companies likely command higher multiples due to their growth characteristics, their business models also appear to be weathering the coronavirus as Tesla’s share price is up 88% and Carvana’s is up 15% since the end of 2019, while traditional auto dealers are down at least 25%.How Auto Dealers Are RespondingWhile these two companies used to be the outsiders, the pandemic has forced many auto dealers to follow in their footsteps. Fiat Chrysler launched a new online sales program this month that allows customers to go through the car buying process online. The purchased vehicle can be delivered to their home without a visit to the dealership, similar to the model Carvana and Tesla follow. Mark LaNeve, Ford Motor Co.’s U.S. Chief of Sales told Reuters that “around 93% of Ford’s 3,100 U.S. dealers are doing some or all aspects of sales online, from virtual tours to financing and home delivery, as the pandemic has shuttered showrooms in a growing number of states.” General Motors has increased efforts toward their online sales program, “Shop, Click, Drive,” that launched in 2013 but had not gained much traction. Other automakers such as Porsche have announced additional incentives for dealers to conduct digital sales as well.Looking Long-TermWith all the different measures being taken to bring car sales online, it is clear that dealerships are willing and able to provide this experience to their customers. However, there are significant costs in these changes, such as technology investment and retraining costs. Furthermore, while dealerships may be able to cut costs in the long-term by not having to utilize personnel to sell vehicles, this would have an adverse impact on employment. An example of this is Amazon’s effect on retailers with total retail employees declining by nearly 200,000 since 2017. The main concern and million-dollar question keeping auto dealers from fully investing in online business is this: Will consumers buy into an online model for the long-haul?Although a heavy investment into online technology may prove beneficial during this pandemic, if things return to “normal” and consumers revert to old buying preferences, dealerships might end up with large sunk costs.For many dealers, the switch to online vehicle shopping has been a long time coming.There are differing opinions regarding whether COVID-19 will lead to a long-term switch in consumer vehicle purchase preferences. For many dealers, the switch to online vehicle shopping has been a long time coming. With consumers being more tech-savvy than ever, e-commerce retail sales as a percent of total sales has grown steadily over the years, reaching 11.4% in Q4 2019. Rhett Ricart, CEO of Ricart Automotive in Columbus, Ohio, and chairman of the National Auto Dealer Association, believes that the coronavirus pandemic “is going to fundamentally change how people view buying a car.” Additionally, he predicts that “By the end of the year, you’re going to see 80%-90% of U.S. new car dealers with full e-commerce capability in their shop” to handle everything online except for the test drive and maybe the final signature. Online sales at his dealership have doubled since the pandemic started to ramp up. Certain data points support this assumption.Before the pandemic struck, 61% of car buyers say that the car buying experience was not better, and sometimes worse, than the last time they purchased a vehicle. A key area of frustration for buyers is how long it takes to purchase a vehicle from the paperwork to negotiation. The cross-selling many dealerships employ to increase profits can also grate on some consumers who don’t want to be upsold. With digital retailing allowing dealerships to reduce the time it takes to buy a car, this could end up alleviating a consumer pain point.While some dealers are more bullish on their predictions for the online vehicle sales market, others remain skeptical. David Smith, CEO of Sonic Automotive, has noted that although consumers can conduct a majority of the sales process online, he has doubts over whether this sales model will be long lasting. “It is such a large purchase for most people,” he said. “It’s not like going to the grocery store. It’s a big deal. It’s a big purchase. People like to see it and browse.” He might be onto something, with 79% of buyers waiting but still willing to buy, there are a whole lot of potential car buyers holding out even though many dealers have gone online. And with the average monthly car payment for a new car being around $550, it’s reasonable that a customer wants to see the car in person before they make such a big commitment. Furthermore, considering that Carvana has yet to turn a profit, and Tesla has only achieved a narrow profitability in the past year, there are still many uncertainties on the success of online vehicle sales.ConclusionUltimately, the jury is still out on whether we are witnessing a revolution in the auto industry such as we saw with Blockbuster and online streaming, or simply an evolution into more tech-savvy dealerships. While we doubt the pandemic will be enough to radically push the entire process online for all consumers, we do believe certain benefits of digital are here to stay.Most auto dealers are trying to find ways to offer customers vehicles in any way they can. The adoption of e-commerce tools for dealerships, even in the short-run, can help to show consumers that dealerships are willing to go the extra mile in order for them to be comfortable making a purchase during this difficult time.After beginning with a Plato quote, I thought it would be fitting to end with one as well: "There are two things a person should never be angry at, what they can help, and what they cannot." In the midst of this unprecedented global pandemic, I find it to be a timely reminder.
Ernest Hemingway, Albert Camus, and Credit Risk Management
In the March 2020 Bank Watch, we provided our first impressions of the “reshaping landscape” created by the COVID-19 pandemic and its unfolding economic consequences.This month, we expand upon the potential asset quality implications of the current environment. One word that aptly describes the credit risk environment is inchoate, which is defined as “imperfectly formed or formulated” or “undeveloped.”We can satiate our analytical curiosity daily by observing trends in positive COVID-19 cases, but credit quality concerns created by the pandemic and its economic shocks lurk, barely perceptible in March 31, 2020 asset quality metrics such as delinquencies or criticized loans.However, the pandemic’s effect on bank stock prices has been quite perceptible, with publicly-traded bank stocks underperforming broad-market benchmarks due to concerns arising from both asset quality issues and an indefinite low interest rate environment.Bridging this gap between market perceptions and current asset quality metrics is the focus of this article.At the outset, we should recognize the limitations on our oracular abilities.Forward-looking credit quality estimates now involve too many variables than can comfortably fit within an Excel spreadsheet—case rates, future waves of positive diagnoses, treatment and vaccine development, and governmental responses.The duration of the downturn, however, likely will have the most significant implications for banks’ credit quality.We neither wish to overstate our forecasting capacity nor exaggerate the ultimate loss exposure.We recognize that transactions are occurring in the debt capital markets involving issuers highly exposed to the pandemic’s effects on travel and consumption—airlines, cruise operators, hotel companies, and automobile manufacturers.Investors in these offerings exhibit an ability to peer beyond the next one or two quarters or perhaps have faith that the Fed may purchase the issue too.To assess the nascent credit risk, our loan portfolio analyses augment traditional asset quality metrics with the following:Experience gleaned from the 2008 and 2009 Great Financial CrisisCollateral and industry concentrations in banks’ loan portfolios“The World Breaks Everyone and Afterward Many Are Strong in the Broken Places”A Farewell to Arms (1929) by Ernest Hemingway, which provides the preceding quotation, speaks to a longing for normality as the protagonist escapes the front lines of World War I.While perhaps a metaphor for our time, the quotation—with apologies to Hemingway—also fits the 2008 to 2009 financial crisis (“the world breaks everyone”) and uncertainties regarding banks’ preparedness for the current crisis (will the industry prove “strong in the [formerly] broken places”?).To simulate credit losses in an environment marked by a rapid increase in unemployment and an abrupt drop in GDP, analysts are using the Great Financial Crisis as a reference point.Is this reasonable?Guardedly, yes; in part because no preferable alternatives exist.But how may the current crisis develop differently, though, in terms of future loan losses?Table 1 presents aggregate loan balances for community banks at June 30, 2002 and June 30, 2007, the finalperiod prior to the Great Financial Crisis’ onset.One evident trend during this five year period is the grossly unbalanced growth in construction and development lending, which led to outsized losses in subsequent years.Have similar imbalances emerged more recently?We can observe in Table 2 that loans have not increased as quickly over the past five years as over the period leading up to the Global Financial Crisis (67% for the most recent five year period, versus 90% for the historical period).Further, the growth rates between the various loan categories remained relatively consistent, unlike in the 2002 to 2007 period.The needle looking to pop the proverbial bubble has no obvious target.Using the same data set, we also calculated in Table 3 the cumulative loss rates realized between June 30, 2008 and June 30, 2012 relative to loans existing at June 30, 2008.This analysis indicates that banks realized cumulative charge-offs of 5.1% of June 30, 2008 loans, although this calculation may be understated by the survivorship bias created by failed banks.The misplaced optimism regarding construction loans resulted in losses that significantly exceeded other real estate loan categories.Consumer loan losses are exaggerated by certain niche consumer lenders targeting a lower credit score clientele.Are these historical loss rates applicable to the current environment?Table 4 compares charge-off rates for banks in Uniform Bank Performance Report peer group 4 (banks with assets between $1 and $3 billion).Loss rates entering the Great Financial Crisis and the COVID-19 pandemic are remarkably similar.We would not expect the disparity in loss rates between construction and development lending versus other real estate loan categories to arise again (or at least to the same degree).Community banks generally eschew consumer lending; thus, consumer loan losses likely will not comprise a substantial share of charge-offs for most community banks.For consumer lending, the credit union industry likely will experience greater fall-out if unemployment rates reach the teens. Regarding community banks, we have greater concern regarding the following:Commercial and industrial lending. Whether due to business opportunities or regulatory pressure to lessen commercial real estate concentrations, we have observed shifts in portfolios in favor of C&I lending and are uncertain regarding the maintenance of underwriting standards.Some evidence also exists that C&I loan losses were increasing prior to the crisis, although the impact appeared episodic. Commercial real estate. While we can claim no originality, our analyses currently emphasize borrower and collateral types to identify sectors more exposed to COVID-19 countermeasures.We recognize, though, that this can obscure important distinctions.For example, hotels reliant on conference attendance likely are more exposed than properties serving interstate highway stopovers.Further, we expect that the pandemic will alter behavior, or accelerate trends already underway, in ways that affect CRE borrowers, whether that is businesses normalizing Zoom calls instead of in-person meetings or consumers shifting permanently from in-store to on-line shopping.In the Great Financial Crisis, banks located in more rural areas often outperformed, from a credit standpoint, their metropolitan peers, especially if they avoided purchasing out-of-market loan participations.This often reflected a tailwind from the agricultural sector.It would not be surprising if this occurs again.Agriculture has struggled for several years, weeding out weaker, overleveraged borrowers.
Additionally, to the extent that the inherent geographic dispersion of more rural areas limits the spread of the coronavirus, along with less dependence on the hospitality and tourism sectors, rural banks may again experience better credit performance.“They fancied themselves free, and no one will ever be free so long as there are pestilences.”The Plague (1947) by Albert Camus describes an epidemic sweeping an Algerian city but often is read as an allegorical tale regarding the French resistance in World War II.Sales of The Plague reportedly have tripled in Italy since the COVID-19 pandemic began, while its English publisher is rushing a reprint as quarantined readers seek perspective from Camus’ account of a village quarantined due to the ravaging bubonic plague.As Camus observed for his Algerian city, we also suspect that banks will not be free of asset quality concerns so long as COVID-19 persists.Another source of perspective regarding the credit quality outlook comes from the rating agencies and SEC filings by publicly-traded banks:Moody’s predicts that the default rate for speculative grade corporate bonds will reach 14.4% by the end of March 2021, up from 4.7% for the trailing twelve months ended March 31, 2020.This represents a level only slightly below the 14.7% peak reaching during the 2008 to 2009 financial crisis.1Fitch projects defaults on institutional term loans to reach $80 billion in 2020 (5% to 6% of such loans), exceeding the $78 billion record set in 2009.2Borrowers representing 17% of the commercial mortgage-backed security universe have contacted servicers regarding payment relief.Loans secured by hotel, retail, and multifamily properties represent approximately 75% of inquiries.Fitch also questions whether 90-day payment deferrals are sufficient.3Delinquent loans in commercial mortgage backed securities are projected to reach between 8.25% and 8.75% of the universe by September 30, 2020, approaching the peak of 9.0% reported in July 2011.4The delinquency rate was 1.3% as of March 2020.Fitch identified the most vulnerable sectors as hotel, retail, student housing, and single tenant properties secured by non-creditworthy tenants.Among these sectors, Fitch estimates that hotel and retail delinquencies will reach approximately 30% and 20%, respectively, relative to 1.4% and 3.5% as of March 2020.The prior recessionary peaks were 21.3% and 7.7% for hotel and retail loans, respectively.For multifamily properties, Fitch projects that bad debt expense from tenant nonpayment will exceed 10%.However, Fitch notes that its delinquency estimates do not consider forbearances.Fitch estimates that hotel loans with a pre-pandemic debt service coverage ratio (DSCR) of less than 2.75x on an interest-only basis are at risk of default.Guarantor support may limit the ultimate default rate, though.Retail and multifamily loans with a pre-pandemic DSCR of less than 1.75x and 1.20x, respectively, on an interest-only basis are at risk of default.Fitch did not apply any specific coronavirus stresses to office or industrial properties.5Among banks releasing industry exposures, Western Alliance Bancorp (WAL) reported the largest hotel concentration at 8.5% of total loans.Data provider STR reported a 79% year-over-year decline in revenue per available room for the week ended April 18, 2020, reflecting a 64% decline in occupancy (to 23%).6First Financial Bancorp (FFBC) reported the largest retail concentration among banks reporting such granular detail at 16% of total loans.Numerous other banks reported concentrations between 10% and 15% of total loans.7Banks tend to be senior lenders in borrowers’ capital structure; thus, the rating agency data has somewhat limited applicability.Shadow lenders like business development companies and private credit lenders likely are more exposed than banks.Nevertheless, the data indicate that the rating agencies are expecting default and delinquency rates similar to the Great Financial Crisis.As for Camus’ narrator, the ultimate duration of the pandemic will determine when normality resumes.Lingering credit issues may persist, though, until well after the threat from COVID-19 recedes.ConclusionCommunity banks rightfully pride themselves as the lenders to America’s small business sector.These small businesses, though, often are more exposed to COVID-19 countermeasures and possess smaller buffers to absorb unexpected deterioration in business conditions relative to larger companies.Permanent changes in how businesses conduct operations and consumers behave will occur as new habits congeal.This leaves the community bank sector at risk.However, other factors support the industry’s ability to survive the turmoil:Extensive governmental responses such as the PPP loan program provide a lifeline to small businesses until conditions begin to recover.The industry enters this phase of the credit cycle with fewer apparent imbalances than prior to the Great Financial Crisis.A greater focus since the Great Financial Crisis on portfolio diversification and cash flow metrics proves that lessoned were learned.The smaller, more rural markets in which many community banks operate may prove more resilient, at least in the short term, than larger markets.Permissiveness from regulators regarding payment modifications will allow banks to respond sensitively to borrower distress.Nonetheless, credit losses tend to be episodic for the industry, occurring between long stretches of low credit losses.The immediate issue remains how high this cycle’s losses go before returning to the normality that ensues in Hemingway and Camus’ work after war and pestilence.1 Emmanuel Louis Bacani, “US Speculative-Grade Default Rate to Jump Toward Financial Crisis Peak – Moody’s,” S&P Global Market Intelligence, April 24, 20202 Fitch Ratings, U.S. LF/CLO Weekly, April 24, 2020.3 Fitch Ratings, North American CMBS Market Trends, April 24, 2020.4 Fitch Ratings, U.S. CMBS Delinquencies Projected to Approach Great Recession Peak Due to Coronavirus, April 9, 2020.5 Fitch Ratings, Update on Response on Coronavirus Related Reviews for North American CMBS, April 13, 2020.6 Jake Mooney and Robert Clark, “US Banks Detail Exposure to Reeling Hotel Industry in Q1 Filings,” S&P Global Market Intelligence, April 24, 20207 Tom Yeatts and Robert Clark, “First Financial, Pinnacle Rank Among Banks with Most Retail Exposure,” S&P Global Market Intelligence, April 27, 2020
Originally published in Bank Watch, April 2020.
A Reshaping Landscape
March 2020 probably will prove to be among the most dramatic months for financial markets in US history.Likewise, the fallout for banks may take a year or so to fully appreciate.Nonetheless, in this issue of BankWatch, we offer our initial thoughts as it relates to the industry.Market Performance U.S. equity markets have entered a bear market, the definition of which is a drop of at least 20%.As of March 27, 2020, the S&P 500 had declined 21% year-to-date and the Russell 2000 was down 32%.Not surprisingly banks have fared worse with the SNL Large Cap Bank Index falling 39% given the implications for credit because of the government’s mandated shutdown of broad swaths of the economy due to COVID-19.Bear markets vary in length and depend upon the severity of the economic downturn, the value of assets before the downturn started, and policy responses among other factors.The 2001 recession, which was shallow, started in March and ended in November according to government statisticians; however, the bear market for equities as measured by the S&P 500 was brutal (-49%) that ran from March 2000 to November 2002. Banks trended modestly higher during 2000-2002 because they entered the downturn cheap to their late 1990s valuations and because real estate values did not fall. The Great Financial Crisis (“GFC1”) that ran from August 2007, when the Bear Stearns hedge funds failed, through year-end 2009 entailed a bear market that saw a 57% reduction in the S&P 500 between October 2007 and the bottom on March 9, 2009.Economists tell us the recession occurred from year-end 2007 throughJune 30, 2009.Unlike 2000-2002, banks were a disaster for investors because credit losses were high, and many had to raise equity at low prices to survive.We do not know how much further bank stocks may fall if at all from late March in what we are taking liberty to define as GFC2.Figure 1 provides perspective on how banks—here defined as SNL’s Small Cap US Bank Index—performed in the two-year period ended March 9, 2009, and March 27, 2020. During GFC1 the bank index fell almost 70% to when the bear market ended. (March 9 was near the date when FASB eased mark-to-market rules and the Obama Administration signaled it would not nationalize the banks.)By contrast the bank index traded sideways between March 2018 and early 2020 before plummeting about 40% at the lowest point in March as investors rushed for the exits as economic activity crashed. Massive intervention in the markets by the Fed has arrested the decline in financial assets for now, but in doing so the important market function of price discovery and therefore capital allocation has been distorted. Revaluation of BanksRelative to history banks are cheap, but that does not mean they cannot get cheaper.Alternatively, valuation multiples may rise because EPS and TBVPS fall more than share prices fall or even trade sideways or higher from here.Presumably GFC2 will be like GFC1 and most bear markets in which prices fall in anticipation of earnings that will decline later as the market discounts fundamentals that are expected to prevail 6-18 months in the future.As of late March, bank stocks were cheap to long-term average multiples with small cap banks trading for 9.4x trailing 12-month earnings and 105% of TBV compared to 7.9x and 122% for the large cap bank index.Dividend yields around 4% are enticing, too, but the downturn could be sufficiently severe to force widescale dividend cuts.We do not know and will not know until the future arrives. Interestingly, small cap banks as of March 27 were trading below the March 9, 2009, bottom at 105% of TBV vs. 118% nine years ago.Net Interest Margins—Lower for LongerPerhaps one of the more depressing expectations for banks is not that credit losses will increase but the Fed promise that short-term rates will remain anchored near zero for the foreseeable future.As shown in Figure 3, the market expects 30/90 day LIBOR to fall from current distressed levels in excess of 1.0% to around 0.3% within a few months and remain anchored there for a couple of years.Those who follow the forward curves know that forward rate expectations can change quickly.Nonetheless, the market today expects LIBOR benchmark rates (and SOFR) to fall toward the Fed Funds target range.Our expectation is that NIMs may fall below the last cycle low of ~3.5% recorded in 1H09 because asset yields are much lower today than in 2008 when the GFC1 was gathering steam.Likewise, deposit rates can be cut somewhat but they, too, are much lower now than was the case in 2008.By way of comparison the NIM for banks with $1 billion to $10 billion of assets in 4Q06 was 3.74% according to the FDIC.By 1H09 the NIM for the group had declined to less than 3.4%.As of 4Q19 the NIM was 3.67%.Credit—Regulatory Forbearance PossibleWe do not know how high credit costs will go.According to the FDIC, losses approximated 2% of loans in 2009 for banks with $1 billion to $10 billion of assets and 3% for banks with $10 billion to $250 billion of assets.Losses were especially high in C&D portfolios because residential mortgage was the epicenter of the last downturn.This time more asset classes look to be at risk because a deflationary shock has been unleashed on the global economy. The hardest hit sectors within most bank loan portfolios will be hotels and restaurants as part of the travel and leisure industry that has been impacted the most by COVID-19.Among a subset of banks in the Southwest, Dakotas and Appalachia potentially will be sizable losses in energy-related credits as oil and gas are at the epicenter of this deflationary shock. Retail CRE will see more problem assets, too, as the shutdown accelerates the shift to digital commerce. An unknown element is how shifts in consumer and business behaviors may impact credit losses.One surprise from the last recession was the move by consumers to pay auto and credit card loans while defaulting on mortgages in order to commute to work and maintain access to revolving credit.Previously consumers would default on other borrowings to save the home. The behavior was an admission by many consumers that they overpaid for houses and were willing to return to renting. In this downturn maybe consumers will let auto loans go because the average auto loan is much larger and has a longer duration than a decade ago, and ride sharing lessens the need for a car.Businesses may decide that much less office space is needed as employees become more adept at working remotely.In short, it is easy to construct a scenario in which credit losses are higher than those experienced during 2008-2010, but it is too early to know for certain.One interesting market data point arguing perhaps not is high yield bonds.The option-adjusted spread (“OAS”) on the ICE BofA High Yield Index peaked on March 23 at 1087bps versus 1988bps in November 2008.If credit losses are notably higher than what was experienced in 2008 then an informal form of regulatory forbearance may be allowed in which losses are slowly recognized to protect capital.Past precedence includes the Lesser Developed Country (“LDC”) crisis of the early and mid-1980s in which money center banks took 5-6 years to write-off large exposures to LDCs as a result of a collapse in oil and commodity prices.Capital and DividendsAs shown in Figure 5, US banks are much better capitalized today than at year-end 2006 immediately before GFC1 began.Ironically, the severely adverse scenario in the DFAST-mandated stress tests will be tested given the magnitude of the economic shut-down.All 18 large-cap banks that were subjected to the Fed’s 2019 test passed with leverage ratios bottoming over an eight-quarter period in the vicinity of 6-7%.Results can be found at the following link http://mer.cr/2JswW1d.A secondary issue is the outlook for common and preferred dividends.We expect first quarter and perhaps second quarter dividends to be paid; however, beginning in the third quarter dividend reductions and omissions are possible if not probable once a better estimate of losses is developed.Aside from written agreements with regulators that preclude payments we assume sub debt coupon payments will continue to be made because a missed coupon payment is an event of default unlike trust preferred securities that provided issuers 20 quarters to miss a payment without tripping a default.M&A—Down but Eventual UpturnFinally, M&A will become more imperative among commercial banks as NIMs go much lower.Executives of Truist Financial Corporation likely are relieved that the respective boards of directors of SunTrust and BB&T had the courage to combine to extract significant cost savings on what will be a lower run-rate of revenues than originally envisioned.As for investors and M&A participants, the challenge as always will be first to think about earning power rather than next year’s estimate and what is a reasonable valuation in terms of earning power.That, of course, is easier said than done when markets are rapidly repricing for a new order.
Originally published in Bank Watch, March 2020.
Uncharted Valuation Territory: What Is A Barrel Or An Acre Worth Today?
Even with Saudi estimations of a 20-million-barrel supply cut, times are tumultuous for the oil and gas industry. News earlier this month was met with no rise in West Texas Intermediate pricing at the time. It hovered around $20.00 per barrel. Last week it fell to the seemingly unconscionable negative territory. It was worse in other places. In Western Canada heavy select oil was around $4.50 per barrel and dropped to $0 last week. It went negative as well.That was not a typo. (The only beacon of “normalcy” was Brent was still trading above $25 per barrel.)World demand for oil has dropped somewhere between 20% and 35% by some estimations, and excess supply has been building for weeks. Thus, we may not even be at the nadir of the market shock. When the smoke clears from this explosive market disruption, there will possibly be some major market ripple effects such as swaths of the Canadian oil market (1.5 million barrels per day) and U.S. backyard “stripper” wells (representing 10% of total U.S. production) permanently going offline, representing a material change in U.S. supply going forward.Something must give, and something will. While global supply and demand imbalance has the industry scrambling in unseen territory, how does this convert to what upstream companies and reserves are worth amid the situation? Is it a 1:1 price to value change ratio? Depending on perspective, the answer is both simple and complicated.Not surprisingly, most potential or actual sellers of upstream assets and companies are praying that they don’t have to find out. Translation: they hope the market will correct itself before they choose (or have) to sell. The reasons for this are multifold. The obvious rationale is that the value of today’s production could fetch the lowest relative prices seen in decades. Secondary rationale is that tomorrow’s production, i.e. reserves, are being hit even harder. Those reserves represent the optionality, expectations, and hopes of an investor for a brighter market tomorrow. Therefore, sellers don’t want to give that up, whilst on the other side of the coin, buyers aspire to acquire the potential opportunity. What is the likely result? Wide bid-ask spreads and little to modest market activity. Put another way – the asset and transaction market could go dark until restructuring transactions hit the market.Navigating Today’s Upstream EconomicsThere are still indicators that can shed light on a dark market. Those include public valuations, reserve metrics, production metrics, and cash flow metrics. In terms of reserve metrics, value erosion usually starts in the bottom categories of a reserve report and moves upwards. Possible and probable reserves typically diminish in value first, then up to the proven categories, and finally to producing reserves. This makes sense because producing reserves are less risky and less expensive to produce, and thus are more value resilient in lower price environments. Consider the costs to produce an existing barrel of oil. In West Texas, this averages about $26 per barrel – some can produce cheaper and others more expensively. This means the average producer is losing $5-6 per barrel today on existing wells. What’s also notable is that these costs are much lower than they were just a few years ago for U.S. shale producers, but still aren’t low enough. Compared to the rest of the world, Saudi Arabia and Russia have the lowest production costs (of which we won’t expound on the reasons why here) and thus the rawest economic ability to weather this low-price environment.
[caption id="attachment_31065" align="alignnone" width="619"]Source: Dallas Fed Energy Survey, Reuters, Seeking Alpha[/caption]
However, when it comes to undeveloped reserves the costs are much higher. Even in the most efficient areas of Texas, oil prices need to be at least $46 per barrel to profitably drill a new well. This illustrates why even proven undeveloped (“PUD”) reserves are worth relatively (and often significantly) less than developed reserves.Therefore, upstream producers are de-incentivized to drill new wells, leading to the value of new inventory decreasing at an even proportionally higher rate. This dynamic has been exacerbated by the market’s focus on cash flows in priority to reserves in recent years. Investors had already been pulling valuations down as their standard tilted more towards shorter-term returns as opposed to longer-term reserves. To be sure, producers have reduced capital expenditures by historic amounts in the past 45 days or so. Extending that perspective, some might think non-producing reserves are worthless. However, they would be wrong. There is an optionality value to those future reserves, also known as acreage, that bears out in the marketplace and is evidenced by transaction prices. Valuations are based on future expectations, and many people believe that prices will not stay low permanently. Therefore, the market is willing to pay a relative premium to immediate economics to account for potential future upside. It also shows up in implied public market valuations as well.Ceding Latitude To Public ValuationsImplied valuations of public companies can provide a living proxy for market values, assuming efficient market theory. There are several metrics that investors and the industry utilize as potential benchmarks including cash flows such as EBITDA and EBITDAX. However, I note in this instance that the first quarter 2020 earnings have not been released yet, so trailing cash flow metric indications are not concurrent. Other metrics can be followed more contemporaneously such as enterprise value per flowing barrel of production. In addition, the drop in equity values push debt ratios higher, thus potentially triggering bank covenants.Predictably, valuations have been in a free fall. What may be unexpected is how those valuations have changed relative to prices or even other companies that are operating in different basins. Mercer Capital tracks groups of public oil and gas companies and categorizes them according to focus. There are integrated global producers, non-integrated global producers, North American focused producers, and even basin focused producers. Mercer Capital follows several valuation-related data points, but some key ones include enterprise value per flowing barrel which shows a company’s publicly traded enterprise value relative to its daily production. The table below shows the median results from those groups and from the entire sample.It's notable that general North American and basin-focused companies typically traded at a relative discount to global companies with one key exception – Permian focused companies. This group, including names such as Concho, Pioneer, and Diamondback, traded at multiples closer to its global counterparts. It’s also notable that debt ratios for most companies were between 30% - 40%, a reasonable historical range. Then the chaos hit, and recent valuation metrics look gaunt comparatively.As of the end of the first quarter, while WTI oil prices per barrel dropped from $61 to $21 or a 66% decline, price per flowing barrel fell only 47% in Mercer Capital’s group indicating that enterprise and asset values were more resilient than short term price fluctuations. This is, in part, a function of the previously mentioned reserve optionality. However, it’s also notable how much equity was lost and how relative debt ratios skyrocketed. The Bakken (Continental, Whiting and Oasis Petroleum) group’s debt ratios were the hardest hit, which may be a response to its pre-existing leverage issues relative to other groups.Finding Transactional DirectionAlthough the merger and acquisition market is likely to reveal limited information, it doesn’t mean that there are no transactions. In fact, just this month there were a few transactions announced that give a glimpse into how valuations are being set from a production and acreage value perspective. Value per acre is another metric that ranges based on numerous factors. However, in recent years depending on those factors, many deals traded around $8,000 to $12,000 per acre. In the Permian Basin, deals often traded above $20,000 per acre. Below is a sample of transactions in 2019 in the Eagle Ford shale area that illustrate this:In the past few weeks, there have been three transactions announced across the SCOOP-STACK area of Oklahoma, the Permian Basin in West Texas and New Mexico, and the Barnett Shale area in North Texas with some revealing financial disclosures. Potential motivations vary in these deals ranging from bankruptcy to prior strategy commitments. They also show why sellers are not incentivized to divest assets right now:Although this is not an apple to apple basin analogy, the contrast is stark. As can be seen in comparison, acreage values have slunk relatively further down than price per flowing barrel metrics indicating more erosion from the bottom of a company’s reserve report. There is a clear disconnect between PV-10 figures and the GAAP-driven Standardized Measure figure compared to market values at present.Destination Unknown?So where does this leave us? Lost? The market could potentially recover the sooner that economies open again. Each day that passes without positive indicators, the state of uncertainty continues. Many small producers can’t hang on much longer. During the Dallas Fed’s recent survey, nearly 40% of respondents would remain solvent for less than two years if prices stayed at $40 per barrel. Figuratively, that was a long time ago.Banks may extend credit lifelines since so many producers are in the same boat. Historically banks have preferred to leave the oil and gas business to their clients, however, this time around may be different as it is reported that major banks are setting up oil companies to operate seized assets. The question is – how realistic and pragmatic is that option? Even so, asset valuations may find a bottom near these prices. Even with today’s bloodbath, the valuation metrics from March 31st appear to be holding. Upstream prices are holding up much better than forward month oil futures. One other note – the oil market is not the only energy sector impacted. Renewable projects have been hammered as well and their economics are not as established as the oil industry. This could set back oil’s energy competition for some time as well. We’ll see.Originally appeared on Forbes.com.
The Family Office
Managing Family Wealth Since 27 BC
Private investment office… Family business advisor... Single-family office… The name differs and the definition varies greatly depending on whom you ask. But the concept remains the same. Wealthy families often seek assistance to manage their accumulated wealth, organize family affairs, and preserve capital for future generations.The concept of a family office dates back as far as 27 BC.The concept of a family office dates back as far as 27 BC when Emperor Augustus Caesar, who at the time controlled approximately 25% of global GDP, employed a group of appointees to manage his estate, businesses, military, and even lifestyle. The concept continued to evolve in the sixth century when it was common for the king’s steward to manage the royal family’s wealth. However, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.A family office is different than a traditional wealth management firm. A family office typically provides a full suite of services including accounting, budgeting, family education, investment management, insurance, charitable giving, and sometimes even concierge services including travel arrangements, personal security, and miscellaneous other household services. However, it is hard to define the “typical” family office as most develop out of a family’s specific needs. Additionally, many wealthy families likely employ professionals who carry out such duties, without necessarily defining or even realizing their function is similar to a single-family office.Single-Family Office vs. Multi-Family OfficeA single-family office is tailored to meet your family’s specific needs. However, to warrant the cost of a single-family office, a family’s assets likely must exceed $100 million, and to afford a full investment practice, assets likely must exceed $250 million. As such, the multi-family office took shape to provide similar services to ultra-wealthy families (typically those with assets in excess of $25 million), while allowing for cost-sharing between multiple families. A multi-family office can be commercially owned by a group of outside investors or privately owned by a founding family with significant wealth. For example, the Rockefeller family office, which has served the Rockefeller family for almost 140 years, recently expanded its services to over 250 clients.There are key legal and regulatory differences between a single-family office and a multi-family office. Because single-family offices serve only one family, they are not registered with the SEC (the Investment Advisor Act of 1940 made single-family offices exempt from SEC registration). Multi-family offices, on the other hand, are typically structured as registered investment advisors (RIAs), which are registered with the SEC, or trust companies, which are typically regulated at the state level.Additionally, a single-family office’s main goal is to preserve and generate wealth for the family. Whereas a multi-family office also seeks to generate a profit for itself. This results in a somewhat lower return on assets for families belonging to a multi-family office as the profits are split between the families and the ownership base. We have compiled what the average income statement for a single-family office and multi-family office looks like to highlight this difference.
[caption id="attachment_31050" align="alignnone" width="784"]Charts Compiled by Mercer CapitalData per The Global Family Office Report 2019AUM = Global Average AUM for SFOs and MFOs Portfolio Return = Average Family Office Portfolio Return from Q1/Q2 2018 through Q1/Q2 2019 in N America Expenses = Average Global Expenses for SFOs and MFOs[/caption]
As shown above, the total return on assets managed by a single-family office (5.2%) is slightly higher than the return on assets managed by the multi-family office (4.9%). The return generated by the multi-family office, however, is sensitive to our assumption of fees charged for family office services. We have estimated multi-family office fees to be 1.0% of AUM. Family offices have varying fee structures but typically include a combination of fixed fees, hourly fees, and asset-based fees. While these asset-based fees typically range between 50bps to 100bps, for comparability, we have assumed a fee at the higher end of this range to provide an estimate for comprehensive services such as would be provided by a single-family office.Investment Performance At first glance, the average return for the portfolio (5.9% for the twelve months ended Q1/Q2 2019) appears rather low, given that wealthier individuals typically have a greater ability to take risk, leading to generally higher returns. However, keep in mind that family offices don’t just manage an individual’s investable assets, as does a typical wealth manager from whom you would likely expect a 7%-ish return. A family office generally manages a family’s entire portfolio, including cash.The “average” portfolio for a family office is shown below.
[caption id="attachment_31052" align="alignnone" width="851"]Source: The Global Family Office Report 2019[/caption]
Recently, family offices have started investing in more diverse and riskier products, such as private companies and distressed debt, that have typically been reserved for institutional investors. Family offices have reduced their allocation to hedge-funds over time, unable to justify such high fees for often mediocre performance and have reallocated these funds to direct investments in debt and equity. Over the last few years, family offices have become somewhat of a disruptive force in the private equity and venture capital space as they are able to offer competitive pricing and terms since their holding periods are longer than the typical private equity fund and they have more flexible investment criteria than a private equity firm who may be working to manage the expectations of hundreds of investors, instead of one family.Growing Presence of Family OfficesEducating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.In the 1980s family offices started to multiply as the number of families who were able to afford such services increased the concept. In 2018, EY estimated that there were approximately 10,000 single family offices worldwide, a ten-fold increase over less than a decade. Looking forward, the number of single and multi-family offices is expected to continue increasing as the number of wealthy families grows and investor preferences continue to shift towards having more control over one’s own wealth. While family offices are more streamlined than traditional investment firms there are some obvious drawbacks of mixing business and family. This is why family education and communication is so important. Educating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.As the family office continues to evolve and wealthy families have more options when it comes to managing their wealth, it will be increasingly important for families to ask who can help them best align the family’s interests, making it easier to operate your business, cooperate with other family members, and allow yourself more time to do what is important to you.
Evaluating the Buyer’s Shares
Jeff K. Davis, CFA and Jay D. Wilson, Jr., CFA, ASA, CBA along with DeVan Ard Jr. (Reliant Bank) originally presented the session "Evaluating the Buyer’s Shares" at the 2020 Acquire or be Acquired (AOBA) Conference in Phoenix, Arizona. A short description of the session can be found below.Although M&A is usually focused on the price (and valuation) sellers realize in a transaction, consideration paid to sellers that consists of the buyer’s common shares raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
RIAs Suffer Worst Quarter Since the Financial Crisis
Most RIA Stocks are Now in Bear Market Territory
Last quarter we blogged about how great 2019 was for the RIA industry. Recent events have rendered that blog post largely irrelevant, as discussions in the industry are now centered on how the COVID-19 global pandemic has impaired RIA valuations. You can tune into Matt Crow and Mindy Diamond’s podcast for a more in-depth discussion on COVID’s impact on the industry, but this post summarizes the effect it has likely had on RIA valuations.The chart below shows there was nowhere to hide last quarter, as all four components of the RIA industry dipped into bear market territory. The primary driver behind the decline was the decline in the market itself, as most of these businesses are primarily invested in equities, and the S&P was down 20% over the quarter. The aggregators are down a bit more since their models rely on debt financing, which exacerbates losses during times of financial strain.Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time. Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last month.Regardless, this bear market has to be placed in proper context. It’s hard to believe, but the industry (excluding the consolidators) is pretty much right where it was a year ago in terms of market caps. We basically just gave up the gains made in the back half of last year though the decline was far more rapid.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value. These multiples show a similar decline in Q1 after a sizeable increase in the fourth quarter of last year.There are a number of explanations for this variation. Earnings multiples are primarily a function of risk and growth, and risk has undoubtedly risen in the last couple of months while growth prospects have diminished. Specifically, future earnings are likely to decline with AUM and revenue, so the multiple has pulled back accordingly. Conversely, the run-up in Q4 reflected the market’s anticipation of higher earnings with rising AUM and management fees. The multiple usually follows ongoing revenue, which is simply a function of current AUM and effective fee percentages, as discussed in last week’s post.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much. Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions. There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter (see chart above). The P/E multiple is another reference point, which has declined 22% so far this year. We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole. Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts. We also look at how much a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts. Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Diminishing OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally diminished with market conditions over the last couple of months. AUM is down with the market, and it’s likely that industry-wide revenue and earnings declined with it. April has been kinder, but volatility remains.If the bid-ask spread between you and your partners has been too high to get a deal done, it may time to re-examine your price expectations. The next generation of ownership may be enticed by more attractive valuations and return to the negotiating table, so knowing your firm’s worth may be more important than ever. We’re happy to walk you through that.
March 2020 SAAR
When Might Things Return to Normal?
The term “24-hour news cycle” doesn’t do justice to the rate at which new information becomes available and is consumed by people trying to understand the significant impact COVID-19 is having on all of us. Stay-at-home orders have created a huge demand shock, which is particularly harmful to a largely service-based economy. In this post, we contextualize some of the fallout that has been experienced and try to answer the question “when will things return to normal?”.March SAARSAAR came in at 11.372 million, the lowest level since April 2010.As expected, SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined considerably in March as the early effects of COVID-19 began to impact just about every industry across the globe. SAAR came in at 11.372 million, the lowest level since April 2010. This also represented a decline of 32.4% from February. The 32.4% decline was only the fourth time since 1976 (when the SAAR was first recorded) that a 30% month-over-month decline has occurred. The first two instances were during a 6-month period of extreme volatility between September 1986 and February 1987, including three monthly increases of over 22% and two declines of 31.6%. Despite these anomalies, the only other significant month-over-month decline occurred in September 2009 when SAAR declined 35.8%. However, SAAR had increased by 14.2% and 28.1% in the two preceding months, so that September’s steep decline was only 6.1% below the preceding June.While the huge drop in volumes in March was certainly historic, it included a couple of weeks that were relatively unscathed by stay-at-home orders. April is likely to show further declines with significant uncertainty about when we will reach the bottom.Putting it in PerspectiveWhile there have been many sharp one-month declines in the SAAR, we note that even seasonally adjusting the data can fail to capture certain calendar anomalies, specifically when one month has an extra selling weekend. In looking at other significant events, such as the stock market crash in ’87 and 9/11, the drop caused by the market crash was relatively short-lived and auto volumes actually spiked in the month following 9/11 as the country braced for war. To better understand where we might be headed and when things might return to some level of “normal,” we analyzed prolonged declines, focusing on the 1981-1982 recession, the Persian Gulf War, and the Great Recession. Though these events do not align perfectly with COVID-19, observing how periods of economic turmoil affect the industry and examining the length of recovery time historically can provide future insight as we seek to climb out of the current crisis.There are numerous ways to measure recovery. For purposes of this post, we measure “recovery” as how long it takes to return to a “steady state” of vehicle sales. We use a steady state figure of 15.6 million annual sales from a 2015 paper written by Austan D. Goolsbee (University of Chicago) and Alan B. Krueger (Princeton University). The paper analyzed the restructuring of General Motors and Chrysler. The inputs into the regression model used in the paper include:Real GDP GrowthThe unemployment ratePopulation growthThe Federal Reserve’s Senior Loan Officers’ Survey (SLOOS) measuring willingness to lend to consumersLog of average real price of a gallon of gasoline (for the preceding quarter)Standard deviation of gas prices over the preceding four quarters
In every year since the paper was published, industry sales have surpassed 17 million, indicating the steady state may be biased upwards if rerun today. However, the data stops in 2007 just before the Great Recession, and because auto sales are procyclical, any increase in the steady state figure would likely be due in part to the longest economic expansion in the country’s history over the past 11 years. Further, since vehicle sales are positively correlated with population growth, we would expect a long-term figure to be higher than early years and lower than more recent years. Ultimately, we find a steady state figure of 15.6 million to be reasonable for this analysis.
A Long Term View of SAAR
A long-term view of SAAR is presented in the graph below:
[caption id="attachment_30880" align="alignnone" width="940"]Source: FRED and Princeton University[/caption]
The 1981 RecessionAt the time, the 1981 recession was the worst economic downturn in the U.S. since the Great Depression. Triggered by a combination of monetary and global energy issues, unemployment reached 11%. While the effects of the recession were widespread, the manufacturing, construction, and auto industries were particularly affected. Auto manufacturers ended 1982 with 24% unemployment. The industry saw 4 straight years of year-over-year declines in sales from 1979 to 1982 with the largest annual decline in 1980 at 19%. SAAR bottomed out in October 1981 with only 9,209,000 annualized vehicle sales; from there, SAAR increased 17% in both 1983 and 1984. SAAR reached over 15.6 million sales in August 1985, approximately 7 years after it first dropped below this threshold in September 1978.As noted previously, population growth likely indicates the 15.6 million is a high threshold for this period, particularly since SAAR was only above this for a brief period in 1978. The precipitous decline at the beginning of 1980 appears to have been restored by the end of 1983, indicating just 4 years before recovery.The Persian Gulf WarThe Persian Gulf War, precipitated by Iraq’s invasion of Kuwait, caused the oil shock of 1990. Though less severe than oil shocks that occurred in the 1970s, oil prices initially soared from a pre-invasion price of around $18 a barrel to above $40 in the late fall of 1990, leading to declining revenues for the auto industry. At the same time, the Fed was tight on interest rates, endangering an already weak economy. This combination of oil prices and economic policy brought the U.S. into a recession that hit the auto industry particularly hard. Vehicle sales declined each year from 1989 through 1991, with the biggest decrease in 1991 at 11%. It took until April 1994 for SAAR to reach 15.6 million again, about 4 years after it first began to drop.The Great RecessionArguably the most impactful event on the industry in recent history was the Great Recession (2007-2009). Precipitated by a financial crisis caused by a severe contraction of liquidity in global markets, businesses were forced to reduce their expenses and investments and layoffs resulted. From December 2007 to June 2009, real GDP declined by 4.3% and unemployment increased from 5% to 9.5%, peaking at 10% in October 2009.The auto industry and other industries reliant on consumer loans (e.g., housing) suffered significant losses. In 2006 and 2007, vehicle sales volumes decreased about 2.5% consecutively, and the auto industry hourly workforce was reduced from over 90,000 to approximately 40,000. Conditions worsened through 2008 and 2009, as sales declined 18% and 21%, which is the largest year-over-year decrease of any time period. SAAR dropped to just a little over 9 million in February 2009, 6.6 million below the steady state SAAR. However, through the assistance of the government in the Troubled Asset Relief Program (TARP) and the end of the recession in 2009, the industry survived and returned to its steady state of 15.6 million vehicle sales in 2013, 5 years after it first dropped below that level in January 2008.COVID-19There are some positive takeaways from looking at these past events.Although economic conditions currently point to a difficult period of uncertain length, there are some positive takeaways from looking at these past events. Periods of high growth have followed periods of low sales as consumers who delayed purchases in rough times returned to the market. SAAR increased 17% consecutively in both 1983-1984, following the 1981 recession. There were increases of 8% in both 1993 and 1994 following the Persian Gulf War. Finally, the auto industry experienced 5 years of expansion following the Great Recession, reaching similar sales as before the crisis and further set new highs in the 5 years after that.Again, it may take a while to return to the 17 million in sales seen in the past few years, but that is above the long-term average and should not necessarily be the level from which we measure recovery. NADA expects it could take three or more years to return to this level, which would be reasonable given historical recovery times.ConclusionThe auto dealer industry is resilient through tough times. We hope dealers are once again able to navigate both the known and unknown problems facing us today. Dealers must grapple with how to continue to pay their employees, alter their sales channels on the fly, and potentially even help teach their children at home.Mercer Capital stands ready to partner with dealers in their time of need. Prior to the nationwide lockdowns, we were anxiously awaiting the NADC Conference in Florida at the end of April as well as the TAA/KYADA Conferences in June. We had hoped to launch this blog in happier times, but we still plan to offer our unique perspective as valuation experts as the pandemic impact unfolds. Working from home, we have more time to write these blogs, and we hope they are interesting to you. Feel free to reach out to us if you have valuation questions as to how your dealership may be affected.Mercer Capital is a financial services firm specializing in business valuation. We also provide litigation support and transaction advisory services for clients big and small. Contact one of our professionals to discuss your needs in confidence. And stay safe.
What Should Your Family Shareholders Know?
Earlier this week, the Wall Street Journal featured an article on the challenges of succeeding at succession in family businesses. Author Cheryl Winokur Munk made five recommendations to help families thrive during generational transfers:CommunicateStart earlyCreate a written planPlan a post-succession lifeLet go when it’s time
This is a great list. While families that are nearing a generational transfer have some very specific communication challenges, effective communication is essential regardless of where the family business is in the corporate life cycle.Communicating Dollars and CentsPositive engagement is enhanced when family shareholders receive regular communication.When it comes to financial matters, family business directors need to treat family shareholders as, well, shareholders. One of the ironies of family business is the generally unspoken assumption that family shareholders are not entitled to adequate financial disclosure and transparency. In other words, family shareholders are often entrusted with far less information than stockholders in public companies. Whatever benefits such secrecy generates are very quickly overwhelmed by the suspicion, distrust, and discontent that naturally develops when communication fails.Positive engagement is enhanced when family shareholders receive regular communication under five primary headings.Financial ResultsPosting annual financial statements to a family portal is not the same thing as communicating financial results to family shareholders. Communicating financial results means translating financial data into a coherent narrative that describes and illustrates the operating and financial performance of the family business over time and relative to appropriate benchmarks.StrategyCommunicating strategy complements the financial results provided to family shareholders. The family business’s strategy provides the best lens through which to view the family business’s financial results. Public companies provide a great template for distinguishing strategy from day-to-day operational decisions. The task of investor relations for public companies is to ensure that current and prospective shareholders know what the strategy of the company is, not to expose every decision management makes to public scrutiny. If your strategy is not easy to communicate, that may be a sign that your strategy could use some refining.ValueNo one with an investment portfolio would tolerate an investment advisor who refused to provide timely updates on the value of the portfolio. Yet it is often assumed that family shareholders do not need to know the value of their investment in the family business. For many family shareholders, their shares represent a large allocation of their personal portfolio. Failing to communicate value forces those shareholders to make important decisions regarding the rest of their personal balance sheets with one eye closed. There is simply no need for that.ReturnsAnnual return is how shareholders measure the performance of their investments. Family shareholder returns come from (after-tax) dividends and changes in value of their shares. Too many family business managers shy away from providing return data to family shareholders. Failing to measure the return to your family shareholders does not keep the returns from happening. The returns are accruing (or not) regardless of whether you are measuring them. Measuring returns can introduce a potentially uncomfortable level of accountability to family business managers. But what is the alternative? Family shareholders will eventually calculate returns themselves. It is better for the family business to provide a regular and consistent return calculation for the family shareholders, along with appropriate benchmarks and commentary regarding the sources of superior or lagging returns.ExpectationsDo your family shareholders know what “the long view” is for your family business?One of the greatest advantages family businesses possess is their ability to take the long view. Do your family shareholders know what “the long view” is for your family business? Avoiding the quarterly earnings treadmill is a good thing, but taking the long view should not be a smoke screen for hiding underperformance or failures to execute. How does your family business’s strategy translate into expectations for revenue, earnings, and cash flow in future periods? If the family business has made a conscious decision to forego current earnings, what is the expected payoff from that decision?ConclusionIf you want to build your family business to survive across multiple generations, you have to take communication seriously. Generational transfer requires positive shareholder engagement. And that, in turn, requires treating your family shareholders as shareholders when it comes to financial disclosures and transparency. Doing so requires trust and, probably, some education. In our experience, that investment is worthwhile. Family shareholders who aren’t treated like shareholders won’t want to be shareholders for long. And that could spell the end of your family business.
Saudi Arabia, Russia, or the United States – Did One of the Players Blink?
It’s been a truly dizzying time in the world of international oil production over the last five weeks. With so much macroeconomic activity, twists and turns, it’s been easy to fall behind as to “what’s gone on”, and for even those who’ve been paying reasonably good attention, you may not be sure what all has occurred. What suggestions were made? What deals were cut? What cooperation was gained? What threats were made, and who, if anyone, “blinked”? To some extent, we may never know the answers to all those questions.How We Got HereSo, what occurred in the last few months that got us to this very dynamic point in time? To summarize:January-February 2020 – The coronavirus “goes” pandemic, spreading throughout the world. While the full extent of damage from the pandemic remains unknown, it’s expected that at least 2 million people will contract the virus, the death toll will easily surpass 120,000 and the economic damage will be of a magnitude that hasn’t been seen in several generations. Due to the need for quarantines, travel restrictions, forced business shutdowns and stay-at-home orders to limit the spread and speed of the spread, oil demand plunged and oil prices sagged.March 6, 2020 – The three-year OPEC+ (OPEC represented by Saudi Arabia and “+” effectively meaning Russia) production/price cooperation pact, set to expire on March 31, fell apart when Moscow refused to support Riyadh’s demand for additional production cuts aimed to offset the reduced demand for oil resulting from the coronavirus pandemic.March 8, 2020 – So what do two strong-willed centrally-run countries do when their oil production control negotiations (for the purpose of supporting oil prices, on which both countries rely) break-down? Keep negotiating? Give-in a little for their mutual good? No. Instead they purposefully shove their thumb into the other party’s eye by boosting production? Make sense? Not really. Unless there are ulterior motives in-play such as, curbing the U.S. shale revolution that buoyed the U.S. to energy/oil independence and the top spot in world oil production. Not a certain motivation, but a potential motivation that has a lot of people talking about the possibility.
Late March 2020 – At this point, Covid-19 has significantly reduced oil demand. In the meantime, the Saudis and the Russians have boosted oil production and oil prices have tanked. The U.S.’s shale producers are in free fall with bankruptcies staring them in the face. U.S. energy independence and oil production leadership are in the crosshairs and the Saudis and Russians are showing no signs of any rational behavior on energy production. Here’s where the geopolitical, oil-production-tied-relationships game starts to get “interesting”.
What’s a Newly Leading Oil Producer With a Threatened Leading Position to Do?It’s at this point that all sorts of possible actions on the part of the U.S. begin to be discussed. Various suggested actions include:Lure Saudi Arabia away from OPEC and into a production-setting relationship with the U.S. – This one was simply a bit hard to imagine having much of a chance at all. First, the U.S. has always been very critical of production controlling cartels, and production setting with the Saudis would be the exact opposite of our long-held free-market values. Second, U.S. anti-trust laws simply wouldn’t allow the U.S. government to engage in limiting production, or oil companies to join together for the purpose of controlling oil production.That being said, the Wall Street Journal reported in late March that officials at the Energy Department were seeking to convince the Trump administration to push for Saudi Arabia to quit OPEC and work with the U.S. to stabilize oil prices. At the same time, Hart Energy was reporting that Energy Secretary Dan Brouillette had indicated that he didn’t know if a U.S.-Saudi oil alliance was going to be presented as a path forward in any formal way as a part of the public policy process, and that no decisions regarding any such alliance had been made. However, it was also reported that the Trump administration would soon send a special energy representative from the Energy Department, to Saudi Arabia, in order to improve talks between the two countries. Brouillette also indicated that the Trump administration would at some point engage in some sort of diplomatic effort with Saudi Arabia and Russia on oil production levels and that he would work with Secretary of State Mike Pompeo and other officials on that effort. This all left the likelihood U.S.-Saudi cooperation open to individual interpretation.U.S. Production Limits Via the Texas Railroad CommissionAlthough the U.S. government may be prohibited from entering into oil production agreements by anti-trust laws, that’s not the case for individual states. In late March, reports began to surface of the Texas Railroad Commission having been approached by two major Texas oil producers with the idea of negotiating for production limits with OPEC. The Texas Railroad Commission? Despite the Commission’s name, it long ago ceased any regulation pertaining to the railroads, however, its regulation of Texas oil production (control granted to it back in 1919) continues to this day. Although the Commission has long had a reputation for markedly lenient regulation of production levels, the current crisis has powerful voices calling for the Commission to consider working with OPEC to reduce production levels in order to save the U.S. oil industry from the devastating impact of sub-$25/barrel oil prices.While this may pose a “workable” process, it comes with multiple layers of required cooperation and agreements. Does the Commission address OPEC directly, or through the Trump administration? OPEC itself requires member cooperation, and the Commission would need the cooperation of other U.S. oil producing states. After all, if the Commission limited production in Texas, but such limits simply triggered higher output in other U.S. states, the effort would be for naught. President of the Texas Oil & Gas Association (TXOGA), Todd Staples, commented on that very matter indicating that if Texas oil and gas operators cut back production in isolation, that reduced production would likely be filled by operators producing in other states.Even if the Commission’s involvement gained the necessary cooperation from the Trump Administration, OPEC and other states, the idea faces headwinds both from a purely practical standpoint and from those that simply don’t want the Commission involved in the production quotas. Some additional items on the practical side of things:Wayne Christian, the Commission’s Chairman, noted that the Commission hasn’t imposed such limits in more than 40 years, the Commission doesn’t have staff with any experience in implementing production limits, the Commission would have to track production across thousands of independent producers, and the Commission’s technological capabilities for handling such a process are quite limited.The Commission’s next meeting was, at that time, weeks away on April 21st, meaning that no action in pursuit of limiting production levels would occur for some time.Other high oil producing states, unlike Texas, don’t have similar regulatory bodies to the Texas Railroad Commission. Without such regulatory bodies, those states may not have the ability to effectively limit in-state oil production.
Even if these practical barriers could be overcome, there remain powerful voices that are opposed to any moves that go beyond market forces. Mike Sommers, the CEO of the American Petroleum Institute, has pushed back against proposals that would involve U.S. officials negotiating a joint production cut with OPEC and Russia. Sommers noted that the U.S. has always supported the market as the determinant of oil prices, and that during times of crisis, those principles shouldn’t be abandoned. Sommers was particularly opposed to the proposal from a Texas Railroad Commission commissioner, that would regulate oil production within Texas. Commissioner Sommers further indicated that any such proposal would be damaging to our posture in the world, and that imposing a production quota on Texas produced oil would penalize the most efficient producers while supporting less efficient companies. Frank Macchiarola, Senior Vice President of Policy, Economics and Regulatory Affairs at the American Petroleum Institute echoed Sommers sentiments indicating that the Institute's position is very simple– quotas are bad. He added that quotas have been proven to be ineffective and harmful, and that there’s no reason at this time to be imitating OPEC.
However, Texas Railroad Commission commissioner Ryan Sitton noted that he’d already spoken with OPEC Secretary-General Mohammad Barkindo regarding an international agreement that would ensure economic stability as the world recovers from the coronavirus outbreak. Sitton stated that Barkindo had invited the commissioner to OPEC’s meeting in June to further discuss the matter. Commissioner Sitton further noted that international cooperation was absolutely necessary if Texas were to decide to limit production. He commented that if Texas limited production as part of an international agreement to balance the markets, he thought the odds of success would be very good. However, he further noted that if reductions were only implemented by Texas, without collaboration with others, the odds of success were near zero.Forget the “Carrot”, Use the StickOf course, there’s always those in favor of the straight-forward approach to motivating others to a preferred course of action through of the “stick”, rather than the “carrot”. Especially those that view the Saudi-Russian production spikes as an overt attempt to damage the U.S. shale oil industry. Senators, including Lisa Murkowski of Alaska and John Hoeven of North Dakota, noted that the American people are not without recourse in responding to the Saudi-Russian actions. They’ve noted that tariffs and other trade restrictions, investigations, safeguard actions, sanctions, and much else are within the arsenal of potential responses. Another similarly minded suggestion is to remove U.S. armed forces from the Saudi kingdom.Others, such as oil industry analyst Ellen Wald indicate that the best option for U.S. in this situation is for the Trump administration to pursue diplomatic efforts to settle things down. Wald noted that sanctions and embargoes aren’t realistic and will having a negative impact for the United States. Sitton seemed to concur with Wald’s position indicating that a diplomatic solution and planned production cuts would be better for everyone. He added that although the Trump administration could embargo Russian and Saudi oil as a form of punishment, his hope was that we don’t end-up going there.Interestingly, suggested use of these more “stick” type actions have not been coming from the Trump administration. Instead, President Trump has remained more measured in his comments, only noting that if the Saudis and Russians didn’t resolve the matter on their own in short-order, that he would get involved at the appropriate time.The Art of the DealPresident Trump, ever the deal-maker, may be looking to a solution that avoids violation of the U.S. anti-trust laws, sidesteps brokering a deal on behalf of the Texas Railroad Commission and doesn’t include the actual application of any “stick” – although maybe using the threat of the “stick.” Within the last week, President Trump tweeted that he expected Russia and Saudi Arabia to agree to cut production by millions of barrels a day. Although the Kremlin soon thereafter denied any talks with the Saudis, officials from the kingdom then noted that they would consider significant production cuts as long as other members in the G-20 group of nations were willing to join the effort. On April 9, OPEC and Russia announced plans to reduce their oil production by more than 20%, albeit also indicating that they expect the U.S. and other top producers to join the effort to prop-up prices. U.S. officials noted that while they had not committed to any specific cuts in production, expectations were that U.S. output would fall substantially over the next two years, sounding ever so much like the U.S. is on-board with participating in the reductions, albeit without crossing the line into anti-trust law triggering commitments. However, one sticking point to the agreement was Mexico, who on April 10 balked at the plan. Mexican President Lopez Obrador refused to sign-off on the agreement as it would necessitate putting his plans for Pemex’s revival on hold. That resulted in Obrador getting a call from President Trump from which the U.S. seemed to be offering to take part of Mexico’s required production cut with some sort of undefined “repayment” to occur at a later date. Ultimately, a deal was reached, with OPEC+ nations agreeing to reduce output by 9.7 million barrels per day, representing approximately 10% of global demand before the coronavirus pandemic. However, with demand down an estimated 35%, the cut does not fully balance supply and demand. Oil prices were largely unchanged on the news of the agreement.Conclusion, or Lack ThereofAs we indicated, it’s been a truly dizzying time in the rough-n-tumble world of oil production. Like they say, if you miss a day, you miss a lot. For now, it at least appears that someone may have just blinked. The Trump administration seems to be on the verge of a truly historic deal to cut worldwide oil production and bring oil prices up to a modestly workable level. And that with the U.S. not committing to forcing domestic producers to cut production levels but indicating that U.S. production would “naturally” decline without the government’s intervention. That coupled with a potential side-deal with Mexico to “cover” part of the production decrease that was being sought from that country, but that Mexico is unwilling to shoulder on its own. Will it work? Will the deal be accomplished?Although an agreement was reached to reduce oil production in light of demand destruction caused by the coronavirus pandemic, oil markets appear to remain oversupplied. Will OPEC+ and other nations agree to another deal to further reduce production? Will U.S. production decline faster than anticipated due to low oil prices? Will the Texas Railroad Commission implement proration orders for Texas producers? All we can say is, stay tuned – and expect the unexpected.
Valuation of Stock Options for Marital Dissolution
The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of property. Designed to both reward performance and retain employees, these benefits can be difficult to value, particularly at a random moment for the purpose of marital dissolution.The American Institute of Certified Public Accountants (“AICPA”) Forensic and Valuation Services Section provides a quick reference guide on valuing stock options, Valuing Stock Options: AICPA’s Financial Instrument Quick Reference Guide (section membership required). We excerpt from the Guide below in order to provide a few highlights.What is a Stock Option?A stock option is a contract that allows the owner of the right, but not the obligation, to buy equity in the company that issued the option at a certain price for a certain period of time. In its most basic structure, an option contract consists of:The identification of the equity that can be purchased or soldThe price at which the equity can be purchased or soldA discrete time within which the equity can be purchased or sold, andA price for the right to own the right to buy or sell equity in the company that issued the optionValuation modelsValuation models can be as simple or as complex as the derivative they are valuing. Each step in the process requires a thorough technical understanding, as well as professional judgment to identify the model that works best for the particular valuation and ultimately be able to explain and support the resultant conclusions.Lattice models are used to value derivatives when discrete, or distinct, points in time need to be part of the model (e.g., days, months). Common lattice models are binomial and trinomial models that are easy to use and highly adaptable to different types of options since it allows for changing assumptions between discrete measurements (e.g., volatility). These are structured by discounting a series of cash flows from the time of maturity to the beginning date of the option contract.The Black-Scholes model is classified as a “close-form” model because it assumes the option is only exercised at the end of the contract term and the underlying assumptions remain constant over the term of the option. This model is useful when trying to value options such as the European options that only have one exercise date. The Black-Scholes model is based on six inputs:type of option being priced (e.g., call or put option) stock price,strike price of the option term of the optionappropriate risk-free ratevolatility of the underlying stockThe Monte Carlo Model (MC) is considered a stochastic model because this method generates a large number of time-dependent scenarios and estimates the value of the option as a statistical expectation of the outcomes of those simulations. Compared to the Black-Scholes formula, MC allows for much more flexibility, including large changes in the interest rates, volatility and the possibility of major events, such as mergers and acquisitions. Statistics are used to quantify the error in the estimates.Accounting for Stock OptionsThere are three main ways to account for stock options. The way these are accounted for depends largely on why and how the options are being issued.Fair market value-IRS Revenue Ruling 59-60 defines fair market value as “the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Fair value measurement- Accounting Standards Codification (ASC) 820: Fair Value Measurement, is the sole source for authoritative guidance on how entities should measure and disclose fair value in their financial statements under U.S. Generally Accepted Accounting Principles.Fair Value Based Measurement- ASC 718 Compensation – Stock Compensation, defines fair value in the context of the employer/employee relationship.ConclusionDue to the complexity of valuing stock options, it is critical to consult a financial expert. As we can glean from the AICPA Quick Reference Guide (section membership required), not only must the financial expert apply professional judgment and technical understanding during the process, but he/she must be able to communicate the process and result conclusion(s). If the divorce case includes stock options, hire a financial expert to value these complex financial instruments. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 1, 2020.
Tennessee Case Review
Tarver v. TarverAppeal from the Circuit Court for Shelby County January 16, 2019This divorce involved issues of property division and alimony, among others. Husband worked for his father’s railroad construction business (the “Company”) since turning 18 years old and eventually was named Vice President, a position which he held for the duration of the marriage. Wife was employed in the health insurance industry, however, stopped employment in 2009 and did not work outside of the home over the remainder of the marriage. Wife filed a complaint for divorce in January 2014, and the trial court entered an amended final divorce decree in July 2017.A key issue in the appeal involved Husband’s salary and payments received from the Company. For background, in 2006, Husband’s Grandfather purchased several unimproved parcels of land for a new business location. Grandfather titled these properties in his name and Husband’s name as joint tenants with rights of survivorship. In 2010, the Company began operating the new location from this property and began paying rent to Husband and Grandfather. Husband received a salary from the Company in addition to the rent payment income. The Company also covered several personal expenses for Husband and his family such as property taxes on the marital residence, uncovered medical expenses, family dining expenses, groceries, clothing, furniture, and travel expenses. After the divorce complaint was filed, Grandfather reduced annual rent payment from the Company to Husband from $180,000 per year to $2,400 per year. Grandfather also stopped paying for Husband’s health insurance policy and other expenses.During the trial, Wife retained a forensic accountant and economist to calculate Husband’s income for purposes of alimony and child support. Wife’s expert calculated Husband’s total annual income as either $285,993 or $216,958, dependent upon if rent was received at historical levels or a reduced rate based on fair market rental value. In the trial court determination, Husband’s income was set at $188,488 per year based on the fair market rental value calculated by Husband’s appraiser and value of personal expenses covered by the Company as calculated by Wife’s expert witness. The trial court ordered Husband to pay $1,332 in monthly child support and the children’s private school tuition. Wife was awarded alimony in futuro of $1,500 per month until the parties’ twins graduate from high school at which time the alimony would increase to $2,832 per month for ten additional years. As for the business interest valuation, the court was unable to conclusively determine whether Husband had any ownership interest in the Company. There was (potential) evidence that suggested a 10% ownership interest in the Company, but the weight of the evidence suggested that he did not in fact own any interest in the business.On appeal, Husband raised the issue of whether the trial court erred in determining Husband’s income for purposes of alimony and child support and in setting the amount of alimony, among other issues. According to the opinion, Husband did not present any analysis of the statutory factors to be considered when awarding alimony or include any discussion of the types of alimony. He did not provide any indication of what he thought an appropriate amount for his income would be. Husband rather argues that the trial court erred in “imputing to him the rental and other forms of income.” In its determination of Husband’s income and ability to pay, the trial court found it appropriate to consider Husband’s base salary of $78,500 in addition to the fair rental value of the property and the amount of personal expenses the Company paid for Husband. The Court notes that this is reasonable given that Husband received a salary of over $250,000 in the three years prior to the divorce. Ultimately, the Court found no error in the trial court’s determination of Husband’s monthly income.As shown in this case, the testimony of an expert witness can significantly assist in the court’s determination of need and ability to pay, as well as historical earnings and “true income” in its decisions regarding spousal support. An experienced forensic accountant can provide a detailed analysis of income that accounts for all relevant sources of income.Click here for the opinion.
AICPA Issues New Forensic Services Standard Effective January 1, 2020
Statements on Standards for Forensic Services (“SSFS No. 1”) are issued by the AICPA’s Forensic and Valuation Services Executive Committee. SSFS No. 1 provides guidance and establishes enforceable standards for members performing certain forensic and valuation services, specifically, for litigation and investigation engagements. These engagements are defined by SSFS No. 1 as follows:Litigation. An actual or potential legal or regulatory proceeding before a trier of fact or a regulatory body as an expert witness, consultant, neutral, mediator, or arbitrator in connection with the resolution of disputes between parties. The term litigation as used herein is not limited to formal litigation but is inclusive of disputes and all forms of alternative dispute resolution.Investigation. A matter conducted in response to specific concerns of wrongdoing in which the member is engaged to perform procedures to collect, analyze, evaluate, or interpret certain evidential matter to assist the stakeholders (for example, client, board of directors, independent auditor, or regulator) in reaching a conclusion on the merits of the concerns
Prior to the issuance of these standards, litigation and investigation engagements were covered by the AICPA Statement on Standards for Consulting Services No. 1 and the AICPA Code of Professional Conduct. As the need for forensic services has grown and evolved, SSFS No. 1 serves to protect the public interest and increase the level of consistency across the profession.
The issuance of SSFS No. 1 reflects a consolidation of relevant forensic services standards into one single standard. These forensic standards are effective for engagements accepted on or after January 1, 2020. Ensure that your hired expert, if applicable, is aware of these new requirements and is aware of the applicable standards for the engagement.
To download the Statement on Standards for Forensic Services click here.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 1, 2020.
Why Involve a Financial Expert in Divorce Mediations
Most family law cases settle at mediation or prior to trial. For example, Tennessee requires that parties must attempt to settle their cases at mediation prior to granting a trial date. Considering both of these facts, when should a family law attorney involve a financial expert in divorce mediations?
Most family law cases that require the use of a financial expert share some combination of the following: a high-dollar marital estate, complex financial issues present, business valuation(s) performed, and/or the need for tracing/classification of certain types of marital and separate assets. Of the family law cases that settle at mediation, most include motivated parties with experienced attorneys that have entered the mediation process properly organized and prepared to negotiate the various financial and parental aspects of the case.How a Financial Expert Can Assist a Family Law Attorney and Client at MediationDepending on numerous factors, attorneys require attendance of their financial expert for either the full mediation or for a particular session of the mediation. In addition, sometimes financial advisors are required to be available by telephone should issues arise. While having your financial advisor involved in the mediation in this way can be costly, a talented financial expert provides benefits to the client and the overall process to aid in its success. This author has participated in divorce mediations as a financial expert many times over the years and, as a result, has identified five ways a financial expert can be helpful to a family law attorney and client during mediations.Communicates Complex Financial Theory in an Understandable WayYour financial expert may have performed a business valuation that resulted in a report or some communication of value conclusions. An experienced financial expert that can communicate those conclusions and other complex financial issues in a clear and understandable manner to the client and the mediator is a priceless asset for your team. Because of this, often during mediation, that expert’s role evolves from a valuation vendor to a trusted advisor. The mediation process can be lengthy and includes significant down time where the attorney, client, and financial expert sit around the table together. It is during this time that the financial expert truly becomes a trusted advisor to the client and their attorney by providing data and expertise to assist in the decision-making process.Defends the Business ValuationIf a case involves a business valuation, there is usually contention around the value of the business. Often, valuation experts from each side are present at mediation and have the opportunity to speak to each other regarding their assumptions and disagreements on conclusions. A good financial expert helps quantify and elaborate on the key issues or differences in the valuations to the mediator to help bridge the gap in negotiations.Helps with Asset DivisionProperty division is one of the crucial issues that must be solved for a mediation to be successful. Property division is often thought of as a puzzle, putting pieces together based on value, transferability, and the motivations/desires of each party to own certain assets. While the attorneys have compiled the marital estate, a competent financial expert assists with real-time decision-making and changing variables through the use of a dynamic model of the marital estate. The flexibility of a dynamic model allows for shifting assets/liabilities from one party’s column to the other or calculating an equalization payment due to the illiquidity and lack of transferability of certain items.Provides Insight into Alimony CalculationsWhile financial experts don’t generally determine actual alimony amounts, they can assist clients and attorneys in understanding the amount, structure, and time value of the proposed alternatives. Often clients look for clarity in the amount either from the viewpoint of the payor (Can I afford to pay this monthly amount?) or from the viewpoint of the payee (Can I survive on this monthly amount?). Some structures of alimony also include accelerated amounts or prepayments of the entire amount. A financial expert aids in the decision-making by providing time value of money calculations to assist in the psychology of those financial decisions.Performs Separate/Marital or Retirement CalculationsFinancial experts often assist attorneys by performing tracing analyses and calculations to determine and/or quantify the separate and marital portion of certain assets. Assets often subject to dispute are retirement accounts that were owned prior to marriage. Some states, like Tennessee, recognize not only the balance of such accounts at the date of marriage, but also the appreciation of that amount during the marriage as separate assets. Financial experts are often asked to perform and explain these calculations at mediation to protect the integrity of the separate portion of those assets.ConclusionWhile the costs of mediation may be high, they pale in comparison to the costs of going to trial. Some states, including Tennessee, already require that cases attempt mediation, so why not head into mediation organized, prepared, and ready to do business? Consider involving a financial expert directly or indirectly to assist in that process and chances of settlement will certainly increase.
When Is It Too Late to Plan?
Takeaways from Moore v. Commissioner
If the senior generation of your family business has not yet crafted their estate tax plan, today is the best day to start. A new decision handed down from the Tax Court last week provides a timely reminder that the costs of procrastination can be very high.The case Moore v. Commissioneraddresses the estate of Howard Moore, who passed away in March 2005 at the age of 89.[1] Mr. Moore was a classic self-made man, building an approximately 1,000 acre farm in Arizona (“Moore Farms”) which he sold for $16.5 million shortly before his death. As described in the opinion, Mr. Moore and his family were a rather colorful cast of characters.The PlanIn a deft bit of foreshadowing, the introductory paragraphs of the Court’s opinion described the genesis of Mr. Moore’s ill-fated estate plan:“Howard Moore was born into rural poverty but over a long life built a thriving and very lucrative farm in Arizona. In September 2004 he began negotiating its sale, but his health went bad. He was released from the hospital and entered hospice care by the end of that year.Then he began to plan his estate.”One of the principal elements of the estate plan was the formation of the Howard V. Moore Family Limited Partnership (“the FLP”), to which Mr. Moore contributed an 80% interest in Moore Farms. The plan included a number of other moving parts that we will ignore for the sake of brevity.The FLP included various restrictions on transfer. Through a living trust, Mr. Moore sold his ownership interest in the FLP to an irrevocable trust at a 53% discount to the pro rata net asset value of the FLP. Although the opinion does not directly say so, the discount was presumably a combined discount for lack of control and lack of marketability. Upon Mr. Moore’s death, the tax return filed by the estate included the proceeds from the sale to the irrevocable trust among the estate’s assets.The ProblemsIn general, the Court was troubled by the timeline of events from late 2004 through Mr. Moore’s death in March 2005.In September 2004, Mr. Moore began negotiating the sale of Moore Farms to its eventual acquirer.In December 2004, Mr. Moore suffered a serious health setback, resulting in his entering hospice care.Following the beginning of his hospice care, Mr. Moore retained an attorney to prepare an estate plan. Within a matter of days in late December 2004, Mr. Moore set up the FLP, a charitable foundation, and a series of trusts.Within a few days of contributing Moore Farms to the FLP, Mr. Moore executed a contract for the sale of the farm.The sale of Moore Farms closed on February 4, 2005.
The Court acknowledged that families often use partnerships such as the FLP. However, to be effective for estate planning, there needs to be evidence of a “legitimate and significant nontax reason for creation of the family limited partnership and the transfer of assets to it” (page 31). The Court rejected the estate’s contention that the principal reason for the FLP “was to bring the Moore family together so that they could learn how to manage the business without [Mr. Moore]” (page 32).The Court concluded that the sale of Moore Farms – which was contemplated prior to the formation of the FLP and executed within days of the FLP’s formation – undermined the estate’s argument.Further, following the sale of Moore Farms, the members of the FLP never met to discuss management of the FLP’s remaining assets.The estate also cited the need for creditor protection as a nontax motivation for the FLP, but at trial, none of the FLP members could identify either creditors or potential litigation threats.The Court found that Mr. Moore’s health problems and the short time from the implementation of his estate plan to Mr. Moore’s death undermined the purported nontax reasons for the FLP.The Court also concluded that the absence of any arm’s length negotiations among the members of the FLP as to its principal terms or relative ownership allocation indicated that the FLP was, in substance, a testamentary instrument for Mr. Moore.Finally, following the transfer of Moore Farms to the FLP, Mr. Moore continued unilaterally to manage the operations of the farm and live on the farm until his death. The Court found that, even though Mr. Moore was not the general partner of the FLP, he continued to make all decisions regarding the FLP’s operations. With respect to the FLP itself, Mr. Moore used FLP assets to pay personal expenses.
In short, the Court found that the FLP did not have any bona fide nontax purpose, and therefore, Mr. Moore’s estate properly included the proceeds from the sale of Moore Farms prior to his death.The PainIn the case of the Moore estate, the valuation discounts applied to determine the fair market value of the interest in the FLP were ultimately irrelevant, and the Court does not address the value of the FLP interests transferred in its opinion. Instead, the Court found that the estate included the value of Moore Farms as if the FLP did not exist (and, essentially, as if the estate plan had never been made).The moral of the story? By waiting too long, Mr. Moore’s estate plan was ineffective, and the expenses of creating and executing the plan, which were not insubstantial, were wasted. With an earlier start to the planning process, it seems much more likely that the nontax purposes for the formation of the FLP could have been demonstrable and convincing. Had the Court found the FLP to be valid for estate purposes, the savings to Mr. Moore’s heirs would have been substantial.ConclusionProper estate planning is a priority for well-run multi-generation family businesses. Don’t wait until it’s too late to plan. As we pointed out a few weeks ago, there’s a good chance we will look back on the current period of depressed asset prices as a uniquely efficient opportunity to accomplish estate planning goals. We understand that may family businesses are facing very pressing and difficult challenges, but try not to let this opportunity pass you by.[1] We are not attorneys, and our summary of the case and the conclusions that follow are offered from a strictly lay perspective.
Looking Back to Look Forward
Lessons for the Auto Dealer Industry
My colleague, Travis Harms, published an article on his Family Business Director Blog entitled “Looking Back to Look Forward” earlier this month making observations from companies that survived the Great Recession. Travis analyzed data from 554 operating companies for two-year periods before the Great Recession (2006 and 2007), two years during the Great Recession (2008 and 2009) and two years following the Great Recession (2010 and 2011). Travis concluded five observations from the data analyzed:Operating leverage can be managedWorking capital really is a source of cash during a downturnCompanies become more disciplined investorsBorrowers reduce debt levelsDividends are much less affected than share buybacks
The pool of selected companies included operating businesses thus excluding financial institutions and real estate companies that were more adversely impacted by the Great Recession. While the search didn’t specifically include auto dealers, several of the observations/lessons can be applied directly to the specific operations and challenges that auto dealers are facing in today’s COVID-19 economic climate. We focus on the first three of these observations as they related more directly to auto dealers.Operating Leverage Can be ManagedThe data from Travis’ study illustrated that the companies experienced a 15.6% revenue decline in 2009, but EBITDA margin only fell slightly by 0.5%. How was that possible? Companies were able to mitigate the decline in revenue from falling to the bottom line by making conscious efforts to reduce expenses. The Auto Dealer revenue model consists of new vehicle sales, used vehicle sales, parts and service, and finance and insurance. As we’ve written about and discussed in this space, new vehicle sales as illustrated by SAAR, have fluctuated with the economic cycle. In times of declining new vehicle sales, successful dealerships have shifted focus to their other profit sources. Additionally, dealerships have focused internally on managing and reducing internal operating costs. In 2019, light vehicle sales in declined in the US, and industry executives were highlighting other aspects of their business model mitigating declining volumes as indicated by SAAR before the spread of the virus. Dealerships already had an eye on monitoring costs from sluggish performance times in the past, and managers can lean on their experience from the Great Recession in terms of finding which costs can be cut.Working Capital Really is a Source of Cash During a Downturn The companies in Travis’ sample reduced working capital by $20.8 billion to mitigate lost revenues of $175 billion. Those in the auto dealer industry know that working capital is dictated and monitored by the manufacturer with requirements usually listed on the front page of the dealer financial statement. If auto dealers aren’t afforded the luxury of reducing their working capital, how can it become a source of cash during a downturn? Throughout the last month, one of the mantras that I’ve heard repeatedly in the auto dealer space is that dealers need to maximize any source of revenue or equity at the dealership. One such place is the inventory – auto dealers should become acutely aware of the economics of every unit on their lot. Most auto dealers obtain floor plan financing for all of their new vehicles and at least a portion of their used vehicles. However, not all auto dealers finance their used vehicles or the entire portion that their lender will allow. During these economic times, auto dealers should consider contacting their lenders to discuss the financing terms on their used vehicles that have yet to be financed. For example, if a dealer currently finances 50% of the value of their used vehicles, but the lender will allow 80%, why not finance the additional 30% to create cash flow?When auto dealers are scouring their lot for used vehicles that aren’t being financed, another strategy they should consider is expediting the sale of aging used vehicles that are not selling in the retail market. Opting to move these vehicles through the wholesale or auction market can turn idle inventory into cash flow, which is key for auto dealers in the coming months.Companies Become More Disciplined Investors The figures from Travis’ study concluded that total investment spending from the companies in the sample declined nearly 80% during the analyzed period. Auto dealers have image and real estate upgrade requirements from the manufacturers. As we’ve previously covered in this space, the quality/condition of real estate is one of the key value drivers in the valuation of a particular store. Successful dealerships have already been maintaining their real estate and image requirements, so they should hopefully be able to minimize their capital expenditures over the remainder of 2020. Manufacturers are also likely to be less forceful in compelling dealers to upgrade their facilities until the economic environment improves. Adding different brands/rooftops is another way an auto dealer can add value, giving consumers more options and spreading overhead costs over more sales. Dealers are less likely to make these investments during economic uncertainty, though it may also entice some local competitors to seek to exit the business, which could provide an opportunity given a mutually beneficial circumstance.ConclusionsAuto dealers are a resilient, adaptable group by nature. It’s one of the reasons many have been able to survive economic hardships or sluggish industry conditions in the past. While we haven’t witnessed the unique totality of the conditions that are present today, auto dealers can adopt some of the principles from the Great Recession to try and mitigate the challenges during the survival mode portion that we currently face.
1st Quarter 2020 Oil & Gas Industry Overview
In the first quarter of 2020 oil benchmarks ended arguably their worst quarter in history with a thud. The concurrent overlapping impact of (i) discord created by the OPEC / Russian rift and resulting supply surge; and (ii) the drop in demand due to COVID-19 related issues was historic. Brent crude prices began the quarter around $67 per barrel and dropped to $50 per barrel by early March before plummeting to $19 per barrel by the end of March. WTI pricing behaved similarly although it continues to trail Brent pricing by a narrowing margin (about $5 per barrel) at the end of the quarter. In some areas of the Permian, local spot prices were as low as $7 per barrel towards the end of March. Natural gas, however, has trended downward, but has been more stable in the U.S. as its pricing has become increasingly more regionally tied and relatively less dependent on world oil price drivers. We will examine the macroeconomic factors that have affected prices in this first quarter.Global Economics: OPEC+ Production Growth Collides With Covid-19 Demand DestructionOn March 5th OPEC and its allies (often referred to as OPEC+) held a meeting in Vienna. The result of that meeting was no agreement on additional production cuts beyond the end of March 2020. This was unexpected and immediately pushed prices downward about 10%. In the meantime, the COVID-19 outbreak has continued to escalate. Worldwide measures have been put in place such as quarantines, shut-ins, social distancing and other actions. This has slowed much economic activity to a crawl and, in a matter of weeks, has led to worldwide demand destruction for oil leading to the collapse of oil prices. Impacts and ripple effects abound, however many of them have yet to be easily observed. This development has upended nearly all prior market estimations from organizations such as the IEA, EIA, research institutions, and investment banks as to demand expectations. As of the end of Q1, worldwide consumption decline in 2020 is now very likely. New and revised estimations were still being developed as this has taken the market by surprise.Logistical Consequences: Physical Markets and Force MajeureOne of the clear indicators that this situation is not simply a supply glut is that refinery margins and oil prices declined simultaneously. A dynamic such as this demonstrates demand decline. Another factor to consider is since COVID-19 originated in China, and China is a demand marker for oil and refined products, how was demand impacted there? In February, Chinese oil demand dropped by about 3 million barrels per day out of about 13 million barrels per day – a 20% drop.This turn of events leads to some potential temporary logistical issues such as tanker demand and ultimately shut-ins if the price doesn’t move upwards soon. Storage capacity is very limited in most exporting nations, perhaps two to three months of storage ability at this pace, so there are not many places the excess supply can go. Therefore, producers may have to consider and analyze whether the cost to shut down is less than the cost to produce. Canadian oilsands may be one of the first to start this potential trend. However, even the lowest cost producer, Saudi Arabia, was struggling to find buyers for its excess supply by the end of March. This excess supply battle between Russian and Saudi Arabia will play out prominently in Europe, where Russia could possibly lose hundreds of thousands of barrels a day of production.Additionally, back in January, the International Maritime Organization (IMO) began enacting the Annex VI of the International Convention for the Prevention of Pollution from Ships (MARPOL Convention), which lowers the maximum sulfur content of marine fuel oil used in ocean-going vessels from 3.5% to 0.5%. The implementation of MARPOL will see the marine fuels landscape change significantly as over 95% of the current market will be displaced. This disruption was already happening beforehand, impacting tanker supply and market share for liquids.On the gas front, LNG import deliveries have been suffering from oversupply and a warm winter. There is no “gas-OPEC” to proffer a supply agreement either. China’s CNOOC has declared force majeure to turn away LNG shipments, even though China reached an accord with the U.S. to reduce tariffs on LNG imported from the U.S.U.S. Production Headed Towards DeclineIn September 2019, the U.S. became a net petroleum exporter, marking the first net export month ever since monthly records began in 1973. This may change soon. Capital expenditures for exploration and production companies immediately fell hard. Rystad expects this to drop by as much as $100 billion worldwide, the most in at least 13 years. With the steep decline curves of existing U.S. shale wells, production should drop in a matter of months.In addition to the investment decline, another historic thing happened in March. The Texas Railroad Commission began engaging with Russian Energy Minister, Alexander Novak about trimming oil output. This kind of thing hasn’t happened in Texas or the U.S. since the 1970’s. However, this is necessary for the U.S. Production costs for oil in the U.S., particularly shale oil, are higher than either Russia or Saudi Arabia. The upstream industry’s existing well base in the U.S. are underwater at low 20’s per barrel pricing. That was happening at the end of March.Sources: Dallas Fed Energy Survey, Reuters, Seeking Alpha However, even though Russia and Saudi Arabia can operate existing wells in this environment, it does not mean that this is sustainable for very long. No one knows how long this price war will last. That said, even a few months of this pricing environment could create chaos for the U.S. energy sector. It had already severely impacted stock prices and demonstrated even day to day volatility in public markets.The CARES ActIn March, the President indicated that the U.S. government may become a material buyer for about 30 million barrels of U.S. produced oil in order to fill the strategic petroleum reserve. However, the funding was not authorized by congress in the CARES Act. Congressional Republicans pushed for it, but Democrats did not want to include a “bailout for big oil.” This could hasten bankruptcy acceleration for leveraged energy companies, however since this is a global event and potentially temporary, banks may table defaults and foreclosures and instead better collateralize their exposures and add more commodity price hedges according to an analyst call by UBS.Interest RatesThe U.S. Federal Reserve cut interest rates twice in the month of March. On March 3, the Fed made an emergency decision to cut interest rates by 0.5% in response to the foreseeable economic slowdown due to the spread of the coronavirus. This cut was anticipated and largely shrugged off by the markets as interest rates continued their precipitous decline.Benchmark rates were again cut on March 15 by a full percent to near zero. The central bank also stated that it would increase bond holdings by $700 billion on the same day. These rate cuts however failed to tame oil and gas markets as Brent fell by 10% and U.S. crude fell below $30. Lower interest rates and new bond repurchasing programs are ineffective in a weak demand environment, and prices continued to plummet through the remainder of the month.ConclusionThe shockwave effects of these events have likely surprised even Russia and Saudi Arabia. However, even though these countries have more ability to weather low prices (see chart above), it is not in their best interest to do so. On April 2, the POTUS tweeted optimism about a 10-million-barrel production cut. This was only speculation, but markets reacted quickly and positively. Middle East, U.S. and Russian tensions will be a highlight going into the next OPEC+ meeting, which as of today has been delayed. Increased disruption could significantly affect global oil demand and price and lead to a flood of bankruptcies. In the meantime, prior expectations of U.S. production growth and exports have been tabled. The situation is dynamic, and much could change in the days and weeks to come. Stay tuned.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have varying impacts on prices. We have assisted clients with diverse valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.
Mercer Capital’s Value Matters® 2020-04
A “Grievous” Valuation Error
Looking Back to Look Forward
We’ve made no secret of the fact that Family Business Director likes data. We are not economic forecasters, so we are not attempting to make any predictions about the coronavirus or its economic effects. However, in an effort to provide some context for ourselves, this week we decided to go back and examine some data from the Great Recession.Specifically, we analyzed the performance of a group of small- and mid-cap public companies over the period from 2006 through 2011. This period allows us to see “normal” conditions prior to the crisis (2006 and 2007), two years of crisis performance (2008 and 2009), and two years of recovery (2010 and 2011).The group we selected for analysis consisted of 554 companies having median revenues in 2006 of $853 million. We started with the current (March 2020) roster of companies in the S&P 1000 index (the sum of the S&P 400 Mid-Cap Index and the S&P 600 Small-Cap Index). We then removed financial institutions and real estate companies so that we were considering the performance of “operating” businesses. Finally, we removed companies that were not publicly traded through the entire period. There is a potential selection bias, as our sample includes only those companies that continue to be publicly traded 10+ years later. Nonetheless, it is the best we can do with our data resources, and we think the resulting data is still instructive.We constructed an aggregate income statement and statement of cash flows for the group. You can see the detailed data here. Sifting through the data, we make five observations regarding how businesses persevered through the Great Recession.Operating leverage can be managed. The first thing that struck us is how effectively companies were able to manage operating expenses to maintain profit margins. The textbooks tell us that, because some costs are fixed in the short-term, margins expand as revenues grow and shrink as revenues fall. While this is undoubtedly true, the data suggests that companies were able to manage costs more effectively than the theory would anticipate.Exhibit 1 summarizes annual growth in revenue and expense for the years analyzed. In the face of a 15.6% drop in revenue during 2009, the companies in our sample trimmed expenses by 15.2%. As a result, EBITDA margin fell only modestly that year, from 12.0% in 2008 to 11.5% in 2009.Exhibit 1
Annual Growth in Revenue and Operating ExpensesWhat steps can your family business take today to help preserve profit margins during a temporary revenue shortfall? How do you balance the near-term benefit of such steps against the long-term sustainability of your family business?Working capital really is a source of cash during a downturn. Cash management takes on extra importance during a recession. However, the data shows us that companies focused on working capital management can free up precious dollars by being intentional in inventory management and collections. As shown on Exhibit 2, the companies in our sample “found” $20.8 billion of cash by reducing working capital levels. For perspective, that’s nearly 12% of the total lost revenue of $175 billion during 2009.Exhibit 2Cash (invested in) / Provided by Working CapitalWhat strategies are available to your family business to help harvest cash from working capital during this cycle?Companies become more disciplined investors. One of the first things companies did to conserve cash during the Great Recession was to curtail investment spending on M&A and capital expenditures. Exhibit 3 depicts investment spending over the period. Relative to the 2007 peak, total investment spending decreased nearly 80% to the 2007 trough.Exhibit 3Aggregate Investment SpendingThe data doesn’t reveal the answer to the most relevant question: what was the long-term impact of the dramatic reduction in investment spending in 2009? Revenue growth accelerated in 2010 and 2011 to rates higher than those experienced in 2007 and 2008. Part of that is likely attributable to pent-up demand from the weak results in 2009, but it does at least give us pause to wonder what portion of “ordinary” investment spending is effectively squandered by companies.How will your family business prioritize investment opportunities during the Coronavirus downturn?Borrowers reduced debt levels. Whether by choice or by lender demand, companies repaid debt during 2009, in contrast to other years in which incremental borrowing is the norm. Exhibit 4 illustrates the net change in debt in each year over the period. After effectively eliminating incremental borrowing in 2008, the companies used $29 billion of available cash flow to pay back debt during 2009. For context, that represents about 83% of the $35 billion reduction in investment spending that year compared to 2008.Exhibit 4Net Incremental Borrowing (Repayment of Debt)What is the status of loan covenants, credit line availability, and other factors that can influence your decision (or need) to borrow or repay debt in a downturn?Dividends were much less affected than share buybacks. Of the 274 dividend payers in our sample, only 57 reduced per share dividends during 2009, reflecting the powerful signaling property of dividend payments. Reducing the annual dividend is likely the last resort for public companies seeking to conserve cash. However, as shown on Exhibit 5, public companies tend to use more cash in share repurchases than dividend payments. From more than $28 billion in 2007, share repurchases fell to $19 billion in 2008, and bottomed out at $4 billion in 2009. The irony, of course, is that due to the depressed share prices, 2009 is precisely when repurchasing shares would have had the highest prospective return for public companies.Exhibit 5Aggregate Shareholder DistributionsMost family businesses don’t redeem shares as aggressively as public companies. As a result, suspending redemptions won’t conserve as much cash as it will for their public brethren. How have you prepared your family shareholders for a potential reduction in dividends? For shareholders deriving a significant portion of their annual income from family business dividends, any reduction can be unpleasant. How will you prioritize dividend payments against investment spending and debt reduction? Do your family shareholders know what your dividend policy is?ConclusionAs we said at the outset, we are not professional economic forecasters. There are certainly many elements of our current situation that are far different than what we encountered over a decade ago. That said, the Great Recession was no walk in the park, either. Yet, companies of all shapes and sizes survived. As we have noted in previous weeks, it is our firm conviction that family businesses are better-suited to handling the type of adversity we are currently facing than non-family businesses.
Eagle Ford Update
Production and Activity LevelsEagle Ford production grew approximately 2% year-over-year through March, lagging behind the Permian (18%), Bakken (6%) and Appalachia (5%). This is driven, in part, by the maturity of the Eagle Ford play relative to other areas, as well as the Eagle Ford’s relatively high proportion of gas production.
The rig count in the Eagle Ford at March 20th stood at 67, down 18% from the prior year. This decline is more severe than reductions seen in the Bakken and Permian, though better than Appalachia and the overall US rig count. The Eagle Ford’s rig count has also seen a strong bounce back from November’s lows. However, rig counts are a lagging indicator, so may fall further in light of recent commodity price declines.
The Eagle Ford is also seeing gains in new-well production per rig. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New-well production per rig in the Eagle Ford increased 8% on a year-over-year basis through March, compared to increases of 15%, 13%, and -18% in the Bakken, Permian, and Appalachia, respectively.
Commodity Prices Fall Amid Coronavirus Outbreak and Russian / Saudi Price WarAfter hitting recent highs in early January, oil prices generally declined in January and February as the spread of the coronavirus raised investor concerns regarding oil demand due to potential travel restrictions and declining economic activity. The decline accelerated on March 6, as Saudi and Russia could not come to an agreement regarding production cuts in light of declining demand, sending WTI futures down 10% to $41.28. The feud escalated over the weekend as Saudi Arabia slashed its official crude oil selling prices and indicated its intent to ramp up production. WTI futures fell an additional 25% the following Monday, March 9.
Since then, prices continued to decline, with WTI front month futures settlement prices hitting $20.83 on March 18. Prices have rebounded somewhat from this level but remain extremely volatile.
Financial PerformanceAll Eagle Ford E&P operators analyzed have had year-over-year stock price declines. EOG and Magnolia outperformed the broader E&P universe (XOP), though Penn Virginia and Silverbow are both down more than 90%.
Despite this financial performance, no Eagle Ford operators have filed for bankruptcy in the immediate wake of the price downturn. However, the commodity price environment has impacted the restructuring processes for Eagle Ford operators that entered bankruptcy in 2019. According to bankruptcy proceedings, Sanchez Energy may not be able to repay its debtor-in-possession (DIP) loan, which would result in no recovery for any legacy creditors. EP Energy announced in early March that its restructuring plan had been approved by the bankruptcy court. However, the deal was called off later in the month as lenders for the company’s exit financing pulled their support.
InfrastructureOne of the Eagle Ford’s key advantages is its proximity to Gulf Coast refineries and export infrastructure. However, that benefit is eroding as demand for refined products is tanking (though storage costs are surging) and some importers are seeking to invoke force majeure clauses to reject LNG shipments.This also comes at a time when new pipelines are coming into service to carry Permian production to the Gulf Coast. The EPIC crude pipeline entered service in February, carrying oil volumes from Orla, Texas, to Corpus Christi. In September 2019, Kinder Morgan’s Gulf Coast Express was placed in service, transporting natural gas from the Permian to Agua Dulce (just southwest of Corpus Christi). Early next year, Kinder Morgan’s Permian Highway natural gas pipeline is expected to come online, carrying volumes from the Permian’s Waha hub to the Gulf Coast. While this infrastructure build-out is helping make energy markets more efficient, it is diminishing the Eagle Ford’s previous marketing advantages.ConclusionCommodity prices are putting immense strain on E&P companies, and there is little relief in sight. The Eagle Ford’s maturity means that many of the lowest-cost, highest-return locations have already been drilled. The basin’s marketing advantages are eroding as new pipeline infrastructure transports surging Permian volumes to the Gulf Coast. With two Eagle Ford operators already in bankruptcy (Sanchez and EP Energy) and unable to exit, we’ll see if anyone joins them over the next twelve months.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Auto Dealership Valuation 101
Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals. Valuations of automobile dealerships are unique even from the valuation of manufacturing, service and retail companies. Automobile dealership valuations involve the understanding of industry terminology, factory financial statements, and hybrid valuation approaches. For these reasons, it’s important to hire a business valuation expert that specializes in automobile dealership valuation and not just a generalist business valuation appraiser.TerminologyUnlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes and Depreciation (“EBITDA”) are virtually meaningless in automobile dealership valuations. Instead, this industry communicates value in terms of Blue Sky value and Blue Sky multiples. What is Blue Sky value? Any intangible/goodwill value of the automobile dealership over/above the tangible book value of the hard assets is referred to as Blue Sky value. Typically, Blue Sky value is measured as a multiple of pre-tax earnings, referred to as a Blue Sky multiple. Blue Sky multiples vary by franchise/brand and fluctuate year-to-year.Another unique aspect of automobile dealership valuations is the reported financial statements. Unlike valuations in other industries where the preferred form of financial statements might be audited/compiled or reviewed financial statements, most reputable valuations of automobile dealerships rely upon the financial statements that each dealer reports to the franchise/factory, referred to as Dealer Financial Statements. Why are Dealer Financial statements preferred? Dealer Financial statements provide much more detailed information pertaining directly to the operations of the dealership than any audited financial statement. Valuable information includes the specific operations and profitability of the various departments including, new vehicle, used vehicle, parts and service, and finance and insurance. Each department is unique and has a different impact on the overall success and profitability of the entire dealership. Automobile dealerships are required to report these financial statements to the factory on a monthly basis. However, an experienced business valuation expert knows to request the 13th month dealer financial statements. If a year only has twelve months, then what are the 13th month dealer financial statements? The 13th month dealer financials typically include the year-end tax adjustments such as adjusting the value of new/used vehicles to fair market value by reflecting current depreciation and other adjustments.Valuation Approaches Asset-Based ApproachThe asset-based approach is a general way of determining a value indication of a business or a business ownership interest using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to adjust the various tangible and intangible assets of an enterprise to fair market value. In automobile dealership valuations, the asset method is utilized to establish the fair market value of the tangible assets. This value is then combined with a Blue Sky “market” approach to conclude the total fair market value of the automobile dealership.Income ApproachThe income approach is a general way of determining a value indication of a business or business ownership interest using one or more methods that convert anticipated economic benefits into a single present amount.The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.How is the income approach unique to the automobile dealership industry? First, projections are rarely produced or tracked by automobile dealers, so historical capitalization methods are mostly used. Second, most automobile dealerships are dependent on the national economy, and sometimes to a larger degree, their local economies. What impact does this have on the income approach? Business valuation appraisers need to analyze and understand the dependence of each automobile dealership to the national and local economy which usually affects the seasonality/cyclicality of operations and profitability. Once again the automobile dealership is unique in that it can experience seasonal/cyclical fluctuation in a given year, or more importantly, it fluctuates over a longer period of more like five to seven years.Market Approach The market approach is a general way of determining the value indication of a business or business ownership interest by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.In the automobile dealership industry, traditional market approaches are basically meaningless. While there are a few publicly traded companies in the industry, they are large consolidators and own numerous dealership locations of many franchises in many geographic areas. Private transactions exist, but generally not in a large enough sample size of the particular franchise of the subject interest to provide meaningful comparisons.So how does a business valuation expert utilize the market approach in the valuation of automobile dealerships? The answer is a hybrid method utilizing published Blue Sky multiples from transactions of various franchise dealership locations. Two primary national sources, Haig Partners and Kerrigan Advisors, publish Blue Sky multiples quarterly by franchise. As discussed earlier, these multiples are applied to pre-tax earnings and indicate the Blue Sky or intangible value of the dealership. When combined with the tangible value of the hard assets determined under the Asset Approach, an experienced business valuation expert is able to conclude a total value for the dealership using this hybrid approach and communicate that result as a multiple of Blue Sky that will be understood and accepted in this industry.ConclusionsThe valuation of automobile dealerships can be more complex than other valuations due to their unique financial statements, varying cost structures and profitability of departments, different terminology, and hybrid valuation methods. Hiring a business valuation expert that specializes in this industry rather than a generalist business valuation appraiser can make all the difference in providing a reasonable valuation conclusion.
Coronavirus and the Value of Your Family Business
As family business leaders continue to make hard decisions in real-time against the ever-changing backdrop of the pandemic, their legal and tax advisors would do well to consider whether this is an opportune time for intra-family ownership transfers. For many family businesses, the current economic uncertainty presents a unique, and perhaps fleeting, opportunity for more tax-efficient estate planning.Wall Street vs. Main StreetInvestors value the shares of public companies on a (nearly) continuous basis. It should not be too surprising that these “real-time” valuations are subject to a good bit of volatility.Is the value of your family business that volatile?Unlike public companies, private family businesses are not subject to continuous public valuation. Reliable valuation data points for family businesses exist only when a competent business valuation is prepared or when there is an arm’s-length transaction with a third party. As a result, whatever day-to-day volatility exists in the value of your family business is not visible. However, just because you can’t see it doesn’t mean it’s not there. Instead, what is often assumed to be limited volatility in the value of a family business is more likely a function of the limited frequency with which value is observed.The same fundamental factors that influence public stock prices – risk assessments, growth expectations, and cash flow projections – also influence the value of private family businesses.We say all that to say this: unless you are a grocer or the like, the value of your family business is likely lower today than it was two months ago.The (Potential) Silver Lining In All of ThisAt this point, you may be thinking that, even if the value of your family business is currently depressed, you have no intention of selling today. But even for families that have no intention of selling in the current environment, the fact that the value of your family business has declined should not be ignored.One of the cornerstones of estate planning is the concept of fair market value (“FMV”). Fair market value is the price at which shares in family businesses can be gifted or otherwise transferred when executing estate planning. In general, the lower FMV is, the more efficiently shares can be transferred in pursuit of estate planning goals.IRS regulations (Revenue Ruling 59-60) define fair market value as:“The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”Fair market value does not depend on whether you are willing to sell your family business today. What does matter is the price that would be received, were a transaction to occur today. And if a transaction were to occur today, the price would reflect the same uncertainty that we see manifest in public markets. In case there was any doubt about this, Revenue Ruling 59-60 offers the following additional guidance, which seems almost prophetic with regard to where we find ourselves today:“The fair market value of specific shares of stock will vary as general economic conditions change form ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.”As the number of confirmed coronavirus cases across the globe grows, we do not yet have a clear sense of what the long-term economic toll will be. Large-scale restrictions on social gatherings are having an immediate effect on the dining, entertainment and other service industries. The size of the economic ripples on other sectors is hard to forecast. However, the real-time impact of the uncertainty on public securities market can be measured.Family business directors are currently facing many pressing issues. Amid all of the chaos, however, directors should know that the estate planning opportunities triggered by lower valuations may not last. Schedule a quick call with your estate planning advisors to see if there are steps you can take to help reduce the burden of future estate taxes on your family business.
Eagle Ford M&A
Steady Transaction Activity Restrained by Unforeseeable Circumstances
Over the last year, deal activity in the Eagle Ford Shale was relatively steady, picking up towards the end of 2019 and carrying into early 2020. The recent uncertainty caused by the coronavirus pandemic and the Saudi-Russian oil production level conflict, however, has hindered M&A activity in the region, and frankly everywhere else. WTI closed below $23/bbl on March 18 with futures prices indicating a depressed price environment persisting for the near term. Although deal count has decreased as of late, the M&A landscape has the potential to ramp up as some companies will need to sell assets in order to bolster their balance sheets amid the challenging commodity price environment, though wide “bid/ask” spreads between buyers and sellers may be difficult to overcome.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. Relative to 2018, deal count decreased by six transactions and the average deal size declined by roughly $650 million.Ensign Natural Resources Entering, Pioneer Natural Resources ExistingEnsign Natural Resources made its first acquisition as a company in May of 2019, acquiring Eagle Ford acreage from Pioneer Natural Resources. Brett Pennington, President and CEO of Ensign, explained that the assets included meaningful production and attractive drilling inventory. Pioneer on the other hand, was ready to become a pure-play Permian operator. In total, Pioneer has sold approximately $1 billion of assets located outside the Permian Basin. Pioneer seemed to make it clear that they are throwing all of their eggs in one basket.Callon Petroleum Expanding their FootprintThe biggest deal, in terms of dollars, was Callon Petroleum’s acquisition of Carrizo Oil & Gas. Callon, a Permian Basin focused company, expanded its position in the Permian and entered the Eagle Ford with the acquired acreage. The deal terms had to be revised after significant investor pushback. The amended agreement stated that Callon shareholder would own approximately 58% (up from 54% initially) of the combined company and Carrizo shareholders will own approximately 42% (down from 46% initially). It should be noted that this deal is not pure Eagle Ford shale. Carrizo’s asset details included 76,500 acres in the Eagle Ford with roughly 600 undrilled locations and 46,000 acres in the Delaware Basin with about 1,400 undrilled locations. The combined assets will include 120,000 net acres in the Permian and 80,000 net acres in the Eagle Ford. The core positions in the Permian and Eagle Ford plan to produce over 100,000 boe/d of pro forma production. Joe Gatto, president, and CEO of Callon, explained his vision of the larger company, which is to employ a more efficient scaled development model that aims to drive a lower cost of supply. The multibillion-dollar merger officially closed in December of 2019, and now seems like unfortunate timing due to the current price environment.Repsol S.A. Picking Up Where Equinor Left OffEquinor, a Norway based petroleum refining company, agreed to sell its Eagle Ford assets to Repsol for $325 at the end of 2019. The agreement gives Repsol, a Spain headquartered oil & gas company, 100% control of the asset while making them the operator. In 2017, Equinor took an $850 million impairment on the asset due to lower than expected output. In 2018, Equinor also released that part of their acreage lies on areas with high water stress variables. Repsol expressed that the acquisition will give their producing assets portfolio a boost while taking advantage of operating synergies and efficiencies. The acquisition is also aligned with Repsol’s intentions to expand in North America. The deal plans to increase total production for Repsol in the Eagle Ford to approximately 54,000 boe/d.ConclusionM&A transaction activity in Eagle Ford was fairly consistent throughout 2019, as companies focused to acquire valuable acreage with production potential. However, no one can ignore the tough current conditions in the energy industry. Acquisitions that closed at the end of last year seem like the least of worries, as companies are simply trying to avoid bankruptcy. If conditions allow only the strongest to survive, it could lead to an increase in transaction activity ahead.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Energy Valuations: Freefall Into Bankruptcy Or Is This Time Different?
This post originally appeared on Forbes.com on Monday, March 9, 2020.
Energy valuations are taking an epic pummeling. Considering declining demand amid COVID-19 concerns, the initial fallout to the Saudi-Russia feud was predictable. Within hours, prices had dropped like an anchor (to $33 a barrel as of this morning). Several companies have already announced cutbacks, including Diamondback Energy, as they dropped two additional drilling crews. Parsley Energy made a similar announcement and more are sure to follow. Perhaps even more draconian, SM Energy’s unsecured bonds fell to $0.42 on the dollar and pushed the yield up to around 25%. These bonds traded above $0.90 as recently as February 24th. Trading has been halted this morning amid the panic. Whether the market fallout has hit rock bottom remains to be seen. Regardless of what Russia may have been thinking, the geopolitical climate has put more pressure on U.S. producers and bankers. Operators who were contemplating hedging production at $50 per barrel but waiting to act are kicking themselves today.
Energy and related bankruptcies that were estimated to rise in 2020 will likely accelerate a few notches. According to Haynes and Boone’s Oilfield Services Bankruptcy Tracker, there were six (6) new bankruptcies in the oilfield services area in the fourth quarter of 2019. Up until this point in 2020, Pioneer Energy Services is the only major oilfield services company to enter Chapter 11 bankruptcy. That’s almost undoubtedly going to change soon. As upstream companies have vowed to spend within their cash flow, oilfield services will take the biggest brunt of this at first. However, producers with high leverage capital structures could quickly follow. Gas prices have held their ground but they’re so low anyway, it’s hard to know how much lower they could go.Can Banks Hold On?The looming factor for companies is how banks will go about determining borrowing bases this year. It’s a tough position to be in at this point. Bankers at the Hart Energy Capital Conference in Dallas last week did their best to portray patience towards the upstream sector, but were also clear about expectations. Those expectations were that borrowers can meet their obligations, and that borrowing bases will shrink with valuations. One of the speakers, Tom Petrie, expressed concern about $110 billion in debt coming due in the next decade for the energy market.As working interest values for producing interests dive, the expected returns have changed from PV10 to closer to PV20. This has degraded credit quality. The mix of below-investment grade debt has worsened in the past year. In high yield markets, CCC or below is the most common rating according to some recent data.High Yield Debt Rating MixSOURCE: JP MORGAN CORPORATE ENERGY & POWER PRESENTATION Even if bankers lending on reserves maintain their lending ratios, the borrowing bases will shrink accordingly. However, based on recent indications, lending ratios have and will continue to shrink alongside values. Debt-to-EBITDA ratios which used to often float in the 3.5x to 4.5x range are now, not surprisingly, in the 2.5x to 3.5x range. Enterprise values for upstream producers were often between 6.0x to 8.0x EBITDA too. That is in the past.Shifting Credit RatiosSOURCE: OCC GUIDELINES AND AMEGY BANK PRESENTATION Impacts appear bad and immediate. However, this plunge could, ironically, buy the market a little more time. The founder of OnyxPoint Global Management, L.P., Shaia Hosseinzadeh, told Bloomberg just last week that “Things are so bad now, that the banks can kick the can down the road and say ‘there’s no point of rushing everybody into bankruptcy, we’ll wait until October.’ But if it’s business as usual, it’s going to be a horror show.” That may be a prescient thought. Another consideration is that fewer banks are even lending to energy companies anymore. The rise of the environmental, social, and governance (“ESG”) movement, alongside weak returns, have pushed many bankers and other investors out of the space. There isn’t as much capital to go around, not that it’s cheaply available right now anyway.Due to valuations being so low, the recovery for bankers coming out of Chapter 7 situations may be less attractive, especially on the oilfield service side. The market value of intangible assets is so depressed compared to other times in the commodity cycle, that it may not make economic sense to rush into the process for some.Can Values Recover?This prognostication about delayed bank behavior may be a moot point if liquids values can’t recoup over time. This is an undercurrent that has been a factor in keeping values down recently. Electrification trends and the idea that liquids demand will wane have proffered the notion that demand for liquids will be flat to even shrinking in the future, all while supply becomes bountiful. Some project the electrical passenger car trends to reach around 20% by the end of this decade. However, while the short-term appears bleak, many projections about the medium- and longer-term remain more optimistic for upstream producers and servicers. J.P. Morgan Cazenove recently suggested that the oil industry may be under-equipped to meet demand recovery in 2021 and beyond. Another way of putting that is downward pressure on prices could be its own cure in the medium term. Capex budgets have been slashed and continue to be. Over 200 oil drilling rigs (and counting) have been shut down in the past six months. Production will suffer, even with drilling and production efficiencies achieved in recent years. Especially in the U.S. shale markets, declines on existing wells drop off so fast, that their effect on supply will show up sooner rather than later.Producers are hopeful for this. Regardless of the market’s relentless pounding down on reserve values, producers know that, particularly proven reserves are next year’s production. They do not want to sell or unload them for the pennies on the dollar (or less) that implied valuation multiples suggest right now. Intrinsically, they have much more value than inferred by market capitalizations. Management teams believe that enterprise values shouldn’t be trading at a fraction of PV10 values over a long period of time. At a minimum, many producers believe there is an optionality to their future drilling inventory.The question remains, could that happen fast enough to save a bankruptcy slog this year? Only time will tell.
Trends with Independent Trust Companies
Independent trust companies are a growing segment of the trust industry. While trust divisions of banks still represent about 84% of the trust industry, there’s been a trend towards independence that parallels that seen in the wealth management industry. In this post, we highlight some of the trends impacting independent trust companies.FeesOver the last decade, there has been a broad-based decline in pricing power across the investment management industry. Assets have poured into low fee passive products, driving down effective realized fees for asset managers. Wealth managers have been more resilient, but the threat of robo-advisors remains. Virtually all discount brokerages were forced to cut trading fees to zero. Consider the relationship between effective realized fees and revenue growth over the last five years for US asset/wealth managers (shown in the chart below). The message is clear. Assets across the financial services industry are gravitating towards lower-fee products.So how have trust companies fared in this environment? Despite the pricing pressure in the broader industry, trust companies have fared remarkably well. According to Wealth Advisor’s 2019 pricing survey, trust company fees are actually heading higher. For many of our independent trust company clients, the story has been similar. Realized fees have remained steady or even increased over the last five years, while assets under administration have grown through market growth and net inflows.Market MovementsThe recent coronavirus induced sell-off will have a significant negative impact on the top line for trust companies, as it will for all investment managers that charge a percentage of assets under management. As of the date of this post, the S&P 500 is down over 20% from its all-time high on February 19, 2020. Trust company revenue will take a big hit. The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the pandemic and containment policies. The range of likely scenarios is beyond the scope of this post, but it suffices to say that there is still significant uncertainty regarding the impact on people, markets, and economic activity.Unlike many asset and wealth management firms, trust companies often have revenue sources that aren’t based on AUM (e.g., tax planning, estate administration fees) which should provide some protection during a market downturn. This, combined with a resilient fee structure, should help trust companies weather the pandemic.DemographicsTrust companies primarily serve high net worth and ultra-high net worth clients, and demographic trends in these markets are favorable for the continued growth of the trust company industry. The number of high net worth individuals (net worth > $1 million) in the United States has grown significantly over the last decade. According to Credit Suisse’s Global Wealth Report 2019, there were over 18 million millionaires in the United States in 2019, nearly double the number in 2010.Additionally, the impending wealth transfer as baby boomers age should spur growth in trust assets. Roughly $30 trillion is expected to change hands between baby boomers and younger generations during the coming years. To the extent that this wealth is transferred via trusts, trust companies stand to benefit.Regulatory Trends As trust law has developed, a handful of states have emerged as being particularly favorable for establishing trusts. While the trust law environment varies from state to state, leading states typically have favorable laws with respect to asset protection, taxes, trust decanting, and general flexibility in establishing and managing trusts. Opinions vary, but the following states (listed alphabetically) are often identified as states with a favorable mix of these features.AlaskaDelawareFloridaNevadaSouth DakotaTennesseeTexasWashingtonWyoming
Over the last several decades, many states such as Delaware, Nevada, and South Dakota have modernized their trust laws to allow for perpetual trusts, directed trustee models, and self-settled spendthrift trusts (or asset protection trusts). The directed trust model in particular is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients. Under the directed trust model, the creator of the trust can delegate different functions to different parties. Most frequently, this involves directing investment management to an investment advisor other than the trust company (this could be a legacy advisor or any party the client chooses). The administrative decisions and choices related to how the trust’s assets are used to enrich the beneficiary are typically charged to the trust company.
The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client.Technology Trust administration is labor-intensive and requires extensive tax, accounting, legal and compliance expertise. Trust companies typically employ CPAs, estate planning attorneys, financial advisors, and trust officers, among other professionals. Many of our trust company clients have spent substantial amounts of money developing software and systems to reduce the administrative and compliance burden on these employees and enable fewer employees to manage more assets. We expect this trend to continue as trust companies seek to reduce overhead expenses and improve profitability. Trust company clients should benefit as well from reduced friction and improved client experience.SuccessionThe ownership profile at independent trust companies is often similar to that seen at asset and wealth management firms. Ownership is often concentrated among the founders, with younger partners owning small pieces of the company. We’ve written in the past about buy-sell agreements for wealth management firms, and much of that discussion is applicable to independent trust companies as well. In short, the dynamic of a multi-generational, arms-length ownership base can be an opportunity for ensuring the long-term continuity of the firm, but it also runs the risk of becoming a costly distraction. As the trust company profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Looking ForwardMany trust companies have performed remarkably well over the last decade, aided by the recently ended 11-year bull market and the trends discussed above. The current market environment is one of incredible uncertainty, and the outlook for trust companies and the economy as a whole will continue to evolve rapidly over the coming months. Beginning next week, we have planned a series of blog posts to explore the impact of the current market environment on investment managers.
Is Your Family Business Ready for a COVID-19 Recession?
While we respect the fundamental divide between Wall Street and Main Street, the official end of the bull market for public stocks signals that Coronavirus-induced disruptions to the global economy are real and are expected to persist. As the pandemic unfolds, the economic effects will eventually reach Main Street, where most family businesses operate. The stock market tends to be the best leading economic indicator, so family business directors would do well to think about how best to position their businesses to weather the slowdown.We are not predicting that there will, in fact, be an official recession, or even how long or significant the economic slowdown will be. However, sluggish economic growth during at least a portion of 2020 seems inevitable at this point. A little over a year ago, we asked our readers whether their family businesses were ready for the next recession.Times of stress like the current period highlight some of the principal benefits of being a family-owned business. Unlike public company managers and directors, family business leaders can respond to current circumstances with a long view in perspective, not worrying about next quarter’s earnings release. That long view includes a focus on operating efficiency, balance sheet strength, and competitive dynamics.Operating EfficiencyA great economy can obscure inefficiencies in your family business. A slowing economy can reveal exactly where actions are needed. From the perspective of a family business, this can be viewed as an opportunity rather than a necessity. Improving operating efficiency is not about boosting next quarter’s earnings, but rather enhancing the long-term sustainability of the family business. A slowdown can be an opportune time for making strategic investments in technology, systems, and processes that will pay dividends both during, and well after, the slowdown.Balance Sheet StrengthIt is more challenging to adapt the family business balance sheet on the fly. Just as the best time to plant a tree is twenty years ago, the best time to secure favorable credit facilities is before everyone sees a slowdown coming. Nonetheless, it is never too late to engage with your bankers to review covenant compliance and ensure that access to existing lines of credit will not be interrupted if and when needed.The best way to enhance financial flexibility in anticipation of an economic slowdown is to identify unnecessary or non-operating assets. Capital is precious in a downturn, and you don’t want to “waste” capital by funding assets that don’t actually support the operations of the family business.Working capital: Have your cash collections been stretching out? Do you have excess inventory?Fixed assets: Do you have idle productive assets or excess warehouse capacity? Is your administrative office space consistent with how work actually gets done these days (telecommuting, etc.)?Other: Does the family business own assets that are really for the private enjoyment of select family members? Now may be the right time for the business to sell those assets to the family members that actually use them.The best way to enhance financial flexibility in anticipation of an economic slowdown is to identify unnecessary or non-operating assets.Competitive DynamicsTaking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity. You don’t have to outrun the bear as long as you can outrun the other hunters. An economic slowdown can prove to be a prime opportunity to solidify your family businesses’ long-run competitive position.It’s not for the faint of heart, but strategic acquisitions during a downturn often provide better long-term returns than those made at the top. If a buyer’s market develops, do you have a strategic plan for what businesses your family business would want to acquire at opportunistic prices?ConclusionWe hope that the economic slowdown triggered by COVID-19 is short and shallow. Regardless of the duration and intensity, however, family business directors should view the challenge it presents as an opportunity to take the long view. The reality of the coronavirus should cause all of us to change some of our ingrained personal habits not just to avoid infection in the near-term, but to live healthier lives in the long-run. In the same way, family business directors should focus on taking prudent steps to manage not just the near-term economic slowdown, but to position their family businesses to thrive for future generations.
February 2020 SAAR
SAAR came in at 16.833 million for February 2020, down about 0.5% from January’s revised figure, but up 1.9% from February 2019. However, part of this gain is attributable to calendar quirks as not only was 2020 a leap year, but this extra day fell on a Saturday, providing the first February since 1992 with five selling weekends. Through February, 2.49 million light vehicles have been sold in 2020, up 4.5% from last year. This increase comes entirely from light trucks, as year-to-date volumes have increased 11% for this segment while autos have declined 11% over the same period. Trucks have made up 74% of light vehicle sales so far in 2020, up from 70% last year and continuing a trend since 2012 when trucks were just under 50%.As seen above, SAAR has been below 17 million in eight of the past twelve months with an average of 16.938 million. Solid performance in the first two traditionally slow months of the year puts 17 million units within reach for the year, though expectations in the range of 16.5 million to 16.8 million certainly seem plausible. February’s performance may not be duplicated in March due to uncertainty surrounding the impact of COVID-19, commonly known as the Corona Virus.On the supply side, the key question will be how the virus impacts automotive manufacturers and their abilities to source products. Shutdown of Chinese plants has caused manufacturers to find alternative means, which can add to costs. If problems linger, the ramifications would likely decrease volumes globally, as Goldman Sachs recently downgraded its outlook on 2020 global auto sales to a 3.5% decline from 2019 per the Wall Street Journal. Vehicle sales in China were down a whopping 80% in February compared to the prior year. Similar effects were felt in countries where the disease has begun to spread with South Korea, Japan, and Italy, down 20%, 10.7%, and 8.8%, respectively. While the impact on the U.S. has thus far been much lower than these countries, sales volumes are likely to be adversely affected. While the mortality rate is estimated at or below 1%, the economic fallout has already proved to be significant due to the uncertainty and panic.As for demand, there is little data available to determine the preliminary affects of the virus. However, should foot traffic decline with consumers limiting their social exposure, sales would likely decrease as internet sales have increased but the online experience remains far from substituting the experience of test drives. As discussed above, selling weekends are particularly important to the industry, which are in jeopardy if consumers opt to stay at home.On March 3, the Fed opted to cut rates 50 basis points to support the economy while citing domestic economic strength. This rare inter-meeting rate cut was the first such cut since October 2008, but this did little to ease markets as the S&P 500 still finished the day down 3%. According to interest rate futures, an additional 25 basis point cut is nearly certain at the meeting on March 19-20 with a greater than 50% chance this cut is 50bps.Lowering interest rates seeks to induce economic activity, and specific to the automotive sector, this cut in part seeks to induce consumers into purchasing vehicles. While discounts may make people buy more on their weekly trip to the grocery store, a relatively small reprieve in ongoing interest payments is unlikely to change the decision of whether to make such a significant purchase as a car for most consumers. Lower funding costs also seek to encourage business expansion, though dealerships’ position in the supply chain (last stop before consumer) limits the impact rate cuts will have on their decision making. Dealers rely on their manufacturers for inventory, who in turn rely on the companies building these parts which means dealers’ supply will feel second-order impacts with minimal ability to navigate these changing market dynamics. However, lower interest rates should reduce floor-plan costs, which represents a nice benefit. If volumes are adversely affected, floor-plan costs will drop even further with less inventory on the lot. But as business owners are acutely aware, not all operating expenses are tethered to activity, and prolonged sluggish activity would weigh on dealerships, like many other businesses, particularly those with significant debt burdens. Like everyone else, we will continue to monitor the situation.The global uncertainty and equity market volatility resulting from COVID-19 may present investors with an opportunity to buy at a depressed valuation. Similarly, auto dealer owners who are bullish on the long-term investment merits of their business may see this as an opportunity to transfer their interests to future generations in a tax-efficient manner. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.
Current Commodity Price Environment May Lead to Next Round of OFS Bankruptcies
When I was given the assignment to author this blog post this week, I thought "Could one possibly 'draw' a more timely assignment?" Several weeks ago, Mercer Capital’s Energy Team noted that we should consider the current condition of the oilfield services ("OFS") industry as the topic of one of our upcoming blog posts. The price for West Texas Intermediate ("WTI") had been declining since mid-February, due largely to decreased demand related to the coronavirus, and the Russia-Saudi Arabia failure to reach an agreement on production cuts. Industry participants were growing a least somewhat concerned – and then came the March 6 news that the Russian-Saudi negotiating difficulties might lead to an actual price war – and then came the March 9 actual start of the price war.More Possible OFS Bankruptcies? How Did We Get "Here"?By way of "background," the U.S. OFS industry went through a major round of bankruptcies following the late 2014 drop in oil prices. From the WTI peak in June 2014 at $106/bbl, prices fell to $58/bbl in mid-December 2014 and on to $30/bbl in January 2016. While there were a couple of upward moves in WTI in April and August of 2015, those were short-lived with the "trend" remaining a fairly clear path downward.
Data provided in Haynes and Boone, LLP’s Oilfield Services Bankruptcy Tracker report (January 2020) show the annual number of identified OFS bankruptcies rising from 33 in 2015, to 72 in 2016, before easing to 55 in 2017 and 12 in 2018. Although the WTI price was generally rising during 2016, the price remained below $55/bbl with the impact of the fall from $60+/bbl pricing continuing to ripple through the industry well into 2017.
During 2018 – through October – WTI had generally ranged between $61 and $74/bbl. OFS bankruptcies slowed, but the industry was hardly prospering. Many industry participants were more accurately described as "hanging-on" or "maintaining operations" – hoping for a rise in demand, or a drop in supply, to lift prices and move the industry to more favorable profitability. However, in November 2018, rising worldwide inventories caused by global supply running well ahead of demand, fueled in part by the continuing growth in U.S. production, resulted in prices dipping to a low point of $43/bbl in December. While pricing improved somewhat in 2019, with WTI generally between $54 and $64/bbl, the loss of $62+/bbl pricing led to an uptick in the number of OFS bankruptcies late in 2019.
Source: Haynes and Boone, LLP Recent Events – Industry and Non-IndustryAs we entered 2020, there didn’t seem to be any specific indications of change ahead for oil prices. Few had ever heard the term coronavirus and no one was anticipating a Russian break from OPEC+, or using the term "price war" in regard to the Russian-Saudi failure to reach an agreement on OPEC+ production cuts. The World Health Organization’s China office had begun receiving reports in December of an unknown virus that had led to cases of pneumonia in Wuhan, a major city in eastern China, but the term "outbreak" wasn’t being used.Within eight weeks that had all changed markedly. By late February we had already gone beyond "outbreak" and had moved on to regularly hearing of the possibility of a pandemic. People and countries began to react. Multiple countries were significantly limiting travel in order to slow the spread of what we all now know as the novel coronavirus, or Covid-19. Quarantines, self-imposed and government-imposed, were reducing economic production and travel, thereby reducing the level of demand for transportation fuels and fuels as a means of production. In addition, it was becoming clear that the Russian-Saudi disagreement on production cuts was more than a minor matter. The possibility of a split in the Russian-Saudi production alliance to maintain oil prices was being actively discussed as having real potential. Oil prices naturally responded with a downward turn, reaching as low as $45/bbl near the end of February.On Friday, March 6th, it was reported that Moscow had outright refused to reduce its crude production in order to offset the fall in demand related to the coronavirus. Over the subsequent weekend, rumors swirled as to the magnitude of the impasse. Then, on Monday, March 9th, the worst possible scenario for oil prices became more than a possibility. An actual price war was initiated as both Russia and Saudi Arabia announced production increases. The anticipated glut immediately pitched prices into a dive with the WTI falling from $41/bbl to $31/bbl by day’s end for a single-day decline of 24%.What to ExpectAs to what we can expect going forward from here, we don't know. The coronavirus, now a pandemic, is obviously spreading. How much and how far are the unknowns, along with how large the impact will be on the U.S. and global economy, and thus, the demand for oil. What is know is that oil demand will be down for a time. What’s also known is that the outbreak will eventually be contained and the economic impact reversed when things return to "normal."So, What About Oil Supply?Well, we have two very significant oil exporters, formerly allied on oil production levels, now markedly un-allied on oil production. Not only un-allied, but both purposefully increasing production levels, in the face of lower demand, for the purpose of causing economic pain to each other. Unfortunately, that economic pain radiates, by extension, to all oil producers and the businesses that provide equipment and services to the oil producers. What does that mean for U.S. OFS market participants in the near term? Pain. Economic pain. For those that have more economic "wriggle-room," better margins, lower financial leverage, more defendable market position, it won’t be good. For those with less of that economic wriggle-room, it could go well beyond "not good." If the alliance break isn’t remedied fairly quickly and the two belligerents remain belligerent, the production glut could last long enough that a new round of OFS bankruptcies could be in the making.What’s absolutely certain is the uncertainty of it all – and at least some very real OFS industry economic pain if either the virus impact, or possibly the Russian-Saudi dust-up, lasts long enough to keep oil prices down at the new current level, or an even worse scenario, lower than the current level.
Today’s Independent Trust Company
How Does Your Trust Company Measure Up?
Historically, the role of a trust was simply for one party (the trustee) to hold property for the benefit of another (the beneficiary). Over time the role of trust companies has expanded to include managing the distribution, administration, and investment of trust assets. Fifty years ago, most local banks had a trust officer who performed these services. Consolidation in the banking industry, changing consumer preferences, and favorable trust law changes in states such as Delaware, Nevada, and South Dakota have led many bank trust officers to leave their local bank and start independent trust companies. (This shift parallels the shift from the broker-dealer to independent RIA model.)As trusts have become more sophisticated, independent trust companies have become increasingly specialized with respect to trust administration. Many independent trust companies today focus on specialized types of trusts or beneficiaries. As part of this trend, trust companies are increasingly outsourcing investment management in order to focus on fiduciary issues.More trust companies are now shifting to a directed trustee model, which absolves the trustee of certain fiduciary responsibilities. With a directed trust an investment advisor is named on the account so that investment decisions are made by the appointed advisor rather than the trust company. This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management. Typically, a directed trustee model calls for slightly lower fees, but much less liability for the trust company.The alternative is a delegated trustee model, where the trustee can delegate fiduciary authority to an investment advisor, as they see fit. However, in this model, the trustee is responsible for properly vetting the investment advisor and supervising their decisions.The Typical Independent Trust CompanyA trust company’s revenue is a function of assets under administration and its fee schedule. Expenses generally consist of personnel expenses and fixed overhead costs.AUA. Over $120 trillion of assets are administered by domestic trust companies /departments. It is estimated that approximately $18 trillion of assets are administered by independent trust companies, with each, on average, administering $1.5 billion. Generally, assets under administration (AUA) growth has been highest within the non-managed (delegated or directed) trustee model.Fees. While the rest of the investment management industry has been dealing with fee compression, trust fees have been increasing. Independent trust companies have typically been more willing than bank’s trust departments to increase fees. Thus, as customers move assets from trust departments to independent trust companies, we expect fees across the industry will continue increasing.Wealth Advisor reported that on average companies charge around 50 basis points per year for vanilla trust services. Trust companies typically don’t require minimum account sizes, but instead require minimum annual fees, which can range from $1,000 to $20,000 depending on the services offered. Fees are typically structured on a sliding scale, where the first million could be charged 60 bps, the next million could be charged 50 bps, and the next million 40 bps, etc. If the trust company also manages the underlying assets, fees will of course be higher. However, larger clients tend to receive discounts, which can correspond to low fees by industry standards, but substantial revenue given the size of the account.Expenses: The relationships between independent trust companies and their clients require the time and energy of a dedicated staff. Thus, most of a typical independent trust company’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and officers. Compensation generally tracks revenue fairly closely, making operating leverage more pronounced with overhead costs than compensation related expenses.Overhead costs for trust companies are generally fixed in nature, which allows trust companies to take advantage of operating leverage over time. Overhead costs include the cost of compliance, technology, and marketing expenditures all which have been increasing over the last few years. We have seen an increased focus on branding as trust companies seek to connect with clients on a more personal level. Additionally, corporate trusts can have significant litigation costs from year to year.How Does Your Trust Company Measure Up? Bringing everything together, the average trust company’s income statement looks similar to the one outlined below.Charging slightly under 50bp on $1.5 billion in assets, the average trust company generated $7 million in revenue in 2019. With an average operating margin of approximately 37%, the average independent trust company had $2.6 million in operating profit, which it could distribute out to its ownership base or invest in new technology or marketing initiatives.A Better ModelAlthough some view the trust industry as mature, the industry has changed significantly over the last decade. The average client today looks different than the average client did ten years ago, which means the average trust company has changed as well. The interests of trust companies and their clients are better aligned today than they were when trust officers worked for the local bank rather than the client. More time is being spent addressing the actual needs of clients, as technological advancements have freed up time and improved service offerings. This new directed trustee model benefits both the client and the trust administrator which is evidenced by the increase in dollars under administration in non-managed trusts.
Notes from Transitions Spring 2020
Family Culture and Dividend Policy
Family Business Director attended the Transitions Spring 2020 conference in sunny Tampa last week. The staff at Family Business magazine does a great job organizing and hosting the gathering of a few hundred representatives from 80 or so successful enterprising families. The hallmark of the conference is the opportunity for families to share their experiences and learn from the experiences of others.
The theme for the conference was family culture. We enjoyed discussing the real-life challenges family businesses face when integrating family culture and dividend policy during two breakout sessions with attendees.
For many family shareholders, the quarterly or annual dividend is the single most effective measure of how the family business is doing. Financial reports may or may not get read, but dividend checks always get cashed. As a result, setting the dividend is one of the most momentous decisions family business leaders can make. Getting the dividend “right” can contribute to growth in the business and harmony within the family, while failing to do so can weigh down the business and sow discord among family members.A successful dividend policy for your family business must “fit” both your family culture and the financial realities of the family businessSetting dividend policy has direct financial effects on the family business. Yet, restricting the dividend decision to financial considerations may prove to be short-sighted. Dividend policy both shapes and is shaped by family culture. A successful dividend policy for your family business must “fit” both your family culture and the financial realities of the family business.There were a few recurring themes from participants in our sessions that we will be thinking about over the coming weeks and months:The family business rarely “means” the same thing to all of the family shareholders. For some shareholders, the family business is a relatively small portion of a well-diversified portfolio, while, for others, the family business is the only basket their eggs are in. This difference is perhaps the greatest obstacle to formulating a dividend policy that promotes positive shareholder engagement.The thorniest aspect of dividend policy for some families is properly segregating returns to capital from returns to labor. When all family members are actively working in the business, there is less incentive to clearly distinguish wages (attributable to working in the business) from dividends (attributable to owning shares). As the family shareholder base inevitably expands to include non-employee family members, the need to separate wages from dividends becomes acute.The tension between paying dividends and reinvesting earnings in the business is heightened in families that are growing biologically. For especially prolific families, the inability of the business to match the pace of family growth means that family shareholders may need to be prepared for the possibility of dilution in per capita dividends from the family business over time.While the non-economic benefits of owning a family business such as legacy and community impact are very real, family businesses still need to provide returns commensurate with the risk borne by family shareholders. The world is full of alternative investments, and as families get into the third and subsequent generations of family ownership, family business leaders need to demonstrate that the total return (dividend yield plus capital appreciation) from owning shares in the family business is competitive with what family shareholders could expect to receive elsewhere.
We don’t think these challenges are insurmountable. But they do underscore the unique difficulties family business directors face when making complex decisions that influence the health of both the family and the business. Venues like the Transitions conference provide a great opportunity to compare notes with other similarly-situated family businesses. We look forward to similar conversations with more family businesses over the course of 2020. If you would like to discuss your situation in confidence, give one of our family business professionals a call today.
Click the link below to download a copy of Mercer Capitals' presentation Family Culture And Dividend Policy
What Does Tesla’s Share Price Soaring Mean for My Auto Dealership?
Tesla, the custom luxury and electric vehicle company, has seen significant fluctuations in its share price in the past few months. On October 24th, the Company announced its first quarterly profit (of $143 million) after losing over $1 billion in the first two quarters. It followed this up with $386 million profit in Q4, including a jump in gross margin from 4.1% to 18.8%. If the company can sustain profitability over four quarters (including profitability in Q2 2020), Tesla will meet the minimum criteria to join the S&P 500 Index. It is approximately the 50th largest company in the US (as of March 6, 2020), and after its recent runup and automotive-adjacent Uber Technologies languishing, Tesla is currently by far the largest US company not included in the large-cap index. Should the company’s profitability remain, its share price may elevate even further as investors buy in advance of its addition to the index, a strategy called “index front running.”While Tesla may or may not qualify later in the year, this isn’t the only trading quirk to exogenously impact the company. Share price skyrocketed to $887 at close on February 4th (up 56% in a week and 180% in three months) due in part to a short squeeze where traders faced margin calls and were forced to close their positions at a loss. There are about 18.4 million shares sold short, or about 12.6% of its float (shares outstanding excluding those held by insiders). While Tesla has accumulated a cult following of people both for and against, its share price likely has little to do with the value of franchised dealerships in the US.How is Tesla Different?Tesla has significant differences from dealerships with established brands across the spectrum such as BMW, Toyota, and Ford. These dealerships buy inventory through their auto manufacturers, whereas Tesla uses a direct sales strategy. The dealer franchise strategy has allowed for a large geographic footprint for other manufacturers whereas Tesla has been less able to mass produce. While less ubiquitous, the Tesla brand has benefited from its exclusivity. Further, its direct sales strategy has eliminated any conflict of interest between manufacturer and dealer. One example of this friction is when manufacturers overproduce and push inventory onto the lots of dealers, increasing floor-plan interest costs and oversupply can limit pricing growth.Tesla’s cars are also unique beyond the initial sale. Unlike other cars, Tesla’s cars cannot be fixed by third-party service providers as easily. Whereas a consumer may opt to go a local body shop for their Ford truck, a Tesla owner is more likely to go to a Tesla related service department, which tends to be a higher margin business for dealers. This represents an opportunity for Tesla, provided it can properly address the service needs particularly as its manufacturing operations continue to scale. While not typically viewed as maintenance, Tesla’s power source is also unique. For electric vehicles, consumers can charge their cars at home or at Supercharger stations instead of gas stations. While electric vehicles are viewed as cheaper and more eco-friendly, adoption of EVs relies on an increasing network effect where charging options approach the abundance and accessibility as gas stations.Future of Electric Vehicles (EV)Tesla did not invent the electric vehicle, nor will it appeal to all consumers as electric vehicles have range limitations particularly on road trips. There are also large upfront costs both for the vehicle and in-home charging stations. Further, numerous brands also offer electric vehicles including Kia, Hyundai, Chevy, Nissan, VW, Audi, Jaguar, and BMW, the latter of which just recently released it's latest and greatest. While the EV market is expected to increase over time, Tesla will clearly not be the only benefactor despite its ability to garner headlines, due in part to their enigmatic founder, Elon Musk. The company’s share price may represent a long-term bet on this power source, though Tesla is not likely to harvest all of the benefits. Still, dealerships and more importantly their manufacturers will do well to keep up with shifting consumer preferences including both EVs and the increasingly prevalent SUVs (particularly the cross-over segment).If Not Tesla, Where Do I Look for Valuation Insights for My Dealership?For dealer principals looking to keep up with the current trends, monthly releases of SAAR give an indication of volumes in the US that is frequently quoted as a barometer for the market. However, this does not factor in a variety of considerations including the level of incentives to induce these purchases. Further it tells little to nothing about a dealership’s service department, where a significant portion of gross profit is made. Public auto dealers, such as Auto Nation and Asbury Auto Group, indicate how investors in public equities view dealerships. However, these are limited comparisons for dealerships that are more geographically concentrated, may carry fewer brands, and have limited access to capital markets. Looking at stock prices and valuations like Tesla or other manufacturers such as Ford and GM may give a look into the overall health of the auto sector but will be even more limited for dealers.Transactions tend to be a reliable indication of value as it shows what someone was willing to pay for a dealership, not just a small, non-controlling fraction of it. Resources such as Haig Partners and Kerrigan Advisors publish quarterly indications of Blue Sky (value of a dealership in excess of net asset value, expressed as a multiple of pre-tax earnings) which cull transaction data. While frequently quoted in the industry, it is unlikely that buyers would simply apply such a blue sky multiple without rigorous due diligence to understand the idiosyncratic aspects of cash flow, risk, and growth, inherent in a target dealership.At Mercer Capital, we provide a variety of services for owners of car dealerships and dealer principals. We analyze 13th month dealer financial statements, evaluate facilities (including rent factors, lots, and service bays) and develop independent and reliable valuation appraisals and calculations for a variety of needs and circumstances including buy-sell agreements, litigation, and more. For an understanding in how your dealership is performing along with an indication of what your dealership may be worth, contact a professional at Mercer Capital to discuss your needs in confidence.
Family Culture And Dividend Policy
A presentation by Mercer Capitals’, Travis W. Harms, CFA, CPA/ABV, that provides an overview of the economic benefits of owning shares in a family business.
Themes from Q4 Earnings Calls
The energy sector gained slight momentum in the fourth quarter as crude prices steadily increased from $54 per barrel at the beginning of October to $61 at the close of 2019. The gradual increase in prices was fueled partly by optimistic market expectations in early 2020, and the announcement of the United States and China Phase One trade deal. In early December, OPEC announced their intent to deepen production cuts through March 2020, applying upward pressure on prices. However, $60 pricing was short-lived in 2020 as concerns regarding the coronavirus, and its impact on global growth and energy demand, sent WTI prices to the $40s. In this post, we examine some of the most discussed items and trends from the Q4 earnings calls, specifically E&P companies and those in the mineral aggregator space.E&P CompaniesOperators experienced a positive earnings quarter to close 2019 as many beat expectations on both EPS and revenue. Cost reductions coupled with an increase in oil production fueled organic growth and allowed E&Ps to produce a level of free cash flow to investors. Participants on the calls were curious on the outlook for 2020, as topics discussed centered around the coronavirus and ESG (environmental, social, and governance) efforts moving forward.Global Health Affecting Supply and Demand Due to the calls occurring in early 2020, participants seemed inclined to question the outlook of the energy sector in light of recent news regarding the coronavirus. Operators, Pioneer Natural Resources and Continental Resources commented on the subject.“Obviously, more bullish, especially with U.S. shale essentially slowing its growth significantly going in 2020 once we get through the coronavirus demand issues. I'm more optimistic that we're going to see a much higher price deck over the next five years.” – Scott Sheffield, President and CEO, Pioneer Natural Resources“We see the oil and gas market as fundamentally oversupplied, with demand even further impacted by the coronavirus. By preserving our high-quality asset for a more structurally sound market; we are further enhancing future value for shareholders.” – Harold Hamm, Chairman, Continental Resources
The Wall Street Journal recently reported that that the coronavirus has sent natural gas prices to their lowest level in years, as natural gas futures for April delivery closed at $1.756/MMbtu. Operators remain optimistic, however, that the outlook of the industry remains positive, assuming the virus is contained.ESG Efforts Intensifying“I want to highlight Continental's continued commitment to ESG. As one of the leaders of the horizontal American energy renaissance and a major contributor to U.S. energy independence we are proud to be a part of the approximately 15% rollback in CO2 emissions that has occurred since 2006, thanks to the affordability and availability of clean-burning natural gas and light sweet crude oil produced as a result of horizontal drilling.” – Harold Hamm, Chairman, Continental Resources“Every individual’s compensation is going to be tied to ES&G metrics. Things like water recycle, spill control, total recordable incidence rate, flaring, those are not subject to discretion. Those are quantitative measures that we will incentivize you know a better performance on. That's one thing that we've proven at Diamondback is, what gets rewarded gets done and we intend to do that in our scorecard.” – Travis Stice, CEO, Diamondback Energy“When you look at Slide #23, where the lowest of our peers in emissions intensity where Pioneer on both greenhouse gas intensity and also methane intensity. And what are the major changes we're making in our ESG in regard to compensation, we're increasing that these from 10% to 15% going forward in 2020.” – Scott Sheffield, President and CEO, Pioneer Natural ResourcesMineral AggregatorsAs we discussed in a previous post, mineral aggregators have continued to attract equity capital in the energy space amid depressed investor sentiment regarding the industry as a whole. While some mineral aggregators centered their attention on acquisitions heading into 2020, others were quiet and reiterated their patience that we covered in our third quarter earnings call post. In the fourth quarter, Kimbell Royalty Partners declared a record financial performance along with their acquisition of the Springbok assets in the Delaware Basin. On the other hand, Brigham Minerals emphasized their patient strategy, in search for larger mineral packages to meet their strict investment guidelines. As the price environment remains uncertain, aggregators are being questioned with their strategy moving forward.Uncertain Price Outlook Leading to Alternative Strategies“That is primarily to give us more exposure to the upside when the gas markets do come back when – if they do, we’re – and also on the downside, adding cash flow to the system in 2021 and 2022 to hedge distributions. So we’re really – we’re playing it in a hedged manner. We’re going to keep a fair amount of exposure to the upside, but we’re also going to put some acreage into play now." – Tom Carter, Chief Executive Officer, Black Stone Minerals“We have received approval to add hedging to our program. We certainly if these prices aren’t going to be hedging oil but some sort of protection on both the spread side or even the gas Waha spread side given the outlook for permitting gases is pretty dire here in 2020. I think we're looking to take that risk out of the Viper story. So we'll be looking at the market and now have approval to hedge from a downside and spread protection perspective.” –Kaes Van’t Hof, President, Viper Energy Partners“It's opportunities like this that only present themselves every three years to four years in terms of being a little consolidate and take advantage of this type of situation where people are concerned about crude oil prices. So, there is some time that has to go by. But I think our message is, if people are panicky, we can be patient and picky in terms of what we buy.” – Robert Roosa, Chief Executive Officer, Brigham Minerals“Oil, natural gas, and natural gas liquids revenues in the fourth quarter increased 18% compared to the fourth quarter of last year to $27.2 million. This increase reflects strong performance from acquisitions made in the past 12 months despite the decrease in realized commodity prices. While current pressures persist for many exploration and production companies operating in the U.S., our broad-based, high-quality asset portfolio continues to outperform expectations.” – David Ravnaas, President and Chief Financial Officer, Kimbell Royalty Partners
The difficult price environment in the energy industry is leading mineral aggregators to plan for the future. The topics discussed revolved around strategies, particularly hedging and reinvestment, to capitalize on the unpredictable nature of the industry over the next few years.
What Can We Make from All This M&A Activity?
Recent Deal Flurry Highlights Investor Appetite for Cost Savings and Recurring Revenue
February was a record month for headline transactions in the RIA industry. Peter Mallouk sold a substantial stake in Creative Planning to PE firm General Atlantic on February 12. Less than a week later, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days ago.Interestingly enough, the smallest and least heralded deal, General Atlantic’s minority interest purchase of Creative Planning, is probably the most notable from our perspective since our clients are typically more similar to CP than Franklin, E-Trade, and LM in terms of size and product offering.Still, we can’t dismiss the implications of these larger transactions and what they say about two sectors of the investment management industry that many analysts believe are dying – active management and discount brokerage. The Franklin / Legg deal was touted as being more about “offense not defense” according to Franklin chief Jenny Johnson, who said the acquisition was about building “an all-weather product line-up and world-class distribution platform.” While that may be the case, the reality is that both firms had suffered significant outflows and increased competition from passive funds. Combining both firms is expected to generate $200 million in cost savings and stem the tide of waning profit margins.Morgan Stanley’s purchase of E-Trade was likely also a defensive maneuver anticipated to yield approximately $400 million in expense reductions for the Wall Street giant. It may have also been Morgan Stanley’s counter to Goldman’s purchase of United Capital last Spring in their bid to enter the mass affluent space. E-Trade’s recent financial woes are primarily attributable to falling commission revenue, which, like active management fees, have been in free fall for quite some time.Both E-Trade’s and LM’s stock price rose over 20% upon announcement, and it naturally leads us to wonder if smaller active managers or broker businesses can expect such a windfall from a prospective acquirer. Scale still matters for most asset management firms, so consolidation rationales are always going to be there especially for an industry looking to cut costs. Brokerage firms’ commission revenue is less proportional to client assets, so bulking up just for the sake of it doesn’t make a whole lot of sense. Many of these businesses are already transitioning to an asset-based revenue model anyways, so we’re seeing fewer acquisitions of brokerage firms in general.Even with asset manager deal-making holding up, the sector’s recent uptick in M&A activity is largely attributable to a growing interest in wealth management firms. The driving force behind this increase is strong demand from RIA consolidators, PE firms, and strategic acquirers that are drawn to the sector’s recurring revenue model and sticky clientele base. The lack of internal succession planning is another catalyst as founding partners look to outside buyers to cash out.Despite this uptick, there are still numerous challenges to sustaining this level of M&A growth for the RIA industry. Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Minority interest acquisitions (à la Creative Planning) sidestep some of these challenges, but the risks are harder to avoid in control acquisitions. Well-structured deals and effective integration strategies can help mitigate risks and align interests, but only to an extent.And yet, with over 12,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus.The performance of the broader market will also be a key consideration for both buyers and sellers in the coming year. The current downturn from the Coronavirus could curtail the recent momentum or spur buyers to negotiate lower pricing. We’ll let you know how it all shakes out.
Is Your Family Business Risky Enough?
The latest issue of the Harvard Business Review includes a provocative article entitled “Your Company Is Too Risk-Averse.” The authors (three McKinsey consultants and Nobel laureate Daniel Kahneman) contend that companies suffer significant opportunity costs because of loss aversion among mid-level managers.Loss aversion describes the tendency to avoid making investments because the pain of loss outweighs the satisfaction that accompanies positive outcomes. Loss averse investors are unwilling to accept risks that offer a probability-weighted positive outcome. For example, if you declined to participate in a coin flip that would pay you $1,100 dollars for heads, but cost you $900 for tails, you are exhibiting loss aversion. The probability-weighted outcome is positive [($1,100 x 50%) – ($900 x 50%) = $100], but the pain associated with losing $900 is sufficient to cause many people to decline the offer.There is no “right” level of loss aversion. Even for the same individual, loss aversion is not a constant.When the potential loss is small relative to income or wealth, loss aversion can essentially disappear (after all, lots of people buy lottery tickets). But as the magnitude of the potential loss increases, people tend to exhibit greater loss aversion.Loss aversion also diminishes as the number of risk-taking opportunities increases. Consider our coin-flip example. For most of us, the prospect of losing $900 is painful enough to give us some pause before accepting the bet. But if you could play the game 100 times, your loss aversion really should evaporate. In that case, you would lose only if heads came up 44 or fewer times, which would be an extraordinary run of bad luck (as illustrated in Exhibit 1).
These two factors (size of loss, and number of risk-taking opportunities) explain why the authors conclude that companies do not take enough risk. Without intentional efforts to modify normal incentives, the perspective of individual managers does not match up with that of the company as a whole.
For an individual manager championing or sponsoring a risky investment, the magnitude of the potential loss can be significant (loss of status/influence within the company, or potentially even loss of employment). But from the perspective of the company as a whole, the potential loss from a bad outcome may not be that significant.Many mid-level managers do not make high-frequency decisions. In other words, they don’t get to play the game again and again, and therefore can’t get bailed out by the law of large numbers. For sizable companies, however, the ability to effectively roll the dice repeatedly means that the degree of loss aversion should be much lower.
In short, individual managers are often unwilling to accept risks that would be beneficial to the company as a whole, and this misalignment represents a significant opportunity cost for the company. The authors propose several strategies for bridging the natural loss aversion gap between managers and the company as a whole. But what most intrigued us about the article was how it might apply in the context of a family business.
The authors make the following statement supporting their contention that companies don’t take enough risk:“In economic theory, unless a failed investment would trigger financial distress or bankruptcy, companies should aim to be risk-neutral,because investors can diversify risk across companies.” (emphasis added)While the last clause makes sense for public companies, it is problematic for many family businesses. Often, family shareholders cannot, in fact, diversify risk across companies, because substantially all of their wealth is concentrated in the illiquid shares of the family business. Whether explicitly acknowledged or not, we suspect this fact explains why many family businesses can become excessively loss averse in the second and third generation, even when doing so may carry a significant opportunity cost.We are not suggesting that there is a “right” level of loss aversion for families. However, in our experience, some families assess risk too narrowly. Consider the two families in Exhibit 2.
Both families are transitioning from the second to the third generations. The Tree family prides itself on minimizing the risk of the family business by scrupulously avoiding debt financing, while the Forest family has incurred a prudent amount of debt at the family business to support more significant distributions over the years. Some families elect to make a one-time, special, dividend instead.
If we limit our perspective to the family business (the top panel of Exhibit 2), the Tree Family bears less risk. But if the Forest Family has used its “excess” distributions over the years to accumulate a portfolio of other investments that are uncorrelated to the family business, the risk assessment shifts. While the risk of the Forest family business is higher because of the additional debt, the overall family balance sheet for the Forests may actually be less risky than that of the Trees.Furthermore, the managers of the Tree family business may be hesitant to accept risky projects because they know that the Tree family’s wealth is concentrated in the Tree family business. Since there is no other source of diversified wealth for the shareholders, the managers of the Tree family may pass on projects that really would be advantageous for the business. As described in the Harvard Business Review article, the opportunity costs associated with such behavior can create a substantial drag on the value of the business over time.
Of course, we are not suggesting that such risk analysis is straightforward. There are other stakeholders (employees, suppliers, communities, etc.) that should be considered. The point is simply this: family business directors should carefully consider how to integrate the risk of the family business with the risk of the family as a whole. Like their publicly traded brethren, it may turn out that some family businesses aren’t risky enough.
Mercer Capital’s Value Matters® 2020-03
A “Grievous” Valuation Error
Mercer Capital's 2019 Energy Purchase Price Allocation Study
Have you downloaded Mercer Capital’s 2019 Energy Purchase Price Allocation Study yet?The study provides a detailed analysis and overview of valuation and accounting trends in these subsectors of the energy space. It enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820.
Download here.
Don’t Get Distracted by Franklin/Legg and MS/E-Trade
Creative Planning’s Minority Sale is the Most Consequential RIA Deal So Far in 2020
Stop and reflect on the significant financial news of the past month - what do you remember? Coronavirus? Warren Buffett’s annual shareholder letter? Morgan Stanley merging with E-Trade? Franklin Templeton buying Legg Mason?It’s hard to imagine, but the most significant deal in the RIA community so far this year happened less than three weeks ago and is already nearly forgotten: Peter Mallouk sold a minority stake in his firm, Creative Planning, to private equity firm General Atlantic. The transaction is easily one of the largest minority transactions in the history of the RIA industry, and potentially provides a blueprint for others to follow.Deal specifics were not given, and we don’t have any inside knowledge of how the transaction was structured. What we do know is that Creative Planning reported just under $50 billion in AUM at year-end 2019, twice the size of United Capital when it was acquired outright last year by Goldman Sachs.Creative Planning’s fee structure is not atypical for the industry, and no doubt some fees on upper-end clients are negotiated. But while we cannot say with certainty what their effective fee schedule is across their overall business, it wouldn’t be unreasonable to assume that Creative Planning realizes 65 to 75 basis points on that $50 billion, for total revenue in the $300 to $400 million range. Stop and take that in for a moment, as very few investment management franchises have achieved a similar scale.We strongly suspect that the margin Mallouk realizes is enviable. Creative Planning posts a smaller headcount than United Capital, despite having twice the assets under management. Investment management is a labor-intensive business, but Creative Planning is efficient, and probably boasts an EBITDA margin north of 25%, maybe as much as 35% (and possibly more). This suggests that the firm makes on the order of nine figures per year in distributable cash flow. Of note, prior to this transaction, Mallouk was the sole owner.We strongly suspect that the margin Mallouk realizes is enviable.As for the multiple paid, we remember the high-teens multiples bandied about last year for the Goldman/United deal and the sale of Mercer Advisors. Mallouk was interviewed by Barry Ritholtz in December and mentioned he was entertaining an offer to sell part of his firm. In the conversation, Mallouk suggested that an appropriate multiple for a minority stake in a firm was 25% less than if it were a change of control transaction. If we benchmark that discount off of the major transactions for similarly scaled franchises last year, we estimate that Creative Planning fetched a low double-digit multiple of EBITDA. That would value Mallouk's business, even on a minority interest basis, at ten figures.
The implication of all this is Mallouk sold a “mid-teens” percentage interest in Creative Planning for nine figures, and possibly as much as a quarter-billion dollars. Mallouk says he’s keeping all this cash in the business, as a cushion to protect his firm in the event of a bad market. More likely, in our opinion, is that the cash will serve as a war chest to fund growth in the event of market stress. If Mallouk did draw a strong multiple in a strong market and is now prepared to buy market share and hire talent in a downturn, this transaction will go down as one of the best in the history of investment management.
As this bull market approaches its twelfth year, it's worth noting how firms are positioning and repositioning for the long term. And it’s worth considering what isn't happening as well. Mallouk didn’t sell the firm outright, and he didn’t go public. He says he sees upside in independence, and he's putting his money where his mouth is.
Mallouk didn’t sell the firm outright, and he didn’t go public.The Creative Planning transaction is very different than the more widely reported deals from February. The Morgan Stanley acquisition of E-Trade is interesting for brand extension into the mass affluent space (a la Goldman/United), and we're curious to see if the Franklin/Legg Mason deal delivers promised expense savings as a larger franchise (we are skeptical). In both cases, though, the firms are managing their downside from changes (fee compression) in the market – which is not characteristic of the operating environment for Registered Investment Advisors. The Creative Planning transaction is about taking advantage of the remarkable upside available in the RIA space. It's the kind of deal we hope to see more of.
An Overview of Salt Water Disposal
Part 3 | Valuation Considerations
Our previous posts on salt water disposal covered provided an overview of the sector and detailed the economics of the industry. In this post, we’ll be taking a deeper dive into specific considerations that are critical to understanding the value of salt water disposal companies.What Does the Valuation Process Entail?There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the equity value of a business is given by subtracting the market value of liabilities from the market value of assets. However, the value of these assets is not always readily available and must be established through other methods, such as the market approach and the income approach. These values can also sometimes be proxied by replacement costs or build multiples, though location and intangible items (like permits and contracts) can make the asset-based approach challenging.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.As discussed in our previous post, cash flows are generally a function of disposal fees and the volume of water processed (with some incremental potential revenue coming from selling oil “skimmed” from the water), less cash operating costs.While some cash flow growth may be driven by operational efficiencies and increasing utilization rates, there is less potential for organic growth relative to other industries given capacity limitations and permitting requirements. Most growth will come in the form of increasing capacity, which requires capital expenditures. And as the sector continues to be the recipient of significant public and private capital, the economics of new projects may deteriorate.The riskiness of the cash flows is determined in part by the contract mix and location. Longer contracts with minimum volume commitments or take-or-pay requirements serve to reduce the risk of the cash flow stream. Uncontracted volumes or shorter contracts based on acreage dedications serve to increase the risk of the cash flow stream. Additionally, salt water disposal operators are subject to a host of regulatory and environmental risks, including concerns regarding potential links between SWD wells and seismic activity.The Market ApproachThe market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In many industries, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. While there are numerous publicly traded companies with salt water disposal operations, none are “pure play.”In fact, the salt water disposal sector sits at an interesting nexus between three oil & gas verticals: exploration & production, midstream, and oilfield services. Rattler Midstream went public in 2019 as a carve-out of E&P company Diamondback Energy. Most of Rattler’s revenues are attributable to salt water disposal operations. NGL Energy Partners was a traditional midstream company providing pipeline transportation for crude oil, NGLs, and refined products. However, over the past several years, it has transitioned its focus to water, with water solutions expected to generate over half of the company’s EBITDA going forward. Select Energy Services is an oilfield services company that provides water-focused services including flowback and well testing, water storage, and fluids handling, but is increasingly investing in pipeline infrastructure and SWD wells.As such, there must be careful consideration of the appropriateness of using public company multiples given operational, size, and geographic differences, among other factors.Fortunately, there have been numerous acquisitions of smaller, private companies in the sector, and valuation multiples can be derived from these transactions. However, this data is often self-reported, and there can be inconsistencies across transactions for both the implied transaction values (e.g., treatment of earnouts) as well as the earnings measure (e.g., does EBITDA include substantial pro forma adjustments from historical levels?) used to derive multiples.The market-based approach is not a perfect method by any means. Industry transaction data may not provide for a direct consideration of specific company characteristics. Clearly, the more comparable the transactions are, the more meaningful the indication of value will be.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue or earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value. A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.ConclusionMercer Capital has long promoted the concept of managing your business as if it were going to market. In this fashion, you promote the efficiencies, goals, and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics.We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.
When Is Our Next Turning Point Breakfast?
Is Your Closely Held or Family Business at a Turning Point and Do You Need to Talk?
About a year ago now, I flew to a major city to have breakfast with a client and friend of many years who is second-generation chairman, CEO, and lead family member of a very successful, third-generation family business. We have worked for this client for about 30 years.Prior to that breakfast, my client and I had had two or three significant discussions about ownership and management transitions and shareholder liquidity. At breakfast, he had important things on his mind about shareholder liquidity for himself and his immediate family, for his second-generation siblings, and for other significant shareholders of this successful private company. He was leaving the country that day for some time and faced an important board meeting upon his return. He wanted to talk, and so we did over a lingering breakfast early on a Sunday morning in a city distant from Memphis.I had been speaking with his chief internal adviser (and client and friend) about similar things for some time. But things hadn't quite clicked at this point for all the parties. The chairman wanted to talk privately.What I was recommending was a significant stock repurchase from family members and other significant owners, a special dividend, or a combination of the two strategies for private company liquidity. Because of my familiarity with the company over many years, I knew that the transaction I was suggesting could be financed by the company with reasonable risk.About mid-year 2019, the company engaged in a substantial share repurchase and special dividend combination transaction. I should add that the transaction occurred at Mercer Capital's appraised price, as had all previous transactions in the company's stock for many years (to the tune of perhaps $200 million or more over the years). The special dividend benefited all shareholders pro rata. Combined with the stock repurchase plan, which was available to family and non-family shareholders, the special dividend dampened the dilution of the buyback for family shareholders who sold shares, and provided a one-time liquidity event for all shareholders. Existing shareholders and qualifying employees were simultaneously offered the opportunity to purchase shares. As I said, it was a significant transaction.Lest anyone think I'm suggesting I did all this, I did not. The company's extremely capable financial staff planned the details of the transaction, checked the boxes for any tax-related issues, arranged its financing, and executed its many details flawlessly. My role was more on the conceptual side and in helping the parties see the near-term and long-term benefits of such a transaction.Yesterday, I received an email from my friend, literally out of the blue. The subject of the email was: when is our next turning point breakfast?The short text touched my heart. I've been working with company clients for going on 40 years (ouch!). I've done a great deal of litigation work over the years, but the satisfaction of that cannot compare with helping private company clients achieve their goals and objectives for management and ownership succession, and for liquidity for owners now, before anyone has to sell a company.The text was very short.We did everything you said to do at breakfast at the [hotel] -- it changed our lives -- when can we do that again? -- NameWell, Name, we can do that as soon as we can make our schedules align.I have to say, that email yesterday morning , was the most gratifying thank you I have ever received from a client.If you are at a turning point in your business life, perhaps it is time for a turning point breakfast -- or lunch or meeting or dinner. We are available here at Mercer Capital to discuss your family business needs in confidence. That conversation might actually be a turning point for you, your family, and your other owners.
Q1 2020 Call Reports
M&A Opportunities a Focus Point for Public Companies
As deal activity continues to accelerate into 2020, M&A opportunities remain an area of focus for public asset and wealth management companies. Notably, however, there is a growing gap in the multiples for private vs public companies which may prove a challenge to M&A for public companies. At the macro level, there are several trends which continue to impact the industry, including fee pressure, the continued bull market, regulatory overhang, and technology advancements. As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominant trends.
Theme 1: Many public asset and wealth managers are eyeing M&A opportunities, particularly in the wealth management industry.[I]t's always been a goal of ours within M&A to increase the size. But I think there's just a few more opportunities today with some of the pressure on smaller firms, keeping up, keeping pace with technology spending and services that are required for their investors. So we're just seeing a few more opportunities for roll-ups. -Greg Johnson, Chairman & CEO, Franklin Resources[W]e're seeing a lot of [M&A] opportunities out there. We have always had a strong interest in private wealth businesses. We find that private wealth businesses are attractive on many fronts particularly because the assets are very sticky, and it dovetails well with what we've been doing around here for 2.5 decades at our Trust company. So we've seen a lot in that area, and we've seen a lot of teams that are stranded, that are looking for a home. And for us, we'd be particularly interested in a firm that has private wealth and has some of the capabilities that we don't currently have such as fixed income. -Brian Casey, President, CEO, & Director, Westwood Holdings GroupAs we have discussed previously, the current M&A environment for wealth management firms remains both active as well as expensive. Silvercrest, however, is involved in multiple conversations at any given time … Regardless of the environment, Silvercrest will opportunistically seek to effectively deploy capital to complement our organic growth … There is a possibility down the road that as the RIA business matures and professionals find themselves unhappy at much larger roll-up type firms or in that situation, they may start to look around the way some of their colleagues are at the brokerages, which is not a fertile hunting ground for us and our business model. It's possible that down the road, that there could be some RIA-type lift outs, but we're not running around seeking those. If you look at the business, the wealth management side with RIAs is highly concentrated. It's not a large number of firms that control a majority of the AUM, Silvercrest being lead among them. -Richard Hough, Chairman, President, and CEO, Silvercrest Asset Management GroupTheme 2: While public companies see opportunities in wealth management M&A, high pricing is a key consideration particularly in light of historically low multiples for publicly traded asset and wealth managers.Of course, we know that private equity and other wealth managers in the mass affluent wealth space are very, very active. And some of the EBITDA multiples being discussed here in the 15x, 16x-plus area, even in businesses that don't actually have the acquisitions closed yet, for example. So it is a very highly competitive space from a rollout perspective because the economics just make so much sense. -Matthew Nicholls, Executive VP & CFO, Franklin Resources
We're certainly looking in [the wealth management] space, and we are keen observers of the price and multiple escalations that's going on there. As we think about our wealth management business and M&A opportunities there, it's really about driving scale. -Ben Clouse, Senior VP, CFO, Treasurer, Waddell & Reed Financial
One of the challenges is that the public multiples and the private multiples still do have a disconnect … We really have to think about strategically and long term and creating value for those transactions that would make sense, we would definitely think about it. Obviously, our view is that the multiples that publicly traded managers are trading at are not in line with historical multiples. So we look at it long term. We look at it what is the right way to build value for the future in terms of that. But again, we're disciplined in terms of how we assess those alternatives. -George Aylward, President, CEO & Director, Virtus Investment PartnersTheme 3: Macro trends like fee pressure, the continued bull market, regulatory overhang, and technology advancements continue to shape the industry. I think we are likely to see more pressure on top line, driven by continuing price competition in the business. At some point, we'll see an equity downturn that will put more pressure on companies. We're -- we think we enter that environment from a position of clear strength with not only a number of market-leading franchises, but also strong balance sheet, strong culture, strong leadership, continuity of approach, focus on this business, great relationships in the market, history of innovation … So we're not all that optimistic at the moment about near-term trends in our industry, but are quite optimistic about our relative position within asset management. -Thomas Faust, Chairman, CEO, & President, Eaton Vance
2019 was marked by heightened geopolitical and trade tensions which created volatility in financial markets. Uncertainty around the U.S. and China trade negotiations, Brexit and other concerns about a slowdown in global growth all impacted investor sentiment, driving industry flows into safer fixed income and cash strategies, cash assets throughout the year … Macro forces are impacting the wealth industry, including a more challenging market environment, heightened customer expectations, more regulation, technology advancements. And this is driving demand for a deeper portfolio -- analytical and risk transparency, portfolio construction, product and scale. -Larry Fink, Chairman & CEO, BlackRock
I regularly speak about the changing distribution landscape: the rise of the wealth channel and relative decline of the traditional institutional market; the importance of reaching people digitally; globalization, a buyer's market in terms of fee structure and vehicle preference; demand for customization and tailored solutions. -Eric Colson, Chairman, President, and CEO, Artisan Partners Asset Management
Value investing, as we practice it at Pzena Investment Management, is the process of studying businesses whose stocks have collapsed, of gathering enough data to make a reasoned judgment about whether the history of the business and industry remains a useful guide for estimating future earnings and for investing when the range of outcomes skew solidly in our favor. We sit at one of those moments where a small number of market darlings have driven market returns to record levels and caused enormous dispersion between value and growth strategies. And yet, we judge that with an opportunity set that looks as good or better than it did a decade ago, the odds of our deep value approach succeeding in the next 10 years seems like a much better place to be than to bet that the winners of the past decade continue to defy analysis. -Richard Pzena, Chairman, CEO, and Co-Chief Investment Officer, Pzena Investment Management
I do think that in an environment where fees are decreasing and costs are increasing, a lot of firms have to sort of think about, particularly in the smaller end, will they be better off partnering. I think the better firms are not in a situation where they have to do something, but they'll certainly consider looking at that. And then on the demand side, there are probably fewer firms that have the financial flexibility to be in the market. -George Aylward, President, CEO & Director, Virtus Investment PartnersSummaryEarnings calls this quarter brought to light the varying challenges and opportunities that asset and wealth management firms face.On the asset management side, macro trends like the shift from active to passive investing have forever changed the active asset management industry, and asset managers are having to re-think their cost structure in order to stay competitive. Increasing operating leverage through acquisitions and outsourcing has allowed asset managers to protect their margins despite declining fees.For smaller wealth managers, an active M&A market and high private market multiples provide an attractive alternative for owners seeking exit options. Interestingly, there is a growing gap between private and public company multiples. The higher multiples we’ve seen for relatively small wealth managers are seemingly at odds with some of the historically low smaller public company multiples, which begs the question of whether mean reversion is on the horizon.
Understanding Oilfield Services Companies & How to Value Them
New Whitepaper
Understanding the value of an oilfield services (OFS) company is by its very nature a complex matter. As participants in the greater energy industry, situated between the exploration and production (E&P) companies and midstream companies, the OFS sub-sector is quite broad. It includes, businesses that have the commonality of their connection to oil and gas prices, but also the significant differences between service providers and equipment manufacturers. It also includes businesses that focus on technology advantages and those that focus on relationships, those that specialize in narrow service/product niches and those that provide a broad range of services/products. Not to mention the differences in the economics that drive OFS companies with a focus on existing production, as opposed to those that focus on exploration. Also, the differences between those that focus on services that are particular to conventional oil versus unconventional oil, oil versus gas, shale versus tight sands.Having a firm grasp on the many similarities and distinctions is crucial in performing valuations of these businesses. That understanding plays into the choice of which valuation approaches and methods are to be applied, and which of those approaches and methods are more reliable, or less reliable, depending on the subject company’s positioning and where the industry is in it’s potentially wide ranging cycles.As part of any OFS company appraisal, one must consider expectations for both shorter-term and longer-term operating results. Industry cyclicality creates challenges in evaluating expectations that can lead to material over-valuations, or under-valuations, unless one has the depth of experience and industry understanding to navigate the many considerations that impact OFS companies.In our latest whitepaper, Understanding Oilfield Services Companies & How to Value Them, we provide invaluable guidance in regard to these aspects of the OFS industry. Click below to download whitepaper.>>Download Whitepaper
RIA “Comps” Don’t Always Tell the Same Story
Divergent Performances of LM, TROW, BEN, and AMG Show Industry’s Susceptibility to Company Specific Events Over Market Forces
As valuation analysts, we often look to comparable publicly traded businesses (“comps”) to glean an appropriate range of valuation metrics and multiples for the companies we value. Calling them “comps,” however, is often a stretch, since it is rare that we can find public companies that are truly comparable to the private company we’re trying to value. The publics are often too large and diverse to be labeled as comps, so we usually seek public companies that are in a similar line of business and call them guideline companies instead.While it’s not unusual for companies in the same guideline group to have divergent share price performance despite facing the same industry headwinds (or tailwinds), publicly traded RIA stock performance can vary dramatically.The past twelve months have been no exception, especially for T. Rowe Price (ticker: TROW), Franklin Resources (BEN), Legg Mason (LM), and Affiliated Managers Group (AMG). TROW and LM have bested the market and asset manager index while AMG and BEN have fallen well short.Performance Over the Last Twelve MonthsSource: S&P Global Market Intelligence
So what’s driving this disparity? Much of it can be explained by performance net of expectations. T. Rowe Price and Legg Mason have consistently beat consensus EPS over the last several quarters on steady gains in revenue and earnings. AMG and BEN have missed Street estimates and recent financial performance has been more volatile.
While we would not ordinarily include these businesses in a guideline group (our clients are typically much smaller than these companies), there is a key takeaway from all this variation in stock performance. Our recurring clients are often surprised when AUM, revenue, and earnings are up year-over-year, yet our valuation of their company goes down. This usually occurs when these key financial metrics fall short of forecast expectations, and the outlook for the business gets revised accordingly. This may happen to your clients’ stock holdings, and it’s no exception for the value of your business.
We’re sometimes surprised by the variations in RIA share price performance since their revenues are so highly correlated with market conditions. The reality is that these businesses are unique, and their values can diverge widely on variations in financial performance and the outlook for earnings. On the qualitative side, new business development, personnel changes, variations in investment performance, and regulatory changes can all drive a wedge in how your business performs relative to your competition. The market certainly has an impact, but there are many other factors that you and your employees can control.
Still, we don’t typically see a 40%+ increase in value (TROW) and a ~25% decline in a bull market (AMG) for two businesses in the same industry, so this disparity is worth a second look. T. Rowe Price was able to lever a market tailwind with cost-cutting initiatives and net client inflows to its mutual fund business unlike many of its competitors. AMG, on the other hand, has struggled with the many headwinds facing asset managers and the consolidators that invest in them.
Your firm’s value has probably not changed this much over the last year. You’ve likely benefited from strong market conditions, but industry headwinds persist, particularly on the asset management side. It’s difficult to assess the net impact of a lot of conflicting forces, especially if you have little or no background in business valuation or corporate finance. This is why we recommend hiring a valuation firm to appraise your business on a regular basis to gauge your progress and have a feel for what your company could sell for when that day comes. We’re here to help.
How to Communicate Financial Results to Family Shareholders (Part 3)
According to author Christopher Booker, all stories fit into one of seven basic plots. While details of character, narrative perspective, setting, and the like can make stories appear quite different from each other, any story can ultimately be reduced to one of a handful of basic plots. With respect to literature, we have no idea whether Mr. Booker’s thesis is sound or not, but we have long suspected that something similar is true for family business. Like stories, no two family businesses appear the same, as demonstrated by the old saw that if you have seen one family business, well, then you’ve seen one family business. Yet, despite their many unique attributes, there are only a few basic underlying plot structures that family businesses follow.More than any other financial statement, the statement of cash flows reveals the basic plot of your family business. The statement of cash flows is the least understood financial statement, so family leaders often ignore it when attempting to communicate financial results to their family shareholders. But for those who know what they are looking for, the statement of cash flows reveals what a company is really up to.This week, we conclude our series of posts on communicating financial results to family shareholders. Having focused on telling the story of the family business through the balance sheet and income statement, we turn our attention this week to the statement of cash flows.The Statement of Cash FlowsYou can discern the basic plot of your family business by answering two questions. First, what time is it? Second, how are we managing financial risk?What Time Is It?For farmers, the changing of the seasons dictates whether it is time to plant or time to harvest. Family businesses are not tied to the cycle of seasons. But at any given time, a family business is either planting or harvesting, and the statement of cash flows tells us what time it is.The statement of cash flows allocates the cash flows of your family business into three categories: operating, investing, and financing. Comparing the operating and investing cash flows reveals what time it is for your family business. The operating cash flows are those generated by the existing operations of the business. The investing cash flows represent the amounts reinvested in the business (generally either through capital expenditures or business acquisitions).Exhibit 1 illustrates how the investing and operating cash flows interact to reveal the “time” for your family business.
If the investing cash flows (the money being put into the business) exceed the operating cash flows (the money coming out of the business), it is planting time for your family business, as is the case in Exhibit 1. For family businesses in harvest mode, the opposite is true, and operating cash flows are greater than investing cash flow.
Since investing cash flows are often lumpy, we find it best to look at the statement of cash flows on a multi-year basis. Examining cash flows on a rolling three or five year basis helps to eliminate the “noise” that may creep into the results for a single year in which a major capital expenditure of acquisition is completed.
Your family shareholders should know what time it is for your family business, and why. It is not unusual for companies to oscillate between planting and harvesting over time, so a format like that in Exhibit 1 can be used with either historical or prospective cash flows, depending on what message you need to convey to your family shareholders.
How Are We Managing Financial Risk?Family businesses manage financial risk through capital structure, or deciding how much money to borrow. Companies that are in planting mode need additional capital, and that capital can come from the bank or from shareholders. In contrast, family businesses that are harvesting have “excess” capital to return to capital providers.Exhibit 2 illustrates how family businesses manage financial risk through capital structure.
Our planting company from Exhibit 1 needs $17 million of outside capital (the excess of investing over operating cash flows). That capital can come from lenders or in the form of new equity from shareholders. Relying primarily on debt increases the financial risk of the company, all else equal. It also potentially increases future returns to family shareholders.
If it is harvest time, the family business will have “excess” capital that can be used either to repay debt or distribute to shareholders through dividends or redemptions. Repaying outstanding indebtedness is the more cautious approach for harvesters, while making distributions to shareholders is the more aggressive path.
Bringing It All Together: What Is the Plot for Your Family Business?Together, the two questions answered by the cash flow statement (What time is it? How are we managing financial risk?) reveal the basic underlying plot for your family business. Exhibit 3 outlines the four basic plots.
The black checkmarks in Exhibit 3 indicate the dominant story threads for each plot, while the grey checkmarks identify secondary themes that may or may not be present in a particular story.
Plot #1 :: Aggressive Planting. When family businesses finance their capital needs during planting season with debt, they are following the aggressive planting script. This is the most nail-biting plot of them all, with the uncertainty of future returns from current investment compounded by increasing financial leverage. If the borrowing is accompanied by shareholder distributions, the risk profile is even more elevated.Plot #2 ::Cautious Planting. Occasionally family businesses in planting mode will opt to finance their capital needs with new equity rather than debt. Family businesses often eschew seeking outside (non-family) equity capital, so this plot is less common. However, with the number of investment funds seeking minority stakes in family businesses increasing and the growing use of joint ventures and other “synthetic” equity raises, this plot may become more prevalent.Plot #3 :: Aggressive Harvesting. Harvesters have “excess” capital to dispose of. Aggressive harvesters prefer to leave existing debt outstanding and distribute to shareholders in the form of dividends or share repurchases. The most aggressive harvesters actually continue to borrow more money to fund even more substantial shareholder distributions.Plot #4 :: Cautious Harvesting. More risk averse harvesters view the “excess” capital at their disposal as an opportunity to repay outstanding debt. In other words, rather than provide an immediate return to family shareholders, the companies use the proceeds from harvest to reduce the risk profile of the family business and/or prepare the balance sheet for the next planting cycle.
The narrative details for your family business will be as unique as your family. Yet, the underlying story for your family business ultimately fits into one of these four basic plots. What is yours?ConclusionOur objective in this series of posts has been to give our readers some examples of how to communicate financial results more effectively. Financial statements include lots of financial data. The first step in effective communication is identifying the key themes that really matter to family shareholders. Exhibit 4 recaps the key themes we have identified from each financial statement.Focusing on these key themes will help you prune away unnecessary numbers and details, allowing you to communicate in a way that can actually promote positive engagement among your family shareholders. And that is an investment with a high return.
Aggregators Continue to Attract Equity Capital
In previous posts, we have delineated between royalty trusts and mineral aggregators and discussed the valuation implications of prevailing high dividend yields of public royalty trusts. Yields remain elevated, and these trusts have declined in their usefulness from a valuation benchmarking perspective. In this post, we focus on mineral aggregators. We also offer insights on the investment landscape at large and particularly as it relates to the minerals subspace by providing an update on the most recent IPO, Brigham Minerals (MNRL).Market Data for Aggregators and TrustsThe following tables provide some critical market data for valuation purposes.
Since our last update, SandRidge Mississippian Trusts I and II (SDT and SDR, respectively) were delisted in mid-November as the stocks fell below $1.00 in May and traded below that mark for six months. All else equal, public royalty trusts are expected to decline in value as investors get their return almost exclusively from yields because production declines over time. Thus, trusts eventually being delisted is not a surprising outcome due to restrictions on acquiring additional acreage or wells. Given the eponymous operator SandRidge Energy’s struggles, it’s even less surprising these two trusts were delisted. SandRidge Permian Trust has avoided this fate for the time being, due in part to its attachment to the prolific Permian and sale to Avalon Energy, but the trust has also been put on notice.
Unlike public royalty trusts, mineral aggregators are not restricted from acquiring additional interests, which makes them more of a going concern by comparison. This is among many reasons investors have increasingly turned towards mineral aggregators. Long-time readers of the public mineral interest portion of our blog will note the revamped look at value drivers and key benchmarks for mineral aggregators.
Public Markets Unreceptive of Energy SectorThe stock market has been booming over the past decade as the economy has ridden the longest expansion in history. Investors in the energy sector, however, have not experienced the same joyful ride. In 1990, energy made up 15% of the S&P 500 sector weightings, but in 2019, that figure was down to 5%. Ironically, over the same period, the United States’ oil and gas production surpassed all countries and claimed the top of the leaderboard, becoming the world’s largest producer. Depressed commodity prices have also likely aided valuations for companies in other sectors as transportation costs are lower in an increasingly globalized economy with two-day shipping becoming common place.The graph below shows the relationship between the Vanguard Energy ETF, created in 2004, and the SPY Index over a 15-year period. Slow economic growth coming out of the recession caused Energy to outperform, but commodity price declines in late 2014 began a reversal that has widened since 2017.Energy vs. S&P 500
There are many reasons that this story has unfolded such as diminishing return on investment, fluctuation in commodity prices, and oversupply, but we do not dive into that in this post. Instead, we want to illustrate the ways in which mineral aggregators have been able to manage some of these issues.
Mineral aggregators are constructed to diversify capital among many superior plays and specific operators. This niche in the energy market allows investors to capitalize on both current yield and capital appreciation with the aggregators’ reinvestment capabilities. Crucially, royalty holders do not bear operating and drilling costs as these costs are paid by upstream E&P companies. Brigham Minerals articulates the benefits of the business model as follows:
“There are many advantages of the mineral acquisition model, including no development capital expenditures or operating costs, no exposure to fluctuating oilfield service costs and higher margins than E&P operators without associated operational risks.”Mineral aggregators receive a royalty based on revenue and are thus isolated from a number of field-level economic issues. This is not unlike the restaurant industry, where franchisors command a much higher valuation than the operators to whom they franchise. Declining same-store sales figures in that industry are hurting profitability for operators grappling with the necessity for capital expenditures to fund future growth while those collecting royalties off the top can prosper with their asset-light models. Sound familiar?Brigham Minerals Seasoned Equity OfferingIn a previous post, we discussed the much-anticipated Brigham Minerals’ IPO in April 2019. The upsized offering was sparked by higher than expected demand. Many saw the IPO as an investment opportunity that promoted cash flow, something that operators in the market were not providing. There was speculation that additional mineral companies would likely IPO over the course of 2019 given the demand for Brigham Minerals, but that turned out not to be the case. In December of 2019, however, Brigham Minerals announced in an S-1 a seasoned equity offering of 11 million common shares. The Company offered 6 million new shares of its common stock, and some selling shareholders sold an additional 5 million shares. Shares were priced at $18.10, likely a psychological threshold, as it was priced just ten cents above the IPO price only eight months prior.
Credit Suisse, Goldman Sachs, and RBC Capital Markets acted as lead booking-running managers for the offering, and they were granted a 30-day greenshoe option totaling an additional 1.65 million shares though these were not exercised as the share price remained above the issuance price, averaging $19.70 for the first month of trading.
Generally speaking, 2019 was a poor year for IPO’s with ride-share companies Uber and Lyft among the high-profile unicorns that floundered. Peloton opened 6.9% below its trading price and multiple companies, perhaps most notably WeWork, decided to scrap the IPO altogether. Brigham’s IPO success and perhaps more importantly its ability to issue additional equity just eight months later may encourage private equity firms invested in minerals companies to test the IPO market.ConclusionMineral aggregators appear to have supplanted public royalty trusts as a key means for investors to get exposure to the sector while avoiding costly drilling expenses. While functionally related to drilling activity and well performance, aggregators allow investors to avoid cost burdens. As such, valuations for the aggregators behave differently than other participants in the energy sector.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Community Bank Valuation (Part 5): Valuing Controlling Interests
To close our series on community bank valuation, we focus on concepts that arise when evaluating a controlling interest in another bank, such as arises in an acquisition scenario. While the methodologies we described with respect to the valuation of minority interests in banks have some applicability, the M&A marketplace has developed a host of other techniques to evaluate the price to be paid, or received, in a bank acquisition.In the Valuing Minority Interests segment of this series, we discussed that valuation is a function of three variables: a financial metric, risk, and growth. From a buyer’s standpoint, the ultimate goal of a transaction, of course, is to enhance shareholder value, which would occur if the target entity can, on balance, enhance (or at least not detract from) the buyer’s financial metrics, risk, and growth. This can be achieved in several ways:The direct earnings contribution of the target, or the accretion to the buyer’s earnings per share if the consideration consists of the buyer’s stock. In a bank M&A scenario, this accretion often derives from cost savings resulting from eliminating duplicative branches, back office functions, and the like.An acquisition can provide diversification benefits, such as different types of loans, additional geographic markets, or new funding sources. If these characteristics of the target reduce any concentrations held by the buyer, the acquirer’s overall risk may lessen. However, numerous buyers have regretted entering lines of business or new markets via acquisition with which the buyer’s management team lacked the requisite familiarity.Accessing new markets or lines or business lines through acquisition gives the buyer more “looks” at new customers and transactions. For many banks, moving the needle on asset size or growth means looking outwardly beyond its existing markets or products, and the needle moves faster with an acquisition strategy versus a de novo market expansion strategy.
These benefits are not without risks, though. Some of the more significant acquisition risks include:Credit surprises. One or two unexpected losses usually do not affect the underlying rationale for a transaction, although it may create some uncomfortable conversations with investors regarding the buyer’s due diligence process. A more significant risk is that the buyer’s risk tolerance differs from the seller’s approach, leading to a potentially significant disruption to future revenues as risk appetites are synchronized. However, credit surprises often cannot be detached from the prevailing economic environment. In a post mortem, many transactions closed in the 2006 time frame look ill-advised given the subsequent financial crisis. Ultimately, factors outside the buyer’s control may have the most impact on post-transaction credit surprises.Cultural incompatibility. While sometimes difficult to detect from the outside, differences small and large between the cultures of the buyer and target can jeopardize the anticipated post-merger benefits. More often than not, this is manifest in personnel issues. Mergers are like chum in the water to competitors; buyers can expect competitors to look for any opening to attract personnel from the target bank.Similarities to Valuations of Minority InterestsThe previous installment of this series introduced the comparable company and discounted cash flow methods to bank valuations. Both of these methods remain relevant in assessing a controlling interest in a bank, meaning an interest of sufficient size to dictate the direction of the bank. Most often, controlling interest valuations arise in the context of an acquisition.Comparable Transactions MethodIn a controlling interest valuation, the comparable company method can be used. However, the resulting values often would be adjusted by a “control premium”, which is measured by reference to the value of historical M&A transactions relative to a publicly-traded seller’s pre-deal announcement stock price. This approach has the advantage of synchronizing the controlling interest valuation to current market conditions, which can be a drawback of the comparable transactions approach.More often, though, the comparable company method morphs into the comparable transactions method in an M&A setting. Comparable M&A transactions can be identified by reference to geography, asset size, performance, time period, and the like. Ideally, the transactions would be announced close in proximity to the date of the analysis; however, narrowly defining the financial or geographic criteria may mean accepting transactions announced over a longer time period. The computation of pricing multiples, such as price/earnings or price/tangible book value, is facilitated by the widespread data availability regarding targets and the straightforward deal structures that usually allow analysts to identify the consideration paid to the sellers. That is, contingent consideration, like earn-outs, is rare. However, deal values are not always publicly reported for transactions involving privately-held institutions.While the comparable transactions approach is intuitive – by measuring what another buyer paid for another entity in an industry with thousands of relatively homogeneous participants – the most significant limitation of the comparable transactions method is created by market volatility. Buyers’ ability to pay is correlated with their stock prices, and most bank M&A transactions include a stock component. Deals struck at a certain price when bank stocks traded at 16x earnings would not occur at that same price if bank stocks trade at 12x earnings without crushing dilution to the buyer. Thus, prices observed in bank M&A transactions need to be viewed in light of the market environment existing at the time of the transaction announcement data relative to the valuation date.Discounted Cash Flow MethodWe introduced the discounted cash flow method as a forward-looking approach to valuation reliant upon a projection of future performance. In an M&A scenario, buyers usually start with the target’s stand-alone forecast, unaffected by the merger. Acquirers then add layers to the forecast reflecting the impact of the transaction, such as:Expense savings. In a mature industry, realization of cost savings typically is a significant contributor to the transaction economics, with buyers often announcing cost savings equal to 30% to 40% of the target’s operating expenses. These are derived primarily from eliminating duplicative branches, back office functions, and the like. As the expense savings estimates increase, there often is a rising risk of customer attrition, with cuts going beyond the back office into activities more noticeable to customers, like branch hours or staffing.
While buyers may expect a certain level of expense savings, it is not clear that buyers “credit” the seller with all of the expense savings the buyer takes the risk of achieving. That is, the risk of achieving the expense savings effectively is split between the buyer and seller, with the favorability of the split in one direction or the other dictated by the negotiating power of the buyer and seller.Revenue enhancements. Buyers may expect some revenue enhancements to occur from the transaction, such as if the buyer has a more expansive product suite than the target or a higher legal lending limit. However, buyers often loathe to include these in transaction modeling, and revenue enhancements are seldom reported as a driver of the EPS accretion expected from a transaction.Accounting adjustments. While fair value marks on assets acquired and liabilities assumed should not drive the economics of a transaction, they can affect the near-term earnings generated by the pro forma entity. Therefore, buyers usually are keenly aware of the accounting implications of a transaction.
One advantage of a discounted cash flow approach is that it allows the buyer to evaluate, for a given price, the level of earnings contribution needed from the target to justify that price. While if you torture the numbers long enough they will confess to anything, as a statistics professor of mine was fond of saying, buyers should not lose sight of the reality of implementing the modeled business strategies.Additional ConsiderationsWhile the comparable transactions and discounted cash flow models crossover – no pun intended with another valuation approach we describe below – from a minority interest valuation environment, several valuation techniques are unique to M&A scenarios.Tangible Book Value Earn-BackAfter the financial crisis, investors became focused on the tangible book value per share earn-back period, sometimes to the point of seemingly ignoring other valuation metrics. There are several ways to compute this, but the most common is the “crossover” method. This requires two forecasts:The buyer’s tangible book value per share, absent the acquisitionThe buyer’s pro forma tangible book value per share with the target
The analyst then calculates the number of periods between (a) the current date and (b) the date in the future when pro forma tangible book value per share exceeds stand-alone tangible book value per share. Ultimately, the earn-back period is driven by factors like:The price/earnings or price/tangible book value multiples of the buyer’s stock relative to the multiples implied by the transaction valueThe extent of the merger cost synergies
The tangible book value earn-back method also exacts a penalty for deal-related charges, as a higher level of deal charges extends the earn-back period. From an income statement standpoint these charges often are treated as non-recurring and, in a sense, neutral to value. However, these charges represent a real use of capital, which the TBV earn-back approach explicitly captures.
Investors often look favorably upon transactions with earn-back periods of fewer than three years, while deals with earn-back periods exceeding five years often face a chilly reception in the market. The earn-back period often is the real governor of deal pricing in the marketplace, which investors often like because it overcomes some limitations posed by EPS accretion analyses.Earnings per Share AccretionAs for the tangible book value per share earn-back period analysis, an EPS accretion analysis requires that the buyer forecast its EPS with and without the acquired entity. EPS accretion simply is the change in EPS resulting from the transaction. The attraction of this analysis lies in the correlation between EPS and value. For a buyer trading at 12x earnings, a deal that is $0.10 accretive to EPS should enhance shareholder value by $1.20 per share, holding other factors constant.But how much accretion is appropriate? Should a deal be 1% accretive to be a “good” deal, or 10% accretive? It is difficult to answer this question in isolation. This is especially true for a deal comprised largely of cash, where the buyer is forgoing the use of its capital for shareholder dividends or share repurchases in favor of an M&A transaction. Recent deal announcements often indicate EPS accretion in the mid to high single digits with fully phased-in expense savings.Contribution AnalysisA contribution analysis is most useful in transactions involving primarily stock consideration. It compares the buyer and seller’s ownership of the pro forma company with their relative contribution of earnings, loans, deposits, tangible equity, etc. In a merger of equals transaction, where the two merger parties are roughly similar in size, this type of analysis is important in setting the final ownership percentages of the two banks.ConclusionA valuation of a controlling interest may take many forms; fortunately, the strengths of certain valuation methods described here offset the weaknesses of others (and vice versa). Value ultimately is a range concept, meaning that there seldom is a single value at which a deal fails to make economic sense. There are good deals, reasonable deals, and dumb deals. Evaluating a number of valuation indications puts a buyer in the best position to slot a transaction into one of these three categories and to negotiate a deal that accomplishes its objective of enhancing financial performance, controlling risk, and developing new growth opportunities. It is crucial to remember, though, that deals are tougher to execute in reality than in a spreadsheet.This concludes our multi-part series examining the analysis and valuation of financial institutions. While approximately 5,000 banks exist, the industry is not monolithic. Instead, significant differences exist in financial performance, risk appetite, and growth trajectory. No valuation is complete without understanding the common issues faced by all banks – such as the interest rate environment or technological trends – but also the entity-specific factors bearing on financial performance, risk, and growth that lead to the differentiation in value observed in both the public and M&A markets.
Jones v. Commissioner
Estate of Aaron U. Jones v. Commissioner, T.C. Memo 2019-101
(August 19, 2019)EXECUTIVE SUMMARYIn May 2009, Aaron U. Jones made gifts to his three daughters, as well as to trusts for their benefit, of interests (voting and non-voting) from two family owned companies, Seneca Jones Timber Co. (SJTC), an S corporation, and Seneca Sawmill Co. (SSC), a limited partnership. These gifts were reported on his gift tax return with a total value of approximately $21 million. The IRS asserted a gift tax deficiency of approximately $45 million on a valuation of approximately $120 million. The Tax Court ruled that value was approximately $24 million, agreeing with the taxpayer’s appraiser.In this case, the Tax Court again concluded that “tax-affecting” earnings of an S corporation was appropriate in determining value under the income method (see also Mercer Capital’s review of the Kress decision). However, there are several other issues of interest in this case which we discuss further in this article.BACKGROUNDSSC was established in 1954 in Oregon as a lumber manufacturer.SSC operated two saw mills – its dimension and stud mill – delivering high quality products that were technologically advanced, allowing SSC to demand a higher price for its products than its competitors.Early in its history, SSC acquired most of its lumber from Federal timberlands.As environmental regulations increased, SSC’s access to Federal timberlands became at risk.Mr. Jones began purchasing timberland in the late 1980s and early 1990s when he became convinced that SSC could no longer rely on timber from Federal lands.SJTC was formed as an Oregon limited partnership in 1992 by the contribution of those timberlands purchased by Mr. Jones.SJTC’s timberlands were intended to be SSC’s inventory.Further, both SSC and SJTC maintained similar ownership groups, with SSC serving as the 10% general partner of SJTC.As of the date of valuation, SJTC held approximately 1.45 million board feet of timber over 165,000 acres in western Oregon, most of which was acquired in those initial purchases between 1989 and 1992.In 2008, approximately 89% of SJTC’s harvested logs were sold directly or indirectly to SSC and SJTC charged SSC the highest price that SSC paid for logs on the open market.GIFT TAX VALUATION In May 2009, Mr. Jones formed seven family trusts and made gifts to those trusts of SSC voting and nonvoting stock. He also made gifts to his three daughters of SJTC limited partner interests. Mr. Jones filed a timely gift tax return reporting values based upon appraisals prepared by Columbia Financial Advisors as shown in Figure 1 on the next page (Petitioner’s Value). The IRS notice of deficiency asserted values much higher.A petition was filed in the Tax Court by Mr. Jones in November 2013. Mr. Jones died in September 2014 and was replaced in the Tax Court proceeding by his estate and personal representatives. His estate then engaged another appraiser, Robert Reilly of Willamette Management Associates. Mr. Reilly was noted by the Court to have “performed approximately 100 business valuations of sawmills and timber product companies.”The original appraiser for the IRS was not noted in the case decision. At trial, the IRS’ valuation expert was Phillip Schwab who, per the Court, has “performed several privately held business valuations.” Additionally, the IRS was noted as having “previously reviewed and completed several business valuations, including several sawmills.”Their conclusions are presented in Figure 2.SUMMARY OF THE COURT’S DECISIONUltimately, the Court sided with Mr. Reilly’s conclusions of values for SSC and SJTC, along with his reported discount for lack of marketability (DLOM).The only distinction the Court made with Mr. Reilly’s DLOM was to correct a typo wherein the Appendix in Mr. Reilly’s report referred to a 30% DLOM, when in actuality, he had applied a 35% DLOM.A summary of the Court’s conclusions are shown in Figure 3.Item 1:SJTC’s Valuation Treatment as an Asset Holding Company or an Operating CompanyThe most critical issue surrounding the large difference in the valuation conclusions of SJTC for both experts centered on the valuation approach.The Court noted that “when valuing an operating company that sells products or services to the public, the company’s income receives the most weight.”Contrarily, the Court noted “when valuing a holding or investment company, which receives most of its income from holding debt securities, or other property, the value of the company’s assets will receive the most weight.”A question in this matter: is SJTC an Asset Holding Company or is it an Operating Company? Petitioners’ experts concluded that SJTC was an operating company and relied on an income approach utilizing projections from management. Conversely, one respondent’s experts concluded that SJTC is a natural resource holding company and relied on the asset approach utilizing real estate appraisal on the underlying timberlands.One of the critical factors the Court relied upon in determining its conclusion of the nature of SJTC’s operations centered on the Company’s operating philosophy.SJTC relied on a practice called “sustained yield harvesting” which didn’t harvest trees until they were 50 to 55 years old.As such, SJTC limited the harvest to the growth of its tree farms, even if selling the land or harvesting all of the trees would be the most profitable in the short-term.As discussed earlier, Mr. Jones began purchasing the timberlands and formed SJTC to supply the lumber to SSC for its long-term operations.The other argument the Court considered when determining how to treat SJTC was the limited partner units in question.Specifically, the subject blocks of limited partner units could not force the sale or liquidation of the underlying timberlands.Recall, SSC maintained the 10% general partner or controlling interest in SJTC and its focus remained on SSC’s continued operations as a sawmill company dependent on SJTC for supplying the majority of its lumber.Based on these factors, the Court concluded that SSC and SJTC “were so closely aligned and interdependent” that SJTC had to be valued based on its ongoing relationship with SSC, and thus, an income-based approach is more appropriate to value SJTC than a net asset value method.With this distinction, SJTC was more comparable to an operating company and less comparable to a traditional Timber Investment Management Organization (TIMO), Real Estate Investment Trust (REIT), or other holding or investment company.Item 2:Reliance of Revised Management Projections in Valuation of SJTC and Impact of Economic ConditionsBoth of Petitioner’s experts relied on management projections in the underlying assumptions of their discounted cash flow (DCF) analyses to value SJTC.The original appraisal utilized management projections that were included in the prior annual report.For trial, Mr. Reilly utilized revised projections from April 2009 in his DCF analysis.Respondent challenged the use of the revised projections, despite the fact that their own second expert, Mr. Schwab, also used the revised projections in his guideline publicly traded company method.He chose to average the revised projections with those from the most recent annual report.The Court specifically noted the economic conditions at the date of valuation, highlighting the volatility during the recession years.As such, the Court determined the revised projections were the most current as of the date of valuation and included management’s opinion on the climate of their market and operations.The impact of the current economic conditions is also referenced by the Court in another key takeaway that we will discuss later.Item 3: Tax-Affecting Earnings in the Valuations of SJTCMr. Reilly computed after-tax earnings based on a 38% combined proxy for federal and state taxes. He further computed the benefit of the dividend tax avoided by the partners of SJTC, by estimating a 22% premium based on a study of S Corporation acquisitions. Respondent argued that since SJTC is a partnership, the partners would not be liable for tax at the entity level and there is no evidence that SJTC would become a C corporation. Therefore, respondent argued that the entity level tax rate should be zero.The Court concluded that Mr. Reilly’s tax-affecting “may not be exact, but is more complete and convincing than respondent’s zero tax rate.” The Court also noted that the contention from respondent on this tax-affecting issue seems to be more of a “fight between lawyers” as the criticism appeared more in trial briefs than in expert reports. In fact, respondent’s expert, Mr. Schwab, argued that tax-affecting was improper because SJTC is a natural resources holding company and therefore its “rate of return is closer to the property rates of return” rather than challenging the lack of an actual entity level tax.Item 4:Market Approach for SJTCThe Court and respondent’s expert agreed with Mr. Reilly’s market approach for the valuation of SJTC.With little to no disagreement, the key takeaway here is on Mr. Reilly’s analysis.The Court detailed the analysis by mentioning that Mr. Reilly selected six guideline companies.The Court also cited the analysis and reasoning behind Mr. Reilly’s selection of pricing multiples slightly above the minimum indications of the guideline companies. Specifically, Mr. Reilly noted that SJTC’s revenue and profitability for the most recent twelve months before the valuation date were below those of the guideline companies.Thus, he accounted for these differences in financial fundamentals in his selection of the guideline pricing multiples. Item 5:Intercompany Debt between SJTC and SSCRespondent argued that Mr. Reilly erred by excluding the receivable held by SSC and the corresponding liability of SJTC. Further, respondent contended that Mr. Reilly’s treatment of SSC’s receivable from SJTC as an operating asset, rather than a non-operating asset, reduced the value of SSC under his income approach since a non-operating asset was not added to that value.On this issue, the Court weaved in earlier themes regarding the symbiotic relationship of the two companies and also the present economic conditions on the date of valuation to make its conclusion.The Court agreed with Mr. Reilly that the intercompany debt could be removed as a clearing account based on the idea that both companies operate as “simply two pockets of the same pair of pants.”The Court rejected respondent’s theories that this treatment of intercompany debt was only to avoid a negative asset valuation of SJTC and to reduce the value of SSC by not including the receivable as a non-operating asset.The Court referenced the relationship of the two companies and how the joint credit agreements of the two companies were secured by SJTC’s timberlands. The Court recognized that SSC could not have obtained separate third-party loans without the assistance of SJTC’s underlying timberlands as collateral. A further detail of the two companies’ relationship was revealed earlier in this decision. 2009 economic conditions also included subprime mortgage lending crises, particularly in the housing market. Around this time, SSC was anticipating a shift in the market from green lumber to dry lumber. Dry lumber production required SSC to build dry kilns and a boiler in a larger renewable energy plant project. Because of economic conditions, SSC was not able to obtain the construction loans to finance the renewable energy plant for itself or with another planned related entity. Instead, SSC was forced to borrow against the timberlands of SJTC.Ultimately, the Court viewed the two companies (SSC and SJTC) as a single business enterprise and concluded that Mr. Reilly’s treatment of the intercompany debt captured their relationship.Item 6:Valuation of SSC – Treatment of General Partner Interest in SJTCRespondent’s criticisms of Mr. Reilly consisted of three items:The treatment of Intercompany debt between the two companiesTax-affecting earningsThe treatment of SSC’s general partner interest. The Court handled the intercompany debt and tax-affecting treatment consistently with SJTC’s valuationMr. Reilly captured the value of SSC’s general partner interest in SJTC by projecting a portion of the expected partnership income in his projections. Specifically, Mr. Reilly projected $350,000 annually for SSC’s general partner interest based on an analysis of the 5-year and 10-year historical distributions from SJTC.Respondent claimed that this approach undervalued SSC’s general partner interest by not considering its control over SJTC and treating it as a non-operating asset to be valued by the net asset value method.The Court concluded that SSC’s general partner interest in SJTC is an operating asset again citing the single business enterprise relationship between the two companies.Further, the value of SSC’s general partner interest is best estimated by the expected distributions that it would expect to receive.Item 7:Buy-Sell Agreement ItemsAlthough not directly discussed and cited in any of the Court’s factors that we have discussed so far, the decision did highlight certain elements from SSC’s and SJTC’s buy-sell agreements as we noted.Both buy-sell agreements contained language that prohibited the sale of the entity or transfers within the units/shares that would jeopardize the current tax status of the Companies as an S Corporation (SSC) and Limited Partnership (SJTC), respectively.Both agreements called for discounts for lack of control, lack of marketability, and lack of voting rights of an assignee (where applicable) to be considered. Finally, both agreements stated that the valuations of the entities should consider the anticipated cash distributions allocable to the units/shares.CONCLUSIONSWhile the Court’s decision to allow the tax-affecting of earnings (like in the Kress case) in the valuations of SSC and SJTC will dominate the headlines, there are additional takeaways from the case that impact the valuations.Of note, the disparity in experience of the appraisers involved, consideration of the current economic conditions, and the purpose and nature of the business relationship of the two companies seemed to influence the Court’s conclusions.Finally, the distinction and eventual valuation treatment of SJTC as an operating company rather than a holding company was of particular interest to us.
Beauty is in the Eye of the Beholder
Drivers of Valuation in Wealth Management M&A
Fidelity recently published a study on M&A activity in the wealth management industry highlighting sellers’ ambitious expectations of the value of their firms. Fidelity found that sellers today expect EBITDA multiples of between 8x and 10x, even though median deal multiples “are still reasonably close to where they were over the five-year period between 2012 and 2017” - around 5x. What is causing the discrepancy? Sellers often focus on “exceptional, highly publicized transaction multiples.”Over the last year, some mergers and acquisitions in the RIA space have touted impressive deal valuations, which many media outlets have highlighted. Echelon Partner’s RIA M&A Deal Report features “deals and dealmakers of the year” with estimated transaction multiples of 8x to 22x EBITDA. The deal sizes, however, ranged from $600 million to $26 billion. By contrast, roughly two-thirds of registered investment advisors have under $100 million in AUM.There is typically more information available about these larger transactions than for the sale of a $100 million manager. 5.0x EBITDA doesn’t make as compelling a headline as 18x EBITDA. But the valuation multiples shown above are by no means normal. Most smaller deals go unreported, which results in inflated averages for reported deal valuations and inflated expectations for sale prices.Additionally, reported deal values often include a contingent consideration which may never be fully realized. An excerpt from our whitepaper on The Role of Earnouts in Investment Management M&A illustrates how this can impact seller expectations.ACME Private Buys Fictional Financial On January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.
The example above supports Fidelity’s conclusion: sellers of investment management firms often “don’t entirely understand what drives valuation.” RIA transaction data is haphazard at best. It’s no wonder why seller’s expectations are inflated if they look only to media sources to understand valuation. In this post we hope to provide insight to the owners of wealth management firms on how likely buyers value their firm.Cash Flow, Growth, and Risk Valuation firms think of value as a function of cash flow, growth, and risk (or cash flow times a multiple).Sustainable Cash FlowThe first part of the equation is simple. Higher cash flow (or EBITDA) implies a higher price tag. But margins have to be real. Disguising partner compensation as distributions to inflate profitability won’t sell, as buyers are typically sophisticated enough to know there will be a replacement cost for selling partners who retire and want to hand over their responsibilities to someone new. Low margins are a more obvious red flag, as heavy overhead is difficult to scale down and makes firms vulnerable in down markets.So, margin has most value within what a buyer considers to be a normal range. Fidelity reported the “median operating margin of firms/deals in the past two years was 28%, with respondents saying the ranges for operating margins fell typically between 20 to <30% on the lower end, and between 30 to <40% in the upper end.”There is more mystery involved in the multiple, but it ultimately depends on the growth trajectory and risk profile of your company. The multiple (and thus the firm’s value) is positively correlated to expected growth and inversely related to risk.Meaningful GrowthAll else equal, a buyer will pay more for an investment manager that is expected to double assets under management in five years, than one in which AUM is expected to double in ten. Higher growth implies higher future cash flows.Over the past year, AUM at most wealth managers increased significantly as markets surged. However, AUM growth that is entirely a consequence of market activity is not sustainable over the long run. Investment performance does impact value, but buyers of wealth managers view growth in terms of net positive inflows of assets. Growth driven by market conditions brings short term increases in cash flow. But growth driven by a new marketing strategy, increased market share driven by a failing local competitor, or a new investment strategy drives long term value. Manageable Risk A buyer will pay more if the future cash flows are relatively certain but less if there is significant risk that your cash flow could deteriorate post acquisition.In general, there is more risk associated with smaller companies. Small investment managers typically have a more concentrated client base, are more dependent upon key individuals to generate business, and have less developed marketing and technology infrastructure to support and grow their business.This size/value relationship even exists in firms with much larger scale than the typical RIA. Looking at the implied valuation multiples of publicly traded investment managers, the multiples of managers with under $100 billion of AUM are generally lower than those of investment managers with over $100 billion in assets.
This is why highly publicized deal multiples of massive investment managers don’t serve as a reliable benchmark for your firm.
Unfortunately, most of the risks outlined above are only truly solved with scale. Customer concentrations are reduced with more assets. Key man dependencies are lessened by hiring well-trained investment processionals (which is expensive) or by training younger professionals (which takes time). Investments in scalable technology are often too costly for small managers. However, formalizing investment processes and establishing a succession plan with a proper buy-sell agreement can reduce the risk of cash flows deteriorating if key individuals depart post acquisition.
What Will a Buyer Pay for Your Firm?Unfortunately, there is not a simple formula to value your firm.A highly concentrated client base may overshadow the high growth potential of your firm. On the other hand, a stable client base, with a higher probability of recurring revenue, can raise your valuation despite mediocre growth prospects.Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is worth more to them simply because it is already in their possession. In any event, just as physicians are cautioned not to self-medicate, and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.The first step of any transaction should be to obtain a valuation to establish decision-making baselines and to set transaction expectations. Mercer Capital’s Investment Management team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services. Call us today to discuss your valuation needs in confidence.
Selling Your Family Business
Selling a business is a three-step process. Some sellers elect to stop at Phase I or II and don’t proceed to closing, while others decide to complete the transaction process. In reality, each of the phases overlaps to some degree, making the process more of a continuum than a finite set of procedures. A turnkey, orderly process will often require four to six months. When extra time is required to prepare and/or when multiple rounds of market outreach are involved, we’ve managed deals that required six to eighteen months and more to reach a close or no-close decision.Ultimately, the collective team goal as seller and advisor is to win the race, whether it be at the pace of the hare or the tortoise.Phase I involves “taking inventory.” Taking inventory means gathering and analyzing financial and operating data for the family business. The milestone goal of this process for most clients is obtaining a valuation in order to establish decision-making baselines and to set transaction expectations. The valuation undertaking helps the advisor learn about the business and relate the “story” of the business to the financial and operating data for the company and its industry. Equally important, Phase I promotes forthright discussions about family and ownership objectives that in turn help the advisor identify the selling family’s priorities and preferred transaction structures. Telling the company’s story in a clear and compelling way is important in creating effective marketing materials. If, on the basis of value expectations and market option assessments from Phase I, the family decides to move forward with testing the market, we then enter Phase II.Phase II involves staging and organizing the relevant financial and operating data into a confidential information memorandum (CIM). The CIM is designed to tell the story of the business, expound on the merits of the business and its market position, and describe the seller’s preferred transaction structure. The CIM should provide enough information for prospective buyers to form an expression of interest (i.e. the initial offer). Of course, prior to receiving the CIM, prospective buyers must execute non-disclosure agreements, which are designed to protect the seller from having their confidential information revealed to unintended audiences.
Parallel with the preparation of the CIM, the financial advisor will create a list of prospective buyers. These prospective buyers often include a mix of competitive and/or friendly industry players, private equity investors, and family offices. Phase II may also involve conducting meet-and-greet exchanges with prospective buyers in order to negotiate and secure expressions of interest in the form of indications of interest (IOIs) or letters of intent (LOIs). After careful study of the offers, the financial advisor will help the selling shareholders select the preferred bid. Signing an IOI/LOI generally marks the end of Phase II.
Phase III By signing and IOI/LOI, the selling shareholder commits to dealing exclusively with that buyer. One of the first steps in Phase III is satisfying the buyer’s due diligence requirements. Parallel with this process, legal advisors to the buyer and the seller begin drafting the legal documents required to complete the transaction.
It is important to understand that the negotiating process from Phase II carries forward until the deal is closed. Deal terms often contain various structural features including non-compete agreements, earn-out arrangements, equity roll-over provisions, escrow and holdback terms, working capital thresholds, real estate considerations, and other important make-or-break considerations. The terms of these side elements can represent a significant portion of total deal value and cannot be overlooked. The wording of the documents is part of the negotiating and deal monitoring process. The focus is making sure that the offer and all its terms are clearly captured in the actual transaction documents.
Assuming everything passes muster, closing occurs. But even then the transaction is not completely finished until the selling family receives all of the consideration promised in the deal. A portion (often 5% to 20%) of the total purchase price is usually held in escrow for 12 to 24 months after closing against potential claims of the buyer for violation of seller representations and warranties. The amount, duration, and conditions of escrow release are important elements of the legal documents governing the transaction. The significance of these terms points to the importance of remaining vigilant and engaged in the process to maximize the outcome.
We hope this quick tour of the selling process helps readers better understand the steps involved in selling the family business. Family shareholders and family business directors owe it to themselves and to their stakeholders to be aware of the liquidity options that may available in the expanding market for private companies.
Mercer Capital’s Value Matters® 2020-02
COVID-19 and the Value of Your Business
Do Win/Loss Records Affect Major League Baseball Revenues and Attendance?
Many people believe that the win/loss ratio doesn’t have much effect on revenues and attendance. They believe the local team has loyal fans who will attend games despite their performance. We investigate that assumption in this article focusing on Major League Baseball (MLB) by sampling a top tier, middle tier, and lowest tier team.We analyze average season attendance of the league over the last five years and then track the three-team sample’s attendance and on-field performance.We have selected three teams to review their attendance vs. winning percentage, along with their playoff and World Series performance. Our sample consists of the Los Angeles Dodgers, the Texas Rangers and the Miami Marlins.As a reference point, average season attendance for the MLB reached a peak in recent years at 2.5 million in 2007 for the American League and 2.8 million for the National League. The MLB averages dropped in the subsequent years and were finally steady around 2.3 million for the A.L. and 2.5 million for the N.L. during the next ten years. League attendance average declined, however, by 140,000 to 2,161,376 in 2018 and 2,039,521 in 2019.Los Angeles DodgersThe Dodgers attendance in 2007 was 3.9 million and stayed above 3.4 million for three years. This figure dropped to 2.9 million in 2011 yet returned to 3.7 million by 2013. Recently, season attendance has slowly climbed to approximately 4 million in 2019, marking an all-time team high.This growth was greatly influenced by the Dodgers being in the World Series in 2017 and 2018, which helped push 2019 to a record high attendance. (See Table 1 for details)Texas RangersThe Texas Rangers have experienced a different attendance history. They peaked in 2012 at 3.5 million after playing in the World Series in 2011 and the playoffs in 2012. The team didn’t make the playoffs in 2013 and 2014 and attendance dropped to 3.2 million and 2.7 million, respectively. The win/loss record dropped significantly from about 59% in 2011 to 41% in 2014.Attendance followed the same trend by dropping 450,000 to 2.7 million in 2014. Even when the team made the playoffs in 2015, attendance fell to 2.5 million as a result of their poor record in 2014. The team’s 2015 win/loss ratio was near 59% and they made the playoffs, but not the World Series. In the following year, attendance increased to 2.7 million. The win/loss ratio dropped below 50% in 2017 to 2019 and they missed the playoffs each year. As a result, attendance dropped steadily to 2.1 million in 2019, a decrease of over 1.3 million people, or 38% from their peak in 2012. (SeeTable 2 for details)Miami MarlinsThe Miami Marlins clearly represent the bottom tier of the MLB in many categories. They built a brand-new state of the art ballpark in 2012 and attendance averaged about 1.7 million from 2014 to 2017. In the fall of 2017, the Derek Jeter group bought the team. and the new owners quickly traded notable high-priced players to other teams, including the NY Yankees, in order to reduce their losses. The new ownership group was hoping to stabilize attendance near the 1.7 million mark, but instead dropped to 811,000 in both 2018 and 2019; 367,000 less than the next worst attendance in MLB, which was Tampa Bay, and about 500,000 less than the third worst team, the Baltimore Orioles. (SeeTable 3 for details)ConclusionWithout attempting to do a statistical analysis, what does the data mean? Yes, the quality of the players counts – especially if the win/loss record corresponds, however, winning percentage also impacts the ability to get into the playoffs and ultimately the World Series. It is clear from our experience and from the three-team sample that win/loss ratios have a major effect on MLB home stadium attendance.
Exploration & Production Purchase Price Allocations
A Review of E&P Transactions Analyzed in Mercer Capital’s 2019 Energy Purchase Price Allocation Study
Last week, Mercer Capital released its 2019 Energy Purchase Price Allocation Study. In this post, we’ll be taking a deeper dive into the Exploration & Production transactions reviewed in the analysis.The E&P sector had the lowest average allocation to intangible assets, at just 2% of total purchase consideration. In fact, only two of the eleven transactions analyzed had any intangible allocation at all. Oasis Petroleum recorded a small ($1 million) intangible asset related to a non-compete agreement in connection with its acquisition of Forge Energy. The major outlier was Concho Resources, which recorded over $2.2 billion of goodwill related to its acquisition of RSP Permian.Exploration & Production is not an intangible asset-driven business model. These companies sell a commodity, so there is no real brand value leading to trademark or trade name allocations. Bill Barrett and Fifth Creek rebranded as HighPoint Resources after their merger, and recently two E&P companies (Ovintiv, formerly Encana, and Battalion Oil Corporation, formerly Halcon Resources) changed names, the latter likely influenced by its emergence from bankruptcy.The commodity is generally sold at market hubs, so specific customer relationships have minimal value. (To the extent the company has derivatives that result in above-market pricing realizations, that asset is captured separately.)And while E&P companies tout their technical prowess, few outside of the majors spend meaningfully on R&D or have protected intellectual property. None of the transactions analyzed in this year’s study included allocations to Developed Technology or In Process Research & Development.Ultimately, the value of an E&P company is driven by its reserves, and purchase price allocations generally reflected that. Based on the transactions reviewed in our analysis, ~90% of purchase consideration was allocated to reserves.Again, the outlier in the data is Concho’s acquisition of RSP Permian, in which over $2.2 billion was allocated to goodwill. In its 2018 10-K filing, Concho rationalized the goodwill value as follows:Goodwill recognized is primarily attributable to the following factors: (i) operating and administrative synergies and (ii) net deferred tax liabilities arising from the differences between the purchase price allocated to RSP’s assets and liabilities based on fair value and the tax basis of these assets and liabilities. For the operating and administrative synergies, the total consideration for the RSP Acquisition included a control premium, which resulted in a higher value compared to the fair value of net assets acquired. There are also other qualitative assumptions of long-term factors that the RSP Acquisition creates for the Company’s stockholders, including additional potential for exploration and development opportunities and additional scale and efficiencies in basins in which the Company operates.Despite the headwinds faced by the E&P sector since the Concho / RSP transaction, Concho has indicated that this goodwill value has not been impaired. The company’s most recent 10-Q indicates that quantitative impairment tests were performed as of July 1, August 29, and September 30, 2019. (However, Concho did take an $81 million goodwill impairment charge related to certain New Mexico Shelf acreage that was divested in 2019.)In an environment of increasingly complex fair value reporting standards and burgeoning regulatory scrutiny, Mercer Capital helps clients resolve financial reporting valuation issues successfully. We have the capability to serve the full range of fair value valuation needs, providing valuation opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. Contact our Energy Industry or Financial Reporting Valuation teams to discuss your valuation needs in confidence.
Are Sponsor-Backed Initiatives Distorting RIA M&A?
Barbarians at the Gate 2 – Electric Boogaloo
Reading up on the commentary about the record number of RIA transactions last year, I’m struck by how simple the predominant narrative is: everybody wants in, valuations are up, and deal-flow continues to flourish.Headlines have their own wisdom, but the underlying reality of M&A activity is necessarily nuanced – especially as we approach the twelfth year of this bull market. If transaction activity is higher and vectoring to grow from here, what is the catalyst?
Investment management is a great business. Firms that don’t need to sell, don’t sell. If transaction activity is up, does this mean that more firms need to sell? If pricing and deal terms are better, are the transactions available today really that much more attractive than those available a few years ago? And is the culture of consolidation that has emerged in the RIA community sustainable?
The Go-Go 90s I’m no Marcel Proust, but these days take me back to the closing months of an earlier bull market that, in many ways, set up where we are today.1999 was a big year for me in what is now called “adulting.” I turned 30, became a CFA charterholder, and celebrated my fifth anniversary of employment (deployment) with the same firm where I, stubbornly, still work. I became an uncle for the first time, and I was about to become a father as well.My colleagues and I watched in disbelief as equity markets rose relentlessly in 1999, and I vividly remember saying that one day we would look back and talk about the “go-go 90s.” It was exciting, but it also made me uncomfortable. Warning signs were everywhere. Nosebleed multiples. Pets.com. Nickelback. The handwriting really hit the wall when I saw that the keynote address at the major business appraisal conference that October was to be given by the authors of a then hot but now forgotten book: Dow 36,000.Cap Rates and CouponsDow 36,000 is a clever fairy tale written by a journalist, James Glassman, and an economist, Kevin Hassett. The authors assert that the bull market of the 1990s was fueled, in part, by multiple expansion that would persist as investors came to understand that stocks were no riskier than treasuries. Stock and bond capitalization rates would eventually converge and - voila! - the Dow would quadruple from the levels at which it was then trading. The book was panned by grouchy economists like Paul Krugman and perma-bears like Robert Shiller, the CAPE-crusader who has since predicted at least nine out of the last two financial catastrophes.
Dow 36,000 forecast a sharp rise in the DJIA within three to five years. It’s been two decades, and we still aren’t there – at least in the public equity markets. In the private markets, though, I’m starting to wonder if Glassman and Hassett’s fanciful outlook on valuation has finally been realized.Adjusted RealityWhen the bull market of the 1990s abruptly ended in 2000, one casualty was an energy trading firm with very empathetic accountants. The death of Enron, and the subsequent murder of its auditor, Arthur Andersen, set a regulatory buildup into motion which made it generally disadvantageous to be a public company. 20 years later, the number of U.S. public companies has been nearly halved, and out of the ashes of the public markets rose the phoenix that is private equity.Private equity can be as much about marketing as it is about markets: convince equity investors to lock up their money for a decade, then convince entrepreneurs to take the money. Cheap debt brings both parties to the table, goading risk-averse investors to chase returns, and teasing sellers with bigger payouts.Twenty years post-Enron, sponsors have raised the art of “heads I win, tails I win more” to a science. A smorgasbord of cheap debt has enabled financial intermediaries to routinely outbid strategic buyers for three years now. Hockey-stick projections have been supplanted by higher order land-grab economics: the first idea to gain monopoly status wins. Banks compete to lend to sponsors buying asset-light businesses based on EBITDA “addbacks.” LPs look the other way as reality-check IPO exits have been replaced by mark-to-model fund-to-fund transactions. And the SEC is talking about relaxing the requirements to be considered an Accredited Investor. What could possibly go wrong?Barbarians at the Gate 2 – Electric BoogalooThe distorted reality of the sponsor community is having an impact on the RIA space as well.The null hypothesis of the RIA community is that investment management is a relationship business that cannot be scaled. What we are witnessing today is big money trying to disprove that power rests within the advisor/client relationship through ensemble practices, roll-ups, robo-advisors, etc.The trouble is the current PE model of raising billions to create a monopoly around some lifestyle essential doesn’t work in investment management. Investment management is fragmented for a reason. It is an owner-operator business model. It is a lifestyle business.Further, what is there to buy? If RIAs only sell when they have to, are consolidators just collections of failed firms? Are they optimized for a bull market? Is it possible to stress-test these models for the next downturn? We’ve recently been passing around a ten-year-old article on consolidation pains in the RIA space that is required reading for anyone who wants to learn from the past, or at least not be blindsided by it.Is there a sustainable consolidation model? Joe Duran scored big with deliberate, strategic acquisitions of local RIAs into one, nationally branded firm – but the cost of being deliberate is time, something that sponsor-backed enterprises don’t have. The sale of United Capital to Goldman Sachs is viewed by many (not necessarily me) as capitulation, maybe an admission that competing for deals with overcapitalized sponsor-backed initiatives was pointless. Some dismiss the strategic importance of the deal because, for Goldman, the $750 million it paid for United wasn’t much money. That may be true, but Goldman doesn’t do many deals, and didn’t have to do this one.The brains behind the United Capital acquisition model, Matt Brinker, is now at Merchant Investment Management. Merchant has more of a co-invest mindset, and permanent capital, which says a lot about what the brains of the industry think is a successful consolidation strategy. The co-invest model, in which a financial partner shares with management in equity ownership on a control or, usually, a minority interest basis, seems to have the most traction. We think that approach can work, so long as returns to equity are clearly delineated from returns to labor.We may have already reached a tipping point. Deal volume was up last year, but deal value was down. The pace of transaction activity established early in 2019 didn’t sustain itself in the fourth quarter – usually a big one. The most visible acquirer in the RIA community, Focus Financial, was called out last summer for becoming over-leveraged. Focus management disputed this, but since then their acquisition announcements have been few.…like it’s 1999The song that Prince recorded about 1999 isn’t about the good times; it’s a song about the end-times. As 1999 drew to a close, people weren’t as concerned about the Mayan calendar or Nostradamus as they were about the disastrous consequences of global IT systems locking up because of bad date programming – a fake crisis brilliantly marketed by the IT consulting community to sell their services. The only real crisis was a missed opportunity to have a good time.My wife and I went out on New Year’s Eve 1999 to a very underattended extravaganza. 80% of the invited guests stayed home, afraid of what I don’t know. Instead of the big blowout that most of us expected in the years leading up to the new millennium, the reality was that partying in 1999 meant withdrawing into a quiet paranoia. If you cringe every time someone talks about selling a company for a big multiple of adjusted EBITDA, you get the idea.
How to Communicate Financial Results to Family Shareholders (Part 2)
Family Business Director recently started watching Christopher Nolan’s 2010 movie Inception. While we are not really competent to comment on the artistic merits of the film, we were more than a bit confused by some of the dream-within-dream-within-dream sequences and the generally non-sequential plotline. We took some comfort from the fact that at least one website devoted to this sort of thing ranked Inception as one of the most confusing movies ever made.If the balance sheet is a still photo, the income statement is a movie.If the balance sheet is a still photo, the income statement is a movie. While the balance sheet records the assets and liabilities of your family business at a particular point in time, the income statement is a record of the revenue earned and expenses incurred by your family business over time.
Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this series of posts, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful. In the last post, we focused on the balance sheet; this week, we turn our attention to the income statement.The Income StatementWhen communicating results from the income statement, you don’t want your family shareholders to feel the way we did while watching Inception. If the income statement is the movie that tells the story of your family business, the goal should be to make the plotline as transparent and easy to follow as possible. The primary threads of the plotline for your family business as revealed in the income statement are growth, margin, and return on investment.GrowthGrowth is essential to family business success. As pointed out recently by David Wells, the “average” family needs to earn anywhere from 8% to 10% annually to maintain real, after-tax, per capita family wealth over time. Since growth is so important, family business managers should emphasize the trend in revenue over time when communicating results to family shareholders.However, revenue growth alone does not tell the full story for most family businesses. After all, the business earns revenue by producing a good or providing a service, and revenue is the product of the volume of goods produced or services rendered and the effective price received per unit of activity. For some businesses, a volume metric is obvious (i.e., cases sold); for others, a bit more creativity may be required. Regardless of the specific volume measure, however, the underlying story is the same: revenue growth is a function of changes in the quantity of goods or services sold, and changes in the effective price received for such goods or services.
Exhibit 1 illustrates how breaking revenue into activity and pricing measures can add texture to revenue growth discussions. Exhibit 1 highlights for family shareholders that the growth attributable to selling more cases of product has been augmented by price increases to drive even faster revenue growth. The same type of presentation can then be used to discuss plans for the future. Telling shareholders that you expect revenue growth is pretty abstract; telling them that you anticipate selling 7% more cases at a 3% higher price is much more concrete and understandable.
MarginRevenue is the source of everything good in business. But your family shareholders benefit only to the degree that revenue outruns expenses. Profit margin measures the efficiency with which you convert revenue into profits. In other words, how many dollars of profit does your family business wring out of $100 of revenue?As with revenue, the challenge for communicating margins to family shareholders is to move from the abstract (our EBITDA margin was 20% last year) to the concrete (we spend these proportions of our revenue on these expenses).Exhibit 2 illustrates one way to depict the family business’s profit margin in a more concrete and understandable manner.
One virtue of the presentation in Exhibit 2 is that it aligns the concept of profit margin with the functional areas of the business. In other words, it clarifies how much of the company’s revenue goes to funding the various necessary functions of the business. This helps to remove much of the mystery about how the family business actually makes money. It also helps link profitability to business strategy by providing perspective on potential investments. For example, if we spend 2% more to acquire higher quality raw materials, we will be able to save 4% on manufacturing costs.
The presentation in Exhibit 2 relates to a single period. By establishing that base, then you can easily benchmark those results against available peer data or the family business’s own performance over time. Tracing where the company’s revenue goes is a great way for your family shareholders to better understand your current profit margin, along with the opportunities and challenges facing the business.
Return on InvestmentInvestors are much more interested in how to earn more per dollar invested.One surefire way to double the interest you earn on your savings account is to double the amount on deposit. While that strategy works, it’s not really what investors want to hear. Investors are much more interested in how to earn more per dollar invested. Yet, when companies report results to their shareholders, they often focus exclusively on the amount of income (profits increased 30%!) while ignoring the question of how much was invested. Return on invested capital (ROIC) is our preferred measure of financial performance for family businesses because it takes into account both earnings and the capital invested to generate those earnings.In its simplest form, ROIC is the ratio of NOPAT (net operating profit after tax) to invested capital (the sum of equity and debt capital invested in the business). So if the 30% increase in profits referenced above was achieved only after increasing the capital invested in the business by 40%, that’s really not such a good thing. Exhibit 3 helps to emphasize that ROIC depends on both the income generated by the business and the amount of capital invested.
ROIC is an especially effective tool for capital allocation decisions within multi-segment family businesses. As shown in Exhibit 4, family shareholders can benefit from a clear presentation of how much capital is allocated to each segment of the family business, how returns compare among business segments, and how returns compare to a specified hurdle rate.
Exhibit 4 helps family shareholders see both the relative capital allocation to each segment and how the returns for those segments relate to the target return of 12%. This sort of presentation can help prepare family shareholders for important discussions about investment priorities going forward.ConclusionThe income statement is the story of your family business, and it is important to tell that story well for the benefit of your family shareholders. Telling the story of the family business is probably not the best time to channel your inner auteur, however. Instead, stick to the basics and focus on an easily-grasped narrative arc that emphasizes growth, margin, and return on investment. Your family shareholders will thank you.
Quality Of Earnings Study: The “Combine” to Help Harvest Top FinTech Acquisition Targets
As we find ourselves at the end of the decade, many pundits are considering what sector will be most heavily influenced by the disruptive impact of technology in the 2020s. Financial services and the potential impact of FinTech is often top of mind in those discussions. As I consider the potential impact of FinTech in the coming decade, I am reminded of the Mark Twain quote that “History doesn’t repeat itself but it often rhymes.”A historical example of technological progress that comes to mind for me is the combine, a machine designed to efficiently harvest a variety of grain crops. The combine derived its name from being able to combine a number of steps in the harvesting process. Combines were one of the most economically important innovations as they saved a tremendous amount of time and significantly reduced the amount of the population that was engaged in agriculture while still allowing a growing population to be fed adequately. For perspective, the impact on American society from the combine’s invention was tremendous as roughly half of the U.S. population was involved in agriculture in the 1850s and today that number stands at less than 1%.As I ponder the parallels between the combine’s historical impact and FinTech’s potential, I consider that our now service based economy is dependent upon financial services, and FinTech offers the potential to radically change the landscape. From my perspective, the coming “combine” for financial services will be not from one source or solution, but from a wide range of FinTech companies and traditional financial institutions that are enhancing efficiency and lowering costs across a wide range of financial services (payments, lending, deposit gathering, wealth management, and insurance). While this can be viewed as a negative by some traditional incumbents in the space, it may be a saving grace as we start the decade with the lingering effects of a prolonged historically low and difficult interest rate environment, and many traditional players are still laden with their margin dependent revenue streams and higher cost, inefficient legacy systems. Similar to the farmers adopting higher tech planting and harvesting methods through innovations like the combine, traditional incumbents like bankers, RIAs, and insurance companies will have to determine how to selectively build, partner, or acquire FinTech talent and companies to enhance their profitability and efficiency. Private equity and venture capital investors will also continue to be attracted to the FinTech sector given its potential.As the years in the 2020s march on, FinTech acquirers and traditional incumbents face a daunting task to evaluate the FinTech sector. Reports vary but generally indicate that over 10,000 FinTechs have sprouted up across the globe in the last decade and separating the highly valued, high potential business models (i.e, the wheat) from the lower valued, low potential ones (i.e., the chaff) will be challenging. Factor in the complicated nature of the regulatory/compliance overlay and investors, acquirers, and traditional incumbents face the daunting task of analyzing the FinTech sector and the companies within it.As a solution to this potential problem, the efficient operations and historical lessons learned in the agricultural sector from the combine may again provide insights for buyers of FinTech companies to learn from. For example, the major professional sports leagues in the U.S. all have events called combines where they put prospective players through drills and tests to more accurately assess their potential. In these situations, the team is ultimately the buyer or investor and the player is the seller. Pro scouts are most interested in trying to project how that player might perform in the future for their team. While a player may have strong statistics in college, this may not translate to their future performance at the next level so it’s important to dig deeper and analyze more thoroughly. For the casual fan and the players themselves, it can be frustrating to see a productive college player go undrafted while less productive players go highly drafted because of their stronger performance at the combine.While not quite as highly covered by the fans and media, a similar due diligence and analysis process should take place when acquirers examine a FinTech acquisition target. This due diligence process can be particularly important in a sector like FinTech where the historical financial statements may provide little insight into future growth and earnings potential for the underlying company. One way that acquirers are able to better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE). In this article, we give a general overview of what a QoE is as well as some important factors to consider.What is a Quality of Earnings Study? A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer in order to assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors. Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long term growth can be expected. This estimate of earning power typically considers trying to assess the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-back; (2) Non-recurring items; (3) Pro-forma adjustments/synergiesCustomer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysisBusiness and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring
These areas are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis
For high growth technology companies where the analysis and valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the some of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers perception for the company and its products.
This article discusses a number of considerations that buyers may want to assess when performing due diligence on a potential FinTech target. While the ultimate goal is to derive a sound analysis of the target’s earning power and potential, there can be a number of different avenues to focus on, and the QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.
Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers. Leveraging our valuation and advisory experience, our quality of earnings analyses identify and focus on the cash flow, growth, and risk factors that impact value. Collaborating with clients, our senior staff identifies the most important areas for analysis, allowing us to provide cost-effective support and deliver qualified, objective, and supportable findings. Our goal is to understand the drivers of historical performance, unit economics of the target, and the key risk and growth factors supporting future expectations. Our methods and experience provide our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows.
Our methodologies and procedures are standard practices executed by some of the most experienced analysts in the FinTech industry. Our desire is to provide clients with timely and actionable information to assist in capital budgeting decisions. Combined with our industry expertise, risk assessment, and balanced return focus, our due diligence and deal advisory services are uniquely positioned to provide focused and valued information on potential targets.
Originally published in Mercer Capital's Value Focus: FinTech Industry Newsletter, Year-End 2019.
RIA Consolidators Drive Record Deal Activity in 2019
Asset and Wealth Manager M&A Continues Decade-Long Upward Trend
Asset and wealth manager M&A continued at a rapid pace during the fourth quarter of 2019, rounding out a record year by many metrics. Total deal count in 2019 rose 6% over 2018, reaching the highest level seen over the last decade. While reported deal volume declined by 50% in 2019, this metric can be a less reliable indicator of transaction activity given the lack of disclosed deal terms and the influence of large transactions (the Oppenheimer/Invesco deal accounted for about a quarter of 2018 reported deal volume, for example).The rise of the RIA consolidator model continues to be a theme for the wealth management sector. Wealth management firms saw a significant uptick in consolidation activity during 2019, which was attributable in large part to strategic consolidators. According to Fidelity’s December 2019 Wealth Management M&A Transaction Report, there were 139 wealth management transactions in 2019 (43% more than 2018) representing $780 billion in assets (38% more than 2018). Some of the more active consolidators included Focus Financial, Mercer Advisors, Wealth Enhancement Group, HighTower Advisors, and Dynasty Financial Partners—each of whom acquired multiple RIAs during 2019.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing. These consolidators are, in general, well-funded (often by PE backers) and have a mandate from their investors to grow rapidly via acquisitions. They’re also not shy about knocking on doors to source deals, and given the demographics of the wealth management industry, their pitch for an exit plan often finds a receptive audience.Sub-acquisitions by consolidator-owned RIAs are a further driver of M&A activity for the sector. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place.There have also been several significant transactions of the consolidators themselves, which illustrates the broad investor interest in the consolidator model. One of the largest deals of 2019 was Goldman Sachs’s bid to enter the mass-affluent wealth management market through its $750 million acquisition of RIA consolidator United Capital Partners. Also during 2019, Mercer Advisors’ PE backers sold a significant interest to Oak Hill Capital Partners.Consolidation Rationales Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side. One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids. The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture. Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.M&A OutlookThe record transaction activity in 2019 marks a decade-long run of steadily increasing consolidation activity in the sector. In 2020, we expect the trend to continue as many of the forces that shaped the industry over the last decade remain in place. Consolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to face pressure as funds flow from active to passive and clients become increasingly fee conscious. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity.
With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The performance of the broader market will also be a key consideration for both buyers and sellers in 2020.
How to Communicate Financial Results to Family Shareholders (Part 1)
Suppose that your exposure to the French language consists of two years of high school classes twenty-five years ago. Imagine how frustrating it would be if suddenly the only news outlet available to you was Le Monde. With no small effort on your part, there’s a good chance you would be able to discern the broad outlines of the day’s events, but the odds of misunderstanding a key part of the story would be high, and any subtleties or nuance in the writing would be totally lost on you.Communication promotes shareholder engagement, but what does it look like to communicate financial results effectively?That is likely how many of your family shareholders feel when it comes to comprehending the financial results of your family business. Perhaps they took an accounting course at some point in their lives. Or simply by virtue of having grown up around the family business, they have developed a vague sense of the differences between revenue and equity, or assets and expenses. As a result, when they read a financial report, they are generally able to discern the broad outlines of performance for the year or quarter, but the odds of misunderstanding a key part of the story are high, and any subtleties or nuance beyond the most rudimentary data are likely to pass them by.Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this series of posts, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful. We start in this post with the balance sheet.The Balance SheetThe balance sheet is a snapshot of what the family business owns, and what it owes, at a single point in time. The most important balance sheet concepts to communicate to family shareholders are scale, composition, and efficiency.ScaleIs $1 million a lot of money? The answer to that question depends, of course, on your perspective. For a family-owned restaurant, it may be everything; but for Ford Motor Company, it is a rounding error. To have any meaning, balance sheet totals need context. As a raw data point, the fact that your business has net fixed assets of $205 million is meaningless to your family shareholders. To really communicate scale, you need a reference point, whether a prior date in your family business’s history, a contemporary peer, or some other benchmark. Exhibit 1 is an example of contextualizing balance sheet scale.
Exhibit 1 helps communicate scale more effectively in several ways.
The icons help reinforce that financial statement balances aren’t just numbers, but correspond to actual stuff in the real world. The family business doesn’t exist to generate financial reports, but to produce real goods or provide real services.Comparing the balance today with that from a decade ago helps to give a sense for what $205 million really means. The meaning of a $205 million fixed asset balance today would be completely different if the balance in 2010 had been $300 million instead of $65 million.The average annual investment figure helps family shareholders to appreciate the cumulative nature of capital investment, and the fact that the need for capital spending is ongoing even though actual expenditures may occur only sporadically.The growth rate provides a benchmark for evaluating other parts of the company’s story, such as revenue growth or the growth rate in other asset categories.CompositionIt is also important for family shareholders to understand the relative proportions of the balance sheet. With regard to the left side of the balance sheet, how are the total assets of the business allocated among the primary asset categories? The most important takeaway from the right side of the balance sheet, which consists of liabilities and equity, is the relative mix of funding sources used to finance the business.It is hard to beat a pie chart or area model for demonstrating the composition of a whole. Exhibit 2 illustrates one way to use area models to communicate the composition of the balance sheet.The balance sheet presentation in Exhibit 2 is effective for a several reasons.First, we have grouped individual line items together in order to reduce the “clutter” found on too many balance sheets. Detail that is appropriate for managers or even directors to consider just distracts from the overall message when the goal is communicating with shareholders.Second, we rearranged things a bit, netting non-debt liabilities against the left side of the balance sheet. This isolates the total invested capital entrusted to management, and helps prepare shareholders for an emphasis on return on invested capital as a primary performance measure.Finally, presenting the various balance sheet categories at scale conveys the relative composition of the balance sheet more intuitively than a series of numbers does.
Occasionally, it will be important to demonstrate the composition of your balance sheet relative to some benchmark, whether a peer group or historical measures for your family business. When comparing composition to differently-sized peers, it is helpful to express the components as a percentage of the whole rather than in dollar amounts, as illustrated in Exhibit 3.
EfficiencyThe final balance sheet concept to communicate to family shareholders is efficiency. Managers and directors are stewards of family capital, and balance sheet efficiency measures demonstrate how effective their stewardship has been.Tracing the elements of the operating cycle conveys how the business operates in a fresh perspective.Efficiency measures include turnover and return statistics. Turnover measures compare a balance sheet item to a corresponding activity measure such as units sold, revenue, or cost of sales. Return statistics have a measure of income as the numerator and a balance sheet measure such as assets, invested capital, or equity as the denominator.The cash conversion cycle measures the working capital efficiency of a business. In other words, how much family capital is tied up in inventory and receivables? Since the return on working capital is often relatively low, managers generally try to reduce their balance sheet allocation to working capital. Exhibit 4 provides an example of how to communicate the cash conversion cycle to family shareholders.Exhibit 4 summarizes each component of the calculation, while also providing an intuitive basis for the calculation. By tracing the elements of the family business’s operating cycle, it conveys how the business operates to family shareholders in a fresh perspective.ConclusionEffective communication unlocks the power of positive shareholder engagement. When it comes to the financial performance of your family business, effective communication is more than simply providing audited financial statements when requested by family shareholders. Doing so is like handing them a newspaper written in their second (or third) language. They may get something out of it, but it will largely be a matter of chance.In this post, we have provided examples of how to communicate the key balance sheet concepts of scale, composition, and efficiency to your family shareholders. The exhibits in the post are simply illustrations; the challenge is identifying the best way to communicate these balance sheet concepts to the shareholders of your family business. In future posts, we will illustrate techniques for communicating the key financial concepts from the income statement and the statement of cash flows.
Wealth Management: Then and Now
How the Wealth Management Industry has Transformed Over the Last Decade
As we enter the new decade, rather than taking time for self-reflection, we prefer to take a step back and reflect on the transformation of the wealth management industry over the last decade.According to the Investment Advisor Association’s 2010 publication, SEC registered Investment Advisors reported $38.6 trillion in assets under management that year. Today, that number has more than doubled to $83.7 million. The number of SEC registered investment advisors, however, has only increased by 12% (11,643 in 2010 and 12,993 today). This means that the average advisor is managing more money today than they were ten years ago, as shown in the graph below.In 2010, advisors reportedly served approximately 30 million clients compared to 43 million today, suggesting that the increase in assets managed by each advisor is a result of having both more and larger clients.These statistics suggest it’s been smooth sailing for wealth managers. However, the investment management industry has changed radically over the last ten years, and wealth managers have been forced to adapt in order to maintain their client base and remain profitable. While these changes have not been easy, they have transformed the industry into one more focused on its clients’ needs and better regulated to ensure the safety of its clients’ assets.BackdropThe popularity of passive funds increased in 2009 when the current bull market began. In 2010, about 30% of U.S. assets were held in passively managed funds; last year, we crossed the 50% mark. While active versus passive may still be an intellectual debate, there’s no debate that trillions of dollars are managed passively today at much lower fees than they were a decade ago. The chart below demonstrates the decline in publicly traded investment managers’ effective fees over the last ten years.Wealth managers, however, have largely side-stepped fee pressure so far, and we don’t hear many instances of wealth management firms bending their stated pricing schedules because of client pushback. However, to justify higher fees in a low fee environment, wealth managers have had to differentiate themselves by providing more specialized solutions for their clients. Ten years ago, Westwood Holdings, a publicly-traded wealth management firm, described themselves as follows on their website:Westwood is built upon one investment philosophy of controlling overall portfolio risk while providing superior, risk-adjusted returns for our clients.Today Westwood’s website touts:At Westwood, we will champion your values and help make your intentions a reality.Wealth managers have changed their marketing strategy to highlight their more tailored investment solutions (with the underlying message that specialized services are worth the higher fees). But their ability to maintain their fee schedules will likely depend on their capacity to continue servicing clients’ evolving needs while connecting with their next generation.The trade-off with more specialized investment management is the cost. Providing tailored investment solutions, takes more time, i.e. more human capital. One area where the asset management model beats wealth management is scalability. You can build a bigger wealth management firm, but it usually requires a corresponding increase in advisors and planners. Additionally, as compliance and technology costs have increased over the last decade, wealth managers have had to pay closer attention to their expense base then they had to ten years ago.At the same time, many principals of wealth management firms reached retirement age over the last decade, often with no plan in place to transition their business. Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. In Schwab’s 2019 benchmarking study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership. The options for succession planning for aging principals have exploded over the last decade. Debt financing providers have bettered the terms for RIAs, private equity firms are giving more attention to the industry, and M&A opportunities have increased as RIAs try to achieve scale.Most notably, however, is the increase of consolidators in the space. RIA consolidators have seized the opportunity to address both the needs of retiring shareholders and continuing principals, by offering liquidity for founders as well as back-office infrastructure. Consolidators can provide selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to the next generation of management. Additionally, they can offer back office services such as IT, compliance, and human resources which allows RIAs to preserve their margins despite the cost of hiring more advisors.2020 VisionLooking forward, wealth managers will have to continue streamlining back office processes so that they can prioritize spending on compensation. Investments in technology and compliance will continue to require additional resources. Wealth managers must make conscious decisions about where they will find cost saving efficiencies without sacrificing superior service for their clients.Going forward, more and more RIAs will have to evaluate offers from consolidators and decide whether this kind of partnership right for them. Planning ahead for the eventual transition of your business will set you up with more options for retirement and a better understanding of where you are willing to make concessions.
Q4 2019 Global Macro Review
U.S. Production Hits Milestones Amid Continued Global Political Tensions
Brent crude prices began the quarter around $59 per barrel and have steadily risen to around $68 to close out 2019. WTI pricing has risen at a similar pace although it continues to trail Brent pricing by about $7 per barrel. Natural gas, however, has been trending in the opposite direction as prices have steadily declined since the end of October. In this post, we will examine the macroeconomic factors that have affected prices in the fourth quarter.Global SupplyOPEC conducted its 177th meeting on December 5th to take note of oil market developments since its last meeting in July and to review the oil market outlook for 2020. Press reports leading up to the meeting indicated that OPEC would extend the existing supply cuts, helping support crude oil prices. Ultimately, the group went a step further, deepening production cuts by 0.5 million b/d. However, the cuts were not extended and only run through the end of March 2020. According to the EIA’s latest Short-Term Energy Outlook (“STEO”), OPEC production is expected to fall in 2020. This is largely related to production restraint from most OPEC members amid concerns of rising oil inventories, continuing sanctions on Iran, and ongoing declines in Venezuela’s crude oil production. EIA forecasts that increased non-OPEC production will more than offset those declines and that global liquid fuels supply will rise by 1.5 million b/d in 2020.International Maritime Organization 2020Beginning on January 1, 2020, the International Maritime Organization (IMO) is set to enact the Annex VI of the International Convention for the Prevention of Pollution from Ships (MARPOL Convention), which lowers the maximum sulfur content of marine fuel oil used in ocean-going vessels from 3.5% to 0.5%. The implementation of MARPOL will see the marine fuels landscape change significantly as over 95% of the current market will be displaced.
The EIA demonstrates the recent shifts in share of OECD Europe oil imports.
These trends could continue in 2020 based on the IMO 2020 regulations. The EIA expects U.S. crude oil production to provide approximately two-thirds of total global liquids growth next year. It is also important to note that U.S. crude oil tends to be a light, sweet grade, which will likely see an increase in global demand due to the implementation of the IMO 2020 regulations, further tilting market share.
U.S. Production Hits All-Time High in Q4In September 2019, the U.S. became a net petroleum exporter, marking the first month ever since monthly records began in 1973. To be exact, the U.S. exported 89,000 b/d more crude oil and petroleum products than it imported in the month of September. Increasing U.S. crude oil production has resulted in a decrease in U.S. crude oil imports as well as the number of import sources. Despite the reversal in September, the U.S. remains a net importer of crude oil, however, and 60% of imports come from Canada and Mexico.The EIA expects U.S. crude oil production to average 13.2 million b/d in 2020, a slight increase from the 2019 level. According to the STEO, slowing crude oil production growth results from a decline in drilling rigs over the past year, which is slated to continue into 2020. Although the rig count is forecast to decline, the EIA forecasts an increase in production as rig efficiency and well-level productivity rises.U.S. – China Trade Deal Phase OneIn early December, the U.S. and China agreed on the first phase of a trade deal. The Phase One agreement means the U.S. is suspending tariffs that were planned on $160 billion in Chinese imports. In addition, the U.S. halved the September tariffs from 15% to 7.5%. As a part of the Phase One deal, President Trump said Beijing has agreed “to many structural changes and massive purchases of Agricultural Product, Energy, and Manufactured Goods, plus much more.” With regard to the trade deficit, U.S. officials signaled that China agreed to increase purchases of U.S. products and services by at least $200 billion over the next two years. Phase One also addressed specific concerns subject to China’s intellectual property practices. President Trump explained that the U.S. and China would begin negotiations over the second phase of the trade deal rather quickly. On the other side, China confirmed that a deal was reached and that the deal will be signed on January 15, 2020.Interest RatesBy the end of October, the Fed had made three rate cuts in 2019 due in part to trade policy uncertainty. In early November, following the last round of cuts, the Fed decided to hold rates steady. After their meeting in early December, the Fed kept the federal funds rate between 1.5% and 1.75%. The Federal Reserve remained optimistic about economic stability but emphasized that their actions will depend on future events. Long-term interest rates began to rise over the quarter from the low of 1.47% for the 10-year Treasury in September. Looking ahead to early 2020, rates are expected to remain flat with quiet Fed activity.Middle East TensionsAn airstrike at the Baghdad Airport on January 3 killed top Iranian military commander, Major-General Qassem Soleimani. Per the Department of Defense, the airstrike was conducted by the U.S. military at the direction of the President. WTI and Brent prices spiked nearly 4% on the breaking of the news. Although further escalations are uncertain, moderate to low-level incursions in the first quarter of 2020 may be possible. Analysts believe that Iran may resume targeting and harassment of oil shipping vessels in the Strait of Hormuz through which almost 25% of global oil consumption passes. Iran sits at a natural choke point on the Strait, and has threatened to close Hormuz in times of heightened tension. Disruption of this level of shipping could have large consequences on global oil demand and spikes in pricing if the U.S. and Iran continue to escalate military responses.ConclusionThe next OPEC meeting is scheduled to occur on March 5, 2020, so decisions on increased, steady, or reduced production cuts on the supply side will not be made until the end of the first quarter. Middle East tensions will be a highlight going into the 178th meeting if the Iran and U.S. conflict escalates. Increased disruption could significantly affect global oil demand and price. In the meantime, strong U.S. production is expected to continue in early 2020, and it is unclear whether the U.S. – China Phase One Trade Deal will lead to continued negotiations and cooperation between the two global players.At Mercer Capital, we stay current with our analysis of the oil and gas industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have varying impacts on prices. We have assisted clients with diverse valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.
All Classes of Investment Management Firms Outperformed the Market in Q4
2019 Was Also a Bull Market for the RIA Industry
As good as the fourth quarter was for the S&P, it was even better for the RIA industry. All classes of investment management firms bested the market, which was up 10% for the quarter. Continued gains in the equity markets have allowed these firms to more than recover from last year’s correction, and many of these businesses are now trading at or near all-time highs.
Despite these gains, the asset management industry is facing numerous headwinds, chief among them being the ongoing pressure for lower fees. Alt managers, on the other hand, are perhaps more insulated from fee pressure due to the lack of passive alternatives to drive fees down.
These headwinds have contributed to a decline in EBITDA multiples for traditional asset managers over the last few years despite the recent uptick in stock price performance. As shown below, EBITDA multiples for these businesses remain well below historical norms, although they have recovered from their low point in December of 2018.
Expanding the performance chart over the last year reveals an upward trend in pricing for most classes of RIAs. Over this longer timeframe, alt managers are still the strongest category, although performance has been volatile. Other pure play managers have generally moved in lockstep with the broader market while the aggregators lagged with AMG and FOCS’s performance.
The relative underperformance of the aggregator and multi-boutique index may come as a surprise given all the press about consolidation in the industry and headline deals for privately held aggregators. Over the last year, there have been two significant deals for privately-held wealth management aggregators: United Capital was bought by Goldman Sachs for $750 million, and Mercer Advisors’ PE backers sold a significant interest to a new PE firm, Oak Hill Capital Management. Both the United Capital and Mercer Advisors deals reportedly occurred at high-teens multiples of adjusted EBITDA.
Implications for Your RIAWith EBITDA multiples for publicly-traded asset managers still well below historical norms, it appears the public markets are pricing in many of the headwinds the industry faces. It is reasonable to assume that the same trend will have some impact on the pricing of privately-held asset managers as well.But the public markets are just one reference point that informs the valuation of privately-held RIAs, and developments in the public markets may not directly translate to privately-held RIAs. Depending on the growth and risk prospects of a particular closely-held RIA relative to publicly-traded asset and wealth managers, the privately-held RIA can warrant a much higher, or much lower, multiple.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs appears to have improved since the significant market drop in December 2018. Since then, industry multiples have rebounded somewhat, and the broader market has recovered its losses and then some—which should have a positive impact on future RIA revenues and earnings.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.
Appalachian Gas Valuations: The Bad, The Ugly, (And The Good)
U.S. dry gas consumption will finish at an all-time high of 84.3 Bcf per day in 2019 and that figure will continue to grow into 2020. However, if gas investors are celebrating, no one knows where the party is. In reality, the investing atmosphere is gloomy with commodity prices consistently below $3.00 per MMcf on the NYMEX and even lower in some locations. The valuation environment is dispiriting for many investors in Appalachia. It doesn’t take long to get buried in a cavalcade of adverse indicators, corporate overhauls, depressed EBITDA multiples and state sized swaths of uneconomic acreage. Data suggests some producers could spend the foreseeable future languishing in shareholder jail or bankruptcy court.How can economics get this jilted in arguably the largest gas field in the world? Perhaps it’s better to wonder why, at this point, would anyone even believe the dry gas investment premise at all? These are fair questions that investors and the broader stock market are asking themselves. Interestingly, there may be fair answers to them that, when analyzed closely, might chart a tough, disciplined course and perhaps eventually even position the Marcellus and Utica to be a globally superior gas field.The BadThere’s no question that valuations are floundering at relative historic lows. Mercer Capital’s group of public Appalachian gas producers has dropped approximately 50% since last year. It’s the largest collective decline of any other publicly traded U.S. basin group. Of the publicly traded Appalachian-based gas producers, some are trading at the bottom of EBITDA multiple ranges, and nearly all trade at the bottom from a price per flowing barrel metric.[caption id="attachment_29435" align="alignnone" width="750"] Mercer Capital's Selected Public Company Information Source: Bloomberg[/caption]
Transaction activity has been quiet as equity markets are closed and management teams are concerned with stewardship of their existing asset base. Deals that did close were production-oriented; some transacting at higher expected rates of return compared to historical norms (15% or even 20% rates of return).
It’s notable to point out that gas prices haven’t fallen nearly by the magnitude that stock prices have. So, what is happening to create such an investor flight? Consider recent developments.
Corporate WranglingTrials are front and center for independent producers. They have been pronounced at Gulfport and EQT, where management and shareholders engaged in some tumultuous struggles this year. Gulfport had board turnover and suspended a share repurchase program that it had initiated only earlier this year (in order to switch to a debt buyback program at a discount). At EQT, corporate governance has also been volatile. Toby and Derek Rice, whose eponymous company merged with EQT in November 2017, waged a successful proxy battle this year, proposing a business plan in September which included a 23% reduction in employees alongside a logistical and strategic overhaul of its drilling plan.Throwing In A Major TowelTrouble in Appalachia is not confined to the independents. Chevron recently announced a $10 - $11 billion write-down. More than half of its impairment is attributable to its Marcellus/Utica assets. Chevron’s large position and presence in the region is now mulling an exit from the play.Cash Flow ChallengesDue in part to the lack of available capital, early projections show capex reductions of 23% in 2020.[caption id="attachment_29436" align="alignnone" width="640"] 2020 Drop in CAPEX (millions) Source: Shale Experts[/caption]
This strategy cuts both ways. It can conserve cash in the short-term to allocate towards debt repayment or share buybacks, but it can also hamstring growth and production in future years, compounding problems with languishing prices. This is top of mind for many producers as they grapple with how to keep investors happy and stay out of bankruptcy court. Some producers are better positioned than others in this aspect, particularly Cabot. The chart below shows the relationship between the total amount of debt principal due over the next five years as compared to trailing levered free cash flow. It shows that some companies have some real challenges in that area.
[caption id="attachment_29437" align="alignnone" width="640"] Cash Flow vs. 5-Year Debt Repayment Source: Capital IQ[/caption]
Strangulation Via RegulationThe Marcellus and Utica Shale plays possess one of the best unused potential advantages in the natural gas world – proximity to the Northeast United States. One of the biggest potential consumers of the vast gas reserves is neighbor to the Marcellus, yet so little of it makes its way to its natural customer base. Why is this? One word: regulation. For example, the Constitution pipeline, approved by FERC in 2014, has been in regulatory purgatory since that time in the state of New York. Fracking is banned in New York and the regional political climate is frigid towards the natural gas industry, to say the least. In the meantime, New York-area utilities are struggling with gas pressure shortfalls for new customers. Also, in a twist of irony, increasing appetite for natural gas in Massachusetts is being met, at least partially, by Russian (yes, Russian) imports. Thus, Appalachia’s oversupply of gas continues to search for markets while the Northeast gets it from elsewhere. When a Russian LNG tanker pulls into Boston Harbor in the winter…that’s a bad sign.The UglyThe near-term doesn’t look any prettier when examining broader economic and commodity trends. In fact, some of it is downright ugly. Supply exceeds demand, futures prices remain anemic and huge areas of quality drilling acreage currently have minimal market value ascribed to them. These factors are putting a boot to the throat of producers and keeping valuations from even getting off the ground.Get Production For Nothing And Reserves For FreeAs we consider the supply and demand imbalance right now, we can change the refrain in one of Dire Straits classic songs to “Get Production for Nothing and Reserves for Free.” It can hardly be understated how much the reserves of dry gas in the U.S. have been turned on its head in the past decade. Flippant investors, to the chagrin of some, now view undrilled reserves as a dime a dozen. This was unheard of not long ago. This points out the most fundamental economic driver to these low valuations – oversupply. This hamstrings acreage valuations. According to the 2018 Year End Proved Reserve report which was released in early December, Appalachian dry gas has nearly doubled since just 2015. Even production gain metrics, which surged 48% over this same period, sit in the vapor trail of reserve growth. There is simply too much of a good thing, and it has cheapened gas for everyone else in the Marcellus’ short reach (especially the consumer).[caption id="attachment_29438" align="alignnone" width="640"] Appalachia (PA, WV, OH) Source: EIA[/caption]
Gas Price LimboEven years out, NYMEX gas futures look so flat, it can hardly be called a curve. Like a frantic swimmer getting pulled by an undertow, producers struggle to breathe in this environment. To make matters worse, Appalachia’s regional market constraints make its supply and demand even more imbalanced, leading to consistently wide pricing differentials. What little midstream capacity does come online gets filled too fast to influence pricing power. This has been and remains an Achilles heel for Appalachia.[caption id="attachment_29439" align="alignnone" width="640"] Natural Gas Prices / Mcf Source: Bloomberg[/caption]
Acreage Values Battling Irrelevancy
At these prices, there are hundreds of thousands of Marcellus and Utica acres that are simply uneconomic. According to a recent analysis by Antero Resources, nearly half (45%) of the needed gas supply in the next four years is currently non-economic at strip prices below $2.48. While that price point doesn’t appear sustainable in the long run, it illustrates why values are so gaunt when it comes to acreage and undrilled reserves. Another way to look at this is to examine companies’ enterprise values as compared to the PV10 values of their proved reserves (including undeveloped reserves), a standardized industry metric.
[caption id="attachment_29440" align="alignnone" width="640"] Current EV / PV10Source: Capital IQ[/caption]
None of the companies even gets very close to a ratio of 1:1. Some companies are trading around production reserve values only. Either way one slices it, future drilling inventory does not appear to be particularly valuable in the market’s view at this juncture.
When going through the laundry list of problems that the industry is facing, it can be difficult to see any upside, silver lining or diamonds in the rough. However, if one subscribes to rational market theory, then there are some things, hidden in plain sight, that could make an investor’s journey worth the long ride.
The GoodIntrinsically, Appalachia remains one of the most strategically important gas plays in North America. Eventually, amid all the obstacles it faces, it has arguably the most potential of any shale gas field and could develop into one of the most profitable shale gas fields in the world for decades to come.Retrenching – Diet And Exercise PayOffThese challenges are certainly testing the mettle of Appalachian producers. Producers’ intense focus on cash flow has multiple long-term benefits. First, it strengthens balance sheets and makes bankruptcy a more remote concern. Second, the limitations on production growth set a course towards price correction. Third, if and when prices do drift upward, more and more acres become economic. Companies are optimistic about their future. It is notable that Appalachian shareholder returns are manifesting themselves mostly in the form of share buybacks as opposed to dividends. That demonstrates companies believe they are intrinsically undervalued. Remember, the geology and hydrocarbons are there, the question is how cheaply they can be produced. Possibly the most challenging gas environment has forced Appalachian producers to have among the lowest development and operating costs anywhere. Therefore, if producers can survive this, then they can survive and thrive almost anywhere. That’s good because in the future this gas will have places to go.Oversupply Doesn’t Mean Lack Of DemandOne constant positive for Appalachian producers is that the demand is strong and growing. Platts Analytics estimates that around 80 Tcf of new supply is needed in the U.S. through 2023. Appalachia is expected to supply 38% of that figure. Even with all of the associated gas produced in the Permian right now (which also has logistics issues), it’s not enough. Gas will flow into the Gulf Coast and Appalachia will help lead the way. Globally, natural gas is the only fossil fuel expected to grow in global demand all the way through 2035.Exports And The LNG Market – A Brass Ring Worth ChasingThe enduring upside for valuations in Appalachia is capitalizing on what’s already in motion: U.S. domination of the worldwide LNG market. It’s not there today, but it is on its way. Between 2017 and 2027, LNG export capacity in the U.S. will have grown tenfold from around 3 Bcf per day to approximately 34 Bcf per day. Price relief for producers could just be a tanker away. Wallowing at $2.50 per MMcf domestically is tough; selling LNG to end markets at up to $9.00 per MMcf is much easier. Global prices are expected to average around $7.00 per MMcf going forward. How does the U.S. fit in this global market? Well, worldwide LNG production growth is flagging, just in time for the U.S. to fill the gap.[caption id="attachment_29441" align="alignnone" width="640"] Natural Gas Trade Source: U.S. Energy Administration[/caption]
The Chinese will need energy to engage in any trade wars and American LNG producers will likely supply it over the next 30 years. The U.S. will make up 67% of the growth in global LNG exports through 2024 and China will be the biggest buyer. Looking again at the Appalachian pricing chart overlaid with historical LNG export prices, the opportunity becomes clear.
[caption id="attachment_29442" align="alignnone" width="640"] Natural Gas Prices / McfSource: Bloomberg[/caption]
A drawback is that compared to the gas basins more proximate to the Gulf Coast, Appalachia has fewer LNG export options. The Elba Island LNG facility is operational, and Cove Point has some capacity, but this pales in comparison to Gulf Coast capacity. At the same time, there are other demand sources, such as Mexico, that will keep overall gas export demand high. Those factors should allow Marcellus and Utica producers more latitude to meet regional demand for east coast population centers. Even if pipeline constraints remain at a minimum, perhaps a tanker with U.S. gas pulls into Boston Harbor instead of a Russian one.
Final ThoughtsOne potential wildcard is the possibility of a renewable energy breakthrough. There is certainly a strong sustained desire by many people for this option. However, economically, there are just no alternative sources that can fill the gap in time to meet domestic and international energy and electricity demand. The gap filler is natural gas, and the basin with long-term solutions is primed to be Appalachia. This is the intrinsic valuation premise keeping long-term investors on board.Originally appeared on Forbes.com.
Five Questions Family Business Directors Should Think About as 2020 Begins
The new year provides a natural opportunity for family business directors to think about the current condition of their family business and ponder what the future might hold. In this first post of 2020, we identify a handful of questions that family business directors would do well to think about.1. What is our Family Business Worth?In contrast to more liquid investments, like a portfolio of marketable securities, the value of a family business cannot be known with precision. The good news is that a precise value isn’t nearly as important as an accurate estimate. And reasonably accurate estimates can be developed.If the family has no intention of selling, why is it important to know what your family business is worth? There are lots of reasons, but we’ll address three of the most important in this post.An accurate valuation helps shareholders better manage their own personal finances. No one would tolerate a financial advisor that refused to divulge the value of your investment portfolio because you’re not going to spend it all this year. Knowing the value of all the assets that you own (liquid and illiquid) is essential to prudent personal financial planning and decision making.An accurate valuation helps facilitate intra-family transactions. Even if the family does not plan to sell the business, certain shareholders may desire to transfer (through gift or sale) shares to other family members. An accurate, up-to-date valuation helps minimize the likelihood that intra-family transfers will unintentionally create economic winners and losers within the family. Some family businesses opt to sponsor redemption programs as a mechanism for providing shareholder liquidity. An accurate contemporaneous valuation is essential for such programs.An accurate valuation helps prepare the family for unsolicited acquisition offers. Capable and motivated buyers can offer to buy the family business even if it is not for sale. Once such an offer hits the table, deciding how to respond often becomes emotionally-charged. A third-party assessment of value that is performed outside the “heat of battle” can go a long way toward ensuring that the board formulates a rational and measured response to any unsolicited acquisition offers.
These different applications highlight the importance of understanding the various “levels” of value. The value of a controlling interest is likely higher than the value of a liquid minority interest, which is in turn likely higher than the value of an illiquid minority interest. An experienced, qualified business appraiser will help directors understand the value of the family business at each “level” and the economic factors that contribute to the resulting discounts and premiums.2. What Return Should our Family Shareholders Expect?Family shareholders are entitled to a future return on their investment in the family business. While the actual returns achieved over a given period are influenced by a host of factors (some of which are within management’s control and some of which are not), what is a reasonable expectation for future returns?Return follows risk. So determining what return family shareholders should expect ultimately comes down to identifying alternative investments of comparable risk. Family business directors should carefully evaluate the risks facing family shareholders relative to a range of potential alternative investments.Establishing the expected return is important for both shareholders and the managers and directors of the family business. For shareholders, the expected return provides an important benchmark for evaluating the performance of their investment over time. For managers and directors, the expected return is a critical component of weighing shareholder distributions against potential available investments. Family capital will eventually flow to its most productive use, whether that is inside or outside the family business, and the expected shareholder return is a key component of capital allocation for the family.3. What Form Should Shareholder Returns Take?Shareholder returns come in two – and only two – forms: distribution yield and capital appreciation. Cash flow that is distributed to family shareholders cannot be reinvested in the business to fuel growth. Alternatively, cash flow that is distributed to family shareholders is no longer at risk of being lost in the family business. Given these tradeoffs, there is no single “right” dividend policy for a family business.As a director, can you clearly articulate what your family business’s dividend policy is (and why it is what it is)? Nearly as important, have you and your fellow directors consistently communicated that policy to family shareholders such that they too understand it and can describe it? Individual shareholders may not agree with it, but you will never be able to make everyone happy. It is essential, however, that your family shareholders know that there is a guiding rationale rooted in thoughtful consideration of required shareholder returns, available investment opportunities, and shareholder preferences. If your dividend policy is perceived to be based on nothing more than the caprice of the board, it will inevitably breed distrust and acrimony.4. What Investments Should our Family Business Make?The process of making corporate investment decisions, referred to as capital budgeting, is essentially the flipside of dividend policy. Operating cash flow that is retained needs to be put to productive use lest it become “lazy.” From your perspective as a director, what segments of your family business seem most attractive for current investment given your family business’s strategy?Capital budgeting should serve strategy. When management presents a significant investment opportunity to the board, can you discern a genuine organic link between the company’s pre-existing strategy and the proposed investment? Given what you, as a director, understand the family business’s strategy to be, what types of investments would make sense in 20202?Maintenance capital expenditures are investments in preserving (or, preferably enhancing the efficiency of) the business’s current productive capacity. Maintenance capital expenditures are not glamorous, but successful family businesses recognize their importance.Growth capital expenditures are investments in increasing the business’s productive capacity. These expenditures allow the family business to expand geographically, add complementary product or service offerings, or diversify away from the legacy business.Whereas growth capital expenditures add to overall industry capacity, mergers and acquisitions are investments that assimilate existing industry capacity to the family business. While a potential acquisition may be attractive on the basis of its own (standalone) investment merits, most M&A transactions are pursued in the belief that adding the acquired operations to the family business will result in enhanced cash flows beyond what either company could generate on its own.5. How Much Debt is Appropriate for our Family Business?Together with investment and dividend policy, financing policy is the third strategic financial decision facing family business directors.
Family businesses are financed with some combination of family equity and debt capital. Debt capital is attractive because lenders are generally content with a lower rate of return than equity holders. As a result, the prudent use of debt can reduce the overall weighted average cost of capital for your family business (and increase returns on the family’s equity capital). But the benefits of debt are not free: adding debt to the company’s capital structure increases the risk faced by the family shareholders. As a director, you should be careful considering how much debt is appropriate for your family business on the basis of the company’s asset base, earnings stability, economic and industry outlook, available borrowing terms, and family shareholder risk tolerances.
ConclusionAs 2020 begins, we encourage you to take the time to think about these five questions. Regardless of the issues you are facing that are specific to your family business, these questions are perennial and common to all businesses. Pondering these questions may simply confirm that the status quo in these areas remains appropriate, or it may trigger some needed new thinking in one or more of these areas.Whether it is providing valuation calculations to estimate the value of your family business or serving as a neutral, independent sounding board in your deliberations, our family business professionals look forward to helping you develop appropriate answers to these questions for your family business. Give us a call today to discuss your needs in confidence.
2020 Outlook: Good Fundamentals, Moderate Valuations but Limited EPS Growth
Bank fundamentals, which are discussed in more detail below, did not change a lot between 2018 and 2019; however, bank stock prices and the broader market posted strong gains as shown in Table 1 following a short but intense bear market that bottomed on Christmas Eve 2018. Our expectation is that 2020 will not see much change in fundamentals either, while bank stocks will require multiples to expand to produce meaningful gains given our outlook for flattish earnings.Fed Drives the Market ReboundThe primary culprit for the 4Q18 plunge and subsequent 2019 rebound in equity prices was the Fed, which has a propensity to hike until something breaks according to a long standing market saw. A year-ago the Fed had implemented its ninth hike in short-term policy rates that it controls despite the vocal protests of the President and, more importantly, the credit markets as reflected in widening credit spreads and falling yields on Treasury bonds and forward LIBOR rates.One can debate how much weight the Fed places on equity markets, but it has always appeared to us that they pay close attention to credit market conditions. When the high yield bond and leverage loan markets shutdown in December 2018, the Fed was forced to pivot in January and back away from rate hikes after forecasting several for 2019 just a few months earlier. Eventually, the Fed was forced to reduce short rates three times and resume expansion of its balance sheet in the fourth quarter after halting the reduction (“quantitative tightening”) in mid-year.Markets lead fundamentals. Among industry groups bank stocks are “early cyclicals,” meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom. One take from the price action in banks is that the economy in 2020 will be good enough that credit costs will not rise dramatically. Otherwise, banks would not have staged as strong a rebound as occurred.Likewise, somewhat tighter spreads on B- and BB-rated high yield bonds relative to U.S. Treasuries (option adjusted spread, “OAS”) since the Fed eased is another data point that credit in 2020 will not see material weakening. The stable-to-tighter spreads in the high yield market today can be contrasted with 2007 when OAS began to widen sharply even after the Fed began to cut rates and the U.S. Treasury curve steepened as measured by the spread between the yield on the two-year and 10-year notes.Bank FundamentalsBank fundamentals are in good shape even though industry net income for the first three quarters of 2019 increased nominally to $181 billion from $178 billion in the comparable period in 2018. On a quarterly basis, third quarter earnings of $57 billion were below the prior ($63 billion) and year ago ($62 billion) quarters. Not surprisingly, earnings pressure emerged during the year as what had been expanding NIMs during 2017 and 2018 began to contract due the emergence of a flat-to-inverted yield curve, a reduction in 30/90-day LIBOR which serves as a base rate for many loans, and continuation of a highly competitive market for deposits. Also, loan growth slowed in 2019—especially for larger institutions.As shown in Table 2, core metrics such as asset quality and capital are in good shape, while profitability remains high. Our outlook for 2020 is for profitability to ease slightly due to incrementally higher credit costs and a lower full year NIM although stabilization seems likely during 2H20. Nonetheless, ROCE in the vicinity of 10- 11% and ROTCE of 13-14% for large community and regional banks seems a reasonable expectation.EPS growth will be lacking, however. Wall Street consensus EPS estimates project essentially no change for large community and regional banks, while super regional banks are projected to be slightly higher at 3%. Money center banks (BAC, C, GS, JPM, MS, and WFC) reflect about 6% EPS growth, which seems high to us even though the largest banks tend to be more active in repurchasing shares relative to smaller institutions where excess capital is allocated to acquisitions, too.The Fed—Presumably on HoldIn the December 2018 issue of Bank Watch we opined it was hard to envision the Fed continuing to raise short-term rates even though the Fed forecasted further hikes. We further cited the potential for rate cuts. Our reason for saying so was derived from the market rather than economists because intermediate- and long-term rates had decidedly broken an uptrend and were heading lower.As the calendar turns to 2020, the Fed has indicated no changes are likely for the time being. The market reflects a modest probability that one more cut will be forthcoming, but to do so in an election year probably would require long rates to fall enough to meaningfully invert the Treasury curve unlike the nominal inversion which occurred in mid-2019.As it relates to bank fundamentals, the impact on NIMs will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies NIMs should stabilize in 2H20 as higher cost CDs and wholesale borrowings rollover at lower rates. Also, if the Fed continues to expand its balance sheet (presently it is doing so through only purchasing T-bills through support of the repo market) then assets may remain well bid. All else equal, stable to rising prices in the capital markets usually are supportive of credit quality within the banking system.Bank Valuations—Rebound from Year-End 2018 “Bargains”A synopsis of bank valuations is presented in Table 3 in which current valuations for the market cap indices are compared to year-end 2018 and year-end 2017 as well as multi-year medians based upon daily observations over the past 20 years.
The table illustrates the important concept of reversion to the mean. Valuations were above average as of year-end 2017 due to policy changes that occurred with the November 2016 national elections that culminated with the enactment of corporate tax reform in late 2017. One year later valuations were “cheap” as a result of the then bear market that reflected concerns the Fed would hike the U.S. into a recession.
Despite the rebound in prices and valuation multiples during 2019, bank stocks enter 2020 with moderate valuations provided the market (and us) have not miscalculated and earnings are poised to fall sharply. Money center and super-regional banks are trading for median multiples of about 10x and 11x consensus 2020 earnings. Regional and large community banks, which include many acquisitive banks, trade for respective median multiples of 12x and 13x.
An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over-time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract. Looking back to last year one might surmise the rebound in valuations reflects the market’s view that the Fed avoided hiking the U.S. into recession.
Bank M&A—2020 Potentially a Great yearM&A activity has been robust with bank and thrift acquisitions since 2014 exceeding 4% of the industry charters at the beginning of each year. It appears once the final tally is made, upwards of 275 institutions will have been acquired in 2019, which would represent almost 5% of the industry. With only a handful of new charters granted since the financial crisis the industry is shrinking fast. As of Sept. 30, there were 5,256 U.S. banks and thrifts, down from about 18,000 in 1985.While activity was steady at a high level in 2019, the most notable development was market support for four merger-of-equals (“MOE”) in which the transaction value exceeded $1.0 billion. The largest transaction closed Dec. 9 when BB&T Corp. and SunTrust merged to form Truist Financial Corp. Others announced this year include tie-ups between TCF Financial Corp./Chemical Financial Corp., First Horizon National Corp./IBERIABANK Corp., and Texas Capital Bancshares Inc./Independent Bank Group Inc. Although not often pursued, we believe MOEs are a logical transaction that if well executed provide significant benefits to community bank shareholders.The national average price/tangible book multiple eased to 157% from 173% in 2018, while the median price/earnings (trailing 12 months as reported) declined to 16.8x from 25.4x (~21x adjusted for the impact of corporate tax reform). The reduction was not surprising given low public market valuations that existed at the beginning of 2019 because acquisition multiples track public market multiples with a lag.We see 2020 shaping up as a potentially great year for bank M&A. The backdrop is an M&A trifecta: buyer and seller earnings will likely be flattish primarily due to sluggish loan growth and lower NIMs; asset quality is stable; and stock prices are higher, meaning buyers can offer better prices (but less value) to would-be sellers. Also, the capital markets remain wide open for banks to issue subordinated debt and preferred equity at very low rates to fund cash consideration not covered by existing excess capital.Summing it UpThis year appears to be the opposite of late 2018 in which a strong market for bank stocks is predicting continuation of solid fundamentals and possibly better than expected earnings. Nonetheless, an environment in which earnings growth is expected to be modest at best likely will result in limited gains in bank stocks given the rebound in valuations that occurred in 2019.Originally published in Bank Watch, December 2019.
Mercer Capital’s Value Matters® 2020-01
Jones v. Commissioner
Family Business Director's Reading List for 2020
Listing the best books one has read over the preceding twelve months is commonplace. Family Business Director eschews the humble-bragging endemic to such lists. Instead, we offer a list of four books that we plan to read in 2020. We confess to reading far more book reviews than actual books, and we selected these books, in large measure, on the basis of generally glowing reviews. Upon completing each book, we will report back in future posts with our own impressions and takeaways for family business directors.The Cartiers: The Untold Story of the Family Behind the Jewelry Empireby Francesca Cartier Brickell
So the Cartier family business might seem a bit more glamorous than yours. But, business is business, and the inside account of a well-known family business that started in 1847 is sure to have plenty of great lessons regardless of what industry your family business is in. The author is a member of the Cartier family but never worked in the business herself, so her perspective on things should be interesting.Patient Capital: The Challenges and Promises of Long-Term Investingby Victoria Ivashina & Josh Lerner
The authors are both professors at Harvard Business School. Investing for the truly long-term brings its own unique set of risks and rewards, and enterprising families are natural long-term investors. We look forward to reading about what the authors find to be essential for successful long-term investing.Clyde Fansby Seth
Yes, apparently Seth gets by on just one name. Family Business Director has never read a graphic novel before, but we are intrigued. The book tells the story of a second-generation member who drove his father’s business – Clyde Fans – into the ground. We are really not quite sure what to expect, but in general, we find that we learn more from good fiction than most non-fiction.Kochland: The Secret History of Koch Industries and Corporate Power in Americaby Christopher Leonard
In order to become a polarizing political influencer, you first have to make a lot of money. Whether you welcome or abhor the political machinations of the Koch brothers, it is undeniable that Koch Industries has been a wildly successful family business. This book purports to be the corporate history of a very secretive family business. We look forward to learning more about how Koch Industries grew, and how remaining a privately-owned family business contributed to (or hindered, as the case may be) the company’s success.
As 2019 winds down, we want to extend best wishes to our clients and subscribers for continued success in 2020. Happy reading!
‘Twas the Blog Before Christmas…
2019 Mercer Capital RIA Holiday Quiz
'Twas the blog before Christmas and throughout our staff
Analysts were separating wheat from the chaffAs midtown Manhattan glistened with snow
We sighed as our Bloombergs warmed us with their glowHedge-funders grinned, computing their carry
While raising a glass to the 2 & 20 fairyWith the yield curve corrected, and cap rates back down
It’s hard to find a real estate guy with a frownLong-onlys dreamt active would once again pay
Before President Warren comes to tax it awayWealth managers gathered at bars with their peers
All hoping a Santa-rally soon would appearBut whatever your alpha, this is still a great biz
So celebrate the season with our RIA quiz!If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrQ3mXQw84VAAdJcw4qiJQXV.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk");
Appalachia M&A
Rangebound Gas Prices and Preoccupied Management Teams Cause Slowdown in Activity
It was a quiet year for M&A in Appalachia as only a handful of transactions occurred. Surging associated gas production in places like the Permian and Bakken have kept a lid on gas prices, which have largely remained between $2 and $3/mmbtu for the year. Near term expectations aren’t much better, with futures prices below $3 through 2029. Management teams were likely preoccupied with various corporate and capital structure issues instead of changes to the underlying reserve base. However, a bright spot is the easing of takeaway constraints that previously plagued the region.Recent Transactions in AppalachiaA table detailing E&P transaction activity in Appalachia during 2019 is shown below. Overall, deal count and average deal size declined relative to 2018. Diversified Gas & Oil’s acquisition of HG Energy II was the only non-royalty transaction of meaningful size during the year. Cabot recently announced a $256 million divestiture of its 20% interest in NextEra Energy’s Meade Pipeline, though that transaction is not included in the E&P transactions listed below.Range Resources ORRI SalesRange Resources was the most active market participant in the basin with two overriding royalty interest (ORRI) sales and the sale of 20,000 non-producing acres in Pennsylvania. The company intends to use the proceeds to paydown debt, offsetting much of the lost cash flow from the assets with decreased interest expense. The company also announced a $100 million share repurchase program.Diversified Gas & Oil Acquisition of Unconventional Assets from HG Energy IIDiversified Gas & Oil acquired 107 gross producing wells and related surface rights from HG Energy II. The acquisition is consistent with the company’s strategy of buying mature, low-decline PDP assets in Appalachia. However, the transaction does represent somewhat of a departure from the company’s historical focus on conventional (non-shale) assets. Management indicated that the transaction would be accretive on various per-share metrics including earnings and free cash flow.Operators Focused on Changes to Corporate and Capital Structure Rather than Asset BaseWhile it has been a quiet year in Appalachia on the M&A front, it was a tumultuous year for management teams and board members.Toby and Derek Rice’s proxy battle for control of EQT made headlines during the first half of the year. The Rice brothers cited EQT’s poor operational performance after its acquisition of Rice Energy as a reason to shake up management and the board. The brothers proposed a business plan which they indicated would generate an estimated incremental $400 - $600 million of pre-tax cash flow and unlock shareholder value. They succeeded in July with Toby Rice replacing Robert McNally as President and CEO of EQT. An organizational streamlining was announced in September, which included a 23% reduction in employees.Gulfport Energy, which has been targeted by activist investor Firefly Value Partners, announced a $400 million stock repurchase program in January 2019. However, the company suspended the program in November, citing “current market conditions and a weak near-term gas price outlook.” The same press release also announced that the company reduced its headcount by 13%, two board members were stepping down, and the chairman of the board would not seek re-election at the next shareholder meeting.Diversified Gas & Oil Company announced a novel financing transaction that may pave the way for other E&Ps looking for creative ways to fund operations. The company created a special purpose vehicle that issued non-recourse, asset-backed securities collateralized by a working interest in the company’s PDP assets. The company plans to utilize the proceeds from the financing to pay down borrowings on its existing revolving credit facility.Antero Resource’s midstream affiliate, Antero Midstream (AM), completed one of the more complicated MLP simplifications earlier in 2019. In June, after Warburg Pincus divested its remaining ownership interest in the company, Warburg’s two board members resigned, reducing Antero’s board to just seven directors. In December, Antero announced a $750 million to $1 billion asset sale program, which the company kicked off by selling $100 million of AM shares back to the midstream affiliate. Management indicated that future asset sales could consist of “lease acreage, minerals, producing properties, hedge restructuring or sale of AM shares to Antero Midstream.” As management teams work to fix capital structures through potential asset sales, 2020 might be a more active year for transactions in the basin.ConclusionM&A transaction activity in Appalachia was muted in 2019 as gas prices remained rangebound and management teams focused on corporate and capital structure issues rather than M&A. However, with operators feeling the pressure from sustained low gas prices, and Antero’s announced asset sale program, 2020 will hopefully be a more active year.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Middle Market Transaction Update Third Quarter 2019
Overall transaction value and volume in the middle market in the third quarter of 2019 increased from the virtually identical levels observed in the first two quarters of the year, and deal value increased to its highest level over the observed historical period.
Will Your Succession be Successful?
A Few Things RIAs Need to Know
We’ve hesitated to put together a whitepaper on succession planning because so many people have already written excellent commentary on the topic. Nonetheless, when we surveyed what had been written about succession for RIAs, we didn’t see the kind of nuts and bolts explanation of the corporate finance aspects of succession.The industry is facing at least three major factors: an aging ownership base, an aging bull market, and – paradoxically – an exponential increase in the sources of capital to sell, grow, or transition. Despite the headline emphasis on consolidation, investment management is still an apprenticeship business model and, therefore, internal succession will be the order of the day for most firms.We hope you will find our whitepaper on the topic both unique and useful. We are here to help you succeed at succession. Click the whitepaper below to download.>>Click Here to Download<<
Making It Through December
While its status as a Christmas song is perhaps debatable, Merle Haggard’s “If We Make It Through December” is classic country music at its finest. The song captures the pathos of economic distress, with the recently-downsized protagonist lamenting his inability to provide the Christmas he wants for his daughter.Although we suspect Mr. Haggard was not writing in this direction, the song has always made Family Business Director think about breakeven analysis. As the year draws to a close, family business directors naturally evaluate the firm’s profitability over the course of the year. For some, profitability was assured months ago. For others, it remains uncertain whether they will make it through December without incurring a loss for the year.What is Breakeven Analysis?The purpose of breakeven analysis is to identify the volume of sales at which the company moves from an operating loss to operating income. Breakeven analysis is a great tool for family business managers and directors to forecast profitability and evaluate business strategies.The fundamental insight behind breakeven analysis is that some costs of a business are variable with respect to revenue, while others are fixed.Variable costs are those incurred in rough proportion to revenue, such as raw material inputs, direct labor, revenue-based royalty payments, or incentive-based compensation.In contrast, fixed costs do not vary with revenue, but are incurred regardless of how much revenue the business generates in a given year. Typical fixed costs include corporate overhead personnel, insurance, rent, and depreciation.
Of course, classifying expenses as either variable or fixed is a bit arbitrary, and depends on the time horizon considered.For example, rent is a fixed expense in the short-term, but when the lease expires, management can decide whether to continue incurring the expense. In the longest of long runs, all expenses are variable.Furthermore, some expense categories have attributes of both variable and fixed expenses. Often, rental agreements for retailers include two components: a base rent that is payable regardless of revenue, and an incentive component that is calculated with reference to sales.
These ambiguities should not deter family businesses from using breakeven analysis. Absolute precision is not necessary to yield valuable insights.
The relationship of variable and fixed costs determines the breakeven level of revenue for a family business. To illustrate, consider Play It Safe Enterprises. Play It Safe incurs fixed costs of $2.5 million annually, and variable costs of $40 per unit, compared to a current selling price of $50 per unit. Exhibit 1 illustrates the resulting breakeven analysis.Play It Safe’s breakeven sales volume is 250,000 units.Why Should Family Businesses Care About Breakeven Analysis?Make no mistake, Haggard – the Poet of the Common Man – is always on heavy rotation at Family Business Director headquarters. Yet, what brought breakeven analysis to our mind was this quote from a Harvard Business Review article about what makes family businesses different from their publicly-traded peers: “Our results show that during good economic times, family-run companies don’t earn as much money as companies with a more dispersed ownership structure. But when the economy slumps, family firms far outshine their peers.” In other words, the family businesses in the study had lower breakeven sales volumes than their non-family peers.To illustrate, consider Play It Safe’s publicly-traded competitor Go For Broke, Inc. Exhibit 2 summarizes the breakeven analysis of Go For Broke.Relative to Play It Safe, Go For Broke has invested more heavily in automated production equipment, resulting in higher annual fixed costs ($4.0 million compared to $2.5 million). The payoff from the decision to automate production is a higher contribution margin per unit sold.Nevertheless, the breakeven sales volume at Go For Broke is 6.7% higher than at Play It Safe. In other words, if Go For Broke is going to “make it through December,” they will need to sell nearly 7% more units than Play It Safe does.In a good year (300,000 units) operating profit is $500,000 for both companies. But in a great year (350,000 units), Go For Broke earns 25% more operating income. During hard times (200,000 units), in contrast, Go For Broke incurs a $1.0 million operating loss while Play It Safe loses only $500,000.
So, operating leverage (the degree to which a business’s operating costs are fixed) is a key part of risk management. Since risk management is ultimately the board’s responsibility, directors should give some thought to breakeven analysis this December.Managing Risk in the Family BusinessWe’ve written often about how family businesses can manage shareholder risk through capital structure decisions. Most directors are well aware of how the decision to borrow money increases both the risk and potential return to family shareholders. In our experience, directors are less likely to consider breakeven analysis in their risk management decisions. Yet, the composition of the family business’s operating cost structure can influence the risks and returns to family shareholders just as much as, if not more than, the business’s capital structure.So which company has the better cost structure, Play It Safe or Go For Broke? Of course, neither structure is inherently better than the other. The right decision ultimately comes down to knowing the risk tolerances and return expectations of your family shareholders and assessing the outlook for industry demand and competitive dynamics. All else equal, strong confidence in the economic and industry outlook suggests that more operating leverage will prove rewarding, while operating in the shadow of recession means shifting to a less leveraged cost structure will be prudent.Once he made it through December, Hag’s protagonist anticipated making a change, as he had “plans to be in another town come summertime.” For family businesses, changing the company’s cost structure generally takes more time. But even changes at the margin can affect results in a meaningful way. As directors, there’s no time like December to think about whether any changes are needed in your family business.Merry Christmas from Family Business Director! We will be off next week, but look forward to being back with more content for our subscribers after the holidays.
Succession Planning for Investment Management Firms
Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: a full 62% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet when RIA principals were asked to rank their firm’s top priorities in 2019, developing a succession plan was ranked last. Fortunately, there are many viable options for RIA principals looking to exit the business.
Themes from Q3 2019 Earnings Calls
The energy sector in the third quarter has experienced a general decline as crude prices have exhibited volatility and have remained depressed relative to last year. U.S. producers continue to cut rigs and capital expenditures due to continued excess supply and concerns of declining demand. In this post, we examine some of the most discussed items and trends from the Q3 earnings calls, specifically E&P companies and those in the mineral aggregator space.E&P CompaniesE&Ps experienced mixed earnings although many beat expectations and were cash flow positive as the industry has been trending in this direction. The two major topics discussed in E&P earnings calls have been capital discipline and treatment of free cash flow.Capital Discipline: Doing More with LessWe also want to highlight our capital discipline. Third quarter non-acquisition CapEx came in slightly lower than the second quarter and almost 10% lower than the first quarter. As we look to the fourth quarter, we continue to expect CapEx to be significantly lower around $550 million. Each quarter it's been lower throughout the year. This is by design as we expect to be roughly in line with CapEx expectations for the year. -John Hart, CFO, Continental ResourcesI'm happy to report that the third quarter operating cash flow before working capital changes of $706 million exceeded exploration and development capital of $670 million. This marks an important return to free cash generation for the company primarily driven by better capital cost. -Jack Harper, President, Concho ResourcesAs we move forward as a combined company, our commitment to capital discipline and returning capital to shareholders remains unchanged. We remain on track to spend within our full year pro forma combined capital budget of $8.6 billion, excluding Africa. Furthermore, we have established a capital budget for 2020 that we expect will fully optimize free cash flow and position us to grow production in a capital-efficient manner while maintaining the safety of our dividend. -Cedric Burgher, SVP & CFO, Occidental Petroleum Corp
The topic of capex budgets and spending has been a major talking point for E&P companies since the oil and gas market took a big hit at the end of 2018. Rising prices for the first three quarters of 2018 begat exuberance, and producers below through their budgets only to see prices fall precipitously. Uncertainties surrounding future commodity prices as well as diminishing capital outlays from the public and private markets forced companies to trim capital budgets and rigidly stick to them to ensure that free cash flow generation was positive.Uncertainties surrounding future commodity prices as well as diminishing capital outlays has forced companies to trim capital budgets.Many of these companies for the first six months of the year were near or over budget in capital spending. And while capital expenditures may be frontloaded for various reasons, a consequence of trying to remain in bounds of the budget has been decreasing active rig counts during the year.However, the reduction in rigs counts for several companies has allowed for more strategic capex dollars to be spent on target infrastructure resulting in improvements in cost per foot. Overall the efficiencies and cost savings have enabled companies to be free cash flow positive for the third quarter.Where is Free Cash Flow Going?As of October 29, we have repurchased 5.5 million shares for $187 million. We plan to continue prioritizing our share buybacks with our excess cash. We see tremendous value in the acquisition of our stock as our share price does not reflect our strong earnings, cash flow and the deep oil-weighted inventory we have for future growth. -John Hart, CFO, Continental Resources, Inc.Well, we're going to look at primarily toward, what is our free cash flow and our free cash flow and I'm debating, I'm still traveling around, we're going to go out and see all of our long shareholders again early next year. But we're trying to determine a long-term strategy of what's best between share buybacks in regard to in addition to increasing the dividend, whether or not to go to variable dividend and balance sheet… we have roughly approximately over the next several years about $5 billion. And so we're trying to come up with the ideal plan to disperse that in regard to all three of those. Obviously, with two-thirds of that going toward shareholder friendly measures such as buybacks and dividends. -Rich Dealy, EVP & CFO, Pioneer Natural Resources…on the how we balance dividend versus stock buybacks. I would say that it would kind of laid out a framework for where we think the free cash flow could be under the different side boards. And I think philosophically you'll see us kind of increase the dividend more in a systematic way and in a way that we can sustain forever. And then every other dollar that's available especially at this price, I'm going to be buying stock back. -Tim Leach, CEO, Concho ResourcesOur consistent industry-leading operational results, combined with our ability to fully deliver on value capture, positions us for a full cycle success and enhances our ability to generate increased excess free cash flow to reduce debt and to return cash to shareholders. Returning excess capital to our shareholders is a part of Oxy's DNA. In the third quarter, we returned approximately $600 million to shareholders. -Vicki Hollub, CEO, Occidental Petroleum Corp.
E&P’s appear to be answering the longtime demands from investors of capital return in the form of dividends and share repurchases. Many companies are continuing large stock repurchase programs through combinations of free cash flow generation and ongoing asset sales. This treatment of free cash flow is a result of the strict capital discipline seen across the industry and may prove to be a worthwhile investment should commodity prices improve going into 2020. External and political changes could help (or mute) this effort.The trade-off for increased free cash flow is slower production growth.However, the trade-off for increased free cash flow is slower production growth. Many companies are putting “caps” on growth in order to achieve their desired levels of free cash flow generation. Vicki Hollub of Occidental says in their latest earnings call, “Our intent is to cap our annual production growth at an average of 5% as we balance the vast opportunities in our portfolio with growing free cash flow.”It's clear that E&P’s believe that their current stock valuations do not reflect the intrinsic value they think they bring to the table, particularly as commodity prices bounced back from year-end 2018 lows but stock prices received less of a boost. However, excessive share buybacks may put limitations on growth and future production, straining growth of cash flow yield should the commodity environment remain depressed.Mineral AggregatorsMineral aggregators had mixed earnings in the third quarter of 2019, but were more stable than E&Ps. While Kimbell Royalty Partners realized a record-breaking performance in the quarter, others such as Brigham Minerals seem more concerned with future performance in the face of underwhelming past performance.Mineral aggregators have had to answer a number of questions regarding potential acquisitions. Although acquisition and divestiture activity is the defining characteristic of the aggregator space, companies among the group seem hesitant to make acquisitions that are perceived as too aggressive at this juncture. The consensus is that it will be worth the wait.Acquisition Opportunities and Strategies: Playing the Waiting GameWe are actively searching for those larger transactions and working with those, dialoguing with individuals. And so, I think what's going to happen is over time and then whether that's in the next, say, 3-months to 12-months or so, we'll find that larger transaction, be able to use our equity to acquire with. -Rob Roosa, Founder and CEO, Brigham MineralsThe macro environment is, frankly, tough right now. And in response to that, we've pulled in our horns, some on acquisition–on the acquisition front and are being more selective. We haven't seen anything that we can't live without. We're being a bit more defensive at the moment. And while we're in that mode, we'll prioritize paying down the revolver, which will position us for future acquisitions or share repurchases. -Thomas Carter, Chairman and CEO, Black Stone MineralsLastly, the acquisition market remains robust, and we continue to evaluate opportunities across our many basins. We continue to see great value for acreage outside of the Permian Basin, even considering dramatically reduced drilling activity in 2020 and beyond. So while just about everyone else is focused on the Permian and although we continue to evaluate the Permian, we are having more success in other basins with significantly less competition. –Bob Ravnaas, Chairman and CEO, Kimbell Royalty PartnersThat said, in this environment, and with the asset base that we have and the operators we have and the clear growth that's immediately in front of us, it seems for us inappropriate to dilute that with acquisitions. -Daniel Herz, CEO and President, Falcon Minerals
Although they have an increasingly specific appetite for acquisitions, mineral aggregators have emphasized their preference for larger packaged transactions. Travis Stice, CEO and Director of Viper Energy Partners, demonstrates this strategy as they expanded their footprint in the Permian via large acquisitions during the third quarter. Large swaths of contiguous acreage continue to be more valuable to aggregators, which opens up the market opportunity for larger players to come in and consolidate some of these mineral owners and sell the combined acreage at a premium. It will be interesting to monitor the transactions space to determine whether the waiting game will pay off.
Dividend Policy and the Meaning of Life (Or, At Least, Your Business)
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, "Does our dividend policy fit?" Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability.Our multi-generation family business clients ask us about dividend policy more often than any other topic. This isn't surprising, since returns to family business shareholders come in only two forms: current income from dividends and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.In other words, dividends are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. Importantly, the “meaning” of the business has implications for dividend policy.Meaning #1 - The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, dividends are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.Meaning #2 - The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Dividends are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.Meaning #3 - The family business is a source of wealth accumulation. Alternatively, the family business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use dividends from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Dividends are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.Meaning #4 - The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Dividends are not necessarily expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance.
From a textbook perspective, dividends are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the dividend policy alternatives available to the directors. For example, eliminating dividends in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be.
Figure 2 illustrates the relationship between “meaning” and dividend policy.
The textbook perspective on dividend policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal dividend policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in dividend policy will more naturally follow.
Once the change in “meaning” has been embraced by the family, the change in dividend policy will more naturally follow.A dividend policy describes how the family business determines distributions on a year-to-year basis. A consistent dividend policy helps family shareholders understand, predict, and evaluate dividend decisions made by the board of directors. Potential family business dividend policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion.Family shareholders should know what the company’s current dividend policy is. As evident from Figure 3, knowing the dividend policy does not necessarily mean that one will know the dollar dividend for that year. However, a consistently-communicated and understandable dividend policy contributes greatly to developing positive shareholder engagement.
So what should your family business’s dividend policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the dividend policy that is appropriate to the company can be determined by the board and communicated to shareholders.
Potential Next StepsCalculate historical shareholder returns, distinguishing returns attributable to capital appreciation from those attributable to distributionsAssess what the business “means” to the family economicallyEvaluate how the prevailing “meaning” of the business corresponds to the challenges and opportunities facing the businessIdentify the target capital structure for the family businessArticulate a predictable dividend policy and communicate that policy to family shareholders
Debt Financing for RIAs
How to Finance an Ownership Transition
As noted in a recent post, there are many viable options for RIA principals when it comes to succession planning. One way to transition ownership while maintaining independence is to sell internally to key staff members. The most obvious roadblock when planning for internal succession is pricing. But once you establish a price, how does the next generation pay? An internal transition of ownership typically requires debt and/or seller financing as it’s unlikely that the next generation is able or willing to purchase 100% ownership in a matter of months. In this post, we consider the expanding options for RIAs seeking debt financing and the typical terms they can expect.Is Debt Financing the Right Solution? Debt financing has become a more practical option for RIA principals working on succession planning as more specialty lenders have entered the market. Some of the benefits of debt financing are outlined below.Debt financing, as opposed to seller financing, allows the exiting shareholder to make a clean break with the business. This benefits both the exiting shareholder and the remaining principals. Exiting shareholders, who are likely at retirement age, receive liquidity at close that they can use to diversify their personal holdings, and the remaining principals don’t have ownership lingering in the hands of a former employee.Debt financing, as opposed to equity financing, allows the remaining principles to maintain autonomy. Excluding loan covenants, lenders have no control over your business. On the other hand, equity partners usually require more intrusive oversight such as a board seat and/or budget approval, which remaining shareholders may not tolerate.Debt financing is cheaper than equity financing. Equity investors, who are subordinated to debtholders, require an additional premium over the average cost of debt.Interest payments are tax-deductible. Interest payments can reduce the borrower’s tax burden during the amortization period.
Despite these benefits, debt financing does increase the remaining shareholders’ personal risk. Debt financing is an obligation to repay the money acquired through it, unlike equity financing which typically does not require repayment. Debt financing for RIAs also typically includes a personal guarantee, which many borrowers are opposed to. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Increasing Number of Specialty Lenders for RIAsAs Financial Planning explained, “the market for RIA-friendly lending options has exploded” over the last two years. Looking back, Live Oak Bank was one of the first to address the specific needs of RIA principals when they began providing favorable terms to independent advisory firms in 2012. As explained on their website, “where most banks look for tangible collateral when they lend money, Live Oak Bank lends on cash flow to companies (like advisory firms) which have little to no collateral.” Prior to this, most RIAs had to turn to local banks, who generally were not comfortable with the asset-light balance sheets and fee-based structure of RIA firms.RIAs now can turn to a growing number of specialty lenders who are accustomed to working with RIAs. Some of the firms offering debt financing specifically for RIAs include Oak Street Funding, Merchant Credit Partners, PPC Loan, and SkyView Partners.Typical Terms for RIAsAdditionally, one provision may be contingent upon another. For example, a higher origination fee could reduce the need for a pre-payment penalty. At the risk of providing an example of terms that may be unachievable for some RIAs, we have outlined terms RIA principals can generally expect when seeking debt financing.Most lenders require a personal guarantee, which is a legal promise by the partners to repay the loan made to their business in the event the business defaults. While it is typical that lenders to small businesses require this additional layer of protection, it is important to understand how a personal guarantee works and what it could mean for your personal finances.Because RIAs do not have fixed assets to use as collateral, a personal guarantee gives your lender the right to pursue your personal assets if your business defaults on the loan. The SBA is of the opinion that a personal guarantee “ensures that the borrower has sufficient personal interest at stake in the business.” Notably, a personal guarantee is not released if you sell the business. While you can ask your lender to replace your personal guarantee with a personal guarantee from a new owner, the lender is typically not required to do so.ConclusionSimilar to evaluating mortgage options, it is important to talk to multiple lenders to guarantee the most favorable terms for your business transition. Having a knowledgeable advisor to manage this process can allow remaining ownership to stay focused on running the business while ensuring consideration of all appropriate options.
Lessons from Recent Engagements
In our family law practice, we serve as valuation and financial forensic expert witnesses. There is typically another valuation expert on “the other side.” In several recent engagements, the following topics, posed as questions here, were raised as points of contention. We present them here to help the reader, whether you are a family law attorney or a party to a divorce, understand certain valuation-related issues that may be raised in your matter.Should Your Expert Witness Be a Valuation or Industry Expert?The financial and business valuation portion of a litigation is often referred to as a “battle of the experts” because you have at least two valuation experts, one for the plaintiff and one for the defendant. Hopefully your valuation expert has both valuation expertise and industry expertise. While industry expertise is not necessary in every engagement, it can be helpful in understanding the subtleties of the business in question.Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?Most businesses are dependent on the climate of the national economy as well as the local economy. For businesses who have a national client base, the health of the national economy trumps any local or regional economy. However, many of the businesses we value in divorce engagements are more affected by changes in their local and regional economy. It’s important for a business appraiser to understand the difference and to be able to understand the effects of the local/regional economy on the subject business. There is also a fine balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the business.If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon?Many of the corporate entities involved in litigation have sophisticated governance documents that include Operating Agreements, Buy-Sell Agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigated matters, focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.Two common questions that arise concerning these agreements are:Has an indication of value ever been concluded using the governance document in the history of the business (in other words, has the business been valued using the methodology set out in the document)?Have there been any transactions, buy-ins, or redemptions utilizing the values concluded in a governance document?
These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. In divorce matters, the out-spouse is often not bound by the value indicated by the governance document since they were not a signatory to that particular agreement. It is always important to discuss this issue with your attorney.Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, internal transactions are a possible valuation data point. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.An important consideration in internal transactions is the motivation of the buyer and seller. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and of the specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.What Do the Owner’s Personal Financial Statements Say and Are They Important?Most business owners have to submit personal financial statements as part of any guarantee on financing. The personal financial statement includes a listing of all of the assets and liabilities of the business, typically including some value assigned to the value of the business. In divorce matters, these documents are important as yet another valuation data point.One view of the value placed on a business in an owner’s personal financial statement is that no formal valuation process was used to determine that number; so, at best, it’s a thumb in the air, blind estimate of value. The opposing view is the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in document under penalty of perjury. Further, some would say that the value assigned to the business has merit because the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.For an appraiser, it’s not a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The business value indicated in a personal financial statement should be viewed in light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as the national and local economy, to explain any difference in values over time.Do You Understand Normalizing Adjustments and Why They Are Important?Normalizing adjustments are adjustments made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask if the business has non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the business to industry profitability data can help the appraiser understand the degree to which the business may be underperforming.An example of how normalizing adjustments work is helpful. If a business has historically reported 2% EBITDA (earnings before interest, taxes, depreciation, and amortization) and the industry data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a business with revenue of $25 million, historical profitability at 2% would suggest EBITDA of $500,000. At 5%, expected EBITDA would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the business to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the business without non-recurring or personal owner expenses.ConclusionThere are many other issues a valuation expert faces in divorce matters; however, the issues presented here were top of mind for us because they were present in recent engagements. Valuation can be complex. Serving as an expert witness can be challenging as well. However, having an expert with valuation expertise and experience is an advantageous combination in divorce matters. In future articles, we’ll discuss other issues of importance to hopefully help you become a more knowledgeable user of valuation services. In the meantime, if you have a valuation or financial forensics issue, feel free to contact us to discuss it in confidence.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2019.
Community Bank Valuation (Part 4): Valuing Minority Interests
In the June 2019 BankWatch we began a multi-part series exploring the valuation of community banks. The first segment introduced key valuation drivers: various financial metrics, growth, and risk. The second and third editions described the analysis of bank and bank holding company financial data with an emphasis on gleaning insights that affect the valuation drivers. We now conclude our series by assembling these pieces into the final product, a valuation of a specific bank.While it would streamline the valuation process, there is no single value for a bank that is applicable to every conceivable scenario giving rise to the need for a valuation. Instead, valuation is context dependent. This edition of the series focuses on the valuation of minority interests in banks, which do not provide the ability to dictate control over the bank’s operations. The next edition focuses on valuation considerations applicable to controlling interests in banks that arise in acquisition scenarios.Valuation ApproachesValuation specialists identify three broad valuation approaches within which several valuation methods exist:The Asset Approach develops a value for a bank’s common equity based on the difference between its assets and liabilities, both adjusted to market value. This approach is less common in practice, given analysts’ focus on banks’ earnings capacity and market pricing data. In theory, a rigorous application of the asset approach would require determining the value of the bank’s intangible assets, such as its customer relationships, which introduces considerable complexity.The Market Approach provides indications of value by reference to actual transactions involving securities issued by comparable institutions. The obvious advantage of this approach is the coherence between the goal of the valuation itself (the derivation of market value) and the data used (market transactions). The disadvantage, though, is that perfectly comparable market data seldom exists. While we will not cover the topic in this article, transactions in the subject bank’s common stock, which often occur for privately held banks due to their frequently widespread ownership and stature in the community, may serve as another indication of value under the market approach.The Income Approach includes several methods that convert a cash flow stream (such as earnings or dividends) into a value. Two broad subsets of the income approach exist – single period capitalization methods and discounted cash flow methods. For bankers, a single period capitalization is analogous to a net operating income capitalization in a real estate appraisal; it requires an earnings metric and a capitalization multiple. Alternatively, bank valuations often use projection-based methodologies that convert a future stream of benefits into a value. The strengths and weaknesses of a projection-based methodology derive from a commonality – it requires a forecast of future performance. While creating such a forecast is consistent with the forward-looking nature of investor returns, predicting the future is, as they say, difficult.
The following discussion focuses on the valuation methodologies used most commonly for banks, the comparable company method and the discounted cash flow method.Comparable Company MethodBank analysts are awash in data, both regarding banks’ financial performance but also market data regarding publicly traded banks’ valuation. Table 1 presents a breakdown by trading market of the number of listed banks in November 2019.
To narrow this surfeit of comparable company data, analysts often screen the publicly traded bank universe based on characteristics such as the following:
Size, such as total assets or market capitalizationProfitability, such as return on assets or return on equityLocationAsset qualityRevenue mix, such as the proportion of revenue from loan sales or asset management feesBalance sheet composition, such as the proportion of loans or dependence on wholesale fundingTrading market or volume
Even after applying screens similar to the preceding, it remains doubtful that the publicly traded banks will exactly mirror the subject bank’s characteristics. This is especially true when valuing smaller community banks, as a relatively limited number of publicly traded banks exist with assets of less than $500 million that trade in more liquid markets. Ultimately, the analyst must determine an appropriate valuation multiple based on the subject bank’s perceived growth opportunities and risk attributes relative to the public companies. For example, analysts can compare the subject bank’s historical and projected EPS growth rates against the public companies’ EPS growth rates, with a materially lower growth outlook for the subject bank suggesting a lower pricing multiple.
Part 1 of this community bank valuation series described various valuation metrics applicable to banks, most prominently earnings and tangible book value. It is important to reiterate that while bankers and analysts often reference price/tangible book value multiples, the earning power of the institution drives its value. Chart 1 illustrates this point, showing that price/tangible book value multiples rise along with the core return on tangible common equity. This chart includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion.
Since banking is a more mature industry, bank price/earnings multiples tend to vary within a relatively tight range. Chart 2 provides some perspective on historical price/earnings and price/tangible book value multiples, which includes banks traded on the NASDAQ, NYSE, or NYSEAM with assets between $1 and $10 billion and a return on core tangible common equity between 5% and 15%. Trading multiples in the first several years of the analysis may be distorted by recessionary conditions, while the multiples reported for 2016 and 2017 were exaggerated by optimism regarding the potential, at that time, for tax and regulatory reform. The diminished multiples at yearend 2018 and September 30, 2019 reflect a challenging interest rate environment, marked by a flat to inverted yield curve, and the possibility for rising credit losses in a cooling economy.
Discounted Cash Flow MethodThe discounted cash flow (DCF) method relies upon three primary inputs:A projection of cash flows distributable to investors over a finite time period » A terminal, or residual, value representing the value of all cash flows occurring after the end of the finite forecast periodA discount rate to convert the discrete cash flows and terminal value to present value1. Cash FlowFirst, a few suggestions regarding projections:For a financial institution, projecting an income statement without a balance sheet usually is inadvisable, as this obscures important linkages between the two financial statements. For example, the bank’s projected net interest income growth may require a level of loan growth not permitted by the bank’s capital resources.Including a roll-forward of the loan loss reserve illustrates key asset quality metrics, such as the ratios of loan charge-offs to loans and loan loss reserves to loans. The level of charge-offs should be assessed against the bank’s historical performance and the economic outlook.Key financial metrics, both for the balance sheet and income statement, should be assessed against the bank’s historical performance and peer banks.While projections can be prepared on a consolidated basis, we prefer developing separate projections for the bank and its holding company. This makes explicit the relationships between the two entities, such as the holding company’s reliance on the bank for cash flow. For leveraged holding companies, a sources and uses of funds schedule is useful.
In preparing a DCF analysis for a bank, the most meaningful cash flow measure is distributable tangible equity. The analyst sets a threshold ratio of tangible common equity/tangible assets or another regulatory capital ratio based on management’s expectations, regulatory requirements, and/or peer and publicly traded comparable company levels. Equity generated by the bank above this target level is assumed to be distributed to the holding company. After determining the holding company’s expenses and debt service requirements, the remaining amount represents shareholder cash flow, which then is captured in the DCF valuation analysis.2. Discount RateFor a financial institution, the discount rate represents the entity’s cost of equity. Outside the financial services industry, analysts most commonly employ a weighted average cost of capital (WACC) as the discount rate, which blends the cost of the company’s debt and equity funding. However, banks are unique in that most of their funding comes from deposits, and the cost of deposits does not rise along with the entity’s risk of financial distress (because of FDIC insurance). Therefore, a significant theoretical underpinning for using a WACC – that the cost of debt increases along with the entity’s risk of default – is undermined for a bank. Analytical consistency is created in a DCF analysis by matching a cash flow to equity investors (i.e., dividends) with a cost of equity.A bank’s cost of equity can be estimated based on the historical excess returns generated by equity investments over Treasury rates, as adjusted by a “beta” metric that captures the volatility of bank stocks relative to the broader market. Analysts may also consider entity-specific risk factors – such as a concentration in a limited geographic market, elevated credit quality concerns, and the like – that serve to distinguish the risk faced by investors in the subject institution relative to the norm for publicly traded banks from which cost of equity data is derived.3. Terminal ValueThe terminal value is a function of a financial metric at the end of the forecast period, such as net income or tangible book value, and an appropriate valuation multiple. Two techniques exist to determine a terminal value multiple. First, the Gordon Growth Model develops an earnings multiple using (a) the discount rate and (b) a long-term, sustainable growth rate. Second, as illustrated in Chart 2, bank pricing multiples tend to vary within a relatively tight range, and a historical average trading multiple can inform the terminal value multiple selection.Correlating the AnalysisIn most analyses, the values derived using the market and income approaches will differ. Given a range, an analyst must consider the strengths and weaknesses of each indicated value to arrive at a final concluded value. For example, earnings based indications of value derived using the market approach may be more relevant in “normal” times, as the values are consistent with investors’ orientation towards earnings as the ultimate source of returns (either dividends or capital appreciation). However, in more distressed times when earnings are depressed, indications of value using book value assume more relevance. If a bank has completed a recent acquisition or is in the midst of a strategic overhaul, then the discounted cash flow method may deserve greater emphasis. We prefer to assign quantitative weights to each indication of value, which provide transparency into the process by which value is determined.Relative Value AnalysisThe analysis is not complete, however, when a correlated value is obtained. It is crucial to compare the valuation multiples implied by the concluded value, such as the effective price/earnings and price/tangible book value multiples, against those reported by publicly traded banks. Any divergences should be explainable. For example, if the bank operates in a market with constrained growth prospects, then a lower than average price/earnings multiple may be appropriate. A higher return on equity for a subject bank, relative to the comparable companies, often results in a higher price/tangible book value multiple. As another reference point, the effective pricing multiples may be benchmarked against bank merger and acquisition pricing to ensure that an appropriate relationship exists between the subject minority interest value and a possible merger value.ConclusionThere are many valuation issues that remain untouched by this article in the interest of brevity, such as the valuation treatment of S corporations and the discount for lack of marketability applicable to minority interests in banks with no active trading market. Instead, this article addresses issues commonly faced in valuing minority interests in any community bank. A well-reasoned valuation of a community bank requires understanding the valuation conventions applicable to banks, such as pricing multiples commonly employed or the appropriate source of cash flow in a DCF analysis, but within a risk and growth framework that underlies the valuation of all equity instruments. Relating these valuation parameters to a comprehensive analysis of a bank’s financial performance, risk factors, and strategic outlook results in a rigorous and convincing determination of value. In the next edition, we will move beyond the valuation of minority interests in banks, focusing on specific valuation nuances that arise when engaging in a valuation for merger purposes.Originally published in Bank Watch, November 2019.
Private Equity’s Silent Push into the RIA Space
Is Private Equity the Solution to Your Succession Planning Needs?
Private equity pervades the RIA industry, but most of their recent interest is through consolidators or roll-up firms. In this week’s post, we’ll discuss the implications of this trend and other considerations for RIA owners’ contemplating the PE route.
You may have not heard much about private equity firms’ addition of RIAs to their portfolios in recent years. But that doesn’t mean they’re not interested. The reality is that PE firms collectively have established an indirect interest in hundreds of RIAs via their investments in RIA consolidators. This strategy enables private equity to achieve diversification and scale in a single purchase rather than buying dozens of investment managers and hoping a majority will work out. Many of the leading RIA consolidators are or have been backed by PE. Recent examples include investments made by Stone Point Capital (Focus Financial), Thomas H. Lee Partners (HighTower Advisors), TA Associates (Wealth Enhancement Group), and Oak Hill Capital Partners (Mercer Advisors).
Since private equity firms are increasingly interested in growing their RIA exposure, there has been a lot of pressure for these PE-backed consolidators to increase their portfolio holdings via acquisition. This has largely been positive for wealth manager valuations as consolidators bid up their pricing to grow AUM and appease their PE backers. Private equity firms have gained broad exposure to the RIA space in recent years through this portal of indirect ownership.
Like any other prospective buyer, there are pros and cons associated with a private equity partnership.Does this mean they’re not interested in making a direct investment in your firm? Not necessarily; but remember that their primary objective (perhaps more than any other type of buyer) is to generate large returns to investors, which may be hard to achieve with an RIA with less than $1 billion under management. Larger investment managers, though, do offer the scale, (usually) higher margins, and predominantly recurring revenue models that have captured the attention of many PE firms over the years.Like any other prospective buyer, there are pros and cons associated with a private equity partnership. At the moment, many PE firms are flush with capital and willing to pay a substantial portion of the total consideration in cash up front. Most can afford to buy a majority interest and typically do so to assume control over future operations. Sellers generally appreciate the down payment but are less enthusiastic about relinquishing control. Many RIA owners aren’t comfortable with the latter, so these discussions sometimes don’t get past the initial call.Private equity, however, is not a permanent solution. PE firms aim to grow their investment as much as possible over the next five to seven years before flipping it to a new buyer at two or three times what they initially paid. This scenario means they often put pressure on RIAs to take on more clients and/or reduce costs, so they can maximize profitability for a prospective sale. Additionally, this means a new owner with new demands will take over in the not so distant future.Is a Private Equity Investment the Right Solution for You? Private equity is sometimes used to cash out a former partner or outside investor when the current owners don’t have the capital or desire to take on this additional investment personally. Selling (outside) partners usually favor this type of investment because PE firms can pay more up front. Principals remaining in the business usually don’t want any ownership lingering in the hands of former employees, but in this scenario, they’ve effectively swapped one outside investor for another. There’s no guarantee that the second one will be any better.Private equity can also be a relatively straightforward path to diversification for existing principals. In many cases, a significant portion of an RIA principal’s net worth is tied up in his or her business with no immediate access to liquidity. PE firms allow these owners to take some cash off the table and reduce their dependency on the business. RIA principals will have to weigh the benefits of diversification and instant liquidity with the costs of losing control to outside ownership.Your due diligence on the prospective buyer is just as important as their due diligence on you.On balance, private equity’s interest in the space has been good for the RIA industry. They’ve likely had a positive effect on wealth manager valuations and are a significant source of liquidity for an otherwise illiquid business. This doesn’t necessarily mean they’re a good partnership for your firm, so you still need to consider what you’d be giving up in a sale and how it could impact other employees and stakeholders. Even if the price is right, it still may not be a good fit for you and your team. Your due diligence on the prospective buyer is just as important as their due diligence on you.We strongly recommend hiring a team of experienced and trusted advisors to help navigate this process.
Why Do Family Businesses Tend to Borrow Less Money?
As recounted in the Harvard Business Review article entitled "What You Can Learn from Family Business," an academic study of family-controlled and non-family public companies found that debt constituted 37% of the capital of family-run businesses, compared 47% for the non-family companies. This finding is generally consistent with our experience working with family businesses of all sizes. In this post, we consider why family-run businesses might be a bit more debt-shy than their non-family peers.Debt and Family Business ValueGreater use of low-cost debt reduces the overall weighted average cost of capital.One of the principal textbook reasons for using financial leverage is to “maximize” the value of the business. According to the theory, greater use of low-cost debt reduces the overall weighted average cost of capital. If the value of a business is equal to the present value of expected future net cash flows of the enterprise, a lower discount rate will result in a higher present value. Since the relevant discount rate for the value of the family business is the weighted average cost of capital, companies that borrow the “optimal” amount of debt will thereby “maximize” their value, or so the theory goes.This theory is unimpeachable as far as it goes, but in our view, a couple sizable grains of salt are in order. First, the difference between the current and “optimal” weighted average cost of capital is often quite modest. As shown in Figure 1 below, increasing financial leverage increases the costs of both debt and equity capital.
Because the absolute cost of the capital components is dynamic with respect to the amount of leverage, the resulting weighted average cost of capital is less sensitive to leverage than one might expect. As a result, borrowing money for the sole purpose of “maximizing” shareholder value has the potential to be a fools’ errand.
Second, when family businesses are sold, buyers are focused on the value of the assets (tangible and intangible). Most transactions are structured so that the seller receives a gross amount of consideration which they must then use to pay off any outstanding indebtedness, with the residual serving as the net proceeds to the family shareholders.
The textbook theory assumes that the company’s shares are freely-traded so that there is a deep and liquid market for minority shares in the company. In that case, the capital structure is a given that will not be affected by trading activity in the shares, and investors are rightly concerned with just what that capital structure is.But the reality for most family businesses is that transactions of minority interests in shares are infrequent, and that the relevant market is that in which the company as a whole will transact; buyers in that market are indifferent to the existing capital structure of the seller.
In this way, the market for family businesses is more like the housing market than the stock market. The value of a house does not depend on the size of the mortgage on that house. In the same way, the value of your family business to a potential buyer does not depend on the amount of debt outstanding.Debt and Returns on Family CapitalIf capital structure management doesn’t influence the value of your family business, why does the amount of debt matter?Why are family businesses willing to accept lower returns in exchange for less risk?Financial leverage may not change the value of your family business, but it absolutely will influence how the return on invested capital is allocated to lenders and family shareholders. Shareholder returns for a given level of ROIC will be higher the more debt financing is used in the family business. But these higher returns are available only in exchange for bearing greater risk. If, as the authors of the Harvard Business Review study maintain, family businesses do, in fact, use less financial leverage than their non-family peers, why are family businesses willing to accept lower returns in exchange for less risk?We suspect there are at least two reasons for this preference on the part of family shareholders.First, the costs of failure for family businesses are much higher than the finance textbook would indicate. In the event of bankruptcy, the shareholders of textbook theory blithely accept the financial loss and continue on their merry way. In contrast, the failure of a family business comes with enormous costs in terms of the socioemotional wealth of the family. The resulting job loss, negative economic impact to the local community, and damaged family reputation weigh heavily on family shareholders but are of no concern to the textbook investor.Second, family shareholder wealth (and, potentially, income) is often concentrated in the family business. As a result, shareholders are naturally more averse to risk than the textbook investor. If you’re going to have all of your eggs in one basket, you need to do everything in your power to protect that basket. For many family businesses, that defensive posture includes borrowing less money than their non-family peers.The Financial Value of ResilienceIn our experience, successful family businesses use debt judiciously to take advantage of attractive capital investment opportunities, enhance family shareholder returns, and on occasion to promote diversification outside the family business. The finding that, on balance, family businesses tend to use a bit less debt than their non-family peers is consistent with our observations over the years. The authors of the Harvard Business Review conclude that family businesses prioritize resilience over performance.Even apart from the concept of socioemotional wealth, resilience pays dividends in the long run. To illustrate, consider the long-term outcomes for two family businesses: Slow & Steady Corp. earns a 10% return each year, while the returns for Up & Down, Inc. alternate between 0% and 20% each year. The average annual return is 10% for each business, yet, after ten years, Slow & Steady Corp. is worth more than Up & Down, Inc.If your family business has a long-term horizon, resilience will prove rewarding. Indeed, the Harvard Business Review study found that – over the long-term – the family-run businesses generated superior returns.Since resilience is rewarded, how are you and your fellow directors enhancing the resilience of your family business through your capital structure decisions?
Are Wealth Management Margins About to Get Buried?
SchwabiTrade isn’t the Only Threat to the Most Consistent Profit Stream in the RIA Community
Last week I was planning a trip to watch my younger daughter compete in a horse show in Birmingham when the news broke about Charles Schwab acquiring TD Ameritrade. For those of you who don’t have fragile but determined children who ride stout but stupid equines over fences, a hunter/jumper competition typically means hundreds of miles of travel and days of standing around in moderately bad weather to watch your dearest risk paralysis for a few minutes in the saddle. It’s 99% utter boredom punctuated by brief moments of tangible panic. In other words, it’s not unlike the relationship most RIAs have with their custodian.Custodial relationships were boring until last week. By now you’ve read plenty about the Schwab/TD Ameritrade deal. Some have questioned whether or not the transaction will be prohibited by anti-trust regulation, but – in the current political environment – I wouldn’t count on that. Together, SchwabiTrade will custody on the order of 75% of RIA assets, and while some RIA pundits are concerned about the service that RIAs, especially smaller ones, will receive from such a behemoth, they might also want to look into the cost of these relationships, not to mention what Schwab’s end-game really is.If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot.Schwab is credited with helping create the RIA space, having launched Schwab Advisor Services over 25 years ago effectively as a plug-and-play custodial offering for independent advisors. If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot. Schwab relentlessly drove down the costs of its RIA backbone over the years, embracing technology and efficiency to build scale and lower fees. There was room for Schwab and TD Ameritrade (its longtime competitor in serving RIAs) in the investment management space, but that was when the industry was expanding and margins were widening. Now zero commissions and cheap money may be prompting a new plan of action for Schwab that extends beyond this merger. David may be facing a new Goliath.The last decade has been witness to oligopolistic consolidation and consequent behaviors across many service industries. Amazon upended retail. Uber (and Lyft) decimated local cab companies and car rental companies. Airline consolidation has raised fares and cut service for many markets, including my hometown. Without debating the merits or evils of creative economic destruction, what is indisputable is that the rise of modern oligopolies has been tough on incumbent industry stakeholders: owners, workers, and (sometimes) customers.It’s hard to see the advent of SchwabiTrade as a good thing for the RIA community – especially the wealth management community. If Schwab is looking to recapture margins from zero commission trading and low rates on sweep accounts, it need look no further than the ten thousand plus RIAs now in its eco-system. Changes will likely be slow and subtle, kind of like how the airlines gradually devalue frequent flyer miles while touting “improvements” to their loyalty programs. Fees drift up. House brands replace independent products. Service declines. And, eventually, Schwab finds a way to go straight at RIA clients – with proprietary technology and their own advisor force. The best thing for Schwab is that they can use revenues from the RIA community to fund the strategy, and they have control of the data to know what will work most effectively.Schwab may not be successful. The sequel to most real-life versions of “The Empire Strikes Back” is indeed “Return of the Jedi.” WeWork’s abject failure is probative insight into the folly of oligopolistic thinking in industries that cannot be cornered, like office space. The advisor community is vast and nimble. Schwab has a huge market share, though, and a forty-year head start. That’s worrisome.Can RIAs escape this by moving to the Fidelity platform, or BNY Mellon, or Raymond James? It’s worth looking into, and no doubt this moment is a huge opportunity for other custodians to grab market share. After the dust settles, though, if Schwab increases fees to “remain competitive,” others will at least try to follow.Real economic profits attract competition.And this isn’t the only existential threat facing wealth management. Goldman Sachs is trying to figure out how to extend their brand to the mass-affluent, and they aren’t the only private bank pursuing this. Other discount brokers and robo-advisors are trying to move upmarket. Suddenly, it seems like everyone has noticed that the stickiest revenue and most reliable margins in the investment community are wealth management firms. Real economic profits attract competition.None of this offers a very upbeat message for Thanksgiving week in an industry that has enjoyed considerable success in recent years. We should all be grateful for the opportunities afforded by a great business. My concerns may be alarmist and unfounded. But I couldn’t stop thinking about how abrupt the advent of SchwabiTrade is as I was sweeping the leaves off my windshield last weekend. This is probably the biggest news to hit the RIA community in 2019. If we’re not paying attention, we’ll all be driving blindly.
Royalty MLP Is Delivering Yield Against Backdrop Of Energy Sector Struggles
Energy commodity cycles can sometimes proffer interesting market dynamics. At various points, participants along the energy chain can benefit or suffer from the natural consequences of these changes. In the long run, commodity prices ultimately drive economics. Right now, exploration and production companies and oilfield service providers are grappling with austerity measures that investors are demanding. Most other upstream areas are struggling too; however, publicly-traded royalty and mineral aggregators are performing relatively better than their operating counterparts. While equity prices have dropped by approximately 30% for producers (according to SPDR Oil and Gas ETF), six publicly-traded royalty aggregators relatively outperformed the SPDR Index. These Royalty MLP’s (a bit of a misnomer as all are not partnerships) have tracked closer to crude oil prices, anchored by sizeable dividend payments, thus buoying sliding equity prices. If dividend yields are added back, some of them have been outperforming crude prices.Upstream Producers Thirsting For CapitalAt recent industry conferences, panelists and management teams for exploration and production companies have consistently lamented the dearth of available capital. As banks re-evaluate their credit facilities, some analysts estimate a 10%-25% reduction in reserve-based lending capacity. Investors have communicated a sink or swim message to the sector and the term “capital discipline” is echoed frequently. Producers must subsist on their own cash flow for the foreseeable future and performance must improve before capital flows back upstream. This trend partially explains why energy currently comprises less than 5% of the sector weighting value of S&P Index, a historical low. It is notable and somewhat ironic that part of the success of the remaining 95% of the S&P has been attributable directly or indirectly to the cheap energy prices being delivered by the energy sector.[caption id="attachment_28934" align="aligncenter" width="813"]Source: S&P 500[/caption]
E&P’s Primed For Consolidating? Bankruptcy Bargains?Cost control and efficiencies are on the top of the industry’s mind. In response, the consolidation trend for upstream producers is underway. Parsley’s acquisition of Jagged Peak and Comstock’s acquisition of Covey Park are examples of this, with more likely to come. Consolidation will occur through bankruptcy sales as well. According to Haynes and Boone bankruptcies in the oil patch have consistently ticked up with nearly $13 billion in new debt under bankruptcy in 2019. Therefore, Section 363 sales to consolidators should be available among other things. The big problem circles back to where this article started – where to obtain the funds to buy them? Those with pocketbooks at this time may be able to unearth some bargains and returns down the road to show for it. In fact, Comstock may be back in that distressed market as there are reports about negotiations for buying Chesapeake’s Haynesville Shale assets.Royalty MLP Subsector Still Has Capital Flowing InMeanwhile, like a small oasis in this desert, Royalty MLP’s have been and continue to successfully attract capital flow to this sub-space. Brigham Minerals, for example, not only went public earlier this year but had its line of credit expanded. Recent third quarter call transcripts from these Royalty MLP’s all suggest that acquisitions and growth (while disciplined) will continue. Indeed, Kimbell Royalty Partners has had one of the biggest dividend boosts in the marketplace this year. The primary reason for this is simple, while benefitting from well production, royalty holders do not bear operating and drilling costs. Therefore, they can get the best of both worlds. Of course, returns are also predicated upon the cost to acquire. Even if Royalty MLP’s overpay for the acreage they acquire, this tends to limit or delay returns as opposed to zero or negative returns at the asset level.[caption id="attachment_28935" align="aligncenter" width="640"]Source: Capital IQ[/caption]
Additionally, Royalty MLP’s will be the logical and likely recipient of larger packages of minerals as private equity firms, who flocked to this sector a few years ago, begin to monetize their funds. This is significant because it is beginning to change the nature of a typical mineral owner’s profile, mindset and holding period expectations. As more investment-minded participants enter the space, the sophistication and expectations of buyers and sellers change along the way. The public royalty firms are preparing for this, which is why their acquisition budgets are steady or growing as opposed to shrinking across the board for producers.
On a side note, this is not isolated to only publicly traded mineral and royalty participants. From a more macro perspective, this growth dynamic can be observed right at the U.S. budget where billions more flow into government coffers. U.S. public lands drove a 30% increase in federal energy and minerals revenue disbursements in fiscal year 2019 to $11.69 billion. The biggest contributor to that boost is in the New Mexico portion of the Permian Basin.
ConclusionOverall the upstream sector has challenges right now, but the royalty and mineral sub-sector is weathering the changes better than some other sub-sectors. Strong dividend payments, with the promise for more in the future aligns more with investor expectations right now. As always, the lynchpin to industry health is commodity prices. Crude prices dropped in the late spring and have been treading water for the past several months. Many industry observers suggest stagnant prices in the $50-$60 range for the foreseeable future. However, others suggest that while the industry tightens its belt, prices may creep back up into the $60-$70 range. If that happens, shareholder returns will accrue to more than just producers and royalty holders.Originally appeared on Forbes.com.
Top Ten Questions Not to Ask at Thanksgiving Dinner
For most of us, Thanksgiving is a time to disregard normal dietary restraint in the company of extended family members that one rarely sees. For some enterprising families, however, Thanksgiving quickly devolves from a Rockwellian family gathering to a Costanza-style airing of grievances. So, in the holiday spirit, we offer this list of the top ten questions not to ask at Thanksgiving dinner. If you have trouble distinguishing between the board room and the dining room, this list is for you.1. Why can’t I work in the family business? Nearly all family businesses welcome the contributions of qualified family members; however, having the right last name is not a sufficient condition of employment for successful family businesses. As families grow into the third and subsequent generations, family employment policies can become especially contentious. Crafting a workable family employment policy that specifies required qualifications and external work experience is often one of the first and most important tasks undertaken by a family council.2. Why does cousin Joe get such a big salary?This can be a great question, and it is quite possible that Joe is either under – or over – paid relative to his contribution as an employee. As family businesses grow, the board should carefully evaluate how compensation practices for family members compare to those for non-family members. Working in the family business should be neither indentured servanthood nor a sinecure. It is a job, and successful families treat it as such. Having one or more independent (non-family) board members can be a great way to ensure that compensation practices in the family business are fair.3. Why does cousin Sam get anything from the business?This question gets to the heart of many family business disputes we have witnessed: the belief that family members who don’t spend their lives working in the family business aren’t entitled to any distributions. Successful families are able to separate the return on labor (wages and benefits) from the return on capital (distributions). Just as the family members providing labor are entitled to market-based compensation, family shareholders are entitled to distributions if and when paid, even if they don’t work in the business. That’s simply what ownership is. It works that way for public company shareholders, and there’s really no reason to treat your family shareholders any differently.4. Why isn’t the shareholder redemption price higher?A shareholder liquidity program can be a great way to promote peace in the family. Even when a shareholder liquidity program exists, however, shareholders often don’t understand that the family business has more than one value. Which value is appropriate for a redemption program depends on the family dynamics and goals for the program.5. Why doesn’t the business pay a bigger dividend?Being wealthy is not the same thing as feeling wealthy. Many family shareholders are wealthy but don’t necessarily feel that way because dividends either aren’t paid or are only a token amount. Having a well-reasoned and easily-articulated dividend policy is an essential step in promoting family harmony and sustainability. Occasionally, founders and second-generation leaders withhold distributions simply on principle, even if the business has limited reinvestment opportunities. This rarely ends well.6. Why doesn’t the business invest more for the future?This is the flipside to the previous question. Funds that are distributed are not available to reinvest in the family business. A single dollar of earnings cannot be both distributed and reinvested – a choice is required. Making that choice wisely requires knowing what time it is for your family business. As the family grows biologically, it is natural to wonder if the family business will, or can, keep up. You have to sow before you can harvest.7. Why doesn’t the business borrow more money?Growth requires capital, and since family businesses rarely have an appetite for admitting non-family shareholders, that means debt may be the only way to fund important growth investments. Prudent amounts of leverage to help finance growth investments can actually help secure, rather than imperil, the family business’s future. But before borrowing money, directors should ask a few key questions.8. Why does the business have so much debt?Some shareholders fret about using too little leverage, while others worry about the risk of having too much debt. Over the long-run, the capital structure of your family business should reflect the risk tolerances and preferences of your family shareholders. The idea that you can financially engineer your way to a lower cost of capital (and therefore, higher value) for your family business through fine-tuning capital structure is over-rated. Capital structure determines how much risk and reward shareholders can anticipate, but does relatively little to influence the actual value of your family business.9. Why don’t we register for an IPO?There are examples of families that have taken their businesses public while retaining control over the board of directors. It’s not always a lot of fun. Despite retaining control, being public means inviting the SEC and other regulators to take a keen interest in your business. Even if your family keeps its eye on the long-run, Wall Street can take you on a wild ride based on the short run. Having publicly-traded shares may be what’s best for your family business, but it’s a big step and a really hard one to take back.10. Why don’t we sell the business?When is the right time to convert the illiquid wealth that is the family business into ready cash? A buyer might approach your family business with an offer that you weren’t expecting, or your family might decide to put the business on the market and seek offers. In either case, you only get to sell the business once, so you need to make sure you have experienced, trustworthy advisors in your corner. Selling the family business will not remove all the stresses in your family; in fact, it may add some.Of course, all of these are really great questions to be asking – the Thanksgiving dinner table is just not the right venue. This Thanksgiving, try setting business to the side for at least one day. Our advice: instead of talking about the family business, stick to a safer topic like politics. Above all, be thankful for the opportunity to be a family that works together.Happy Thanksgiving!
Parsley’s Acquisition of Jagged Peak Highlights Key Consolidation Trends
On October 14, 2019, Parsley (PE) announced that it was acquiring Jagged Peak (JAG) in an all-stock transaction valued at $2.27 billion. The market’s reaction to the announcement was generally negative, as Parsley closed down more than 10% on the date of the announcement. This appears to be driven, at least in part, by investors’ desire for Parsley to be acquired rather than be the acquirer.
Despite the negative market reaction, we believe this transaction is emblematic of key trends we expect to see during the next wave of consolidation.
All-Stock TransactionJagged Peak shareholders will receive 0.447 shares of Parsley stock per JAG share. Legacy Parsley shareholders will own 77% of the combined company, while legacy Jagged Peak shareholders will own 23% of the combined company.With equity capital markets largely closed to E&P companies and investor concerns regarding leverage, we don’t expect to see any cash/debt-financed acquisitions in the near future. The exception might be a transaction by a supermajor as Exxon and Chevron reported cash balances of $5.4 billion and $11.7 billion, respectively, at the end of September.Low- or No-Premium AcquisitionConsideration to Jagged Peak shareholders represented an 11.2% premium relative to JAG’s preceding closing price. However, given JAG’s recent stock price decline, the implied price was only a 1.5% premium to JAG’s 30-day VWAP.
Investors are increasingly focused on metrics like return on capital employed and cash flow per share accretion/dilution. As an acquisition premium increases, these metrics worsen.
After Callon announced its acquisition of Carrizo for 2.05 CPE shares per CRZO share, implying a 25% premium based on closing prices before the announcement (though the press release cited the lower 18% premium based on Carrizo’s 60-day VWAP), Callon faced intense investor pushback, especially by hedge fund manager John Paulson. Last week, Callon and Carrizo announced revised deal terms in which Carrizo shareholders will receive only 1.75 CPE shares per CRZO share, resulting in a more modest 11% premium based on prevailing prices. However, the press release again cited a lower premium, this time of 7% based on pricing just before the original transaction announcement in July.
Low- or no-premium acquisitions are more palatable to sellers in all-stock transactions as they have the potential to realize the transaction’s synergistic benefits over time given their continued ownership interest in the combined entity. With an all-cash acquisition, benefits to the sellers can only be realized from the purchase price, so meaningful take-over premiums are typically necessary.
Corporate, Rather than Asset, TransactionA&D activity recently has been modest, with wide bid/ask spreads separating buyers and sellers. However, with corporate transactions, public stock prices help align buyers and sellers on value. Also, the inherent G&A expense associated with a corporation gives the buyer an obvious target for synergies.Focus on Concrete Cost Synergies Rather than Nebulous Strategic RationaleIn the acquisition presentation, the “Synergy Scorecard” slide (page 10) clearly emphasizes the G&A and operational synergies that Parsley expects to realize from the acquisition. While the strategic benefits are also highlighted (and take up most of the real estate on the page), it is clear that these take a backseat to the tangible cost reductions.ConclusionParsley’s acquisition of Jagged Peak largely follows the playbook we expect to see in upcoming M&A announcements. Despite the expected cost synergies and strategic benefits, shareholders reacted negatively to the news. Even with the addition of Jagged Peak, Parsley’s status as the fourth largest operator in the Permian (based on rig count) would remain unchanged. This will likely cause management teams to re-evaluate their thoughts on optimal size and scale as they survey the acquisition landscape.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Family Businesses and Scarce Capital
We were recently whiling away the hours scrolling through the archives of the Harvard Business Review when an article caught our eye. “What You Can Learn from Family Business” was written by Nicolas Kachaner, George Stalk, Jr. and Alain Bloch, and appeared in the November 2012 issue. It is well worth reading, and can be found here. In the article, the authors describe an empirical study they undertook to discern the ways family businesses are different from their non-family owned peers.The authors examined data from 149 family-controlled public companies as the foundation for their study. For what it’s worth, we suspect publicly-traded family businesses look at the world a bit differently than their private brethren, but you have to go where the data is available. In any event, the reported findings were generally consistent with our experiences working with private family businesses.The authors identify seven attributes of family businesses that differentiate them from non-family owned peers. The overall conclusion of the study is that family businesses focus more on long-term resilience than short-term performance.Family businesses are frugal in good times and bad.Family businesses keep the bar high for capital expenditures.Family businesses carry little debt.Family businesses acquire fewer (and smaller) companies.Many family businesses show a surprising level of diversification.Family businesses are more international.Family businesses retain talent better than their competitors do.
In a series of posts over the next several weeks, we’ll take a closer look at some of the attributes identified by the authors, particularly from the perspective of privately-held family businesses. This week, we’ll consider how family businesses make capital expenditure decisions.Family Businesses and Capital ExpendituresThe authors describe family businesses as “especially judicious” with regard to capital expenditures. We suspect that this stems from the fact that spending family capital just plain hurts more than spending anonymous shareholder capital. As family businesses mature, the tension between reinvesting in the business to support future growth and distributing earnings to the family for consumption and outside investment often becomes acute. As a result, family business managers are keenly aware that dollars spent on capital expenditures are dollars that are not distributed to the family.Equity Capital ConstraintsSetting up a joint venture can allow the family business to act bigger than its balance sheet.Beyond the psychological hurdle noted above, an additional constraint on capital spending for privately-held family businesses is the common aversion to raising equity capital from outside (non-family) investors. Family business directors know that even minority investments from outsiders come with strings attached in the form of governance and economic rights. The institutional investor that becomes a 20% or 30% shareholder in your family business will not be shy about exerting influence over significance strategic decisions. And it is quite unlikely that the investment horizon for the institutional investor mirrors that of the family. That’s not to say that outside equity capital may not be the right solution for your family business, but accepting outside capital will most definitely change your family business.Some families balance the need for outside capital to fuel growth with the desire to protect family control of the business by using joint ventures or other similar structures. When there is a discrete growth initiative that the family business wants to undertake, but doesn’t have the financial capacity to tackle by itself, setting up a joint venture with a strategic or financial partner can allow the family business to act bigger than its balance sheet. Of course, shared investment means shared upside, but that can be preferable to sitting out on an otherwise attractive investment opportunity for a lack of funding. While the joint venture partner will have significant say over the conduct of the joint venture, they can be effectively fenced off from the governance of the family business as a whole.Capital Rationing and StrategyIn the face of capital scarcity, family business directors must select a limited number of capital projects to approve. The selection process is referred to as capital rationing. Capital rationing is common to all businesses; even when capital is readily available, other constraints, like the availability of human capital, place limits on how much capital investment can be made in a given period.Family business directors and managers often give much attention to measures of financial feasibility like net present value, internal rate of return, and payback period.Net present value (NPV) is a comparison of the marginal cost of a capital project to the present value of the expected marginal benefits associated with the project. The expected benefits are discounted to the present at the weighted average cost of capital.Internal rate of return (IRR) is the discount rate at which the present value of expected marginal benefits is equal to the marginal cost of the project.The payback period measures the number of years it will take to recoup the marginal cost of the capital project.
These measures are crucial, and directors should not approve capital projects that do not pass these tests. However, passing the financial test is not enough. NPV, IRR, and payback period are not substitutes for a coherent strategy.Prioritizing strategy will enhance the long-term sustainability of your family business.Since the number of projects with acceptable financial returns likely exceeds the amount of capital the family business has available to invest, a common approach is to simply increase the minimum hurdle rate until fewer projects pass. While this is an effective way to address capital rationing, in our view, it gives short shrift to strategy. We believe most family businesses are better off investing in a project that advances the company’s overall strategy and has an IRR of 13% than an alternate project with an expected IRR of 18% but only a tenuous relationship to the strategy of the family business.Assessing strategic fit of potential projects to address capital rationing is not as easy as simply inflating hurdle rates, but we are convinced that prioritizing strategy will enhance the long-term sustainability of your family business.ConclusionThe authors conclude that parsimony when it comes to capital expenditures may cost family business some short-term growth opportunities, but ultimately enhances the resilience of family businesses when recession comes. And recession has always, eventually, come.So what about your family business? Are you spending family capital wisely? Have you explored alternative sources of equity capital? Do you have a disciplined process for reviewing potential capital projects for both financial feasibility and strategic fit? In short, are you managing for long-term resilience or short-term performance?
What Should You Expect as an RIA Buyer or Seller?
Advisor Growth Strategies’ New Study Offers Insights into RIA Deal Mechanics
RIA M&A has been a well-publicized topic in the industry. There was a record level of RIA M&A in 2018, and so far in 2019 there are no signs that deal pace is slowing down. Against this backdrop, a new study conducted by Advisor Growth Strategies (AGS) and sponsored by BlackRock sheds light on the realities facing RIA buyers and sellers. Based on transaction information for over 50 RIA deals, the study examines the relationship between deal price and deal terms. The full study is available here.The study categorizes RIA deals based on purpose (short-term or long-term), size (small target or large target), and payment structure (certain or uncertain). The synthesis of these factors impacts the transaction multiple, as shown in the chart from the study below.[caption id="attachment_28869" align="aligncenter" width="493"]Source: Advisor Growth Strategies[/caption]
While the deal multiple is a convenient short-hand way to summarize a transaction, as the chart above suggests, it does not tell the full story. Still, the deal price and multiples are what makes the headlines (if terms are publicly disclosed at all) because the nuances of an earn-out arrangement don’t make for an exciting press release.
You Pick the Price, I’ll Name the TermsBecause of the lack of transparency and media focus on non-price deal terms, the market norms and trends for this important aspect of RIA M&A are often unfamiliar to first time buyers or sellers. However, non-price deal terms can be just as important or even more important than the deal price. This is particularly true in RIA deals, where buyer stock and/or contingent consideration may account for a significant portion of total deal value. The AGS study provides some insight into the state of deal terms in the RIA M&A market from the perspective of both buyers and sellers. We’ve highlighted some of the key takeaways from the study below.While there are many small (and successful) RIAs, the largest 5.4% of firms by AUM control 63.2% of AUM. The largest RIAs command premium multiples, but these firms are a minority. The study (which focused on smaller RIAs) found that the median adjusted EBITDA multiple for M&A transactions between 2015 and 2018 was 5.1x, and there was little variation over the period. RIAs must choose between pursuing scale through inorganic growth or maintaining a boutique approach.Large acquirers (e.g., Focus Financial, HighTower, CapTrust, Mercer Advisors) are setting the pace for deal terms. Given the proliferation of capital providers in the space, providing a successful long-term outcome is now the differentiator for these “acquisition brands.” Compared to smaller, less frequent RIA acquirers, the acquisition brands have a leg up based on their demonstrated and repeatable growth engine, robust human capital and technology, ability to add service diversification, and access to capital. For sellers, the turn-key offerings provided by acquisition brands are a benchmark for establishing rational expectations.RIA deal terms now provide an average of 60% of cash consideration at closing. For buyers, this means a high barrier to entry and critical need for a solid integration strategy. For sellers, liquidity at close is nice, but accepting a relatively high upfront payment may not maximize the overall valuation.While RIA cash flows have been increasing, multiples have remained relatively consistent between 2015 and 2018. Buyers must find a balance between price and terms based on the transaction’s purpose to get sellers to commit.Up to 40% of consideration is being paid in buyer stock. In general, larger deals saw a greater proportion of total consideration in the form of buyer equity. For buyers, this means that it is critical to demonstrate the merits of their business model and to articulate a path to liquidity (particularly for privately held acquirers). For sellers, the burden is on them to evaluate the investment merits of their acquirer. When buyer stock is part of the consideration, the buyer and seller are in the same boat after the transaction, so it is critical that both parties evaluate the investment merits of the combined entity.Buyers are assuming more of the risk in RIA transactions. 75% of the transactions in the study had less than 25% of the total consideration allocated to contingent consideration, and the contingent payments were relatively short-term (all were less than three years). Given these terms, buyers must be willing to assume some of the risk of the transaction and have a clear integration plan.M&A OutlookWith over 11,000 RIAs operating in the U.S., we expect that consolidation will continue and deal volume will remain strong. The AGS study suggests that, at least for most firms, multiples have been relatively consistent over the last several years. Without major changes to deal terms and structure, this may continue to be the case. Market forces have and will continue to impact non-price deal terms. Acquisition brands are a growing force in the industry, and their influence on deal terms will likely grow accordingly. At some point, every RIA will likely become either a buyer or a seller and will confront the tradeoffs between price and deal terms and other market realities as they exist at that time.
Q3 2019 Call Reports
Differentiated Strategies of Asset Managers, Wealth Managers, and RIA Consolidators
During Q3 2019, most classes of RIA stocks underperformed major equity markets, which are having their best year, so far at least, in more than two decades. In general, base fees for RIAs were up due to higher average AUM (driven by market growth), however, each sector experienced unique challenges. As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominate trends.Theme 1: Asset managers are responding to fee pressure either through acquisitions to achieve scale or by outsourcing administrative tasks to reduce overhead.I've been in the investment business well over 30 years and there's never been a time when fee rates have been going up. How you grow and how you achieve attractive margins in this business tends to be based on scale, the ability to offset reductions in fee rates tied to per dollar of assets by growing the base of assets you manage and leveraging the spending in support of that asset management. […] We expect continued modest declines in our average fee rates. – Tom Faust, Chairman & Chief Executive Officer at Eaton VanceWe recognize the pressure that the industry is under, and it is very top of mind with all the senior management to look [at] every kind of saving that we can generate to continue to invest in the parts that we think are going to be incremental to getting inflows and in a few years. – Matthew Nicholls, Executive Vice President Chief Financial Officer at Franklin ResourcesMergers are more immediately accretive because of consolidation benefits. There are many transactions, you have all the obvious consolidation benefits that you would expect, which is office consolidations overhead maybe cross sell, pricing changes or other things here that you would see in a merger, but you wouldn't see in a holding company transaction. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus FinancialWe always thought there'd be opportunity to save more than $475 million. By the time of the [Invesco - Oppenheimer] transaction closing we only had a clear line of sight regarding the $475 million of savings. After we closed the deal we were able to look deeper into the business and we started making significant progress on the integration. And we now see that we can run the business with this lower expense base. – Loren Starr, Chief Financial Officer at InvescoLeveraging our scale can also take different forms. In certain areas delivering partnerships with industry leading service providers through our affiliates can be more efficient and provide better outcomes, particularly where AMG's scale can improve pricing, access and service. For example, we've recently partnered with ACA Compliance Group to support affiliates seeking to lower their compliance cost and access a greater breadth of services. – Jay C. Horgen, President and Chief Executive Officer at Affiliated Managers GroupTheme 2: Wealth Managers, who are generally more resilient to fee compression, are growing the bottom line by increasing headcount rather than cutting costs.There's no question the resiliency of the overall fees for wealth management has been -- is pretty inelastic so far. We are starting to see some of the e-brokers charge much lower fees than the traditional wealth management platforms in terms of the overall advisory fee. But unquestionably when commissions are free, the investor is going to have to make a choice. Is […] the value proposition of having that advice worthwhile versus having a commission free relationship? And every client is going to have to make that assertion. – Laurence D Fink, Chairman and Chief Executive Officer at BlackRockWe've been staffing up our recruiting department over the last few months and the pipeline has been building. With regard to the advisors that we're focusing on […] the higher performing or higher producing type advisors that are more in line and more consistent with our current average productivity of advisors. […] So, we're continuing to see that expand as we move into 2020 and intend on hitting an inflection point from a growth perspective as we continue to progress forward as the pipeline continues to grow. – Shawn M. Mihal, Senior Vice President, Wealth Management at Waddell and ReedTheme 3: Consolidators attempt to ease investor concerns over their debt burden in the wake of a potential market correction.At the same time we continue to maintain a prudent level of leverage and have repositioned our balance sheet over the last several quarters extending duration while maintaining flexibility and capacity to capitalize on growth opportunities even in challenging markets. – Thomas M. Wojcik, Chief Financial Officer at Affiliated Managers GroupWe are looking at our capital management policy really to align with our overall strategy. We want to create flexibility and right now, our priorities are to delever. About 90% of our free cash flow has gone and probably will go toward delevering. We do have a small buyback program. We do have a small dividend program. We view these as ancillary parts to our strategy. We look at the buyback as a way to manage shares -- outstanding shares. So, we are going to focus on delevering. – David C. Brown, Chairman and Chief Executive Officer at VictoryAssuming constant markets, we anticipate that our net leverage ratio will remain essentially unchanged at 4.3 times from Q3 to Q4. We intend to delever gradually, starting in 2020 as we execute against this solid pipeline and satisfy earn outs associated with the transactions we have closed in the past, and plan to operate with a net leverage ratio between 3.5 and 4.5 times. We are comfortable that this range gives us the flexibility to pursue larger strategic transactions while also accelerating the growth of our existing partner firms in Focus and investing to drive organic growth. […] Please see [the earnings supplement] which provides a sensitivity analysis on the net leverage ratio impact of a material equity market correction. We will continue to manage our capital resources carefully while maintaining sufficient flexibility to invest in the growth of our business. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus Financial
Earnings calls this quarter brought to light the varying challenges and opportunities that different RIAs face.
The shift from active to passive investing has forever changed the active asset management industry and asset managers are having to re-think their cost structure in order to stay competitive. Increasing operating leverage through acquisitions and outsourcing has allowed asset managers to protect their margins despite declining fees. Wealth managers are taking a different approach to increase cash flow. The wealth management industry, which depends on the advisor-client relationship, is staffing up as additional advisors can mean additional sales. Meanwhile, consolidators like Focus Financial, AMG, and Victory Capital are providing solutions to both asset managers, who hope to achieve scale, and wealth managers, who look to expand their reach.
Build or Buy?
Is Your Family Business a Builder or a Buyer?
Software developers must regularly decide whether to purchase existing software for desired functionality or to write the software themselves. In fact, software developers make these decisions so often that there is an entire literature devoted to helping them make the best “build vs. buy” decision in any particular situation. Family business directors face a similar decision when it comes to making capital investments. There are essentially two options for capital investment:Capital expenditures (i.e., “build”)Acquisitions (i.e., “buy”)
As shown on Exhibit 1, we classified each of the operating companies the S&P 1000 as either “Builders” or “Buyers” based on the relationship between aggregate cash flows for capital expenditures and acquisitions from 2013 through 2015.
As groups, the Builders allocated 89% of total capital investment to capital expenditures, while acquisitions accounted for 81% of total capital investment for the Buyers. With regard to median size (measured by revenue) and operating margin, the two groups are virtually indistinguishable. The Buyers’ relative capital investment was greater, contributing to modestly faster revenue growth over the three years ending in 2018. Buyers are over-represented in the healthcare and IT sectors, while consumer sector (both discretionary and staples) is more hospitable to Builders.
So how should you and your fellow family business directors decide whether to build or buy? What will be the most effective form of capital investment for your family business? Since software developers think more about the build vs. buy decision than most of us do, we thought it would be interesting to apply a software-related decision framework to family business investment decisions. For purposes of this blog post, we follow the six step decision framework advocated by Justin Baker.
Step #1: Identify Functional RequirementsFor family businesses, all capital investment should begin with strategy. What strategic objectives require capital investment? What competitive advantage is the company seeking to extend, strengthen, or defend? Strategy should guide family businesses in selecting capital investments; too often, family businesses attempt to formulate a strategy out of available capital investments.Step #2: Define the Scope of Work and Reconcile Against ConstraintsFamily businesses face both financial and non-financial constraints when evaluating capital investments. Directors should be carefully attuned to both of these constraints. Since family businesses are often reluctant to raise equity capital from outside the family, the amount of capital available for investment is limited to operating cash flow and available debt financing. Non-financial constraints are most often either cultural (is there any precedent for making acquisitions?) or managerial (does our management team have the requisite capacity or skill set to execute the proposed capital project successfully?). If there is a managerial constraint, are there family members with the needed skills, or will it be necessary to bring in non-family managers? Regardless of the answers to these questions, a clear-eyed assessment of the relevant constraints will help ensure that directors are evaluating a feasible set of build or buy options.Step #3: Solution DivergenceSolution divergence simply means identifying the potential build and buy options. On the buy side, this might mean keeping a running list of competitors, suppliers, or customers that could provide a compelling strategic combination with the family business. On the build side, operating managers are often the best source of potential capital expenditures. In either case, is your family business’s corporate strategy have enough visibility throughout the organization so that operating managers have a good feel for what acquisition targets or capital projects are going to be worth pursuing? Has the board and senior management communicated a list of “must haves” for any capital investment? It can quickly become demoralizing for operating managers when there are no clear criteria against which proposed investments will be evaluated. Solution divergence is ultimately about nurturing a process for generating a sustainable pipeline of proposals (both “builds” and “buys”) for directors to evaluate.Step #4: Solution ConvergenceWhereas solution divergence describes the process of identifying potential capital investments, solution convergence refers to the process for selecting the capital investments to be made. In addition to strategic considerations, the selection process should also reference financial return metrics like internal rate of return (IRR) and net present value (NPV). Satisfactory financial metrics are a necessary, but not sufficient, condition for selecting a capital project. Capital investments should satisfy both financial and strategic objectivesShould financial hurdles be different for “build” projects than “buy” projects? Some families, concluding that acquisitions are inherently riskier than capital expenditures, assign higher hurdle rates to acquisitions. The risks traditionally ascribed to acquisitions include the tendency to overpay in competitive bidding situations and the difficulty of assuring a healthy cultural fit between buyer and seller. These risks are certainly real, but capital expenditures are not without their own unique risks. Specifically, capital expenditures create incremental industry capacity, and forecasting market demand and the impact of additional supply on pricing can be just as challenging as integrating acquisitions. The use of “premium” hurdle rates for acquisitions is ultimately neither right nor wrong, but simply a form of capital allocation by another name. Regardless of the hurdle rate selected, capital projects must satisfy both financial and strategic criteria to merit investment.Step #5 – Build or Buy or BothThis is the execution phase. Selecting the capital investments to be made is not the end of the process. Successful family businesses translate forecasts into operating results. Directors cannot just assume that the hand-off from the corporate development and finance teams to the operations team will be done well. In the case of an acquisition, integrating new employees and realizing planned synergies while minimizing negative surprises take top priority. For capital expenditures, avoiding cost overruns and delays that can eat away expected returns on projects is critical.Step #6 – Develop Guidelines for ReassessmentCapital investments are hard to reverse. Nonetheless, family businesses need feedback processes to ensure that the family doesn’t throw good money after bad, and to help improve forecasting techniques and improve accountability in the interest of making better capital investment decisions in the future.ConclusionIs your family business a builder or a buyer? Which factors contribute to your build vs. buy decisions? Do you employ a consistent framework for evaluating these decisions? Do you have a robust process for seeding a pipeline of potential future projects for consideration? Do you understand the cultural factors that make acquisitions or capital expenditures more palatable for your family shareholders? Simple answers elude each of these questions, but directors should assess what processes are in place or need to be developed to ensure that family capital flows toward the most productive uses in the family business, whether in the form of building or buying.
Public Royalty Trusts: More Than Meets the Eye
Yield Traps, Depressed Commodity Prices, and Stage of Decline May Decrease Utility of Public Yields
In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners. We have differentiated between mineral aggregators and public royalty trusts and introduced some other considerations for how to pick the appropriate comparable. In this post, we will discuss the prevailing high dividend yields of public royalty trusts. We will also offer some reasons for why these trusts may be declining not just in production but also their comparability, from a valuation perspective, to some privately held mineral interests.Market Data for Trusts and AggregatorsThe following tables gives some critical market data for valuation purposes:We note that the yields are significantly lower for mineral aggregators than the public royalty trusts, who also have significantly lower market caps. Previously, we’ve explained what a royalty trust is; however, to understand these recently elevated yields, we may need to back up and discuss why royalty trusts are started in the first place.Why a Royalty Trust?Royalty trusts represent a unique financing tool for E&P companies. Instead of holding onto wells and collecting revenue over a longer holding period, operators can monetize these wells upfront by selling the wells to a trust. This allows operators to reinvest the proceeds back into its operations in an industry where cash is key. Trust distributions are determined by the level of production of the wells and commodity prices. By selling the wells to a trust, the operator can avoid the need for hedging the price risk. Also, since production of the wells is expected to decline over time, operators can avoid the drawn out, declining marginal utility of the wells. This is particularly helpful considering a dollar today is worth more than a dollar down the road.Potential Pitfalls of Public Dividend Yields as a Proxy for RiskWe’ve discussed the importance of scrutinizing each royalty trust individually in order to determine the comparability with private interests. Some of these considerations include:Commodity mix (oil vs natural gas)Idiosyncratic issues with the operatorRegion/basin
However, these are not the only considerations, and they may not provide the proper sanity check in the context of the elevated yields that have persisted in recent months.Some further considerations include:Stage of productionCalculation method of the dividend yieldFriction in equity market pricingOperating Expenses in a depressed commodity price environmentWhere are you on the Production Decline Curve?As oil and gas is extracted from a well, its production declines over time. As production declines, the yields tend to increase (more on this later). This can misrepresent the risk to reward opportunity as timing must line up. The value of a mineral interest that has been producing for an extended period of time should not be compared to a well that has just started production or is even still in the drilling or development stage. These situations are two different points on the production curve and represent different risk profiles. For a PDP (proved, developed, producing), there is less risk than any other stage (compared to PUD, P2 or P3). It is important to consider the relationship between these stages of production instead of simply looking to the public markets and being prisoners of the moment or uninformed of the differences between public trusts and a privately held interest. The stage of production and decline rate must reasonably reconcile to private interests to ensure that yields and commensurate risk are compared apples-to-apples.Trusts are frequently prohibited from acquiring additional wells to replace production, unlike E&P companies and mineral aggregators. With production declining, the share price of trust units tends to decline as well, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation. Yield is dividends divided by price, and a declining denominator can lead to higher yields. As production declines, the yields may begin to shift from a reasonable expectation of the risk associated with expected future cash flows to a reflection of the minimal life of the well.Different Dividend Calculations Can Lead to Significantly Different IndicationsThe calculation of dividend yield can also be crucial to understanding risk. Taking the dividends paid in the past year may not be representative of future dividends. While annualizing the most recent dividend may cause issues with seasonality, it may be more appropriate given the commodity price outlook. Annualizing the most recent dividend causes a significant divergence in the implied yield for more than half of the royalty trusts, while the yields change by less than 2% for all of the mineral aggregators.Take Prudhoe Bay (BPT) for example. Its 63% yield as of October 30th includes a $1 dividend per share in January 2019. However, distributions have only been only $1.23 in the next three quarters combined as its 10-K estimated a significantly declining outlook. Annualizing the most recent dividend of 34 cents per share drops the dividend yield closer to 28%, notably lower than 63%. While 28% may seem high even in the context of mature production, current commodity prices indicate the trust may cease payouts after January 2020. Calculating yields by annualizing more current dividends can help normalize yields to better indicate the underlying value of the trust’s production.Public Equity Markets May Complicate Intrinsic Value of Royalty TrustsIn theory, trading in a public marketplace gives public royalty trusts an indication of market value. There is friction, however, between the stock market price and the intrinsic value of the trust. It is common for public royalty trusts to have relatively small share prices. Also, as they age and decline over time, they will become less productive, and investors would be less likely to want to incur the trading costs to build up a position in a stock with little to no residual value. Investing in a small stock creates the need to load up on shares to make a meaningful investment. Doing so, however, can cause the price to move unfavorably. This is particularly the case if the stock is thinly traded.This problem can be compounded by float, that is, the number of shares actually available for trading. As an extreme example, Permianville Royalty Trust (PVL) has just over half of its shares free floating. These issues further complicate the ability to use yields from public royalty trusts as a proxy for risk for private interests.Operating Expenses Become Increasingly ImportantSince royalty trusts are not encumbered with production expenses, trust operating expenses tend to be fixed and minimal. However, revenue tends to be volatile with commodity prices. In the currently depressed commodity price environment, particularly for natural gas, these operating expenses become more pronounced. As we see with the SandRidge Trusts (SDT) (SDR) and ECA Marcellus Trust I (ECT), yields can be higher for trusts with higher operating expenses as a percentage of revenue. Lower prices make the sensitivity to operating expenses more apparent as margins are tighter.ConclusionWhen using it as a pricing benchmark for private royalty interests, there are many reasons to scrutinize the public royalty yields and their comparability. Further analysis is required to ensure these provide meaningful valuation indications. It is important to assess the implied shelf life of the interest and stage of production. Yield also must be considered both in the context of historical and expected future dividends; they must also consider the equity market ecosystem in which the trusts trade. Lastly, yield and implied risk must consider the prevailing commodity price environment and its impact on royalty trust’s operating expenses.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Acquisitions of Consolidators Continue to Drive RIA Deal Activity
Asset and Wealth Manager M&A Keeping Pace with 2018’s Record Levels
Through the first three quarters of 2019, asset and wealth manager M&A has kept up with 2018, the busiest year for sector M&A during the last decade. Transaction activity is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and mounting cost pressures.Total deal count during the first three quarters is set to exceed 2018’s record levels. Reported deal value during the first three quarters was down, although the quarterly data tends to be lumpy and many deals have undisclosed pricing. Dollar value in 2018 was also boosted by Invesco’s $5 billion purchase of OppenheimerFunds.
Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model and yet one more approach to building a national RIA brand.
Acquisitions by (and of) RIA consolidators continue to be a theme for the sector.Mercer Advisors’ recent sale to Oak Hill Capital Partners is further evidence of growing interest in the RIA consolidator space. While deal terms weren’t disclosed, some industry analysts estimate a high teens EBITDA valuation that exceeded $500 million.
These RIA aggregators have been active acquirers in the space with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first three quarters of 2019.
Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are further drivers of M&A activity for the sector. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation Rationales Sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side. One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids. The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings. While these factors are nothing new, sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture. Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly-traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned following the correction at the end of last year.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity.
With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both buyers and sellers for the remainder of this year and the next.
What Time is it for Your Family Business?
It is harvest time in rural America. Farmers are working long hours gathering the crops that have been planted, fertilized, watered and worried over since springtime. While the cycle of planting and harvesting is an annual one on the farm, for family businesses, the cycle can span decades or even generations.There are many different ways to classify family businesses, but one simple distinction that we find ourselves coming back to often is that between planters and harvesters.Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. Since these companies are focused on sowing the seeds for future growth, family shareholders should expect near-term returns to come primarily in the form of capital appreciation.In contrast, harvesters generate more cash flow from current operations than they are investing for future growth. While there likely will still be some degree of expected capital appreciation for these firms, they offer their family shareholders the potential for greater current income.
So what time is it for your family business? Is it planting season or harvesting season? You can easily tell by taking a look at the statement of cash flows. This generally underappreciated financial statement has three sections.The operating section summarizes the sources of cash flow from existing operations (principally earnings, depreciation and other non-cash expenses, net of changes in working capital).The investing section details the cash flows allocated toward corporate investments, the most significant components of which are capital expenditures and business acquisitions.The financing section reveals whether the company is a net borrower or lender, has issued or repurchased equity shares, and whether or not it pays dividends to shareholders.
We can classify family businesses as either planters or harvesters by simply comparing the first two sections of the statement of cash flows. For planters, total investing outflows exceed operating inflows. Harvesters, on the other hand, generate more operating inflows than investing outflows.
Once you determine whether your family business has been a planter or harvester in the past, it is time as a director to determine whether a change is appropriate in the future. To help us think about the characteristics of planters and harvesters, we examined statements of cash flow for companies in the S&P 600 (small-cap) and S&P 400 (mid-cap) indexes. After screening out financial and real estate businesses, we were left with a sample of 741 companies having median revenue in 2018 of about $1.5 billion. We classified each firm based on aggregate cash flows from 2013 through 2015; 40% of the companies were planters and 60% were harvesters. Exhibit 1 summarizes some characteristics of each group.
In the aggregate, planters invested $1.94 per $1.00 of operating cash flow, compared to $0.57 for harvesters. Harvesters tended to be more profitable, with a median operating margin of 10.0%, compared to 6.9% for planters. The net effect of more aggressive investing was a combination of faster revenue growth and improving profit margins for planters. Of course, return is the ultimate test for shareholders, and over the following three years (2016 through 2018), harvesters generated higher returns than planters (7.8% compared to 3.5%).
Peril and PromiseIt is easy to determine whether your family business has been a planter or harvester in the past. The real question for directors is assessing whether it should be harvest time or planting time for your family business now. Neither planting nor harvesting is inherently superior to the other. Directors need to read the calendar for their family business, understanding the peril and promise of each time.Planting Time: PromiseThe promise of planting time is the opportunity for a greater future harvest. As families grow over time, directors should evaluate the appropriate relationship between family and business growth. Planting time offers the promise that the growth of the business can keep pace with, or potentially exceed, the growth of the family, fueling per capita growth in family capital. What’s more, prudent planting can create opportunities for family members to assume roles of increasing responsibility in the business and promote shareholder engagement.Planting Time: PerilBusiness would be easy if planting decisions could be deferred until harvest outcomes are known. Sadly, that is simply not the case. You have to plant before you harvest. As a result, the principal peril of planting time is the risk that the harvest will turn out to be less attractive than expected. Referring back to Exhibit 1, the planters’ investments did contribute to faster revenue growth and improving margins. However, it is not clear that the incremental benefits from investment were truly sufficient relative to the investment made. The weaker observed stock returns for planters suggest that – for many of the companies – the harvest was not as robust as planned. In other words, the market concluded that at least some of the companies in our sample misread what time it really was, planting when they should have been harvesting.Harvest Time: PromiseIt is nice to be rich, but it’s even better to have money. The promise of harvest time is that the family will finally reap the benefits of the risks and investments of previous generations, turning the “paper” wealth of illiquid business value into liquid, readily diversifiable wealth. Harvest time can facilitate the transition from being a business family to an enterprising family. Harvest time can allow families to reduce their economic risk profile by moving at least some of their hard-won eggs into new baskets. As families grow, diversifying family wealth can be a critical component of overall family harmony and sustainability.Harvest Time: PerilOne of the biggest perils of harvest time is complacency. An over-emphasis on harvesting can starve the family business of needed investment. If the family business does not keep up with the growth of the family, the resulting pressure on per capita wealth and earnings can add stress to family relationships and erode shareholder engagement. Even from the perspective of the family business, the positive impact of investing for growth can be easily overlooked. As shown on Exhibit 1, the harvesters experienced some margin decay over the following three year period, suggesting that at least some harvesters allowed their competitive advantages to wither during the harvest. Directors need to take a balanced view of the long-term reinvestment needs of the business.ConclusionWhile there is some persistence in companies’ investing behavior over time, the companies in our sample did evolve. We reclassified each of the companies in our sample based on cash flow data for the three years from 2016 and 2018. Approximately half of the original planters became harvesters in the succeeding period. Harvest time is not a final destination, however, as about 30% of harvesters turned into planters. From this evidence, we conclude that your family business is never “stuck.” Family business directors need to regularly check what time it is for their family business, and not assume that the characteristics of the past year or decade are appropriate today. So, what time is it for your family business?
Pipeline Bottlenecks And Worthless Acreage: The Downsides Of World-Leading Oil Production
Oil and gas production in the United States continues to grow. Last year a momentous occasion came and went when the U.S. unseated Russia and Saudi Arabia as the world’s leading oil producer on a daily production basis. The last time that happened was 1973, and a lot has changed since then. There were genuine concerns at the time that conventional oil recovery was at or near a peak. Back then, resources and drilling inventories were widely perceived as limited and thus investors paid a premium for companies that possessed more robust reserve reports while perceived demand for midstream assets waned. This has changed. Some side effects of this current market have included choke points in pipeline capacity and a precipitous drop in prices for undeveloped oil and gas acreage.While fracking techniques have existed in prior forms since the 1940s, the innovations in fracking technology have allowed companies to stimulate previously uneconomic wells. This revolutionized production and reframed mindset as to whether oil recovery was at a peak or not. In fact, production patterns improved so quickly over the past five years that infrastructure such as pipelines, processing and logistics has had trouble keeping up.The Bakken and Three Forks formations located in the Dakotas and Montana are a good example of this. For years, there has been a dearth of pipeline access to the formation and most of the oil produced has been transported out of the region by rail, a less efficient solution compared to pipelines. This issue has been even more acute for natural gas transportation. According to the EIA, in 2017 Bakken operators flared 88.5 billion cubic feet of gas, worth about $220 million and enough to heat 1 million homes.The Dakota Access Pipeline, which was much discussed in the news due to protests, opened in 2017 and is proposed to expand. It helped correct steep pricing differentials as compared to West Texas Intermediate crude pricing. There is still more to come (gas flaring is still prevalent), but constraints should lessen as time goes on.Another trend has been flagging prices for undeveloped acreage. We researched transaction data in the Bakken over the past two years and according to our research from the fourth quarter 2017 going into the fourth quarter 2019, average prices for acreage in the Bakken dropped from $14,250 per acre to $11,919 per acre. While limited in sample size, what’s particularly interesting about these statistics is that on a flowing barrel basis the average price for production increased ($53,338 per flowing barrel in the period entering the fourth quarter 2018 vs. $55,246 going into the fourth quarter 2019).[caption id="attachment_28685" align="aligncenter" width="640"]Source: Shale Experts[/caption]
This indicates that current production valuations remain steady while acreage values for future production weaken. The explanation for this dynamic is layered yet connected, and it is not isolated to the Bakken area.
At Hart Energy’s A&D Strategies and Opportunities Conference, industry participants emphasized a theme of seeking to buy current oil and gas production as opposed to longer term developmental acreage. This is a result of the capital discipline and returns that investors are demanding. Thus, with public markets struggling to show returns to many investors, acquisition and divestiture activity has slowed. The most prominent transaction oriented activity in the Bakken this year was ironically QEP’s decision to terminate a deal to sell its assets for $1.73 billion. Part of this is driven by public funding drying up. Some companies are turning to creative asset backed bonds to facilitate fundraising.
This dearth of funding incentivizes investors to be particularly selective in their asset purchases and be more weighted to current returns. Thus, there is less capital available to invest in longer term drilling inventory. The valuation theory is straightforward: there is more sensitivity of the price paid today for drilling inventory that may not be monetized for 10 or 15 years or more from a net present value perspective. It’s not worth much in today’s dollars, and thus becomes challenging to justify the significant capital outlay considering alternative investments.
Another factor driving declines in acreage values is large swaths of private equity backed properties that are considering monetizing their assets due to expiring fund holding periods. While perhaps up to $5 billion of non-operated oil and gas packages are potentially available in the Bakken, many aren’t currently transacting because of the low prices and wide bid-ask spreads. This may not last, and funds will eventually have to sell their assets. When that happens, acreage prices could drop even further if commodity prices or other fundamentals do not improve. It may not appear reasonable to some sellers, but it is fair in many buyers’ minds. It’s a somewhat unexpected side effect alongside a global shift in energy markets.
Originally appeared on Forbes.com.
WeInvest?
The Best Business Model in the RIA Industry Depends Not on Who You Ask, but Who’s Asking
Earlier this month we had the pleasure of participating in a panel discussion on the value of wealth management firms in a transaction setting for the CFA Society of New York. In conversation after the event, one of the audience members asked me what I thought was the most successful business model to follow in the wealth management space. It’s a question we hear fairly often, and I try to avoid punting on the answer and saying “it depends.” In reality, though, it does depend.
Because I don’t care about movies made about comic book characters, I don’t see many movies these days. Next month is the release of a movie I can’t wait to see, however. “Ford v Ferrari” is based on the true story of Ford Motor Company’s failed attempt to buy Ferrari in 1963. Discussions broke down when Enzo Ferrari realized that Ford expected the transaction to include Scuderia Ferrari, his racing team, and not just the road car manufacturer. Enzo’s business might have been selling cars, but his persona was racing cars. Scuderia Ferrari was not for sale. Henry Ford II was offended at having been rebuffed, and he vowed to build a car to end Ferrari’s dominance at the annual endurance races at Le Mans. The result was a grudge match at the 1966 24 Hours of Le Mans. Ford’s purpose-built car, the GT40, beat the Ferrari 330s decisively, the first win at Le Mans for an American team.
Despite the win, Ford gave up competing at Le Mans a few years later, and no longer targets Ferrari on racetracks or in the showroom. The 1966 win did foretell a Ferrari challenger, though. The winning driver was Bruce McLaren, a New Zealander whose eponymous racing and road car company is today a major rival to almost everything Ferrari does.The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals.Back to my discussion of business models. The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals: Ford was a high-volume automaker that competed as a marketing gimmick (“race on Sunday, sell on Monday”). Ferrari was a low-volume automaker that sold road cars to finance Enzo’s racing teams. Ford wanted to make money. Ferrari needed to make money. It wouldn’t have been an easy marriage.In the investment management industry, the question of the best business model generally comes down to opinions about scalability. At the atomic level, an RIA is composed of the relationship between one advisor and one client. Building an RIA is a debate over the best way to grow the size of client relationships, the volume of client relationships, the volume of advisors, or some combination of the three. By “best” I mean finding the right balance of margin, growth, and sustainability.I think the “best” business model is different for different people, however. Ken Fisher built a twelve-figure AUM wealth advisory company by creating a social media marketing machine to funnel mass-affluent investors into a network of highly regimented advisors. Unfortunately for him, Fisher isn’t as regimented in his own professional interactions. Nonetheless, he proved that a high-volume, homogenous, and replicable approach to investment management is both possible and profitable.The “best” business model is different for different people.On the other end of the spectrum, a friend of mine retired from the hedge fund industry a few years ago and is building a boutique wealth management practice that caters to the needs of successful hedge fund managers. It is the opposite of the Fisher model: low-volume, highly specialized, and difficult to replicate. I don’t think either Fisher or my friend would be interested in pursuing the other’s approach to wealth management, but they both found models that worked for them.For some valuable extracurricular reading on this topic, don’t miss Scott Galloway’s blog post on margins, scalability and growth. Galloway’s August blog post opened the floodgates for criticism of WeWork, and is legendary in our world where frank investment analysis is all too rare.Galloway’s more recent post is a thorough and compact digression on the basics of business models and valuation. If, as he contends, the world really is shifting from a focus on growth to a focus on profitability, the investment management profession may stand to benefit in two ways: valuations should improve (much to the relief of every publicly traded RIA executive and shareholder) and value investing may finally regain its prominence (and, along with it, active management). We’ve seen “green shoots” suggesting the latter of these over the past few months in the form of an increase in active manager searches. It hasn’t shown up in public RIA share prices, though.[caption id="attachment_28540" align="aligncenter" width="819"] EBITDA multiples have sagged for smaller public RIAs in recent years. Is this the beginning of the end, or the end of the beginning?[/caption]
Galloway also offers remarks that could be interpreted as throwing cold water on consolidation efforts in the RIA space. “Services businesses (high margin) usually involve the most unpredictable and messy of inputs — people — and are dependent on relationships (also not scalable).” I don’t know if Galloway would describe certain investment management firm roll-up models as “WeInvest,” but it’s something to consider.
There may be no perfect business model, but there is a business model that’s perfect for you. The Ford v Ferrari competition today takes place on the Big Board. Globally, Ferrari sells about 8,500 cars per year, whereas Ford sells nearly twice that many cars per day. Despite the obvious scale differential, Ferrari (NYSE: RACE) sports a 50% higher earnings multiple, not to mention a 10% greater equity market cap, than Ford (NYSE: F). Advantage: Ferrari.
Lessons for the Long Haul
While public companies are planning for the next quarter, successful family businesses are planning for the next decade. While private equity firms anticipate exit, successful family businesses anticipate transitioning to the leadership of the next generation. A recent profile in the New York Times of Rumiano Cheese provides a great example of how family businesses persist and endure over generations. Rumiano Cheese is celebrating its centenary this year, and the company’s story provides some great reminders for all family businesses that are in it for the long haul.Successful Family Businesses Adapt to Market DemandAt its founding in 1919, Rumiano was producing a dry parmesan cheese that was reminiscent – to the largely immigrant customer palate – of more scarce parmesan cheese. When World War II created demand for a shelf-stable cheese product, Rumiano ramped up the production of so-called “American” cheese. As consumer preferences have shifted to organic food, Rumiano has adapted in both its own branded cheeses and its ability to supply cheese ingredients to organic food manufacturers.What about your family business? Are you meeting market demand, or hoping the market will accept what you want to produce? How is market demand different today than it was five years ago? What will customer preferences look like five years from now?Successful Family Businesses Match Investment with OpportunityRumiano expanded production to keep pace with the war-driven demand for “American” cheese. When demand waned in the post-war years, Rumiano scaled back production capacity to meet demand. Consistent with an ROIC mindset, the leaders at Rumiano were careful to match investment to available opportunities. When consumer infatuation with whey protein presented a new opportunity, Rumiano committed $20 million in capital to meet the opportunity.What about your family business? Does your balance sheet match your income statement, or are you holding on to assets that no longer serve a purpose? Conversely, are you willing to commit the resources necessary to meet new opportunities in your markets?Successful Family Businesses Navigate External ChallengesFamily business observers sometimes talk as though all of the challenges associated with running a family business are internal (family dynamics, etc.). They are not. Before a family business can earn the “privilege” of addressing internal family-related challenges, it must successfully navigate a steady stream of external challenges that disrupt the status quo. For Rumiano, those external challenges have included changing government regulations, unpredictable weather patterns, and the actions of competitors.What about your family business? What external threats need immediate attention? What emerging threats do you need to plan for? What external challenges can be turned into opportunities by identifying and implementing creative solutions that actually strengthen your business?Successful Family Businesses Take Advantage of Local ResourcesWhile it is true that successful family businesses are those that adapt to changing market demand, it is also essential not to forget where you come from. Amid all the change and evolution at Rumiano, one constant has been to take advantage of local resources – an abundant supply of high-quality milk from the many organic dairy farms located near the company. You don’t have to own the resource to take advantage of it, but proximity is important. The local dairy resources readily available to the company help forge Rumiano’s strategy of providing fresh, organic cheese. This strategy frees the company from competing directly with the much larger industrial cheese producers based in the Midwest.What about your family business? What local resources are available that can contribute to sustainable competitive advantage? What partnership or joint venture opportunities are available to help you make the most of the local resources that have the potential to make your company unique?Successful Family Businesses Take Advantage of Global MarketsSuccessful family businesses may find their competitive advantage in their own backyards, but they may need to go across the globe to fully exploit that advantage. The demand for whey protein is a global, not local, phenomenon, and Rumiano has followed that demand into protein-hungry Asian markets where growth opportunities for organic suppliers are abundant.What about your family business? Is there global demand that you possess a competitive advantage in addressing? What emerging markets can you establish leadership in today? What resources are required to execute in global markets? Are there potential partners having valuable experience in global markets with whom you can work and learn from?ConclusionWhether your family business’s planning horizon is five years or five decades, it is always instructive to hear the success stories of those who have been in it for the long haul. Odds are that most of our readers are not in the cheese business; regardless, reading the 100-year story of Rumiano Cheese offers a great opportunity to reflect on where your family business has been, is, and is heading.
How to Perform a Purchase Price Allocation for an Oilfield Services Company
When performing a purchase price allocation for an oilfield services company, careful attention must be given to both the relevant accounting rules and the specific nuances of the oil and gas industry. Oilfield services companies can entail many unique characteristics that are not present in non-oilfield related businesses such as manufacturing, wholesale, non-energy related services, or retail. Our senior professionals bring significant experience in performing purchase price allocations in the oilfield services area where knowledge of these characteristics is crucial to determining the proper allocation among the subject company’s assets.For the most part, current assets and current liabilities are relatively straight forward. The unique factors of an oilfield services company are found in the fixed assets and intangibles: specialized drilling and production equipment, service contracts, proprietary technology (patented, or unpatented), methods, or software, in-process research and development assets (IPR&D), etc. In addition, the proper consideration of contributory asset charges in the appraisal of existing customer relationships or technology in the context of oilfield services companies requires a thorough understanding of how such contributory assets are utilized in generating the subject company’s expected operating results. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.The unique factors of an oilfield services company are found in the fixed assets and intangibles.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.It should be noted that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General GuidanceWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).
This can be particularly daunting if the reviewer of the purchase price allocation report does not have significant experience in working with oilfield services industry participants. The oilfield services industry is particularly strong in industry-specific terminology and jargon that can lead to a lack of understanding among purchase price allocation report reviewers that lack a deep industry background.Definition of AssignmentA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Understanding of the BusinessThe purchase price allocation report should include a discussion related to the acquired company which demonstrates that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that plays a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.In the case of acquisitions within the oilfield services industry, the pertinent facts include a thorough understanding as to the demand for the subject company’s services across the various basins within the target market. Unlike many other industries, oilfield services businesses may provide services that are specific to certain basins. Therefore, expectations regarding the specific basins served may be of much greater importance than expectations for the overall oil and gas industry.Intangible AssetsThe discussion of the subject intangible assets should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the assets that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.Upon reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Within the oilfield services industry, in particular, one may have to spend a significant amount of time in the determination of what intangible assets were acquired, what intangible assets should recognized as a separate asset from goodwill (based on the legal/contractual rights and separability considerations) and what intangible assets are likely to have a material value. These can differ markedly across industries and such considerations can be somewhat unique in the oilfield services industry.Past PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.The historical financial performance of the acquired company provides important context to the story.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Understanding an oilfield services company’s past financial performance requires knowledge of industry-specific trends that can impact activity levels, pricing for particular services, competing service providers, and profit margins. The oilfield services industry is subject to potentially wide fluctuations in activity that can be driven by commodity prices and technological changes. A thorough understanding of these dynamics is necessary in order to correctly interpret past performance among industry participants.Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Determination of ValueThe purchase price allocation report should provide an adequate description of the valuation approaches and methods relevant to the project. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Any of a number of valuation methods could be appropriate for a given intangible asset depending on the specific situation. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.In the closing discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This part of the purchase price allocation report should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Within the oilfield services industry determination as to the reasonableness of the indicated allocation of value (purchase price) is often a factor of whether the subject company’s services are subject to proprietary technology, the level of fixed assets required to provide the subject company’s services and the level of personal interaction with customers. Based on such factors, the allocation of value might be reasonably expected to be skewed to particular types of assets, with higher, or lower, expected levels of goodwill.Keep in Mind, it’s Not a BlackboxA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
Valuation Issues in Auto Dealer Litigation
In our family law and commercial litigation practice, we often serve as expert witnesses in auto dealership valuation disputes. We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes. The following topics, posed as questions, have been points of contention or common issues that have arisen in recent disputes. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.Should Your Expert Witness be a Valuation or Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts, one for the plaintiff and one for the defendant.In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry.It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques.Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples.Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy.Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy.The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer.For example, a luxury or high-line franchise in a smaller or poorer market would not be expected to fare as well as one in a market that has a larger and wealthier demographic.In those areas that are dependent on a local economy/industry, an understanding of that economy/industry becomes just as important as an understanding of the overall auto dealer industry and national economy.Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a fine balance between understanding and acknowledging the impact of that local economy without overstating it.Often some of the risks of the local economy are already reflected in the historical operating results of the dealership.If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon?Many of the corporate entities involved in litigation have sophisticated governance documents that include Operating Agreements, Buy-Sell Agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process.Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigated matters, focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers.Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document?These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document.Some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney.Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an auto dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.An important consideration in internal transactions is the motivation of the buyer and seller. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and of the specific facts of the transactions, it becomes trickier to include some, but exclude others.The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing.The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, these documents are important as another data point to valuation.One view of the value placed on a dealership in an owner’s personal financial statement is that no formal valuation process was used to determine that number; so, at best, it’s a thumb in the air, blind estimate of value.The opposing view is the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in document under penalty of perjury.Further, some would say that the value assigned to the dealership has merit because the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.For an appraiser, it’s not a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them.The dealership value indicated in a personal financial statement should be viewed in light of value indications under other methodologies and sources of information.At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as the national and local economy, to explain any difference in values over time.Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data?The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries.As such, any sole comparison to general industry profitability data should be avoided.If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this is problematic.RMA’s studies are organized by the North American Industry Classification System (NAICS).Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data does not distinguish between different franchises.Is there better or more specialized data available? Yes, the National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data.However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships and Mass Market Dealerships.While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available.Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than the actual profitability of the business.The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are adjustments made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming.An example of how normalizing adjustments work is helpful. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point.For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000.At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified.For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101.ConclusionThe valuation of automobile dealerships can be complex. A deep understanding of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. If you have a valuation issue, feel free to contact us to discuss it in confidence. Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2019.
Q3 2019 RIA Market Update
Asset and Wealth Management Stocks Languish in the Third Quarter
Broad market indices were generally flat over the last quarter, while most categories of publicly-traded asset and wealth manager stocks were off 5% to 10%.Our index of traditional asset and wealth managers ended the quarter down 5.4%, underperforming the S&P 500 which was up 0.4% over the same time. Aggregators and multi-boutique model firms declined 8.3%. Alt managers were the bright spot in the sector, up 3.5%.
The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees. Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last quarter. Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down.
These headwinds have contributed to a decline in EBITDA multiples for traditional asset/wealth managers, which in turn has resulted in lackluster stock price performance. As shown below, EBITDA multiples remain well below historical norms, although they have recovered somewhat from the low point seen last December.
Expanding the performance chart over the last year reveals similar trends in asset/wealth manager performance relative to the broader market. Over this longer timeframe, alt managers are still the only category with positive returns, although performance has been volatile. Traditional asset/wealth managers generally moved in lockstep with the broader market until the third quarter of this year when relative performance declined significantly. Aggregators and multi-boutique have declined over 30%.
The 30%+ decline in the aggregator and multi-boutique index may come as a surprise given all the press about consolidation in the industry and headline deals for privately held aggregators. Over the last year, there have been two significant deals for privately-held wealth management aggregators: United Capital was bought by Goldman Sachs for $750 million, and Mercer Advisors’ PE backers sold a significant interest to a new PE firm, Oak Hill Capital Management. Both deals reportedly occurred at high-teens multiples of adjusted EBITDA.
It appears the market may have grown skeptical of the purely financial consolidator strategy.Meanwhile, stock of Focus Financial, a publicly traded wealth management aggregator, has declined significantly. On September 30th, Focus stock closed at $23.80, about half its price a year prior and about 35% below the price at its July 2017 IPO.So why has Focus stock languished while Mercer Advisors and United Capital have both sold significant interests at attractive valuations? One explanation is different business models. The latter two firms are more “true” consolidators, where acquired firms are rebranded and integrated, then presented to the market as a coherent whole. Focus, on the other hand, is a pure financial consolidator. Acquired firms continue to operate as they did before the acquisition, and the only real difference (other than some back-office integration) is how the economics of the firm are distributed. There are pros and cons to each model, but given the poor performance of Focus Financial’s stock since IPO, it appears the market may have grown skeptical of the purely financial consolidator strategy.Implications for Your RIAWith EBITDA multiples for publicly traded asset and wealth managers still well below historical norms, it appears the public markets are pricing in many of the headwinds the industry faces. It is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs. Depending on the growth and risk prospects of a particular closely-held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs. Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The outlook for RIAs appears to have improved since the significant market drop in December 2018.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations and create synergies.On balance, the outlook for RIAs appears to have improved since the significant market drop in December 2018. Since then, industry multiples have rebounded somewhat, and the broader market has recovered its losses and then some—which should have a positive impact on future RIA revenues and earnings.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal-making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.
Questioning Your Family Business Balance Sheet
If the income statement is a movie that records how your family business performed during a particular period, the balance sheet is a snapshot that records what your family business looked like at a particular date.The balance sheet answers two core questions:What are the assets our family business owns? and,How has our family business paid for those assets?
We’ll flesh out the first question in this week’s post, and turn our attention to the second question in a subsequent post.What is an asset?While we are generally dismissive of accountants on this blog, the bean-counters actually do an admirable job of defining what an asset is. According to accountants,Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.The defining characteristic of an asset is that it represents a future economic benefit. So, as you study your family business’s balance sheet, your focus should not be on how much the various assets cost, but instead on what future economic benefits those assets will generate. As a family business director, you need to focus not just on what assets your business owns, but more importantly, why your family business owns those assets.Family businesses report many different assets, but it is generally helpful to classify them under four broad headings.Cash & equivalents. Cash is obviously an asset, but a rather peculiar one, as the probable future economic benefits generated by cash are quite limited. While too little cash will lead to insolvency and failure, too much cash dilutes the returns generated for shareholders.Working capital. Working capital consists of accounts receivable, inventory, and prepaid expenses, net of accounts payable and accrued expenses. Working capital is the “grease” that makes a family business run smoothly. While an appropriate amount of working capital is essential, family businesses should be aware of the diminishing marginal utility of working capital. As the amount of working capital exceeds the level necessary to operate the business, the incremental future economic benefits associated with working capital get smaller and smaller.Net fixed assets. Net fixed assets include real estate, production equipment, rolling stock, and other long-term productive assets of a business. One of the most important tasks of a family business director is ensuring that the business has deployed the right assets in the right places to execute the company’s strategy and capitalize on the available market opportunity.Net other assets. Family businesses own sundry other long-term assets (minority investments in other businesses, goodwill & intangible assets from previous business combinations, and deferred tax items are common examples).
Table 3.2 of The 2019 Benchmarking Guide for Family Business Directors summarizes balance sheet composition for the companies in our data set by industry. Exhibit 1 below summarizes the data for the small cap (S&P 600) companies in our benchmarking universe.Examining the data for the public companies, we think there are four questions that family business directors should think about with regard to their company’s asset base.1. What is your family business’s cash strategy?We see cash fulfilling a number of different roles for our family business clients:Liquidity to meet current obligations as they come due. This is the most fundamental (and necessary) use of cash in a family business. Do you have a target level of cash to meet the operating needs of the business?Sinking fund for future capital expenditures or debt repayment. Accumulating cash balances to pay for anticipated investments or loan repayments can eliminate transaction costs for financing events, reduce interest expense, and reduce the risk that credit will not be available when needed. These are worthwhile objectives for many family businesses, but there is a cost to these benefits in the form of depressed returns on family capital.Hedge against uncertainty. Some family businesses maintain additional cash balances to provide a margin of safety against the uncertainty inherent in their business model. We can see some evidence for this in Exhibit 1, as utilities, which generally face the least near-term uncertainty regarding operations, also carry the smallest cash balances.Insurance against failure of corporate strategy. Eventually, prudent risk management morphs into unhealthy risk aversion as some family businesses hold such large cash balances that they are no longer hedging uncertainty, but attempting to insure against failure. In addition to dragging down returns of family capital, this use of cash can promote management complacence (we never have to worry about making payroll, etc.) or encourage inefficient capital investment (all that money does eventually burn a hole in someone’s pocket). Directors should carefully evaluate just whose risks are being managed in this case: the family shareholders, or management?The asset of last resort. Finally, for some family businesses, cash can become the asset of last resort. This most often reflects some degree of family dysfunction, often expressed in the belief of family leaders that family shareholders can’t be trusted with dividends, so the money is safer in the company. And if the company doesn’t have a productive use for the capital, it just sits there, weighing down returns on family capital.2. What opportunities do you have to optimize your cash conversion cycle?The most comprehensive measure of working capital management is the cash conversion cycle, which measures the time elapsed from when cash is paid for inventory to when cash is received from customers. Different industries and business models have different cash conversion cycle expectations. As noted in Exhibit 15, some sectors (industrials and materials) require significant inventory balances, while others that rely on subscription-based models (communication services) actually have negative cash conversion cycles. Exhibit 2 illustrates the cash conversion cycle and identifies some key questions for family business directors with regard to each major component. Less working capital is not always best; there may be potential strategic advantages to maintaining deep inventories or providing generous customer financing terms, but if such is the case, the rationale and corresponding benefits (superior pricing, etc.) need to be clearly noted.3. How effective is your capital budgeting process?The balance of net fixed assets is the cumulative result of all the capital budgeting decisions your family business makes. How effective is that process? Do managers have a clearly-articulated strategy that guides what sorts of capital investments are needed? Has the board established hurdle rates for capital investment to define financial feasibility for proposed projects? Does the company have a strategy for minimizing the impact of cognitive biases that lead to over-optimistic projections? Is there a feedback mechanism in place to ensure that actual results are compared to projections for proposed capital projects? As evident from Exhibit 1, net fixed assets account for a large portion of the total capital invested in businesses; as a family business director, you should be diligent to ensure that the capital budgeting process works to advance the company’s strategy.4. Do you know what makes your family business valuable?This is not the same thing as knowing what your family business is worth (although that is important, too). Instead, the focus is on understanding what the core attributes of your family business make it valuable. In one sense, your family business can be viewed as a portfolio of assets. If those assets work together in executing an effective strategy that takes advantage of – and builds – the company’s sustainable competitive advantages, the value of the whole can be far greater than the sum of the individual assets. Exhibit 3 summarizes data from the S&P 600 companies in our data set comparing the market value of each public company to the total invested capital (or sum of the asset values). The overall median for the group is approximately 1.6x, meaning that for every $1.00 of capital invested in the business (whether debt or equity), the assets work together to generate $1.60 of market value.
The dispersion of individual observations is quite wide, however. Some of the companies actually experience a negative relationship between market value and invested capital (i.e., they turn $1.00 of investor money into assets valued by the market at less than $1.00). The competitive advantages that drive higher market values become progressively more difficult to sustain. The bottom line is that each of the companies with ratios well above 1.0x has a story and a strategy that support their market valuation. What is your family business’s story and strategy? What makes it valuable? Without a clear answer to these questions, your family business is likely to get “stuck” and eventually experience slowing sales growth and shrinking returns, both of which have unpleasant side effects on the family.
As a family business director, your role is akin to that of a portfolio manager. As a good portfolio manager, you should care not just what assets your family business owns, but why it owns them. In other words, what makes your family business valuable, and how does the current portfolio of assets contribute to enhancing and sustaining that value?
M&A in the Bakken
Deals May Be Slow, But Production Remains Steady
Acquisition and divestiture activity in the Bakken for last twelve months has been minimal. The lack of deals, however, does not mean that activity or production hasn’t been meaningful. In fact, as mentioned in our most recent post, production has grown approximately 10% year-over-year through September with new well production per rig increasing over 29%. Also, while other major basins have been decreasing rig counts, the Bakken has remained steady year-over-year as of the end of September.While the fundamentals of this basin are strong, relatively few companies remain interested. As such, deal activity has largely involved the familiar faces in the region. Companies with smaller positions in the region have continued to divest “non-core” positions as they focus their efforts in other regions. Contrast this trend to the controlling acquisitions or takeovers like those that have been popular in the Permian.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Balance Sheet Cleanup: Whiting and AbraxasA recurring theme observed throughout the year in multiple basins has been the optimization of assets. The theme continues in the Bakken for 2019 as transactions in the basin have primarily consisted of offloading portions of non-operated assets, the largest of which was the deal with Whiting Petroleum and an undisclosed buyer for $53 million. However, Whiting remains the third largest holder of net acreage in the basin.Abraxas Petroleum also sold approximately $16 million in non-operated assets in June. These assets were not part of Abraxas’ core Williston position. However, Abraxas appears to be open to conversations with parties interested in acquiring both operated and non-operated assets, as the company is seemingly in deal talks with Whiting Petroleum.Given the age of the basin and smaller number of players, consolidation and strategic deals between operators have been prevalent. Several players have left the Bakken for the Permian, and as a result, the top five net acreage holders account for roughly half of the existing operating acreage in the basin. Abraxas undertook a sizable debt load in 2018 to finance further capital expenditures and restructure debt maturities ($180 million due in 2020-20211). An exit from the Bakken to pay down its debt and expand their Permian operations does not seem unreasonable.Continued Non-Operator Acquisitions: Northern Oil and GasSimilar to trends observed in the Bakken last year, acquisitions by non-operators have continued into 2019. For instance, Northern Oil and Gas has made several deals in the basin and its acquisition of private equity-backed Flywheel Energy LLC in April 2019 was one of the largest of the year, and represents a continuance of this trend.Northern Oil and Gas has been the basin’s most consistent acquirer of non-operating interests. As a nonoperator, Northern can enjoy cash flows received from acreage without the operator risk that has become ever more prevalent in the current environment, and consequently, the company has the luxury of continuing to strategically consolidate acreage in the basin. Since the start of 2018, the company has made four large publicly announced transactions totaling more than $820 million.Below is a map of the acreage Northern Oil and Gas acquired in the Flywheel transaction as well existing acreage to show its overall footprint in the basin.ConclusionEven though transaction activity in the Bakken has been minimal compared to basins like the Permian, production is up, and rig counts are steady. Acquisitions for operators and non-operators alike have been strategic and pinpointed as the experienced players look to build and maintain their large positions relative to others in the area. Despite a slowdown of A&D activity in the back half of 2019, the operators and non-operators in the Bakken appear undeterred and are staying the course.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.1 Abraxas Petroleum Corporation Annual Report December 31, 2018
Alternative Asset Managers
Performance Update
In May of this year, assets in passively managed funds equaled assets actively managed for the first time in history. As investors seek low-cost solutions, alternative managers are working to solidify their place in investors’ portfolios. Despite the headwinds the asset management industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle. In this post, we take a closer look at how alternative asset managers are performing in light of the broader shift from active to passive management and increased fee pressure.Industry OutlookWhile hedge funds are not a perfect proxy for the broader alternatives industry, we can better understand the pressure the industry faces by analyzing hedge fund asset flows. Hedge funds recorded their fifth consecutive quarterly withdrawal in Q2 2019 and the largest semiannual outflow ($47.4 billion) since the second half of 2016. Despite this, hedge fund assets under management grew 4.4% since the end of 2018 as positive performance offset fund flows. While hedge funds have underperformed over the last decade (since 2009 the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags performance, so we expect to see asset outflows slow in the coming months as investors reallocate their portfolios in light of recent performance.Alternative assets typically serve to either increase diversification or enhance portfolio returns. In a near-zero interest rate environment, institutional investors have sought return generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative assets in order to chase higher risk, higher return assets. It is typically more difficult for the average investor to gain exposure to alternative assets due to the often significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers. Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios.In terms of diversification, investors have started positioning themselves for longer-term volatility due to increased geopolitical tensions and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history, recent volatility could push investors back to the asset class.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance, especially in the alternatives space, and one way to directly impact investor returns is to reduce fees. After a decade of lackluster performance, reducing costs has become a key issue for alternative managers seeking to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization in key strategies for scale. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.Industry ValuationsIn the eyes of market participants, the industry has performed well over the last year. Generally, alternative asset managers have been more resilient to price declines than traditional asset and wealth managers. Our alternative asset manager index is up 4.4% year-over-year, compared to our index of traditional asset and wealth manages which was down for the year.
Price to LTM earnings multiples have recently increased for alternative asset managers as prices over the last year increased by a median of 16%. Current pricing is close to the 52 week high and forward multiples are noticeably lower than LTM multiples, suggesting that publicly traded alternative asset managers are currently trading at peak valuations and earnings are expected to increase over the next twelve months.
Summary Despite improving performance over the last few years, the industry continues to face a number of headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with a goal of imitating private equity returns. Innovative products are being made available to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today despite the recent uptick in alt manager valuations.
Five Trends to Watch in the Medical Device Industry
The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population. The elderly account for nearly one third of total healthcare consumption. Personal healthcare spending for the population segment was $19,000 per person in 2014, five times the spending per child ($3,700) and almost triple the spending per working-age person ($7,200). According to United Nations projections, the global elderly population will rise from approximately 607 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from less than 8% in 2015 to more than 21% of the total population by 2060. 2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.5 trillion in 2017 to $6.0 trillion in 2027, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.0% observed from 1990 through 2007, it is more rapid than the observed rate of 4.3% between 2008 and 2017. Projected growth in annual spending for Medicare (7.9%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. Healthcare spending as a percentage of GDP is expected to expand from 17.9% in 2017 to 19.4% by 2027.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2017. Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services. Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $591 billion in 2017, and are expected to reach $1.3 trillion by 2028. The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. On a per person basis, Medicare spending is projected to grow at 4.6% annually between 2017 and 2027, compared to 1.5% average annualized growth realized between 2010 and 2017, and 7.3% during the 2000s. As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers. In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016. In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance. The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 34% of payments were tied to APMs, a 5% increase from 2016 to 2017. Some expressed concern that the shift toward value-based care would encounter difficulties with the current administration. In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures. However, indications are that the CMS supports value-based care and wants pilot programs to accelerate. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment. The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion. In November 2018, the FDA announced plans to change elements of the 510(k) clearance process. Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 1o years. The FDA also announced in its statements plans to finalize guidance establishing an alternative 510(k) pathway in early 2019. This alternative pathway would allow manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete. Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades. Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years. SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.
Community Bank Valuation (Part 3): Important Relationships Between a Bank and Its Holding Company
The August 2019 BankWatch described key considerations in analyzing the financial statements of banks. However, we did not address one crucial set of relationships – those between a bank holding company (“BHC”) and its subsidiary depository institution.Most banks are owned by bank holding companies. While investors often state that they own an interest in a bank, this may not be legally precise. Usually, they own a share of stock in a bank holding company, which in turn owns a controlling interest in a subsidiary bank’s common stock. Where a bank holding company exists, this entity’s common stock generally is the subject of valuation analyses.Part 3 of the Community Bank Valuation series explores important relationships between banks and their holding companies, focusing particularly on cash flow and leverage.The Holding Company’s Balance SheetCompared to a bank’s balance sheet, a holding company’s balance sheet has fewer moving parts. The “left side” of its balance sheet, or its assets, usually is rather boring. The more intriguing analytical question, though, is how the bank holding company finances its investment in the bank. The following table presents a balance sheet for a BHC controlling 100% of the common stock of a bank with $500 million of total assets.
Usually, the holding company’s assets consist virtually entirely of its investment in its subsidiary bank or banks, which equals the bank’s total equity. The investment in the bank is carried at equity, meaning that it increases by the bank’s net income and decreases by dividends paid from the bank to the holding company, among other transactions. Other material assets may include:
Cash. BHCs with cash obligations paid at the holding company, such as interest payments or compensation, often will maintain a cash buffer to cover several months of operating expenses. In some cases, BHCs will maintain a larger cash position to react opportunistically if the bank subsidiary needs a capital injection for its growth or to repurchase BHC shares.Other Assets. Non-bank assets typically are relatively modest and consist of investments in other entities (such as an insurance agency), intangible assets related to acquisitions that were not “pushed down” to the subsidiary, or facilities. In periods marked by higher levels of nonperforming assets, BHCs may hold problem assets, which is one strategy to reduce the bank’s classified asset/ capital ratio.
Interestingly, BHCs can borrow from banks – just not their bank subsidiary – and other capital providers. If the funds are downstreamed into the bank, the borrowings can be transformed from an instrument not includible in the BHC’s regulatory capital into Tier 1 capital at the bank. In order of seniority these funding sources include:Bank Stock Loans. These loans are collateralized by the subsidiary bank’s stock and typically are obtained from another bank. As a secured borrowing, these loans generally have a lower cost than other alternatives. However, in the event of a default, the lender can foreclose on their collateral (i.e., the bank stock).Subordinated Debt. After passage of the Dodd-Frank Act and the Basel III capital regulations, subordinated debt became a more prominent funding source, usually for organic growth or acquisitions. Various regulatory requirements govern subordinated debt offerings, but most community bank placements provide for a ten year term with the interest rate fixed for five years. The securities may be considered Tier 2 capital for the holding company.Trust Preferred Securities (“TruPS”). TruPS were created in the 1990s to combine the Tier 1 capital treatment of preferred stock with the tax deductibility of debt. Rightly or wrongly, this instrument was viewed negatively by some regulators after the financial crisis, and the Basel III regulations effectively nullified new issuances. Many BHCs still hold grandfathered TruPS, though, which often do not mature until the 2030s. TruPS generally have interest rates that float with LIBOR, are subordinated to all other BHC obligations, and provide the issuer the right to defer payments for up to five years without triggering a default. TruPS count as Tier 1 capital for BHCs with under $15 billion in assets that are considered to be “large” BHCs that fie Y-9LP and Y-9C call reports with the Federal Reserve.
A BHC’s equity usually consists almost entirely of common stock, which generally must be the principal form of capitalization under BHC regulations. However, BHCs can issue preferred stock, and regulations view most favorably non-cumulative, perpetual preferred stock.Analytical ConsiderationsWhy do holding companies exist? First, they provide an efficient way to raise funds that can be injected as capital into the bank, thereby accommodating its organic growth. Second, they can facilitate acquisitions. Third, BHCs can more efficiently conduct shareholder transactions, such as repurchases.By using leverage, a BHC can enhance the bank’s stand-alone return on equity (or exacerbate the ROE pressure arising from adverse financial scenarios). As indicated in Table 2, BHC leverage magnifies the subsidiary bank’s 12.0% ROE to 12.9% after considering the cost of the BHC’s debt.
As for a non-financial company, too much leverage can mean that the beneficial effect to shareholders of a higher ROE is swamped by the additional risk of financial distress. Various metrics exist to measure the holding company’s leverage, but one is the “double leverage” ratio, which is calculated as the investment in the bank subsidiary divided by the BHC’s equity. As indicated in Table 1 on page one, the BHC’s ratio is 113%, which is consistent with the median reported by all smaller BHCs at June 30, 2019 (112%, excluding some BHCs for which the BHC’s equity exceeds the bank investment).
Cash FlowUnfortunately, BHC regulatory filings and audited financial statements do not provide a sources and uses of funds schedule, although some cash flow data is provided. Nevertheless, understanding the BHC’s obligations, and the cash required to service those obligations, is essential.Sources of funds consist principally of the following:Dividends from the bank subsidiary. The depth of this source of cash flow should be evaluated in light of the bank’s profitability, capital levels, and growth opportunities.Debt issuancesCommon stock salesIntercompany payments. For example, the bank may reimburse the holding company for certain expenses paid by the BHC. Additionally, banks and BHCs often have tax-sharing arrangements. If the holding company incurs expenses, then it may realize an offsetting tax benefit.
Uses of funds include the following:Debt serviceShareholder dividendsShare repurchasesOperating expenses. Expenses such as compensation, directors’ fees, and certain insurance premiums may be recorded by the holding company
Analysts should compare a bank’s ability to pay dividends, given its profitability level and need to retain earnings to fund its growth, against the BHC’s various claims on cash. Mismatches can sometimes arise due to changes in the bank’s performance or operating strategy. For example, consider a BHC that historically has paid high dividends to shareholders. If its subsidiary bank adopts a new strategic plan focused on organic growth, then the bank will need to retain earnings rather than pay dividends to the BHC and, ultimately, BHC shareholders. Additional borrowings could fund a short-term gap, but this is not a long-term solution to a BHC cash flow mismatch.
Two other special circumstances arise when analyzing BHC cash flow:Acquisitions. Prior to entering into a transaction, the BHC’s plan for funding any cash consideration should evaluate the availability and desirability of dividends from the bank, debt offerings, and stock sales. Further, the cash acquired from the target BHC may provide another source of transaction funding.S Corporations. Shareholders in an S corporation rely on the BHC for distributions to offset their pass-through tax liability, while the BHC in turn relies on the bank for dividends to fund those tax payments. There are no special capital rules at the bank level that provide flexibility regarding the payment of dividends to offset BHC shareholders’ tax liability when other restrictions on dividends may exist. That is, C corporation and S corporation banks face the same capital regulations. Boards of S corporations may desire to operate, at the margin, with a greater capital buffer to avoid a situation where the shareholders have taxable income but the BHC is unable to make distributions.CapitalCapital requirements for BHCs vary based upon their asset size. Under current regulations, BHCs with assets below $3.0 billion are subject to the Federal Reserve’s Small Bank Holding Company Policy Statement. This regulation does not establish any specific minimum capital ratios for small BHCs; however, a debt/ equity ratio limitation exists for debt arising from acquisitions. Therefore, small BHCs have significant flexibility in managing their capital structure, although the Federal Reserve theoretically remains a check on their creativity.Large BHCs are subject to the Basel III regulations, which involve capital ratios calculated based on Tier 1 and total capital. Tier 1 capital generally is limited to common equity, non-cumulative perpetual preferred stock, and grandfathered TruPS. In addition to the allowance for loan losses, Tier 2 capital may include subordinated debt. Large BHC management can balance these capital sources to minimize the BHC’s weighted average cost of capital, maintain flexibility for unexpected events or opportunities, and ensure compliance with regulatory expectations.ConclusionWhile the subsidiary bank receives most of the analytical attention, the holding company on a standalone (or parent company) basis should not be overlooked. This is particularly true if the holding company has significant obligations to service debt or pay other expenses. By understanding the linkages between the bank and holding company, analysts can better assess a BHC’s potential future returns to shareholders and risk factors posed by the BHC that could jeopardize those returns.Originally published in Bank Watch, September 2019.
Context is Important When Considering Transaction Data Relevance
A Look at WeWork’s Failed IPOIn last quarter’s issue of Portfolio Valuation we raised the issue as to whether public market investors are more critical (or discerning) in establishing value than private equity investors.The evidence this year largely is, yes—at least for companies where there is skepticism as to whether meaningful profitability can be achieved. Lyft, SmileDirectClub and Uber are examples of unicorns that saw share prices marked sharply lower after the IPO (Lyft, SDC) or during the roadshow (Uber); and The We Company’s planned IPO never occurred due to pushback by investors. At the other extreme is Beyond Meat, which as of early October had risen about six-fold from its May IPO.The We Company’s (formerly “WeWork” and will be refered to in this article as WeWork) valuation journey is interesting (maybe even fascinating).WeWork, which was founded in 2010, is a real estate company that signs long-term leases for pricey real estate that it refurbishes then releases the space short-term. The company describes itself somewhat differently as a “community company committed to maximum global impact.” The S-1 disclosed not only massive losses, but also significant corporate governance issues.Year-to-date revenues through June 30, 2019 doubled to $1.5 billion from the comparable period in 2018, but the operating loss also doubled to $1.4 billion.EBITDA for the six months was negative $511 million, while capex totaled $1.3 billion. That is a big hole to fill every six months before factoring in rapid growth to be financed.Cash as of June 30 totaled $2.5 billion, while the capital structure entails a lot of debt and negative equity. From a valuation perspective, WeWork is problematic because operating cash flows are deep in the red with little prospect of turning positive anytime soon. Nonetheless, the increase in value private equity investors placed on the company was astounding. The company pierced the unicorn threshold in early 2014 when affiliates of JPMorgan invested $150 million in the fourth funding at a post-raise $1.5 billion valuation. T. Rowe Price and Goldman Sachs invested $434 million in late 2014, which resulted in a post raise valuation of $10 billion. The 7th and 8th funding rounds are where the valuation really gets interesting.In August 2017 SoftBank Vision Fund invested $3.1 billion, which implied a valuation of $21 billion.SoftBank Group Corp., which sponsors the Vision Fund, invested $4.0 billion in January 2019 at an implied valuation of $47 billion. When the underwriters were forced to pull the plug on the IPO the targeted post-raise valuation reportedly was $10 billion to $15 billion—a value the company apparently was willing to accept because it needs the cash.We do not know exactly how private equity investors valued the company.Presumably discounted cash flow (DCF), guideline public company and guideline transaction methods were used, perhaps overlaid with a Monte Carlo simulation.The valuation history raises an important question: how was a stupendous valuation achieved in the private markets by a cash incinerator such as WeWork? A similar question could be asked about many high-profile PE-backed investments.The short answer is that Softbank thinks the valuation increased significantly even though the company’s fundamentals argue otherwise. Prospective investors such as the public ones who were offered WeWork shares in an IPO could prepare their own DCF forecast to value the company.They also could examine past transactions in the company for relevant valuation information. Likewise, they could examine capital transactions in similar companies.Both sets of data fall under the guideline transaction method. A transaction in a privately held company infers a meaningful data point about value to investors, but there are a couple of caveats.One is an assumption that both parties are fully-informed and neither is forced to transact.Great values were realized by those willing to buy during the 2008 meltdown because there were so many forced sellers that ran the gamut from levered credit investors forced to dump bonds to the likes of Wachovia Corporation and National City Corporation. The price data was legitimate, but many sellers faced margin calls and had to dump assets into an illiquid market.Is the valuation data relevant if “normal” market conditions prevail?The second issue relates to private equity valuation generally, but especially those where start-up losses and ongoing capital requirements can be huge.The valuation issue relates to using transaction data from investments in other money losing enterprises.Is it always valid to apply multiples paid by investors in a funding round of a money-losing business to value another money-losing business? The valuation data may be factual, but it may be nonsense when weighed against the business’ operating and financial performance.One can question Softbank’s motives.Did Softbank need a higher valuation to offset losses in other parts of the portfolio in order to maintain investor and lender confidence? Was a higher valuation necessary to support upcoming capital raises? We do not know, but prospective public investors were dismissive of Softbank’s valuations and they appear to be dismissive of the prior two raises given how low the price talk had fallen by the time the IPO was pulled. We at Mercer Capital respect markets and the pricing information that is conveyed.The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.Mercer Capital can assist with the valuation of your portfolio companies.We value hundreds of debt and equity securities of privately held companies every year and have been doing so for nearly four decades.Please call if we can assist in the valuation of your portfolio companies.Originally published in Mercer Capital’s Portfolio Valuation Newsletter:Third Quarter 2019
Does the Public Market Believe in Unicorns?
The IPO market is hot thanks to the intersection of investor enthusiasm and a new crop of venture capital-backed, and in some instances traditional private equity-backed, firms that have gone public. Unicorns (pre-IPO valuation of $1 billion or more) in particular have caught investors’ attention. There is nothing new about a hot IPO cycle in the U.S. IPO activity waxes and wanes with markets. The last massive wave occurred in 1999 when a mania swept through markets as then internet and other technology-focused companies captured investors’ imaginations.1999 vs. 2019Why has 2019 become the year of the unicorn IPO? It could be a matter of timing and monetary policy. After a nearly ten-year bull market, private equity is monetizing while the IPO window remains open after it more or less closed in the fourth quarter of 2018. Also, easy money policies the past decade arguably have incented investors to shower capital on growth-focused tech companies. With the Fed likely to begin cutting rates again in 2019, capital flows may intensify again.Nonetheless, the current IPO wave is different from 1999 and other peaks on three related counts. One is the length of time most venture-backed companies have remained private before going public. The other is the staggering amount of losses incurred even on an “adjusted” basis before going public. The link between the two differences has been the willingness of deep-pocketed investors, such as SoftBank, to fund losses through multiple capital raises. The link gives rise to the third difference: staggeringly large private market valuations for some.Looking at how several of the big name public offerings have fared this year, we can’t help but wonder:Do current losses matter to public market investors?Did the private market overvalue these unicorns?What does all of this mean for other unicorns planning to go public in 2019?The short answers are: perhaps, probably, and hurry.Sentiment Toward Recent UnicornsPublic investors seemingly have been more discerning about losses than private investors who pushed valuations higher for many companies with successive funding rounds. Price performance in the post-IPO market has been uneven as would be expected, but it points to less tolerance among public market investors to the extent big money losers such as Lyft and Uber have much lower valuations today than expected when their IPO roadshows were launched. Blue Apron is a poster child for a disaster post-IPO stock, but it is not alone.Lyft and Uber point to the more critical view public investors have taken of each company’s business model as it relates to future earnings. Lyft priced near the high end of the range targeted initially by lead underwriter JPMorgan and then saw strong first day performance; however, it now trades about 15% below the IPO price.Uber has traded down modestly from the IPO price, but lead underwriter Morgan Stanley had to sharply reduce the IPO price from when the roadshow started with price talk of a $90 billion to $100 billion post-raise valuation compared to about $73 billion presently.Uber and Lyft posted the highest revenue growth over the prior three years, but also the largest losses. The losses didn’t prohibit the companies from going public, but the uncertainty of a future path to profitability has led to disappointing performance relative to the hype that has surrounded the companies. Perhaps investors see a better outlook for Slack Technologies, which went public via a direct listing on the NYSE in mid-June. Although the company is not yet profitable, the shares rose nearly 50% on the first day of trading as either investors see a path to profitability or too few shares were floated. On the other hand, both Tradeweb and Zoom among a number of newly minted tech companies have performed well since their respective IPOs. Both were profitable in the year prior to the IPO, which is more in line with the kind of pre-offering financials that public investors are used to seeing. The market has rewarded the two companies accordingly. The next big name to test investors’ willingness to fund sizable losses is The We Company. The company confidentially filed for an IPO at the end of 2018 and is expected to begin a roadshow soon. The We Company may be the ultimate unicorn to test the market. It is minting losses. Only through the company’s defined term “community adjusted” EBITDA, which is akin to a twice-adjusted EBITDA, does the company post positive EBITDA. Also, the company has a huge $45 billion valuation based upon its last fundraising round; yet, its business model may be suspect in that it entails acquiring expensive real estate that generally is leased under short-term arrangements. Presumably, in a recession, lease rates would plummet as vacancies soar.Some have raised legitimate questions about valuation processes employed by private equity and VC firms and whether private market valuations are too high. Others have noted investors can, in effect, mark-up the value of prior investments by investing in follow-on capital raises for a given company at a higher valuation. ConclusionWe do not mean to disparage anyone with the issues raised in this article. We respect markets and the pricing information that is conveyed. The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.At Mercer Capital we have been valuing private equity and private credit securities for nearly four decades and have deep experience in most industries. If we can help you establish the value of securities held in your fund or offer a second opinion, please call. We would be glad to assist. Stock Performance Since IPO (Pricing as of 6/20/19)Three Year Financial PerformancePrivate vs. Public Valuation (Pricing as of 6/20/19)Originally published in Mercer Capital’s Portfolio Valuation Newsletter: Second Quarter 2019
Valuation Assumptions Influence Valuation Conclusions: How to Understand the Reasonableness of Individual Assumptions and Conclusions
In contested divorces where one or both spouses own a business or a business interest with significant value, it is common for one or both parties to retain a business appraiser to value the marital business interest(s). It is not unusual for the valuation conclusions of the two appraisers to differ significantly, with one significantly lower/higher than the other.What is a client, attorney, or judge to think when significantly different valuation conclusions are present? The answer to the reasonableness of one or both conclusions lies in the reasonableness of the appraisers’ assumptions. However, valuation is more than “proving” that each and every assumption is reasonable. Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.A short example will illustrate this point and then we can address the issue of individual assumptions. In the following example, we see three potential discount rates and resulting price/earnings (“P/E”) multiples. Let’s assume that for the subject company in this example, there is significant market evidence suggesting that similar companies trade at a P/E in the neighborhood of 10x earnings.In the figure below, we look at the assumptions used by appraisers to “build” discount rates. We show differing assumptions regarding four of the components, and none of the differing assumptions seems to be too far from the others. So, we vary what are called the equity risk premium (“ERP”), the beta statistic, which is a measure of riskiness, the small stock premium (“SSP”), and company-specific risk.The left column (showing the low discount rate of 9.6% and a high P/E multiple of 15.2x) would yield the highest valuation conclusion. The right column (showing the high discount rateof 16.6% and the low P/E of 7.4x) would yield a substantially lower conclusion. That range is substantial and results in widely differing conclusions.However, as stated earlier, market evidence suggests that companies like our example are worth in the range of a 10x earnings. In our example, the assumptions leading to a P/E in the range of 10x are found in the middle column.In either case, appraisers might have made a seemingly convincing argument that each of their assumptions were reasonable and, therefore, that their conclusions were reasonable. However, the proof is in the pudding. Neither the low nor the high examples yield reasonable conclusions when viewed in light of available market evidence.So, as we discuss how to understand the reasonableness of individual valuation assumptions in divorce-related business appraisals, know also that the valuation conclusions must themselves be proven to be reasonable. That’s why we place a “test of reasonableness” in every Mercer Capital valuation report that reaches a valuation conclusion.Now, we turn to individual assumptions.Growth RatesGrowth rates can impact a valuation in several ways. First, growth rates can explain historical or future changes in revenues, earnings, profitability, etc. A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate.Growth rates, as a measure of historical or future change in performance, should be explained by the events that have occurred or are expected to occur. In other words, an appraiser should be able to explain the specific events that led to a certain growth rate, both in historical financial statements and also in forecasts. Companies experiencing large growth rates from one year to the next should be able to explain the trends that led to the large changes, whether it is new customers, new products being offered, loss of a competitor, an early-stage company ramping up, or other pertinent factors. Large growth rates for an extended period of time should always be questioned by the appraiser as to their sustainability at those heightened levels.A long-term growth rate is an assumption utilized by all appraisers in a capitalization rate. The long-term growth rate should estimate the annual, sustainable growth that the company expects to achieve. Typically, this assumption is based on a long-term inflation factor plus/minus a few percentage points. Be mindful of any very small, negative, or large long-term growth rate assumptions. If confronted with one, what are the specific reasons for those extreme assumptions?AnnualizationIn the course of a business valuation, appraisers normally examine the financial performance of a company for a historical period of around five years, if available. Since business valuations are point-in-time estimates, the date of valuation may not always coincide with a company’s annual reporting period.Most companies have financial software with the capability to produce a trailing twelve month (“TTM”) financial statement. A TTM financial statement allows an appraiser to examine a fullyear business cycle and is not as influenced by seasonality or cyclicality of operations and performance during partial fiscal years. The balance sheet may still reflect some seasonality or cyclicality. Note if the appraiser annualizes a short portion of a fiscal year to estimate an annual result. This practice could result in inflating or deflating expected results if there is significant seasonality or cyclicality present. At the very least, the annualized results should be compared with historical and expected future results in terms of implied margins and growth.ForecastsDepending on the industry or where the company is in its business life cycle, a forecast may be used in the valuation and the discounted cash flow method (“DCF”) may be used.Most forecasts are provided to appraisers by company management. While appraisers do not audit financial information provided by companies, including forecasts, the results should not be blindly accepted without verification against the company’s and its industry’s performance.During the due diligence process, appraisers should ask management if they prepare multiple versions of forecasts. They should also ask for prior years’ forecasts in order to assess how successful management has been in estimations as compared to actual financial results. Be mindful of appraisers that compile the forecasts themselves and make sure there is some discussion of the underlying assumptions.Divorce Recession“Divorce recession” is a term to describe a phenomenon that sometimes occurs when a business owner portrays doom and gloom in their industry and for current and future financial performance of the company. As with other assumptions, an appraiser should not blindly accept this outlook.An appraiser should compare the performance of the company against its historical trends, future outlook, and the condition of the industry and economy, among other factors. Be cautious of an appraisal where the current year or ongoing expectations are substantially lower, or higher for that matter, than historical performance without a tangible explanation as to why.Industry ConditionsMost formal business valuations should include a narrative describing the current and expected future conditions of the subject company’s industry. An important discussion is how those factors specifically affect the company. There could be reasons why the company’s market is experiencing things differently than the national industry. Industry conditions can provide qualitative reasons why and how the quantitative numbers for the company are changing. Look carefully at business valuations that do not discuss industry conditions or those where the industry conditions are contrary to the company’s trends.Valuation Techniques Specific to the Subject Company’s IndustryCertain industries have specific valuation methodologies and techniques that are used in addition to general valuation methodologies. Several of these industries include auto dealers, banks, healthcare and medical practices, hotels, and holding companies. It may be difficult for a layperson reviewing a business valuation to know whether the methods employed are general or industry-specific techniques. An attorney or business owner should ask the appraiser how much experience they have performing valuations in a particular industry. Also inquire if there are industry-specific valuation techniques used and how those affect the valuation conclusion.Risk FactorsRisk factors are all of the qualitative and quantitative factors that affect the expected future performance of a company. Simply put, a business valuation combines the expected financial performance of the subject company (earnings and growth) and its risk factors. Risk factors show up as part of the discount rate utilized in the business valuation.Like growth rates, there is no textbook that lists the appropriate risk factors for a particular industry or company. However, there is a reasonable range for this assumption.Be careful of appraisals that have an extreme figure for risk factors. Make sure there is a clear explanation for the heightened risk.MultiplesAnother typical component of a business valuation is the comparison and use of market multiples while utilizing the market approach. Multiples can explain value through revenues, profits, or a variety of performance measures. One critique of market multiples is the applicability of the comparable companies used to determine the multiples. Are those companies truly comparable to the subject company?Also, how reliable is the underlying comparable company data? Is it dated? How much information on the comparable companies or transactions can be extracted from the source? This critique can be fairly subjective to the layperson.Another critique could be the range of multiples examined and how they are applied to the subject company. As we have discussed, take note of an appraisal that applies the extreme bottom or top end of the range of multiples, or perhaps even a multiple not in the range. Be prepared to discuss the multiple selected and how the subject company compares to the comparable companies selected.Time Periods ConsideredEarlier we stated that a typical appraisal provides the prior five years of the company’s financial performance, if available. Be cautious of appraisals that use a small sample size, e.g. the latest year’s results, as an estimate of the subject company’s ongoing earnings potential without explanation. The number of years examined should be discussed and an explanation as to why certain years were considered or not considered should be offered.Some industries have multi-year cycles (further evidence of the importance of a discussion of industry conditions and consideration of recognized industry-specific techniques in the appraisal).The examination of one year or a few years (instead of five years) can result in a much higher or lower valuation conclusion. If this is the case, it should be explained.ConclusionBusiness valuation is a technical analysis of methodologies used to arrive at a conclusion of value for a subject company. It can be difficult for a client, attorney, or judge to understand the impact of certain individual assumptions and whether or not those assumptions are reasonable. In addition to a review of individual assumptions, the valuation conclusion should be reasonable.If the divorce case warrants, hire an appraiser to perform a business valuation. If the case or budget does not allow for a formal valuation, it may be helpful to hire an appraiser to review another appraiser’s business valuation at a minimum to help determine if the assumptions and conclusions are reasonable.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2019.
Valuation Assumptions Influence Valuation Conclusions: How to Understand the Reasonableness of Individual Assumptions and Conclusions
In contested divorces where one or both spouses own a business or a business interest with significant value, it is common for one or both parties to retain a business appraiser to value the marital business interest(s).
Bakken May Lack Flash, But Has Fundamentals
The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Appalachia plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Bakken Shale.Production and Activity LevelsBakken production grew approximately 10% year-over-year through September. While this growth rate lags behind the Permian, it is in line with production growth in Appalachia and meaningfully bests the Eagle Ford.
The rig count in the Bakken at the end of September was unchanged from the year prior at 53. While not impressive at first glance, the total U.S. rig count declined nearly 20% over the same period. Eagle Ford, Permian, and Appalachia rig counts declined 22%, 15%, and 17%, respectively.
The Bakken has also seen the biggest gain in new-well production per rig relative to our other coverage basins. While this metric doesn’t cover the full life cycle of a well, it is a signal of the increasing efficiency of operators in the area. New well production per rig in the Bakken increased 29% on a year-over-year basis through September, compared to increases of 2%, 12%, and 7% in the Eagle Ford, Permian, and Appalachia, respectively.
Financial PerformanceBakken E&P operator financial performance was a mixed bag over the past year. Canada’s Crescent Point Energy (CPG) was the only positive performer of the Bakken-focused operators, up 23% year-over-year through September. While down 16%, Hess outperformed the broader S&P Oil & Gas Exploration & Production Index (XOP). However, this was likely attributable (at least in part) to positive developments out of Guyana, where Hess has a 30% interest in the massive Stabroek block. The Stabroek block is one of the largest offshore oil discoveries in the past decade, with more than 6 billion boe of discovered, recoverable resource.
Continental, Whiting, and Oasis all unperformed the broader E&P index during the past year, with Whiting down a notable 85%. Oasis is funding its Permian development program with cash flows generated from its Bakken position, a strategy that has fallen out of favor with investors who now seek capital discipline and free cash flow generation. Whiting is down largely on concerns regarding leverage and inventory life. All three saw margin compression, with Whiting’s EBITDAX per boe down nearly 30% year-over-year.
Despite this financial performance, the Bakken hasn’t been impacted by the recent batch of bankruptcies that have afflicted the Mid-Con (Alta Mesa, White Star), Eagle Ford (Sanchez, EP Energy), and even the Permian (Halcon). However, Whiting did announce a major restructuring in which it will terminate 254 positions (around one-third of the company’s workforce). As a result, the company anticipates approximately $50 million in annual savings.
Commodity Prices Largely Unchanged in Aftermath of Saudi AttackOn September 14, a missile attack on Saudi Arabian oil production facilities took out 5.7 million barrels a day of production, amounting to about 5% of global production. Both WTI and Brent crude prices surged more than 10% in the immediate aftermath of the attack.
However, the price reaction was short-lived, as the Saudis were able to bring 2 million bbl/d of production back online within days, with the remainder expected to be back online within weeks. WTI and Brent prices ended September lower than on the day prior to the attack.
Realized pricing in the Bakken has improved markedly relative to last fall, when a combination of Midwest refinery turnarounds and a glut of Canadian production sent the Clearbrook Bakken / WTI differential to more than $20/bbl. At the end of September, the differential stood at approximately $2.50/bbl. While thinly traded, basis futures indicate expected differentials of $2.50 to $4.30/bbl over the next several years.
Infrastructure IssuesThe Dakota Access Pipeline largely alleviated crude takeaway constraints out of the basin. And with a proposed expansion of the pipeline, the announced Liberty Pipeline, and excess crude-by-rail capacity, E&P operators likely won’t have issues getting crude to end markets.However, both Whiting and Oasis indicated that issues with natural gas processing infrastructure adversely impacted performance during the quarter.In the Q2 earnings call, Whiting CEO Brad Holly stated,To minimize flaring, we are producing some wells at constrained oil rates, while we focus on increasing gas capture through the installation of mobile combustion units, building out gathering systems, and completing our ray gas processing plant. Constraints also impacted the pace of planned operating activity.Oasis CEO Tommy Nusz put a finer point on his commentary, specifically stating that downtime at the company’s Wild Basin gas complex reduced 2Q19 production by 3,000 boe/d.These constraints should moderate, though, as additional natural gas infrastructure comes online in late 2019 and early 2020.MLP Simplification Trend ContinuesThe recent trend of MLP simplifications, driven in part by tax reform, FERC policy changes, cost of capital considerations, and a desire to reach a broader investor base, continues. Hess Midstream Partners (HESM) announced that it is acquiring Hess Infrastructure Partners (HIP) in a $6.2 billion transaction. HIP owns HESM’s General Partner (GP) units and Incentive Distribution Rights (IDRs), as well as an 80% interest in HESM’s oil and gas midstream assets. Unlike most simplifications that have occurred once GP/IDR distributions are “high in the splits” (with the GP/IDR holder typically taking 50% of incremental distributions above a certain threshold), HESM was only at the 25% split level.Fellow Bakken midstream operator Oasis Midstream Partners remains on a rapidly shortening list of MLPs that still have IDRs.ConclusionNow that the Bakken’s crude infrastructure issues have been (somewhat) resolved, the basin has seemed to take a backseat to other areas in terms of news coverage and investor attention. While the Bakken hasn’t kept up with the Permian’s growth, its static (rather than declining) rig count, higher oil to gas ratio, and sufficient crude takeaway capacity bode well for the basin relative to its domestic counterparts.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Transitioning Your Business to the Next Generation of Leadership
Successful Succession for RIAs
Continuing with our succession series, this week’s focus is on internal transitions. If you’ve ever wondered why there aren’t more transactions in the RIA space, it’s largely because most of these businesses ultimately transition their ownership internally to younger partners at the firm. These deals typically don’t get reported, so you probably don’t hear about most of them. Still, it’s the most common type of transaction for investment management firms and probably something that’s crossed your mind if you’re approaching retirement.A gradual transition to the next generation is a good way to align your employees’ interests and grow the firm.These types of transactions are common for a reason. Most RIA owners like working for themselves and will eschew outside interference at all costs (unless the price is right). Because many clients enjoy working with a wholly independent advisor, internal transitions are a good way to accomplish this in the long run. Further, a gradual transition of responsibilities and ownership to the next generation is also usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit.The most obvious roadblock when planning for internal succession is pricing. We recommend that all firms have a buy-sell agreement that specifies the terms and the price that shares are transacted at as an owner exits to retire. Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the price and terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama.In their recent book Success and Succession, Eric Hehman, Jay Hummel, and Tim Kochis examine the complexities of the leadership transition process and summarize their findings from their own experience:Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner. The founder could feel the need to resume full-time involvement in operations, fearing for his ongoing financial benefits from the firm. The authors advise both founders and successors to take a long-term view and not focus on this short-term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible as his or her guidance is crucial when the successor faces major issues early on. However, it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long-term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible. Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in the day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward. The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder has taken on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt that he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden. The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third-party valuation. While it might seem easier to rely on rules-of-thumb metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.”
Obviously, there’s a lot to think about, and this is certainly not an exhaustive list. It’s never too early to start planning for your succession. The longer you wait, the more likely you are going to fall short or have to make series concessions on pricing. Unfortunately, we see this more often than not, so don’t become another statistic. We’re here to help with the valuation and advisory aspects, but it’s up to you to get the ball rolling.
Four Questions to Ask About Debt in Your Family Business
One of the first questions our family business clients ask us is how much debt they should have. We refer to this as the capital structure question. Capital structure is simply the relative proportion of debt and equity capital used to finance a business. Figure 1, depicting a family business balance sheet, illustrates the capital structure decision.
The operations of Capulet, Inc. and Montague Corp. are identical. In other words, the two families have answered the capital budgeting question (“What investments are worthwhile uses of family capital?”) in the same way. However, the Capulets and Montagues have reached very different conclusions regarding the capital structure question (“What mix of debt and equity financing should we use?”). The Capulets have relied primarily on equity financing while the Montagues have favored debt.
Answering the capital structure question well requires considering both business and family characteristics. We find that discerning what the business means to the family is a critical first step. We also find that referencing and interpreting relevant benchmarking data can help families reach consensus when answering the capital structure question. We present benchmarking ratios relevant to the capital structure question in Chapter 6 of the 2019 Benchmarking Guide for Family Business Directors (“the Benchmarking Guide”). In this post, we identify four questions that directors should ask about the use of debt in their family business.
Question #1 – How Good Is Our Collateral?Rational lenders seek to minimize their risk of loss, and one way of doing that is by identifying the collateral that can be used to secure their position in the event of default. So the first question to ask about debt in your family business relates to collateral – what assets does your family business own that will provide security to a lender?In the consumer context, home and auto loans are often described using the loan-to-value (“LTV”) ratio. The LTV ratio describes the relationship between the amount of debt outstanding and the underlying collateral value. In other words, if you borrowed $30,000 to finance the purchase of your $40,000 car, the LTV ratio on your loan is 75%. In the business context, the analogue to the LTV ratio is the ratio of debt to net operating assets. Figure 2 summarizes data from Table 6.1 of the Benchmarking Guide.
Not all assets are equally useful as collateral. For example, real estate and utility companies have a high proportion of fixed assets having alternative future uses in their asset bases, while health care and information technology company assets tend to be more concentrated in goodwill and intangible assets for which lenders have less enthusiasm.
Smaller family businesses lacking sufficient collateral will sometimes rely on personal guarantees of certain family shareholders to provide security to lenders. This is effectively a subsidy, and all shareholders (both guarantors and not) should be aware of the implications of such guarantees.
Question #2 - Can We Service the Debt?Collateral value matters most in the event of default. Of course, most family business borrowers would prefer not to enter default. So, the second question to ask about the use of debt in your family business relates to the ability to make timely payments of principal and interest when they come due.The most common ratio used to evaluate the ability of family businesses to service their debt is the ratio of debt to EBITDA (earnings before interest taxes and depreciation). For a more thorough discussion of the merits and shortcomings of EBITDA as a measure of financial performance, check out this post. Table 6.4 in the Benchmarking Guide presents EBITDA leverage data for public companies. As shown on Figure 3 below, EBITDA leverage varies by industry.
Debt capacity as measured by the Debt / EBITDA ratio depends on the perceived riskiness, or volatility, of cash flow. For example, companies in the consumer staples sector are less sensitive to economic conditions than those in the consumer discretionary sector; as seen in Figure 3, consumer staples companies borrow more per dollar of EBITDA that their counterparts in the consumer discretionary sector. Larger companies are also often perceived to be less risky than smaller companies. With a few exceptions, the large cap companies in Figure 3 have higher Debt / EBITDA ratios than their small cap brethren.
Question #3 - How Much Will It Cost?The more debt a family uses to fund its operations, the more expensive the debt will be. This is intuitive since the greater the debt balance, the greater the likelihood that lenders will not be repaid. Table 6.6 of the Benchmarking Guide describes the effective interest cost for the public companies in our sample set. Effective interest cost is the quotient of interest expense to the average debt balance for a period.In Figure 4, we pop the hood and look a little deeper at the data, comparing the effective interest cost for companies in the industrials sector. We sorted the companies by Debt / EBITDA ratio, and then computed the median effective interest cost for those companies with leverage ratios less than, or greater than 2x.
While we suspect this analysis would not pass muster statistically, it does confirm the reasonableness of our intuitive hunch that companies with more debt pay a higher effective interest rate, all else equal. The data on Figure 4 also illustrates the effect of company size on risk, with larger companies having lower effective interest costs than their smaller peers.
Question #4 - Will We Be Able to Sleep at Night?Increasing leverage not only increases the cost of borrowing, it also increases the risk – and therefore cost – of equity. So the final question to ask with regard to the use of debt in your family business is this: Will we be able to sleep at night? Unfortunately, there is no cut-and-dried academic answer to this question. More than anything, the answer depends on the risk tolerances and preferences of your family shareholders.Observers often focus on the use of debt to minimize the overall cost of capital for a company and thereby maximize its value. And while that may be, to some degree, possible, the increasing costs of debt and equity with leverage mean that the overall cost of capital is relatively flat across a wide span of potential capital structures, as shown in Figure 5.
As shown in Figure 5, the weighted average cost of capital does not vary appreciably across a wide range of potential capital structures. What this suggests is that, for family businesses, the capital structure decision has less to do with increasing the value of the family business and much more to do with financing growth and allocating risk and return among the debt and equity holders. If family shareholders are willing to accept more financing risk, their available returns will be higher. If, on the other hand, the preference of family shareholders is to minimize risk, then they should expect a lower return. Going back to our example in Figure 1, the Capulets bear less risk, but the Montagues have the potential for greater returns. Return always follows risk, and there are no shortcuts.
ConclusionWhat’s the right capital structure for your family business? We find that the best answer to that question can be found only after asking a series of other questions: How good is our collateral? Can we service the debt? How much will this cost? And perhaps most importantly, will we be able to sleep at night? Sadly, there are no shortcuts, but the long-term rewards for your family business of answering these questions well can be significant. Capital structure decisions affect the long-term sustainability of your family business and can be costly to unwind. Much better to measure twice and cut once than to arrive quickly at the wrong answer.
Planning to Succeed
In the late 1930s Henry Ford’s son, Edsel, commissioned a one-off convertible version of the Lincoln Zephyr to drive while he vacationed in Florida for the winter. While the initial design is said to have been penned in about an hour, legend has it that Edsel Ford kept tweaking the details and wearing out the engineers such that they finally locked him out of the shop to finish the car. Edsel Ford took his Lincoln, dubbed the “Continental,” to Florida, and came back with 200 orders. Ford suddenly had a halo car, and Lincoln became a durable brand for decades.The Continental story is significant for many reasons, one of them being that it was a big success for second-generation leadership at Ford Motor Company. Many businesses start and grow by force of the personality of the founder, and wither and die when there is no successor leadership to take over when the founder is no longer at the helm. Ford succeeded where many other automakers failed, which is why this blog post is starting with that company instead of Pierce-Arrow, Packard, or Duesenberg.Succession is as often discussed as it is misunderstood.If succession is difficult to achieve in a “products” company like an automaker, it is mind-numbing to engineer in a “services” business-like investment management. Riffing off the over-repeated metaphor to describe the substance of an RIA, if the assets get on the elevator and go home every night…does a change in assets mean a different company altogether?Succession is as often discussed as it is misunderstood. While many practice management issues revolve around industry expectations, regulations, client expectations, and basic economics, succession involves all of those things plus personality, culture, and skill sets. And while much has been written about succession in the RIA industry, we’ve seen plenty of topics get little, if any attention. This post is dedicated to some of the latter.Internal Succession is the Default Plan for Most RIAsDespite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Even though there are on the order of 15,000 RIAs in the U.S. which are all generally in the same business (providing investment management consulting services in exchange for fees priced relative to the dollar amount of client assets), there are also about 15,000 business models. Investment management firms are idiosyncratic, with practices and cultures unique to the individuals involved in the practice and the market niche served by the practice.Staff who grow up, or whose careers develop, at a given firm understand, inherently, the values and expectations of their workplace, and are in the best position to perpetuate the business after the prior generation of leadership retires.Strategic Transactions Rarely Obviate the Need for Succession PlanningLeadership transition issues can loom large even in strategic transactions. We worked on a dispute situation a few years ago in which a strategic acquirer bought a substantial wealth management practice without even meeting the next generation of leadership. The ink was hardly dry on the purchase agreement when generation two started looking for the exit, knowing many of their clients would follow them. Litigation eventually resolved this in one respect, but most arms’ length observers would conclude that all parties (buyer, seller, and the second generation) were worse off as a result.RIAs often pride themselves on having a team-oriented atmosphere, which is great for serving clients, but not so great for negotiating succession issues. When team members become buyers and sellers, temperaments that were heretofore aligned become opposed. Arguments can easily break out between members of buyer and seller groups when goals diverge or perspectives on the future of the firm conflict.Some see strategic transactions as a way to avoid the uncomfortable conversations that accompany internal ownership transition. Not so. If the strategic transaction does not align with the priorities of the group responsible for leading the firm after the deal closes, then the likely outcome will be suboptimal.Continuity Planning is the Dog that Wags the Succession TailThe client doesn’t really care who owns your firm. The client cares about the firm serving their needs. It’s easy to forget this because…Succession is a Strategic Issue Often Mistreated as a Tactical IssueWhen managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. We would suggest, instead, that the starting point is strategic planning for the business.Ownership should be a consequence of the business strategy, not the other way around.Ownership is the single biggest distraction for most closely held businesses. But ownership should be a consequence of the business strategy, not the other way around. Think of the strategic priorities of an investment management firm in the same order they appear on the P&L.Revenue comes first. So, at a basic level, strategic planning for an RIA starts with growing client relationships and value provided to the clients to maximize revenue opportunities.Next comes operating expenses, which for an investment management firm consists mostly of employee compensation. Spending on talent and tools to achieve the strategic revenue goals form the organization to be owned.Profits are at the bottom of your P&L for a reason. They matter, of course, but returns to equity are the residual of client interaction and the organization formed to serve them. Ownership is a by-product of strategy, and, at best, can be structured to support strategic initiatives.Timing is Everything, and so is TimeAnother famous Lincoln, whose first name was Abraham, famously said that if he was given seven hours to chop down a tree, he’d spend six hours sharpening his axe. We would say this ratio of planning to implementation is about right for dealing with the issue of succession as well.
The Fair Market Value of Oil & Gas Reserves
Due to the historical popularity of this post, we revisit it this week. Originally published in 2017, this post helps you, the reader, understand how to determine the fair market value of oil and gas reserves.
Oil and gas assets represent the majority of value of an E&P company. The Oil and Gas Financial Journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed before, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves, but none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations.
The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus, the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that:
The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income.
Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example, a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead, they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below.
The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.
Middle Market Transaction Update Second Quarter 2019
Overall transaction value and volume in the middle market in the second quarter of 2019 remained virtually unchanged from the first quarter.
The Family Business Director To-Do List
Share Redemption / Liquidity Programs
Family business leaders are well-acquainted with the tyranny of the urgent. In this series of posts, we offer to-do lists for family business directors. Each list relates to a particular family business topic. The items offered for consideration won’t necessarily help your family business survive the next week, but instead, reflect priorities for the long-term sustainability of your family business.In last week’s post, we explored how family businesses can use periodic share redemptions or ongoing liquidity programs to promote shareholder engagement and satisfaction. This week’s to-do list includes important tasks for family business directors to complete whether planning for a one-time share redemption or establishing a family shareholder liquidity program.Identify existing shareholder clienteles and determine the needs, objectives, and preferences of each.Identifying shareholder clienteles requires more than just refreshing the family tree. Kinship ties may be a factor in defining shareholder clienteles, but may be secondary to other attributes that influence risk tolerances and liquidity preferences. Ferreting out how shareholder clienteles are really defined may require administering a confidential shareholder survey.Assess the company’s financial capacity to support an ongoing shareholder liquidity program.An ongoing shareholder liquidity program is a use of capital that ultimately competes with other potential investment alternatives. How does the expected return on share redemptions compare to returns expected on alternative capital investments? What portion of projected operating cash flow are directors willing to allocate to a shareholder liquidity program? Are there any covenants in the company’s credit facility that limit amounts used to fund share repurchases? Does the company have unused borrowing capacity that can be used to support a more substantial one-time share redemption?Determine whether the company or other shareholders will be buyers.If the family business does not have the financial capacity to support an ongoing shareholder liquidity program, one or more of the family shareholders may have the interest and financial capacity to purchase additional shares. Opening up the redemption program to shareholders as potential buyers allows the company to preserve capital for potentially more attractive investment opportunities and may allow the different shareholder clienteles to more closely achieve their liquidity and return preferences.Define the frequency, size/availability, and terms of a shareholder liquidity program that best meet the objectives of the shareholders and needs of the business.For an ongoing shareholder liquidity program, there are several key terms that family business directors need to weigh carefully before implementation. First, is liquidity available to selling shareholders at any time, or will redemptions be restricted to periodic windows? Second, will the opportunity to sell shares under the plan be subject to any volume limitations (whether in aggregate or per shareholder, expressed as a dollar amount, share count, or percentage of shares outstanding)? Finally, what form will the liquidity take? Will selling shareholders receive cash, a note, or some combination of the two? If a note, what will the terms be?Define the level of value to be used for shareholder liquidity program purchases.The term “value” is susceptible to multiple interpretations. When structuring a shareholder liquidity program, it is essential that you have a clear understanding of what the different “levels” of value are for your family business, and which one of those levels you will use to repurchase shares from family members. Different levels will be appropriate for different family businesses, so family business directors need to choose carefully with an eye toward which level will be most likely to promote the objectives of the shareholder liquidity program.Obtain a qualified independent business valuation at the selected level of value.Once you have specified the relevant level of value, the next step is to select and retain a qualified independent business valuation professional (we have plenty to choose from here) to perform a valuation. You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).The initial valuation is important to establish expectations. The valuation report should demonstrate a thorough understanding of your business and its position within your industry, and contain clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support. You should be able to recognize your family business as the one being valued, and when finished reading the report you should know both what the valuation conclusion is, and why it is reasonable. Unless there have been significant changes to the business that warrant a change to the overall valuation framework, subsequent valuations should rely on the same valuation methods, with changes to the assumptions and conclusions reflecting new circumstances at the company, within the industry, or among relevant market data. Subsequent valuations should not be mere copies of the original valuation, but should demonstrate a consistency of approach and perspective. Having a consistent valuation process from period to period enhances the credibility of the liquidity program with your family shareholders.Design education and communication tools to ensure that shareholders are well-informed regarding the liquidity program.Finally, when it comes time to implement the liquidity plan, it is essential that your family shareholders understand what their options are under the plan, the level of value being used to establish price, and the consideration they will receive for their shares. A shareholder liquidity program is ultimately a tool for promoting positive shareholder engagement. By implementing the plan, you are moving your family shareholders from being passive recipients of occasional dividends to more active owners. If you are going to grant family shareholders the right to sell a portion of their shares, you must also empower them to do so on an informed basis. When a shareholder liquidity program is in place, family business directors must give renewed attention to shareholder communication and reporting.The professionals in our family business advisory services practice have decades of experience helping family businesses execute major share redemptions, provide independent valuation opinions, and design and implement shareholder liquidity programs. Call us today to help you get started on knocking out your to-do list.
Who’s In and Who’s Out?
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week one of these key questions and offer possible next steps. As family businesses evolve, the family’s leaders need to determine the appropriate relationship between membership in the family and ownership in the business. As the third, fourth, and subsequent generations of the family reach adulthood, it becomes increasingly likely that the interests of at least some family members will diverge from the interests of the business. Family businesses can adopt one of two broad strategies to address this situation:Maintain broad-based ownership and make positive shareholder engagement a strategic priority; or,Use share redemptions and liquidity programs to achieve concentrated ownership among a subset of the family. Neither strategy is inherently superior to the other. We discussed the benefits (and challenges) of developing positive shareholder engagement in Chapter 1. In this chapter, we focus on the second strategy.Motivations for Selling SharesIn this chapter, we focus on voluntary, rather than involuntary, sales of shares. Involuntary sales of shares include those triggered by, and governed by, the relevant terms of the company’s buy-sell agreement. Chapter 8 provides a brief overview of the issues associated with buy-sell agreements.In some families, selling shares in the family business is perceived as nothing short of treason. Yet, there are often legitimate reasons for family members to sell shares in the family business, such as a desire for diversification, proceeds to start a new business venture, or funding education or other major life events.In our experience, the desire of family shareholders for liquidity (whether full or partial) can usually be traced to some form of “clientele” effect. The clientele effect names the fact that a company’s shareholder base is not monolithic: different shareholders have different portfolios, risk preferences, income needs, and expectations. In multi-generation family businesses, we find the clientele effect to be common. As the family grows numerically and spreads out geographically and occupationally, it is only natural for shareholders no longer to look so much alike. Differing shareholder needs and preferences are not wrong, but when treated as such, the resulting suspicion can lead to resentment, open conflict, and in too many cases, litigation.Shareholder clienteles can form along many different potential axes: kinship, geography, employment status, etc. To illustrate the concept, consider the economic role the family business can fulfill in different households, as depicted in Figure 11.It is only natural that family members in the upper right quadrant view the family business very differently from their cousins or siblings in the lower left quadrant. Those in the upper right quadrant are likely to be very risk-averse, desiring preservation of capital and the current level of dividends above all else. Shareholders in the lower left quadrant will much more closely resemble public market investors, supporting corporate strategies that enhance returns at acceptable risk levels.For public companies, the clientele effect sorts itself out because shareholders self-select; if the attributes of the company don’t align a shareholders preferences and risk tolerances, it is very easy for the shareholder to sell their holdings and find assets that are a better fit. For family businesses, however, things are not nearly so tidy.Faced with multiple shareholder clienteles, family business leaders can seek to adopt distribution and reinvestment policies that accommodate as many shareholders as possible. Or, the family can adopt a formal share redemption or liquidity program with a view to providing shareholders greater flexibility in tailoring the economic benefits of family membership to the unique circumstances of their particular household.Elements of a Shareholder Liquidity ProgramWhile every shareholder liquidity program is unique, there are certain structural elements that all plans, whether formal or informal, must have.BuyerThere has to be a source for the liquidity made available to selling shareholders. The default assumption is generally that the business will redeem the shares sold under the plan. However, the available liquidity pool may be supplemented by individual shareholders who are able and willing to purchase additional shares.If the business redeems shares, the ownership of all the non-selling shareholders increases on a pro rata basis, resulting in no change to the relative ownership. And, since the business is paying for the shares, the redemption will either reduce the company’s liquid assets and/or increase the company’s indebtedness. In either case, the redemption changes the financial risk profile of the family business.If shares are instead purchased by other family shareholders, the relative ownership of the buying shareholders will increase. Further, the company’s financial position is unaffected, since it is serving the role of matchmaker, but is not actually a party to the transaction. If there are shareholders with the financial capacity and willingness to purchase additional shares, the family can benefit from having a liquidity program that does not take capital away from the business.FrequencyLiquidity may be available on a continuous basis or at specified intervals. A continuous plan provides the most flexibility for shareholders, but restricting redemptions to specific dates (annual or potentially even less frequent) is generally more efficient and predictable for the managers of the business, and allows the business to accumulate capital to fund the redemption.AvailabilityLiquidity plans generally include caps on the aggregate dollar amount of liquidity to be made available, whether to individual shareholders or in total. Higher caps increase the perceived value of the liquidity program to family shareholders, but at the cost of greater uncertainty to the business. As noted above, however, the uncertainty to the business can be hedged, or even eliminated, if some or all of the purchases are made by other shareholders rather than the company.TermsLiquidity programs may provide for immediate cash payment, or require the selling shareholder to accept a note upon tendering their shares. While selling shareholders generally prefer cash, using notes (or a combination of notes and cash) increases the company’s flexibility and may allow for a larger redemption pool. If the terms of the note issued in exchange for shares feature a belowmarket interest rate, the economic value of the transaction will be less than the nominal price.PricingFinally, a liquidity program must specify the price at which shares can be sold. There are essentially three options for the price to be paid, and each option has consequences for the selling and non-selling shareholders.Change of Control. The first option is a change of control value. This is akin to the value in exchange for the business. The change of control value contemplates that potential acquirers may anticipate making changes to the business to increase cash flow. If the acquirer is a so-called strategic acquirer, the magnitude of such changes can be quite large. While selling shareholders would prefer to receive a change of control value, it can be difficult for the company (or purchasing shareholder) to finance the purchase since the business is not actually being sold and will presumably continue to be operated with the existing level of cash flow.As-If Freely Traded. The second option mimics how the company’s shares would be priced if they were traded in the public stock market. If the change of control value is value in exchange, the as-if freely traded value is value in use. The as-if freely traded price contemplates that the business will continue as an independent entity, so incremental benefits to be expected by a potential acquirer are not included in the projected cash flows. While this value is less attractive to selling shareholders, it is more feasible for the purchaser (whether the company or another shareholder) to finance the purchase at this price. If the company is later sold to a strategic acquirer, shareholders taking advantage of the liquidity program may feel taken advantage of themselves.Discounted for Illiquidity. Finally, the price used in the liquidity program may include a discount to reflect the illiquidity of family business shares. Investors prefer to have the ability to easily sell their shares, so it is widely acknowledged that minority shares in private companies are worth less than otherwise comparable shares that are publicly traded. Redemptions at a discounted price confer an economic benefit upon the non-selling family shareholders. Stated alternatively, use of a discounted price imposes an economic penalty on the selling family shareholders. Whether that is desirable or not depends in large part on the family’s posture toward selling shareholders (i.e., is selling stock akin to treason?). Figure 12 summarizes the various consequences of the different pricing options. There is no inherently “right” choice for the price to be used in a liquidity program. The company’s directors should weigh the consequences of the various options noted above against the objectives of the liquidity program for the family.Implementing the Liquidity ProgramAn effective and sustainable liquidity program should be predictable. Predictability is achieved by having clearly-defined terms that are well-understood by all interested parties, and having regular appraisals of the company’s shares prepared by a qualified independent business valuation expert. A qualified business appraiser will perform periodic valuations on a consistent basis, taking into account the financial performance of the family business, fundamental changes in the operations and outlook for the business and the industry, as well as relevant market changes. At the direction of the company, valuations can be prepared at any (or all) of the three levels noted above.Implementing a liquidity program increases the importance of shareholder education. If family shareholders are going to have the ability to sell shares, they need to do so on an informed basis. It is essential that selling shareholders have a firm grasp of the company’s financial performance and strategy, and understand the key factors that drive the valuation.Liquidity programs are not cure-alls, but when carefully designed and implemented, they can relieve many of the pressure points that face growing multi-generation family businesses.Potential Next StepsIdentify existing shareholder clienteles and determine the needs, objectives, and preferences of eachAssess the company’s financial capacity to support an ongoing shareholder liquidity programDetermine whether the company or other shareholders will be buyers supporting a shareholder liquidity programDefine the frequency, size/availability, and terms of a shareholder liquidity program that best meet the objectives of shareholders and the needs of the businessDefine the level of value to be used for shareholder liquidity program purchasesObtain a qualified independent business valuation at the selected level of valueDesign education and communication tools to ensure that shareholders are well-informed regarding the liquidity program
Do Oil And Water Mix? The Biggest Energy IPO Of 2019 Might Answer That Question
The capital markets in the upstream sector are leaving companies and investors in the lurch right now. Compared to 2018, equity and debt issuances have declined markedly and IPO’s in the sector have been relatively quiet apart from Brigham Minerals’ successful offering.[caption id="attachment_28082" align="alignnone" width="717"]Source: Shale Experts[/caption]
Saltwater disposal and integrated water logistics companies have attracted a higher proportion of the sparsely available capital flowing into the sector, highlighted by the largest energy IPO of this year: Rattler Midstream LP. The continuing austerity trend toward cash flow sustainability for shale oil companies has provided limited attractive options for investors. In the meantime, drilling activity (particularly in West Texas) continues to grow, and therefore efficiency and scale grow ever more important across the board for upstream companies to remain competitive. One of the challenges producers face is handling the enormous amounts of water that have become part and parcel to the Delaware and Midland Basins. This is where saltwater disposal enters the picture.
A horizontal well in the Delaware Basin can average four barrels (sometimes even up to 10 barrels) of water for every barrel of oil produced. Once produced, all that water must go somewhere and that somewhere is a saltwater disposal well. This is no new phenomenon as produced water has been an element of production for over 70 years. What is different in the Permian Basin is the higher ratio of water to oil (often called a “water cut”) that’s produced due to the native geology and today’s production techniques. Today’s U.S. oilfield water production is already around a colossal 50 million barrels a day. This contrasts with the U.S. producing only 15 million barrels of petroleum liquids every day. Most of that water is produced in the Permian Basin and there’s only going to be more of it. Much more. That’s to say nothing of the amount of water needed to fracture the rock during the production process. In a recent Raymond James research report, the authors noted that each well completion uses thirty Olympic swimming pools worth of water.
[caption id="attachment_28080" align="alignnone" width="640"]Source: EIA, Drilling Info, Baker Hughes, Raymond James Research [/caption]
This water needs to be transported, sometimes long distances, and logistically managed. This function is trending towards consolidation whereby a single entity combines these assets and services. Until the past couple of years there was very little aquatic pipeline infrastructure. Most was handled by trucking, but that is changing as increasing volumes are raising scrutiny on the inefficiency of trucking. Growing demand in West Texas has opened up an estimated $12 billion-dollar market potential in the Permian Basin alone, according to Raymond James.
Fees for transporting and disposing produced water typically range from $0.50 to $2.50 per barrel. In addition, there is skimmed oil that can be gathered as well. However, where long distances stand between a production site and disposal infrastructure it can creep up to $4.00 to $6.00 per barrel. In today’s commodity price environment and focus on break-even prices, every dollar per barrel counts. Thus, there is a real incentive to improve infrastructure and push service costs lower.
The investment merits of this water infrastructure include the opportunity for more steady business; with long term contracts tied to dedicated acreage, and stable cash flows that can fetch higher valuations than even some of the shale producers themselves in the region. It has been noted that some producers cannot begin drilling in certain areas until the water infrastructure is in place. In addition, there are consolidation opportunities for more fragmented business models between saltwater disposal facilities, equipment rental companies and pipeline companies. More integrated firms that combine these services will function more like traditional midstream operators. The trend has already begun and is being seen in valuations already. Rattler’s $765 million IPO opened at over 18 times EBITDA and recent water driven asset sales have traded between five- and ten-times EBITDA. For example, private equity backed WaterBridge purchased $325 million of Delaware Basin assets (assuming earnouts are paid) from Halcon Resources at an implied 14.5x trailing EBITDA multiple. Firms like NGL Energy Partners and EVX Midstream are also active in the space. Additionally, the opportunity for yield (which energy investors are craving) in the future can be more demonstrable than many upstream opportunities in the oil patch.
[caption id="attachment_28081" align="alignnone" width="640"]Source: Company Filings. WaterBridge transaction assumes earnouts. Rattler transaction assumes total units outstanding not just traded ones.[/caption]
Amid this activity, landowners are also finding another source of income from royalties stemming from new pipeline and below ground storage rights as well, leading to more local income for ranchers and residents as well as another potential asset base for mineral aggregators and related investors to pursue. Oil and water do appear to mix, and energy bankers will be glad to know they do because it is filling gaps for an otherwise tight capital market space.
Originally appeared on Forbes.com.
Selling Your RIA to a Consolidator
Successful Succession for RIAs
As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning. In this post, we will review some of the considerations when partnering with an RIA consolidator.The opportunity for consolidating wealth management firms is well publicized: an industry composed of many small, fragmented firms with aging ownership bases and no clear succession plans is supposedly poised for consolidation. RIA consolidators have emerged to capitalize on this landscape, promising a means for ownership transition, back-office efficiencies, and best practices coaching.Acquisitions by consolidators represent an increasing portion of deal volume in the sector.Consolidators have been gaining traction in the industry. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of deal volume in the sector.For RIA principals that are looking for an exit plan, selling to a consolidator is one option to consider. A sale to a consolidator typically provides the selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to next generation management.There are several considerations when considering a sale to an RIA consolidator. Price, of course, is the big one. But after the deal closes, the selling shareholders will typically have to stick around for several years at least (the deal terms will make sure of that). Thus, another important feature to consider is what life will look like after the deal closes. RIA owners who are considering selling to a consolidator should think carefully about which aspects of their business they feel strongly and how those aspects of the business will change after the deal closes.Consolidator Models There are several different consolidator models, and they can vary significantly in terms of the effect they have on the day-to-day operations of the acquired RIA. This is largely a function of the amount of integration that consolidators do for their partner firms.At one extreme, there are consolidators such as Focus Financial that standardize only the minimum level of business processes across their acquired firms, which typically include back-office tasks such as compliance and accounting. This “stay as you are” model has minimal impact on how the firm is run and theoretically maintains the selling partners’ sense of entrepreneurship. Acquired firms can retain their own branding and client-facing processes after the deal closes, and there is usually little or no impact from the perspective of the firm’s clients. This model also mitigates the risk of culture clash since acquired firms aren’t forced into a one-size-fits-all mold.At the other extreme, there are consolidators like United Capital (now part of Goldman Sachs) or Mercer Advisors, which unify the branding of acquired firms and present a homogenous wealth management platform to clients. Under this model, most functions of the acquired RIA—things like marketing, HR, and technology—are moved under the corporate umbrella. Sellers have much less control after the deal closes under this model. Some sellers may see this as gaining freedom from the day-to-day management of their firms, but others may be reluctant to relinquish that much control.Deal PricingThe multiples paid by consolidators will vary depending on the current market environment, but they are generally competitive with other exit strategies. Different consolidator models can have characteristics that more closely resemble either a financial buyer or strategic buyer, and this classification can impact the multiple that the consolidator is able to pay.Different models have characteristics that resemble either a financial buyer or strategic buyer, which impacts the multiple that it is able to pay.Consolidators like Focus Financial, which make minimal changes to the acquired business, are best classified as financial buyers. Financial buyers purchase the business “as is”, with few plans to make changes to the way the business operates beyond moving selected business functions to the corporate office. There may be some plans for expense reductions or revenue enhancement, but financial consolidators are unlikely to pay the buyer for those potential benefits.Other consolidators can be considered strategic buyers. Companies like Mercer Advisors fall into this category. By making major changes to the way the acquired RIA operates, strategic consolidators have more opportunity to realize synergies and initiate growth-oriented strategic objectives. In theory, this gives strategic consolidators the ability to pay a higher multiple, but at a cost to the selling shareholders of giving up more control in how the business is run after the deal closes.Deal StructureConsolidators typically purchase 100% of RIAs, but that doesn’t mean that they purchase 100% of the acquired firm’s economics. RIAs are for the most part owner-operated businesses, so some portion of the acquired firm’s earnings before owner compensation (EBOC) needs to be diverted to the selling shareholders in order to keep them around and align incentives after the close. For RIAs, it can be difficult to disentangle EBOC into returns to equity versus returns to labor. As a practical matter, the normalized or post-closing compensation for selling shareholders is a negotiating point when striking a deal with a consolidator.The selling shareholders are likely to maintain an ongoing interest in the economics through earnouts, employment agreements, or other deal features. For example, Focus Financial structures its deals so that a portion of the acquired EBOC is directed to a newly established management company owned by the selling shareholders. Initially, this structure provides the selling shareholders with compensation that varies with the profitability of the firm. In the longer term, the management company equity can, in theory, be sold to the next generation of management when the selling shareholders retire.Cash vs Stock ConsiderationIt’s also worth noting that consolidators often use their own stock as part of the total consideration. For publicly traded companies like Focus Financial, it’s clear exactly how much that’s worth at any given time. For closely-held aggregators like Hightower and Captrust, their stock price is not readily apparent.Even if the consolidator is publicly traded, you should be wary of any lock-up provisions since stock prices for these companies can be volatile.Facilitating M&AAnother purported benefit of selling to a consolidator is that the acquired firm gains access to the consolidator’s balance sheet to pursue its own acquisitions. The low cost of capital for consolidators can allow the acquired firms to complete their own acquisitions in a way that is still accretive to the selling shareholders.Many partner firms of Focus Financial, for example, have completed their own acquisitions, and presumably, these deals make financial sense for the partner firm’s principals. For firms that are considering inorganic growth, this aspect of a sale to a consolidator may be a key consideration.Other OptionsSelling to a consolidator is just one exit strategy among many, and RIA owners should carefully weigh the pros and cons selling to a consolidator relative to those of other exit strategies. In subsequent posts, we will discuss other viable exit options for RIA principals.
FAQ: How Should Financing Affect Capital Budgeting Decisions?
Family business directors must properly distinguish between capital structure and capital budgeting decisions to make the best decisions. In this week’s post, we answer a frequently asked question that leads us into a discussion of what is known as the “separation principle.” In short, what are the relevant cash flows for capital budgeting analysis? And, when is it appropriate to combine investing and financing decisions? If you have ever struggled with these questions, this week’s post has the answers you need.Q: Should we deduct interest expense when calculating the IRR on a project?A: No. For most capital budgeting applications, interest expense should not be deducted from forecast cash flows when calculating IRR. When the hurdle rate reflects the weighted average cost of capital, the relevant measure of return should reflect cash flows available to both debt and equity holders (i.e., before deducting interest expense).As a general rule, family business directors should strive to keep investing decisions separate from financing decisions. There are two primary rationales for this “separation principle”:The operating managers responsible for selecting and executing capital projects generally have no control over the family business’s financing decisions. Considering potential capital projects on a debt-free basis aligns the analysis with the perspective of the responsible manager. The specific financing used to fund a given capital project is rarely the responsibility of an operating manger, but is ultimately the decision of corporate directors.The actual funding sources used to finance the specific project are not relevant to the decision to accept or reject the project. At first blush, this is counter-intuitive – surely the funding sources actually used are what matter the most. The flaw with this reasoning is that family business capital structures can generally be modified independently of investment activity.Let’s consider a simple example to illustrate. Assume a family business has a target capital structure of 75% equity and 25% debt. Following a couple very profitable years, the company’s actual capital structure has drifted to approximately 80% equity and 20% debt. As a convenient means of moving back toward the target, the company plans to finance 100% of a proposed $5 million capital project. What is the appropriate hurdle return for this project? The appropriate hurdle return is the weighted average cost of capital (75% equity / 25% debt) despite the fact that the actual financing will rely on 100% debt. Failing to do so would inadvertently give this project credit for the fact that the company was under-leveraged at the time the project happened to be under consideration. Undertaking this capital project is not the only means by which the company can re-lever its capital structure. Through a refinancing transaction, the company can “fix” its capital structure problem without engaging in any capital investment.Are there any exceptions to the separation principle? Yes, a couple. First, occasionally projects include access to financing not otherwise available to the family business. For example, if a proposed project would be eligible for uniquely advantageous bond financing through a municipality, it may be appropriate to evaluate that project on an equity basis. Second, real estate investments are often evaluated net of the leverage that will be used to finance the project. For many real estate investors, individual projects stand or fall on their own, in contrast to family businesses for which capital projects form an integrated portfolio of activities which are financed as a whole. Furthermore, since many real estate investors are tax pass-through entities, it is customary to calculate returns on real estate on a pre-tax basis.Whether calculating the internal rate of return on a total capital or equity-only basis, it is essential to ensure consistency among the project cost, the relevant cash flows, and hurdle rates, as summarized in the following table.The following simple example illustrates proper alignment between the components of the internal rate of return analysis described in the preceding table.
From a total capital perspective (the traditional and preferred viewpoint for capital budgeting), the total investment is the relevant cash outflow against which returns are measured. The aggregate (pre-interest and debt service) cash flows result in a 12.4% internal rate of return. From a financial point of view, the project is acceptable if the weighted average cost of capital for the family business is less than 12.4%.
From an equity perspective (appropriate for the exceptional cases noted above), the relevant cash outflow is only the equity contributed by the family business to the project. Annual project cash flows are reduced by both principal and (after-tax) interest payments on the assumed debt, yielding an internal rate of return of 17.6%. While this IRR is higher than that under a total capital approach, the relevant hurdle rate for evaluating the acceptability of the project is the family business’s cost of equity (which will exceed the weighted average cost of capital).
Why Does This Matter?Family business directors face three principal inter-related strategic financial questions:Capital Structure: How should is the appropriate mix of debt and equity financing for our family business?Capital Budgeting: What are the optimal reinvestment decisions for our family business?Dividend Policy: What form should returns to our family shareholders take?
As depicted in the preceding chart, the answers to each of these three questions have consequences for the others, and family business directors should strive to answer these questions on an integrated, rather than piecemeal, basis.
How to Perform a Purchase Price Allocation for an E&P Company
This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016.
When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.The report should outline the three approaches to valuation, regardless of the approaches selected for use in the valuation.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
Community Bank Valuation (Part 2): Key Considerations in Analyzing the Financial Statements of a Bank
The June BankWatch featured the first part of a series describing key considerations in the valuation of banks and bank holding companies. While that installment provided a general overview of key concepts, this month we pivot to the analysis of bank financial statements and performance.1 Unlike many privately held, less regulated companies, banks produce reams of financial reports covering every minutia of their operations. For analytical personality types, it’s a dream.The approach taken to analyze a bank’s performance, though, must recognize depositories’ unique nature, relative to non-financial companies. Differences between banks and non-financial companies include:Close interactions between the balance sheet and income statement. Banking revenues are connected tightly to the balance sheet, unlike for nonfinancial companies. In fact, you often can estimate a bank’s net income or the growth therein solely by reviewing several years of balance sheets. Banks have an “inventory” of assets that earn interest, referred to as “earning assets,” which drive most of their revenues. Earning assets include loans, securities (usually highly-rated bonds like Treasuries or municipal securities), and short-term liquid assets. Changes in the volume of assets and the mix of these assets, such as the relative proportions of lower yielding securities and higher yielding loans, significantly influence revenues.The value of liabilities. For non-financial companies, acquisition motivations seldom revolve around obtaining the target entity’s liabilities. The effective management of working capital and debt certainly influences shareholder value for non-financial companies, but few attempt to stockpile low-cost liabilities absent other business objectives. Banks, though, periodically buy and sell branches and their related deposits. The prices (or “premiums”) paid in these transactions reveal that bank deposits, the predominate funding source for banks, have discrete value. That is, banks actually pay for the right to assume another bank’s liabilities.Why do banks seek to acquire deposits? First, all earning assets must be funded; otherwise, the balance sheet would fail to balance. Ergo, more deposits allow for more earning assets. Second, retail deposits tend to cost less than other alternative sources of funds. Banks have access to wholesale funding sources, such as brokered deposits and Federal Home Loan Bank advances, but these generally have higher interest rates than retail deposits. Third, retail deposits are stable, due to the relationship existing between the bank and customer. This provides assurance to bank managers, investors, and regulators that a disruption to a wholesale funding source will not trigger a liquidity shortfall. Fourth, deposits provide a vehicle to generate noninterest income, such as service charges or interchange. The strength of a bank’s deposit portfolio, such as the proportion of noninterest-bearing deposits, therefore influences its overall profitability and franchise value.Capital Adequacy. In addition to board and shareholder preferences, nonfinancial companies often have debt covenants that constrain leverage. Banks, though, have an entire multi-pronged regulatory structure governing their allowable leverage. Shareholders’ equity and regulatory capital are not the same; however, the computation of regulatory capital begins with shareholders’ equity. Two types of capital metrics exist – leverage metrics and risk-based metrics. The leverage metric simply divides a measure of regulatory capital by the bank’s total assets, while risk-based metrics adjust the bank’s assets for their relative risk. For example, some government agency securities have a risk weight equal to 20% of their balance, while many loans receive a risk weight equal to 100% of their balance.Capital adequacy requirements have several influences on banks. Most importantly, failing to meet minimum capital ratios leads to severe repercussions, such as limitations on dividends and stricter regulatory oversight, and is (as you may imagine) deleterious to shareholder value. More subtly, capital requirements influence asset pricing decisions and balance sheet structure. That is, if two assets have the same interest rate but different risk weights, the value maximizing bank would seek to hold the asset with the lower risk weight. Stated differently, if a bank targets a specific return on equity, then the bank can accept a lower interest rate on an asset with a smaller risk weight and still achieve its overall return on equity objectives.Regulatory structure. In exchange for receiving a bank charter and deposit insurance, all facets of a bank’s operations are tightly regulated to protect the integrity of the banking system and, ultimately, the FDIC’s Deposit Insurance Fund that covers depositors of failed banks. Banks are rated under the CAMELS system, which contains categories for Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. Separately, banks receive ratings on information technology and trust activities. While a bank’s CAMELS score is confidential, these six categories provide a useful analytical framework for both regulators and investors.Understanding the Balance SheetWe now cover several components of a bank’s balance sheet.Short-Term Liquid Assets and SecuritiesBanks are, by their nature, engaged in liquidity transformation, whereby funds that can be withdrawn on demand (deposits) are converted into illiquid assets (loans). Several alternatives exist to mitigate the risk associated with this liquidity transformation, but one universal approach is maintaining a portfolio of on-balance sheet liquid assets. Additionally, banks maintain securities as a source of earning assets, particularly when loan demand is relatively limited.Liquid assets generally consist of highly-rated securities issued by the U.S. Treasury, various governmental agencies, and state and local governments, as well as various types of mortgage-backed securities. Relative to loans, banks trade off some yield for the liquidity and credit quality of securities. Key analytical considerations include:Portfolio Size. While there certainly are exceptions, most high performing banks seek to limit the size of the securities portfolio; that is, they emphasize the liquidity features of the securities portfolio, while generating earnings primarily from the loan portfolio.Portfolio Composition. The portfolio mix affects yield and risk. For example, mortgage-backed securities may provide higher yields than Treasuries, but more uncertainty exists as to the timing of cash flows. Also, the credit risk associated with any non-governmental securities, such as corporate bonds, should be identified.Portfolio “Duration.” Duration measures the impact of different interest rate environments on the value of securities; it may also be viewed as a measure of the life of the securities. One way to enhance yield often is to purchase securities with longer durations; however, this increases exposure to adverse price movements if interest rates increase.LoansA typical bank generates most of its revenue from interest income generated by the loan portfolio; further, the lending function presents significant risk in the event borrowers fail to perform under the contractual loan terms. While loans are more lucrative than securities from a yield standpoint, the cost of originating and servicing a loan portfolio – such as lender compensation – can be significant. Key analytical considerations include:Portfolio Composition. Bank financial statements include several loan portfolio categories, based on the collateral or purpose of each loan. Investors should consider changes in the portfolio over time and compare the portfolio mix to peer averages. Significant growth in a portfolio segment raises risk management questions, and regulatory guidance provides thresholds for certain types of real estate lending. Departures from peer averages may provide a sense of the subject bank’s credit risk, as well as the portfolio’s yield. Analysts may also wish to evaluate whether any concentrations exist, such as to certain industry niches or customer segments.Portfolio Duration. Banks compete with other banks (and non-banks in some cases) on interest rate, loan structure, and underwriting requirements. Most banks will say they do not compete on underwriting requirements, such as offering higher loan/value ratios, which leaves rate and structure. To attract borrowers, banks may offer more favorable loan structures, such as longer-term fixed rate loans. Viewed in isolation, this exposes banks to greater interest rate risk; however, this loan structure may be entirely justified in light of the interest rate risk of the entire balance sheet.Allowance for Loan & Lease Losses (“ALLL”)Banks maintain reserves against loans that have defaulted or may default in the future. While a new regime for determining the ALLL will be implemented beginning for some banks in 2020, the size of the ALLL under current and future accounting standards generally varies between banks based on (a) portfolio size, (b) portfolio composition, as certain loan types inherently possess greater risk of credit loss, (c) the level of problem or impaired loans, and (d) management’s judgment as to an appropriate ALLL level. Calculating the ALLL necessarily includes some qualitative inputs, such as regarding the outlook for the economy and business conditions, and reasonable bankers can disagree about an appropriate ALLL level. Key analytical considerations regarding the ALLL and overall asset quality include:ALLL Metrics. The ALLL – as a percentage of total loans, nonperforming loans, or loan charge-offs – can be benchmarked against the bank’s historical levels and peer averages. One shortcoming of the traditional ALLL methodology, which may or may not be remediated by the new ALLL methodology, is that reserves tend to be procyclical, meaning that reserves tend to decline leading into a recession (thereby enhancing earnings) but must be augmented during periods of economic stress when banks have less financial capacity to bolster reserves.Charge-Off Metrics. The ALLL decreases by charge-offs on defaulted loans, while recoveries on previously defaulted loans serve to increase the ALLL. One of the most important financial ratios compares loan charge-offs, net of recoveries, to total loans. Deviations from the bank’s historical performance should be investigated. For example, are the losses concentrated in one type of lending or widespread across the portfolio? Is the change due to general economic conditions or idiosyncratic factors unique to the bank’s portfolio? Is a new lending product performing as expected?Charge-off ratios also provide insight into the amount of credit risk accepted by a bank, relative to its peer group. However, credit losses should not be viewed in isolation – yields matter as well. It is safe to assume, though, that higher than peer charge-offs, coupled with lower than peer loan yields, is a poor combination. While banks strive to avoid credit losses, a lengthy period marked by virtually nil credit losses could suggest that the bank’s underwriting is too restrictive, sacrificing earnings for pristine credit quality.Loan Loss Provision. The loan loss provision increases the ALLL. A provision generally is necessary to offset periodic loan charge-offs, cover loan portfolio growth, and address risk migration as loans enter and exit impaired or nonperforming status.DepositsAs for loans, bank financial statements distinguish several deposit types, such as demand deposits and CDs. It is useful to decompose deposits further into retail (local customers) and wholesale (institutional) deposits. Key analytical considerations include:Portfolio Size. Deposit market share tends to shift relatively slowly; therefore, quickly raising substantial retail deposits is a difficult proposition. Banks with more rapid loan growth face this challenge acutely. Often these banks rely more significantly on rate sensitive deposits, such as CDs, or more costly wholesale funds. Therefore, analysts should consider the interaction between loan growth objectives and the availability and pricing of incremental deposits.Composition. Investors generally prefer a high ratio of demand deposits, because these accounts usually possess the lowest interest rates, the lowest attrition rates and interest rate sensitivity, and the highest noninterest income. Of course, these accounts also are the most expensive to gather and service, requiring significant investments in branch facilities and personnel. With that said, other successful models exist. Some banks minimize operating costs, but offer higher interest rates to depositors.Rate. Banks generally obtain rate surveys of their local market area, which provide insight into competitive conditions and the bank’s relative position. Also, it is useful to benchmark the bank’s cost of deposits against its peer group. Deposit portfolio composition plays a part in disparities between the subject bank and the peer group, as do regional differences in deposit competition.Shareholders’ Equity and Regulatory CapitalHistorical changes in equity cannot be understood without an equity roll-forward showing changes due to retained earnings, share sales and redemptions, dividends, and other factors. In our opinion, it is crucial to analyze the bank’s current equity position by reference to management’s business plan, as this will reveal amounts available for use proactively to generate shareholder returns (such as dividends, share repurchases, or acquisitions). Alternatively, the analysis may reveal the necessity of either augmenting equity through a stock offering or curtailing growth objectives.The computation of regulatory capital metrics can be obtained from a bank’s regulatory filings. Relative to shareholders’ equity, regulatory capital calculations: (a) exclude most intangible assets and certain deferred tax assets, and (b) include certain types of preferred stock and debt, as well as the ALLL, up to certain limits.Understanding the Income StatementThere are six primary components of the bank’s income statement:Net interest income, or the difference between the income generated by earning assets and the cost of funding.Noninterest income, which includes revenue from other services provided by the bank such as debit cards, trust accounts, or loans intended for sale in the secondary market. The sum of net interest income and noninterest income represents the bank’s total revenues.Noninterest expenses, which principally include employee compensation, occupancy costs, data processing fees, and the like. Income after noninterest expenses commonly is referred to by investors, but not by accountants, as “pre-tax, pre-provision operating income” (or “PPOI”).Loan loss provisionSecurity gains and lossesTaxesNet Interest IncomeThe previous analysis of the balance sheet foreshadowed this net interest income discussion with one important omission – the external interest rate environment. While banks attempt to mitigate the effect on performance of uncontrollable factors like market interest rates, some influence is unavoidable. For example, steeper yield curves generally are more accommodative to net interest income, while banks struggle with flat or inverted yield curves.Another critical financial metric is the net interest margin (“NIM”), measured as the yield on all earning assets minus the cost of funding those assets (or net interest income divided by earning assets). The NIM and net interest income are influenced by the following:The earning asset mix (higher yielding loans, versus lower yielding securities)Asset duration (longer duration earning assets usually receive higher yields)Credit risk (accepting more credit risk should enhance asset yields and NIM)Liability composition (retail versus wholesale deposits, or demand deposits versus CDs)Liability duration (longer duration liabilities usually have higher interest rates)Noninterest IncomeThe sensitivity of net interest income to uncontrollable forces – i.e., market interest rates – makes noninterest income attractive to bankers and investors. Banks generate noninterest income from a panoply of sources, including:Fees on deposit accounts, such as service charges, overdraft income, and debit card interchangeGains on the sale of loans, such as residential mortgage loans or government guaranteed small business loansTrust and wealth management incomeInsurance commissions on policies soldBank owned life insurance where the bank holds policies on employees
Some sources of revenue can be even more sensitive to the interest rate environment than net interest income, such as income from residential mortgage originations. Yet other sources have their own linkages to uncontrollable market factors, such as revenues from wealth management activities tied to the market value of account assets.
Expanding noninterest income is a holy grail in the banking industry, given limited capital requirements, revenue diversification benefits, and its ability to mitigate interest rate risk while avoiding credit risk. However, many banks’ fee income dreams have foundered on the rocks of reality for several reasons. First, achieving scale is difficult. Second, cross-sales of fee income products to banking customers are challenging. Third, significant cultural differences exist between, say, wealth management and banking operations. A fulsome financial analysis considers the opportunities, challenges, and risks presented by noninterest income.Noninterest ExpensesIn a mature business like banking, expense control always remains a priority.Personnel expenses. Personnel expenses account for 50-60% of total expenses. Significant changes in personnel expenses generally are tied to expansion initiatives, such as adding branches or hiring a lending team from a competitor. Regulatory filings include each bank’s full-time equivalent employees, permitting productivity comparisons between banks.Occupancy expenses. With the shift to digital delivery of banking services, occupancy expenses have remained relatively stable for many community banks, while larger banks have closed branches. Nevertheless, banks often conclude that entering a new market requires a beachhead in the form of a physical branch location.Other expenses. Regulatory filings lump remaining expenses into an “other” category, although audited financial statements usually provide greater detail. More significant contributors to the “other” category include data processing and information technology spending, marketing costs, and regulatory assessments.Loan Loss ProvisionWe covered this income statement component previously with respect to the ALLL.Income TaxesBanks generally report effective tax rates (or actual income tax expense divided by pre-tax income) below their marginal tax rates. This primarily reflects banks’ tax-exempt investments, such as municipal bonds; bank-owned life insurance income; and vehicles that provide for tax credits, like New Market Tax Credits. It is important to note that state tax regimes may differ for banks and non-banks. For example, some states assess taxes on deposits or equity, rather than income, and such taxes are not reported as income tax expense.Return DecompositionAs the preceding discussion suggests, many levers exist to achieve shareholder returns. One bank can operate with lean expenses, but pay higher deposit interest rates (diminishing its NIM) and deemphasize noninterest income. Another bank may pursue a true retail banking model with low cost deposits and higher fee income, offset by the attendant operating costs. There is not necessarily a single correct strategy. Different market niches have divergent needs, and management teams have varying areas of expertise. However, we still can compare the returns on equity (or net income divided by shareholders’ equity) generated by different banks to assess their relative performance.The figure below presents one way to decompose a bank’s return on equity relative to its peer group. This bank generates a higher return on equity than its peer group due to (a) a higher net interest margin, (b) a slightly lower loan loss provision, and (c) higher leverage (shown as the “equity multiplier” in the table).Income Statement MetricsThe figure below cites several common income statement metrics used by investors, as well as their strengths and shortcomings.Sources of InformationBanks file quarterly Call Reports, which are the launching pad for our templated financial analyses. Depending on asset size, bank holding companies file consolidated financial statements with the Federal Reserve. All bank holding companies, small and large, file parent company only financial statements, although the frequency differs. Other potentially relevant sources of information include:Audited financial statements and internal financial dataBoard packets, which often are sufficiently extensive to cover our information requirementsBudgets, projections, and capital plansAsset quality reports, such as criticized loan listings, delinquency reports, concentration analyses, documentation regarding ALLL adequacy, and special asset reports for problem loansInterest rate risk scenario analyses and inventories of the securities portfolioFederal Reserve form FR Y-6 provides the composition of the holding company’s board of directors and significant shareholders’ ownershipConclusionA rigorous examination of the bank’s financial performance, both relative to its history and a relevant peer group and with due consideration of appropriate risk factors, provides a solid foundation for a valuation analysis. As we observed in June’s BankWatch, value is dependent upon a given bank’s growth opportunities and risk factors, both of which can be revealed using the techniques described in this article.1 Given the variety of business models employed by banks, this article is inherently general. Some factors described herein will be more or less relevant (or even not relevant) to a specific bank, while it is quite possible that, for the sake of brevity, we altogether avoided mention of other factors relevant to a specific bank. Readers should therefore conduct their own analysis of a specific bank, taking into account its specific characteristics.Originally published in Bank Watch, August 2019.
Partnering with a Minority Financial Investor
Successful Succession for RIAs
As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning. In this post, we will review some considerations of partnering with a minority financial investor to achieve a successful transition of ownership.What is a minority financial investor?There are two features of a minority financial investor to breakdown: minority and financial.A minority investor does not seek control of your business. Often, a change of control is thought to occur when greater than 50% of the equity changes hands. However, the notion of control can be more complicated with RIAs as an “assignment” of client contracts necessitates client consent. When a “controlling block” of voting shares changes hands, the SEC considers there to have been an assignment of client contracts. While the SEC does not define a “controlling block,” it is typically thought to be the holder of 25% of voting shares or a partner who has the right to receive 25% of the capital upon dissolution.A financial investor is contrasted to a strategic investor. Financial buyers can generally be classified as investors interested in the return they can achieve by buying a business. They are interested in the cash flow generated by a business and the future exit opportunities from the business. Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may be related to expanding into a new market or consolidating administrative tasks to realize efficiencies.Bringing the two together, a minority financial investor is typically interested in acquiring less than 25% of your business to participate in the distribution of cash flow or upside from selling your company in a few years to another investor or strategic acquirer.Is a minority financial investor the best solution for you?As mentioned above, a minority financial investor does not seek control of your business. Therefore, the majority of your company’s management team must agree to stay on after the capital infusion. While the lack of interference in day to day operations is an attractive feature to some management teams (if, for instance, they’re looking to transition out retiring partners, recycle ownership to future generations, and maintain control of day to day operations), a minority financial investor is not the solution for management teams hoping to achieve a clean break.How is a minority financial investment structured?In general, a minority financial investment can be structured as a term investment or a permanent investment. PE firms typically invest for a five to seven-year term with the goal of improving the company’s financial profile in order to sell it at a higher multiple, while permanent capital investors (often single-family offices) are more interested in the business’ long-term cash flow potential.While every agreement with a minority financial investor will have differences in the details, there are generally two ways to structure these deals.1. Revenue Share 2. Preferred EquityRevenue ShareA revenue share is a right to a percentage of revenue instead of a right to distributable cash flow. This structure works exceptionally well for passive minority investments because the minority investor’s distribution is not affected by the operational decisions of management, such as the size of the bonus pool, because their distribution is determined before the removal of expenses. With that, a revenue share generally does not include board representation.There are benefits to a revenue share for businesses that have stable or expanding margins. As shown in the example below, as margins expand and more flows through to the bottom line, the revenue share as a percentage of EBITDA (as a proxy for free cash flow) decreases, and the common equity holders split a larger share of the distributable cash flow. On the flip side, if margins contract, the size of the revenue share as a percent of EBITDA will increase and the revenue shareholder will gain a larger share of distributable cash flow.A revenue share usually includes customary minority protections. For example, consent is typically required for certain matters such as:Bringing on excess debt or changing the company’s capital structure in a way that would adversely affect the revenue share ownerEntering into a JV, related party transactions, or new lines of businessChanging accounting/billing practices or tax election in a way that would adversely affect the revenue share ownerPreferred EquityLike a revenue share, preferred equity holders participate in the distribution of cash flow before common equity holders; however, preferred equity holders distribution is determined by the bottom line, not the top. Because of this, preferred equity holders are more interested in operational decisions such as executive compensation and budgeting because their distribution could be reduced with additional expenses. Preferred equity holders typically ask for board representation and veto rights on certain key items. Such protective rights include:Required distributions of excess cash flowBudget approvalApproval of executive compensationTag along rightsPreemptive rights to protect preferred equity holders from dilution
Although preferred equity holder’s rank higher than common equity holders, a preferred equity holder faces more risk than a revenue shareholder. In the example of margin compression explored above, the preferred equity holder would likely face a similar decline in distributions as the common equity holder.
Because of the risk profile of each investment, a revenue shareholder may be able to offer more in terms of pricing than a preferred equity investor. A minority financial partner can help you successfully transition ownership from retiring partners but is not the solution for every RIA.
In the next few posts, we will continue to discuss other viable exit options for RIA principals when it comes to succession planning.
Five Reasons Your Family Business Should Focus on ROIC
Family Business Director calls Memphis, Tennessee home, and among other things, Memphis is a basketball town. In the 2017 NBA playoffs, former Grizzlies coach David Fizdale launched a meme when he wrapped up his post-game press conference with an epic rant on the unbalanced officiating during the game by citing a litany of statistics, walking off exclaiming, “Take that for data!”
Both the sports and business worlds are increasingly data-driven, and access to relevant data is essential to making good decisions. Our goal in publishing the 2019 Benchmarking Guide for Family Business Directors was to make such data available for family business directors. We have written often of our fondness for return on invested capital (ROIC) as the best comprehensive measure of financial performance for family business. Table 4.3 of the Guide, reproduced below, summarizes ROIC measures for the population of public companies from which we drew observations.
Hoping to make Coach Fizdale proud, we took a closer look at the data this week to see if could confirm our hunch that ROIC matters. To do so, we divided our population of companies into two groups. The first group includes those companies with ROIC greater than their respective industry and size group median, and the second group consists of the below median ROIC companies. Dividing the population this way ensures that the groups are balanced with respect to size and industry composition.
As shown in Exhibit 1, the median ROIC for the overall population is 8.7%, while the medians for the High ROIC and Low ROIC groups are 13.4% and 5.3%, respectively. This week, we examine other attributes of the firms in each group to see whether ROIC is, in fact, a good predictor of positive outcomes for family shareholders. Exhibit 2 summarizes the data.
Having analyzed the data, we can identify five reasons family businesses should focus on ROIC.#1 – High ROIC Companies Grow FasterThe first thing we notice is that companies in the High ROIC group tend to have higher historical revenue growth rates than those in the Low ROIC group. We measure historical revenue growth on a three-year compound annual basis. This measure includes both organic and acquisition-fueled growth. As summarized in Exhibit 2, the median compound annual growth rate for the High ROIC group is 7.0%, compared to 5.4% for the Low ROIC group.There is no necessary correlation between ROIC and revenue growth. So why do the High ROIC companies grow faster than the Low ROIC companies? We can hazard a couple of guesses:First, companies that are attentive to ROIC tend to have less lazy capital on their balance sheets. As a result, the assets that are held are more productive, and managers are more effective in finding revenue-relevant uses of corporate assets.Second, ROIC-mindful managers and directors tend to be more discriminating acquirers of other businesses. By focusing on the marginal ROIC impact of proposed acquisitions, these companies do a better job of weeding out poor acquisitions that dilute revenue growth.#2 – High ROIC Companies Distribute More CashThe good news does not end with revenue growth, however. Perhaps the firms in the High ROIC group generate faster revenue growth simply by reinvesting earnings rather than distributing earnings to shareholders. If so, the revenue growth differential would merely be a side effect of stinginess towards shareholders. Happily, however, this is not the case. The companies in the High ROIC group actually distribute earnings to shareholders more liberally than their counterparts in the Low ROIC group. Combining both dividends and share repurchases, the median aggregate payout ratio for the High ROIC group is 69% of earnings, compared to 54% for the Low ROIC group.ROIC is a natural deterrent to the empire-building tendencies which can be especially prevalent in family businesses. Managers and directors who benchmark to ROIC would prefer to distribute earnings than reinvest those earnings in capital projects that do not provide adequate returns. This is especially significant for family businesses, since many family disputes are rooted in reluctance or unwillingness to pay dividends.#3 – High ROIC Companies Are Less RiskyBut perhaps, the ROIC skeptic may claim, the High ROIC companies are merely accepting greater levels of risk – after all, return follows risk. However, the data seems to rule out this possibility. We considered two measure of risk: financial leverage and beta.Measured as a percentage of total invested capital, debt comprises 38.9% of the total for the High ROIC group compared to 42.5% for the Low ROIC Group.Beta is a measure of relative riskiness for equity holders: the higher the beta, the greater the risk. The median beta for the High ROIC group is 1.05x, compared to 1.13x for the Low ROIC group.
These differences may not seem very large, but what is most important is what they tell us the High ROIC companies don’t do. They don’t fund higher shareholder payouts by borrowing more money than their Low ROIC peers. Nor do they chase returns by engaging in riskier projects. As we noted above, we constructed our High ROIC and Low ROIC groups to be balanced with respect to both industry and company size, so those factors do not account for the observed differences in financial leverage and beta.#4 – High ROIC Companies Provide Better ReturnsIs ROIC simply a manipulation of accounting data with no traction in the real world, or does it actually translate into superior shareholder returns? To answer this question, we calculated total shareholder returns (capital appreciation plus dividend yield) for each of the companies in our population for calendar year 2018. As noted in Exhibit 2, the median shareholder return for the High ROIC group outperformed the median for the Low ROIC group by approximately 9.6% (negative 5.6%, compared to negative 15.2%). Calculating ROIC is not merely an exercise for overly-excitable accountants, but is a tool for directing strategy and managerial attention to the behaviors that generate shareholder returns.Does your family business track shareholder returns over time? If so, how do the shareholder returns compare to various benchmarks? If not, is it because historical valuation data is not available, or because family leaders are reluctant to perform the calculation? Paying attention to ROIC today is a reliable way to improve shareholder returns tomorrow.#5 – High ROIC Companies Are Worth MoreFinally, High ROIC companies are worth more than Low ROIC companies. This will not come as a surprise to readers familiar with the work of consulting firm Stern Stewart in the mid-1990s. The greater the sustainable return per dollar of invested capital, the more a given dollar of invested capital is worth. The most straightforward way to measure this is by calculating the ratio of the market value of total capital (MVTC, the sum of debt plus the market value of equity) to total invested capital (TIC, the sum of debt plus the book value of equity).If the ratio is 1.00x, the capital entrusted to management by lenders and shareholders is neither enhanced nor diminished by the stewardship of management.If the ratio is greater than 1.00x, management’s efforts are increasing the value of the family’s capital; if the ratio is less than 1.00x, family capital is actually being squandered in the business.
In the lexicon of Stern Stewart, MVTC/TIC is a proxy for Market Value Added. The median MVTC/TIC ratio for our High ROIC group is 2.51x compared to 1.46x for the Low ROIC group, confirming our intuition that High ROIC companies are more valuable.ConclusionReturn on invested capital is not a silver bullet – it will not solve all of the challenges facing your family business. It can even be misused. However, when we let the data speak for itself, the benefits of ROIC are undeniable.
Posturing for a Successful Succession
This post serves as an introduction to our succession planning series, which is intended to address an overlooked but critical issue facing many RIAs today.A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning. We’ll outline these options in this post and expound upon them in more detail later in the series.Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option is not as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes a lot of time and financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience, but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered.
If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.
Are Metrics Really Undermining Your Family Business?
We have not been shy about our affection for return on invested capital (ROIC) as a comprehensive measure of financial performance for family businesses. In fact, we think financial performance measurements are so important for family businesses that we recently published a compendium of potential benchmarking measures. So the provocatively-titled cover article of the current issue of the Harvard Business Review – “Are Metrics Undermining Your Business?” – certainly made us do a double take.Metrics can have a distorting impact on corporate behaviors, and derail the very strategies the metrics were meant to advance.The authors of the article (Michael Harris and Bill Taylor) take as their starting point the well-publicized mess at Wells Fargo. In an effort to give concrete form what was ostensibly a reasonable strategy of cross-selling services to existing customers, the bank established a metric based on the number of accounts opened. In response to reportedly intense pressure to meet aggressive goals surrounding the metric and financial incentives tied to the metric, many Wells Fargo employees prioritized the metric – number of accounts – over the actual strategic objective – deepening and strengthening retail customer relationships. The reputational and financial cost to the bank has proven to be enormous.The authors contend that an emphasis on metrics leads to surrogation, which they define as confusing what is being measured (deeper and stronger customer relationships) with the metric being used (number of accounts). When employees and managers fall prey to surrogation, metrics can have a distorting impact on corporate behaviors, and actually derail the very strategies the metrics were meant to advance.Metrics and Family BusinessWells Fargo is an extremely large publicly traded financial institution, not a family business. So are family businesses more or less likely to be burned by metrics? The authors’ recommendations for reducing the odds of surrogation in an organization provide a great framework for answering this question. The authors offer three steps to promote healthy use of metrics in business.#1 – Get the people responsible for implementing strategy to help formulate it.This really goes to corporate culture. Is your family business marked by a top-down authoritarian management structure, or does strategy emerge from all levels of the organization? Are non-family employees involved in strategy discussions, or is formulating strategy the exclusive preserve of family members? Do selected metrics serve the broader corporate strategy, or are the selected metrics replacing the corporate strategy? Or, perhaps even subverting the corporate strategy?Capital budgeting is one area that we see a lot of family businesses struggle with. One risk facing family businesses is that a capital budgeting metric like internal rate of return can change from being a necessary condition to a sufficient condition to approving a project. In other words, instead of letting corporate strategy dictate which financially-feasible capital project should be pursued, family businesses may undertake what appears to be a financially-feasible capital project and then adapt the corporate strategy to fit the project. It is critical that family business directors understand what questions a financial metric like net present value is designed to answer (“Are the expected returns from this project acceptable?”) and what questions it cannot answer (“Should we undertake this capital project?”).#2 – Loosen the link between metrics and incentives.Do your incentive structures promote metric-maximization at the expense of overall performance?The timeworn adage “You get what you pay for” is certainly true when it comes to employee performance. Financial incentives are tricky because employees will give – or attempt to give – employers the behaviors that maximize their personal compensation packages. The risk is that any metric that is concrete enough to influence actual day-to-day employee behavior will be so narrow that it may not – if pursued with single-minded intensity – always promote the overall health of the organization.Do your incentive structures promote metric-maximization at the expense of overall performance? Are employees rewarded for identifying and acting on those situations in which blindly following the metric would actually be counterproductive? For example, inventory turnover is a common financial metric used to improve working capital management and cash flow. All else equal, faster inventory turnover contributes to greater capital efficiency and higher return on invested capital. But all else is never, in fact, equal. A purchasing manager with compensation incentives based on inventory turnover may resist taking advantage of discounted pricing for a special bulk purchase that would benefit the company because it would reduce inventory turnover. Family business leaders need to take care that compensation incentives do not become so closely tied to isolated metrics that counterproductive business decisions are made.#3 – Use multiple metrics.Managers have long recognized that a “balanced scorecard” approach to metrics is healthier than obsession with a single number. This can be challenging for family businesses where the prior success of the company is linked – in the corporate culture, if not in actual fact – to a single performance metric. While a particular metric may have been a perfect proxy for the overall health of the business in the past, changes in the business or industry are likely to cause the relevance of particular metrics to change. The scorecard for your family business needs periodic updating to ensure that you are tracking what drives success today rather than in the past.This is true for the value of family businesses as well. We still occasionally see buy-sell agreements that attempt to enshrine a “valuation formula” to determine the value of the business at future dates. No matter how appropriate the formula may be when adopted, it is almost certain to distort the value of the business when a triggering event actually occurs years or decades later.Family Businesses and Return on Invested CapitalSo what about ROIC? Does the threat of surrogation cause us to re-think ROIC as the best comprehensive measure of family business performance? In short, no. While the article offers some appropriate warnings for family business directors, there is no reason to abandon ROIC. As we discussed in a recent post on innovation, family business directors do well to consider broader notions of family wealth that encompass more than just dollars and cents. But even in the context of broader definitions of family wealth and/or business purpose, return on invested capital is a great tool with which to coordinate the activities of your family business to support your strategy.
Purchase Accounting Considerations for Banks Acquiring Asset Managers
Due to the historical popularity of this post, we revisit it this week. The purpose of this post is to help you, the reader, understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in transactions between banks and asset managers.
As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients. Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired. As noted in the following figure, the acquired assets are measured at fair value.
Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions.
Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce.
Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction. The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name. This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base. However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction. Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base. Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price. If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely. Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.
Themes from Q2 2019 Earnings Calls
Will “Capital Efficiency” Prevent Bankruptcy and Maintain Production as E&P’s Reduce CapEx?
While large, rapid commodity price declines are certainly harmful for near-term profits and long-term planning, persistently low prices may be more ominous for industry operators and investors. Prices rebounded from a low of $45/bbl, but crude has been below $60 for nearly 3 months. Natural gas prices have similarly languished, remaining below $2.50/mmbtu in that time. Two Houston-based E&P companies (Halcon & Sanchez) recently filed for Chapter 11 bankruptcy within days of each other, raising questions about the state of the industry. Size and operational efficiency may enable some players to stave off issues, while others may be forced into difficult decisions between preserving capital and investing over budget to produce enough debt-servicing cash flow.Theme 1: Bankruptcies May Return if Prices Remain Low Over the last year, we have taken proactive steps to address the challenging oil and natural gas price environment, including stabilizing our production profile, improving our capital efficiency, and reducing our overall cost structure. Undergoing a financial restructuring through a voluntary process represents the next phase for Sanchez Energy, as we work with our creditors on a plan to right-size our balance sheet, further invest in our assets and generate long-term value for our stakeholders. - Tony Sanchez III, CEO, Sanchez EnergyRagan [incoming CFO] is joining Halcon at a critical time [bankruptcy restructuring] and will help lead our focus on capital discipline, cost control, and strategic plans for developing the Company’s assets to maximize shareholder return. - Rich Little, CEO, Halcon Resources
We start with quotes from companies that didn’t actually host earnings calls. Sanchez Energy has been beleaguered for years now, unable to turn a profit since the drop in oil prices. Once the third most active driller in the Eagle Ford, Sanchez filed for Chapter 11 bankruptcy on August 11th. Sanchez’ CEO touches on capital efficiency like many executives in the industry, as we’ll address later. He also harps on generating long-term value for stakeholders, a slight twist on the predictable “providing long-term value to shareholders” due to their debt-laden predicament.
Sanchez certainly isn’t alone. Halcon Resources filed for bankruptcy on August 7th. However, the company expects a 60-day turn around, during which it will continue to pay vendors, royalty owners, and others as part of ordinary business through the bankruptcy process, subject to approval from the courts. This is the second time since 2016 that the company has buckled under its debt load.
The Sanchez quote came as part of its press release regarding the bankruptcy proceedings, and the Halcon quote addresses the hiring of a new CFO in the wake of its filing. Each CEO outlines a critical issue for industry operators. Large scale, multi-year projects employ debt financing to lower the cost of capital, but too much debt can raise the cost of capital due to the increased risk of making the required payments. Fluctuating commodity prices further hamper the ability of E&P companies to make these payments. When companies are forced to file for Chapter 11 bankruptcy, they are usually able to resume operations, though the shareholders essentially lose all, or a substantial portion, of their investment. Industry operators will hope that these low prices will not persist, or other companies may join Sanchez and Halcon.Theme 2: Size MattersWe have a very large footprint though that allows us to work within certain areas over a vein, within certain areas due to these [Bakken gas processing] constraints. So we are able to work around them. And we have led the industry up there with gas capture we still do. - Harold Hamm, CEO, Continental ResourcesCombining Oxy and Anadarko will create a diverse portfolio of high quality and complementary assets, well suited for our core competencies. As we apply our development approach to the combined portfolio, we expect this to be the low-cost producer in all of the areas we operate. For example, along with the expertise I've already mentioned, we will apply our proprietary drilling process, Oxy drilling dynamics across Anadarko acreage. To date, Oxy drilling dynamics has reduced costs by at least 30% in all of the areas that we've applied it, and we expect to achieve similar results in Anadarko’s onshore and offshore developments. - Vicki Hollub, CEO, Occidental PetroleumOne final point on our pending acquisition of Carrizo and one of the most important aspects of the transaction is the ability to optimize long-term development value of our combined inventory. By merging these two companies we are creating a vehicle that can effectively compete in a lower commodity price environment without the need to high-grade near-term target zones at the expense of other zones that are left behind for less efficient future development after the passage of time. - Joseph Gatto, CEO, Callon Petroleum
Size allows companies to achieve scale in their operations, spread expenses over larger amounts of revenue, access capital markets, and even negotiate lower capital costs. Larger E&P companies are typically less at risk of bankruptcy than smaller players in the industry.
Chevron began the quarter with its announcement of plans to acquire Anadarko Petroleum, but Occidental stepped up with a larger offer and eventually won the day. While this transaction has stolen the headlines, Callon’s smaller acquisition of Carrizo after quarter-end echoes the trend in the industry. Size allows these companies to achieve synergies, apply techniques to more acreage, and survive in low-price environments.Theme 3: Capital Efficiency to Bridge Gap Between Production Estimates and CapEx BudgetsWe have also achieved the efficiencies throughout the first-half of 2019 that will allow the reduction of drilling rigs from 19 rigs in SCOOP STACK to 12 rigs on early fourth quarter of 2019. […] I am proud that our teams can exceed production estimates with lower rig activity, that is operating and capital efficiency at its best. […] We're very committed to meeting our CapEx and other corporate guidance for the year, and have the flexibility to do so as we're demonstrating. - Harold Hamm, CEO, Continental ResourcesFor two quarters in a row we delivered more oil for less capital. With efficiency gains and new technology, we are achieving strong capital and operating cost reductions, while at the same time delivering excellent well performance. […] Looking ahead to the remainder of 2019, we modestly increased our full year U.S. oil production guidance as a result of better well performance. There is no change to our activity level in 2019. We will remain disciplined and still expect capital expenditures to be within the original range of $6.1 billion and $6.5 billion. - Bill Thomas, Chairman/CEO, EOG ResourcesTowards the end of the quarter, we shifted our focus to the completion of our first Delaware mega pad, which importantly utilized a simultaneous operation of two completion crews to increased efficiency and reduced cash cycle times. As we've emphasized previously, increased use of this model is made possible within a larger entity and is a clear strategic benefit of the Carrizo merger. - Joseph Gatto, CEO, Callon Petroleum
Shale oil production has increased output, and U.S. E&P companies have provided much of the supply growth in global production. However, shale’s inherently higher declines rates require more drilling to replace more rapidly declining production, making investors wary to receive their share (dividends) of the returns on these investments. This, in combination with depressed commodity prices at year-end, led to lower capex budgets for 2019. Seeking to keep their promises after blowing through their budgets last year, E&P companies have preached capital efficiency. They tout the operational efficiencies that will allow them to decrease their capital spend to close 2019. These efficiencies are crucial because according to data compiled by Shale Experts (subscription required) in the below table, many E&P companies have already spent over half their budget.
There are many factors at play in this number. Capex can and tends to be frontloaded due to seasonal factors. Still, executives will be hoping that their drilling efficiencies are achieved. Some companies may find issues hitting their production targets while decelerating drilling activities. They may be stuck between a rock and a hard place: failing to reach production targets or failing to remain within capex budgets.
Theme 4: Parent-Child Problem Continues to Plague OperatorsIn the Delaware Basin, the 23 well Dominator project was designed to test logistical capabilities and well spacing that was approximately 50% tighter than our current resource assessment. While initial rates were solid, current performance data indicates that we developed the Upper Wolfcamp too densely. We're incorporating the data into our development model to adjust spacing on future projects including those projects set to spud in the second half of 2019. -Tim Leach, CEO, Concho ResourcesWe've always been conservative in our spacing assumptions, and we don't really have any plans right now, especially as commodity price continues to decline, to look at any reasons to increase well spacing. This is one of those things where we've been pretty steadfast in our strategic development objectives on spacing. And we would pay attention to other spacing results that go on in the Permian Basin. And we try to learn from those as well too without exposing our shareholders to down spacing risks. -Travis Stice, CEO, Diamondback Energy
As we noted earlier, E&P companies are always looking to gain efficiencies. This can come from strategic M&A, contiguous acreage, repeatable drilling methods, and many other sources. However, there are limits. Specifically, well spacing has become increasingly important in the Permian as the parent-child problem continues to plague operators. Stated plainly, the first well drilled in a pad (the “parent”) tends to be the strongest well, getting the most bang for your buck in the reservoir. Subsequent wells drilled in the pad (the “children”) allow for more oil to be harvested quickly but at a decreasing rate per well. Trying to fit more wells onto pads may be more efficient from a drilling standpoint, but geological factors tend to lead to diminishing marginal returns from this approach.
As Concho’s CEO admitted at the beginning of the earnings call, their Dominator project was not properly spaced. This news was not well received, as Concho’s stock dropped 22.2% on the day and has slid even further since. It appears Diamondback’s approach to conservative well spacing was well received as its stock increased 2.7% on its announcement and has continued its upward trajectory.ConclusionCommodity price will always be at the forefront of the oil and gas industry. Higher prices allow for more investment, higher profits, and lofty valuations. On the downside, operators must make it through lean times while avoiding bankruptcy. While keeping debtholders happy by making their required payments, they must also seek to please equity investors by achieving production growth on a tight capex budget. Size tends to help both of these as capital becomes cheaper and scale allows for successful drilling techniques from one basin to be applied to operations in other areas.At Mercer Capital, we have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. We can help companies navigating the bankruptcy process, considering M&A in an acquisitive market, or maintaining their operations business as usual. Contact a Mercer Capital professional to discuss your needs in confidence.
Family Business Industry Spotlight: Auto Dealer Industry
This week’s post is a part of a periodic series called “Family Business Industry Spotlights.” In these posts, we will share conversations with our family business advisory professionals who have deep experience working with family businesses in a particular industry. We think the conversations promise to be of interest to family business directors regardless of their industry. This week, we talk with Scott A. Womack about the challenges and industry trends facing families in the Auto Dealer Industry.1. How have auto dealers performed over the past decade?As with most questions, this isn’t a quick and easy answer. Generally, I would say that the auto dealer industry has rebounded from two very poor years during the recession (2009 and 2010) and performed favorably since 2011. A seasonally adjusted annual rate (SAAR) for new lightweight vehicle sales is a leading indicator for the health of this industry. Since June 2011, the SAAR has been generally climbing and has maintained a figure above 14 million units since January 2012.The longer answer is more complicated. In addition to the national economic trends, the success of an auto dealer can be sensitive to more local economic conditions. Further, the auto dealer industry tends to be somewhat cyclical. For instance, it is very common for an auto dealer to have several good years, followed by a down year or two.Brands or manufacturers also have a big impact on the profitability and success of a particular auto dealer. Some brands have historically been more desirable than others, and the perceived values of other brands have fluctuated over the past decade for a variety of reasons.2. In your experience, how do families in the auto dealer industry deal with ownership and management transition?Like many other industries, many auto dealers are in to the second and third generation of family ownership at this point. We see many current owners facing the potential decision to sell because the next generation either doesn’t have the desire or ability to continue running the business. Another unique element of this industry is that each dealership has to have a factory-approved dealer principal. Approval of proposed new principals is not always a given, and we have seen many hiccups in this process at death of an owner, transition to other family members, or proposed sale to a third party.The other trend that we are seeing occurs when a family has several children and some are active in the business and some are not. Some families are choosing to transfer interests in the business only to those children that are active in the management/operations. For the non-active children, retaining an interest in the real estate may be an option to reach an equitable outcome. Most auto dealers are set up with the operations as an entity and the real estate held in a separate holding-company entity. It can become quite important to have both properly valued for any tax implications with these gifts/transfers, but also for the transparency to the children that the different gifts/transfers have been equitable.3. What are some important trends in this industry that families should be thinking about?As the SAAR begins to flatten out and show small signs of decline in the first two quarters of 2019, auto dealers are probably also experiencing similar trends with their new vehicle sales. Opportunities exist for auto dealers to capitalize on used vehicle sales during these times. Also, auto dealers should be able to focus on their Fixed Operations (parts & service). As the average age of vehicles in service continues to rise, more consumers are spending money to repair existing vehicles rather than purchase new vehicles. Finally, we are seeing more auto dealers practice expense controls to mitigate the current revenue trends.4. If you could add one agenda item to the next auto dealer’s board or management meeting what would it be?In the last few weeks, we have bid on two large projects in this space: one involving an IRS-challenged valuation impacting a taxable estate and another involving a family transition and buy-sell agreement stemming from the last family transition dispute. In both cases, a proper valuation from an industry-qualified appraiser would have greatly remedied the situation. The auto dealer industry is very specialized, from the way dealers report their financial statements (factory dealer statements) to the terminology used (Blue Sky value). Don’t be afraid to ask an appraiser for their specific industry experience and what specialized methodologies should be used for this industry. Be wary of general valuation appraisers that are not alert to factors such as LIFO adjustments and potential normalization adjustments for real estate, leasehold improvements and rent.5. If a family is considering or has made the decision that they want to sell their dealership, what things should they be thinking about?Even before a family reaches this point in the decision process, I would recommend having the business valued. While certain obvious events dictate the need for a formal valuation (death of owner, divorce, litigation, transaction), sometimes it can be too late. Not only would a valuation provide a current indication of value, but it can also manage expectations around what the family thinks the value should be. Additionally, the valuation should help identify many of the value drivers in this industry which would allow for the family to assess and monitor over time if they wished to try to increase the current value to be more in line with their expectations.Another item a family should consider is the potential timing of a sale during the calendar year, as the timing may impact the tax consequences. An earlier sale in the calendar year could limit the wages for that year’s tax return that could offset a large ordinary income event from LIFO and depreciation recapture and other ordinary income. Whenever possible, contact your accountant or tax planning consultants to discuss the timing of a proposed sale.
How Does Your RIA Measure Up?
Schwab’s 2019 Benchmarking Study Offers Insights Into the RIA Industry
Schwab recently released its 2019 RIA Benchmarking Study. The survey contains responses from over 1,300 RIAs that custody their assets at Schwab to questions about firm operating performance, strategy, and practice management. The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm. We’ve highlighted some of the key results from the study below. You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA. Not surprisingly, top-line growth is a top-line priority—most RIAs ranked gaining new clients through existing client referrals or business referrals as their primary focus. Just behind new client acquisition was improving productivity through new technology (e.g., taking advantage of CRM efficiencies). Developing or enhancing a succession plan was at the bottom of the list, a result which is generally consistent with our experience working with many different RIA clients. Succession plans are easy to put off because there is no immediate benefit for developing one. But eventually every firm will need one, and developing a succession plan may very well be the lowest hanging fruit to enhance firm value, protect clients, and improve career satisfaction.GrowthThe firms participating in the survey have seen strong five-year growth on average. Between 2014 and 2018, AUM grew at a compound annual growth rate (CAGR) of 7.5%, while revenue and number of clients grew at a respective 9.5% and 5.4% CAGR. The best-performing firms (Schwab defines this as the top 20%) saw positive AUM growth even in 2018 (the worst year for market performance covered by the survey) due to strong net organic growth. Interestingly, the fact that revenue growth has outpaced AUM growth suggests that the effective realized fees for these firms has increased over the last five-years, despite reports of fee pressure across the industry. This could be attributable in part to the fact that the respondent firms reported an increased breadth of services offered between 2014 and 2018. All of the RIA size categories identified in the survey saw similar growth over the last five years, although firms managing less than $2.5 billion in AUM generally experienced higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years. 4% of firms acquired new clients by M&A in 2018, and 18% of firms have completed an acquisition in the last five years. Over the past five years, 13% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since 62% of firms are still primarily led by their founders. Eventually, of course, all of these founder-led firms will need an exit strategy for the founding partners, whether that is through internal succession or a sale to a third party. A full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership. Most firms, however, have added non-founders to the ownership base—only 29% of firms reported not sharing equity with non-founders. 26% of firms reported sharing equity with non-founders to support succession planning, while a further 27% reported sharing equity to retain key talent. These equity purchases are mostly financed either by the employee (self-financing) or by the current shareholders (seller financing), although there are an increasing number of options for third-party financing of equity purchases.ProductivityRespondent firms reported increases in productivity between 2014 and 2018. Over this period, AUM per professional increased from $88 million to $97 million, and the number of clients per professional increased from 46 to 52. Also over this period, hours per client for operations and administration decreased from 19 to 17, while hours per client for client service remained flat at 34, suggesting that these gains in productivity were the result of administrative efficiencies, not a decrease in client service.ProfitabilityThe respondent firms reported strong standardized operating margins across size categories, ranging from 26.4% for the $2.5 billion + AUM category to 30.0% for the $1.0 to $2.5 billion size category. Even the smallest size category, RIAs with $100 to $250 million AUM, reported standardized operating margins of 28.9%.As indicated by the Schwab survey, succession planning is at the bottom of many firms’ to-do lists, but it’s a critical issue that all firms will have to face eventually. For more information on RIA succession planning, keep an eye out for our upcoming whitepaper, Buy-Sell Agreements for Wealth Management Firms (scheduled for release in early September).
A Guide to Corporate Finance Fundamentals
Part 4 | Finance Basics: Distribution Policy
This post is the fourth and final installment from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure?
These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #3: Distribution PolicyCapital structure and capital budgeting intersect at the point of the cost of capital, which serves as the hurdle rate for evaluating potential capital projects.As shown in Exhibit 1, capital budgeting also shares an intersection point with distribution policy.If capital projects having expected returns in excess of the cost of capital are abundant, it may be appropriate to retain a greater proportion of earnings for reinvestment than if attractive capital projects are scarce.Ultimately, the total return available to shareholders is determined by the operating performance of the business.Beyond that, however, the board does have some measure of discretion with regard to the form of that return (yield vs. capital appreciation).Family shareholders are likely to have a unique set of preferences with regard to the composition of their total return.Those preferences may vary over time and, potentially, within the shareholder base at a particular point in time.In the public markets, shareholders can sell shares if the mix of return components does not correspond to their preferences.Family business shareholders do not have ready liquidity, so it is important for directors and managers to solicit input regarding shareholder preferences.The ability to configure the desired mix of return components is constrained by the availability of incremental debt and equity capital.For example, for a given level of operating cash flow and capital investment, higher dividends can be achieved through incremental borrowing, new share issuance, or asset sales.In each case, boosting dividend yield would come at the expense of capital appreciation.Incremental borrowing capacity may be limited if the company’s capital structure is already optimally leveraged.For family businesses, it may be infeasible to issue illiquid shares at a fair price.And asset sales are not a sustainable source of cash flow.If family shareholders have diverse preferences regarding the composition of total return, perhaps the best means of tailoring returns is to implement a share repurchase program.Shareholders desiring current income can sell a portion of their shares to the company, which fuels capital appreciation for those preferring future upside.In order to implement this strategy, however, there must be a mutually agreeable share price.If the price is too low, the selling shareholders will effectively be subsidizing the remaining shareholders, while a price that exceeds fair market value will benefit the selling shareholders. Topics for Board DiscussionDistribution policy is the most transparent board action for family shareholders.There may be many things shareholders are content not to know regarding the company, but the timing and amount of periodic dividends will not be one of them.Where is the company in its life cycle? Mature companies with more limited opportunities for attractive capital investment are more natural dividend payers.How does the company’s current capital structure compare to its target capital structure?Over time, the board can use dividend policy to migrate the company to its target capital structure while minimizing transaction costs.What are shareholder preferences?Do the shareholders have a consistent set of expectations regarding return composition or do different shareholder groups have conflicting preferences?What type of distribution policy best fits the company and its shareholder base: a set dollar amount, fixed payout ratio, fixed yield on value, or residual distributions after attractive capital investments have been funded? Dividend policies can provide much desired predictability to shareholders, but can also place artificial constraints on the board.How much financial flexibility does the company have to accommodate shareholder preferences?Can the company borrow additional funds?Is there a market for issuance of new shares?If so, at what price?Is a share redemption program feasible? Can the board formulate a market-clearing price that does not unduly reward or punish either group of shareholders?
WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper
An Overview of Saltwater Disposal
Part 2 | Economics of the Industry
In a prior blog post, we provided an overview of the saltwater disposal (SWD) industry, detailing the source of demand for SWD services, the impact of the shale boom, geographic distribution, site selection, construction, and regulation. We now take a look at the economics of the SWD industry and the trends that impact the economics.SWD EconomicsIn the past, SWD wells were typically drilled and operated by producers for the purpose of handling the producers’ own disposal needs. However, the growing inefficiency of individual operators having in-sourced SWD operations has in recent years created an increased demand for specialized outsourced SWD services. The expertise and economies of scale provided by these independent SWD service providers allow for reductions in the saltwater transportation and disposal expense to the producer. As a result, the operation of SWD facilities as a stand-alone business has shown enormous growth in recent years.Revenue StreamsRevenues streams to SWD operators consist primarily of disposal fees – typically in the range of $0.50 to $2.50 per barrel – and skim oil sales. Produced water contains significant amounts of suspended crude oil that the SWD facility “skims-off” (by various methods) and sells to increase revenues. Where disposal services are abundant, the cost is typically in the lower third of the indicated range. Locations with fewer available SWD facilities can see fees in the upper end of the range. Skim oil volumes are typically quite small relative the volume of produced water received for disposal. However, the sale of the skimmed oil can account for 10% to 30% of total SWD revenues. The portion of revenues attributable to skim oil sales depends on the SWD facility’s skimming and impurity removal capabilities, in addition to the presence of a local market for alternative skim oil use.Revenues streams to SWD operators consist primarily of disposal fees – typically in the range of $0.50 to $2.50 per barrel – and skim oil sales.Additional revenues may be generated by providing trucking services for the purpose of transporting the produced water from the well site to the disposal facility. Revenues from such services can vary widely. Transport rates are typically near $1 per barrel per hour of transport time. Where SWD facilities are readily available and the distance from the well site is minimal, the trucking cost may only add $0.50 per barrel. However, the incremental revenue can reach $4 to $6 per barrel where facilities are lacking and the distance is significant.As with the in-sourcing of SWD operations by producers, the provision of trucking services by SWD facility operators is on the decline. As the oilfield waste disposal industry has rapidly grown in recent years, the ability to provide specialized services at significant economies of scale has led to oilfield waste transportation services being provided as a stand-alone business. As detailed below, the growing benefits of transporting produced water to SWDs via pipeline has also contributed to the decline in trucking services among SWD facility operators.Cost StructureThe structure of a SWD facility’s expenses is significantly skewed to fixed costs relative to variable costs. Like other fixed asset-intensive businesses, a large portion of a SWD facility operator’s costs are incurred up-front in the construction of the facility, including the cost of drilling the primary disposal well and any back-up well. While drilling costs can vary markedly based on the site geology, the target zone, and well depth, the total facility cost can easily reach $3 million to $4 million even if the facility offers no produced water transportation via pipeline.Ongoing expenses are fairly limited and are primarily comprised of power and maintenance/repair costs. Incremental costs are typically quite low, often less than $1 per barrel. Labor costs vary little whether disposal volumes are high or low. Ticketing and invoicing processes are typically heavily automated, and therefore, related expenses do not vary significantly with volumes.The one area of expense that is to some degree within the control of the SWD operator is maintenance expenses. The SWD operator is well advised to exercise diligence in the maintenance of the SWD well as any downtime, expected or unexpected, can be costly in terms of lost revenues.Focus on VolumeGiven the fixed-heavy cost structure, the SWD facility operator’s primary lever for improving operating results lies in increasing volumes. However, for the well operator, the primary consideration in choosing a SWD facility is the transportation cost, which is largely a factor of the distance from the well site to the disposal facility. So, once the SWD facility is sited, the primary SWD decision driver – distance – is fixed and can’t be altered. To gain more disposal business, SWD facilities often provide transport services via truck. However, as previously indicated, recent trends have moved SWD facility operators away from trucking services.Trends in Volume AcquisitionHistorically, the transportation of produced water to a commercial disposal facility has been heavily weighted toward trucking. Due to the smaller volumes of water requiring disposal and the typical patchwork of acreage controlled by any single E&P company, the construction and use of pipeline systems for gathering and transporting produced water to a central disposal facility was cost-prohibitive. However, with the vast increase in produced water volumes in recent years, and the recent trend among the E&Ps to aggregate more contiguous acreage, the feasibility of pipeline systems has grown. With trucking costs now more than doubling pipeline transportation costs in many markets, the large up-front cost of constructing a pipeline network is often no longer an economic hindrance.Similarly, several producers have put in place longer-term programs for the systematic development of their large – and more contiguous - acreage holdings. As part of these programs, the producers have found it economically viable to build out pipeline systems for gathering and transporting produced water to local SWD networks. Although the trucking of produced water is still dominant in some areas - the Bakken and the Eagle Ford - SWD operators in the Delaware Basin have indicated that piped volumes are likely exceeding trucked volumes in that pipe-heavy area. Data from NGL Energy shows the progression of piped versus trucked produced water in recent years.
While many of the more extensive pipeline systems were originally operated by the E&Ps, much of the current systems are held by businesses that specialize in oilfield waste disposal via E&P asset drop-down and asset sale transactions.
Produced Water ContractsAlong with the rise in the prevalence of produced water pipeline gathering and transport systems has come the need for the owners/operators of those systems to ensure the disposal volumes into their systems will be sufficient to service the debt taken on related to the pipeline construction or acquisition. In pursuit of steadily produced water volumes, SWD operators and E&Ps have begun entering into contractual commitments that often include dedicated acreage and/or take-or-pay volumes. These contractual relationships are often multi-year agreements, ensuring a steady stream of produced water. The enhanced economies of scale result in a risk/return profile that is less like that of oilfield service providers and more like midstream companies. This lowers the cost of capital for SWD operators.Produced Water RecyclingOne detrimental economic trend in the SWD industry is produced water recycling.One detrimental economic trend in the SWD industry is produced water recycling. Hydraulic fracturing requires enormous amounts of water and therefore results in enormous amounts of produced water. Traditionally, fracking operations only utilized freshwater. However, in recent years operators have begun experimenting with mixes of fresh and produced water for fracking purposes with largely favorable results. This brings the potential for significant quantities of produced water no longer heading to SWD facilities for disposal but instead being recycled and reused at the well site. While reducing both freshwater supply and produced water disposal expenses would seem to be an obvious benefit to the operator, produced water recycling carries its own cost.Produced water recycling entails a multiple-step process with each step removing a certain part of the produced water mix. Although the recycling process does not have to bring the produced water to a “drinking water” level of freshness, recycling to the level required for use in fracking can entail a significant expense. The recycling economics often hinges on the availability – and therefore cost – of freshwater for fracking use. In areas where freshwater is abundant and inexpensive, recycling economics are less beneficial. In areas where freshwater is scarce and expensive, recycling often makes economic sense. As recycling technology improves and greater efficiencies are realized, it’s likely that a greater percentage of produced water will be reused, rather than removed for disposal. However, research by Raymond James indicates that fracking-related water demand growth falls far short of estimates of produced water disposal demand growth, even with produced water recycling considerations.[caption id="attachment_27673" align="aligncenter" width="940"]Source: EIA, Drilling Info, Baker Huges, Raymond James Research[/caption]
As of now, recycling of produced water is still in early development with estimates of disposal to recycle ratios at 20:1.
SummaryAs detailed, the outlook of the SWD industry is quite favorable although the economics are, and will continue to be, in a state of flux as the industry grows and matures. Despite some potential detrimental market dynamics along the way, the overall direction points to strong benefits to investors as the business of SWD continues to evolve away from a being cost center for operators, to a cash flow generating third-party service provider to operators.
Buying Off the Discount Rack?
For bargain shoppers, the discounts at Nordstrom have been eye-catching lately. And we don’t mean the clothes. The shares of the fourth-generation family retailer, whose shares have been publicly traded since the early 1970s (ticker: JWN), have lost nearly 40% of their value during 2019.For bargain shoppers, the discounts at Nordstrom have been eye-catching lately. And we don’t mean the clothes.According to a Wall Street Journal report, the Nordstrom family is preparing a bid to increase its ownership stake in the company from approximately one-third to over 50%. Although the exact form of the proposed transaction has not yet been specified, it is almost certain that the family would need to offer a premium to the current share price to complete such a transaction.
One interesting twist to this family drama is that at least some observers believe that the shares are depressed because of the inept management of the very family members who are proposing to increase their ownership stake. The company is managed by two fourth generation brothers (three, until the oldest died unexpectedly in January), but a majority of board seats are held by non-family independent directors. Amid stagnating operating performance, some on the board have been seeking to bring in an unrelated outsider to replace the family managers.
These developments come after directors rejected a bid by the family to take the company private in 2017 for $50 per share (the shares closed on Friday at $29.30).
Some stocks are underpriced; others are cheap for a reason. Assuming the family’s proposal to increase its ownership stake goes forward, the independent directors will need to decide which is true of Nordstrom’s shares. Reported earnings for 1Q19 fell 55% from the prior year as total revenue slid by 3.5%. At Friday’s closing price, JWN shares imply a value of approximately 6.2x trailing EBITDA. Department store peer Macy’s (ticker: M), whose shares have also languished during 2019, trades at a comparable 6.5x multiple. As always, whether Nordstrom shares are undervalued or properly assessed by the market remains a matter of difficult judgment.
Some stocks are underpriced; others are cheap for a reason.Since very few family businesses are publicly traded, their directors do not have to engage in these difficult deliberations under the public microscope. The core issues however, are not uncommon to private family businesses. The alternatives available to the Nordstrom investors likely include some combination of the following:Negotiate a transaction price at which the Nordstrom family could increase their ownership stake above 50% while remaining publicly-traded. If the directors accept a Nordstrom family proposal to increase their ownership, it would likely result in the family exerting more direct control over the company in the future. If the current family managers are, in fact, a source of the company’s underperformance, allowing the family to gain control of the board could consign the remaining public shareholders to ongoing underperformance.Replace family management with non-family professionals. If the directors believe that recent performance does not reflect the company’s true operating potential, the best course of action may be to remove the current family managers and allow a new group of outside managers to steward the shareholders’ resources. The principal risk with this decision is that Nordstrom’s recent poor performance is a function of inevitable industry trends that will not be eliminated by a new management team. If that is the case, the shareholders (both family and public market investors) may see continued erosion in the value of their investment in future years.Solicit a financial partner to help take the company private. The past is the past, and allowing sunk costs to influence future courses of action is probably the most pervasive cognitive bias that afflicts family business decision-making. That said, the fact that the board passed on an offer of $50 per share two years ago undoubtedly rankles for some shareholders while the share price now hovers around $30. The price for a going private transaction today may not be as high as the former $50 per share offer, but is almost certain to exceed the current market price. A financial partner may be allied with the Nordstrom family and allow the current management to remain, or a prospective partner may envision making substantial management and strategic changes following the going-private transaction.Sell the company to a strategic buyer. If the directors conclude that the current market price provides a realistic portrait of Nordstrom’s likely future within the new retail landscape, selling the company to a motivated strategic buyer may be the best financial outcome for the shareholders. When motivated strategic buyers exist for a business, the potential synergies and strategic benefits available from the combination may increase the transaction price beyond what the selling shareholders could reasonably expect from any other outcome.Enterprising families should understand, however, that while selling the family business may eliminate some challenges, it creates new ones. In an insightful article for the New York Times over the weekend, Paul Sullivan describes the new challenges faced by several families after selling the family business.Without the “glue” provided by the business, family ties may weaken.Ownership of the family business confers other forms of socioeconomic wealth. Following a sale, these benefits may evaporate.Stewarding an active business provides a greater sense of purpose than managing a portfolio of passive investments. Upon selling the business, family members previously active in the business may find they are somewhat adrift personally.The publicity around a sale of the family business can change perceptions of the family’s wealth, and create new claims on that wealth.Future returns from reinvestment of transaction proceeds may be less attractive than those earned from owning the family business.
Most of the family business leaders we know are probably relieved they don’t have to make decisions under the burden of public and market scrutiny like the directors at Nordstrom do. However, the types of decisions that they are called upon to make are often just as challenging. Whether it is assessing the value of your family business, benchmarking the performance of your family business, or evaluating strategic alternatives, our experienced family business advisory professionals are here to help. Call us today to discuss your needs in confidence.
Public Royalty Interests: Picking the Right Comparable
In previous posts, we have discussed the relationship between public royalty interests and their market pricing implications to royalty owners. Here, we will define our group of royalty interests which can be used to gain valuation insights. Specifically, we will look at mineral aggregators, natural gas focused trusts, and crude oil focused trusts and the statutory differences between them. We also consider how dividend yields and other public data can be used to imply value for private mineral interests while being judicious in our application of such metrics.What is a Royalty Trust?Historically, the most common way mineral interests have been structured for public investment has been in the form of a trust. The trust’s sponsor (frequently though not always the operator) conveys a percentage interest in specified properties, and the trust is prohibited from acquiring more interests. In some cases, the trust has a defined termination date, but this can also be based on a certain threshold of production, or there may be no specified termination at all.The most common way mineral interests have been structured for public investment has been in the form of a trust.Distributions are paid on an established schedule (monthly is the most common), and these distributions are based on commodity prices and the level of production. While the former depends on market forces, the latter tends to decline over time as the resources are drained from the specified properties. Thus, the stock prices of these trusts decline over time, and the return comes almost exclusively from the dividend yield, with minimal opportunity for capital appreciation.Because they are structured as a trust, these investment vehicles are required to distribute a substantial portion of their income. However, trusts can withhold a certain percentage of cash flows to pay trust administrative expenses or create a reserve for future distributions. Because the interests in the specified properties are typically revenue interests, the trust is not required to pay for any expenses related to production, so expenses are relatively minimal.What is a Mineral Aggregator?The more popular investment vehicle for mineral interests recently has been the emerging sector of mineral aggregators. Aside from Dorchester Minerals, LP, which IPO’d back in 2003, the remaining five aggregators have gone public in the past five years, including Falcon Minerals and Brigham Minerals in the past twelve months.1 While aggregators also allow investors to gain exposure to the energy sector without investing directly in E&P companies or commodities, there are differences between aggregators and trusts, beginning with their structure.Dorchester, Viper Energy Partners, Blackstone Minerals, and Kimbell Royalty Partners are all structured as MLPs, while Falcon and Brigham are corporations.2 Eschewing the trust structure provides certain benefits to these entities. Aggregators are not restricted from acquiring more interests, and as their name implies, they seek to reinvest their earnings into the acquisition of new properties. The value of units in a public royalty trust tend to decline with production over time, but aggregators stem the tide of these losses with their reinvestment, and they do not have the statutory termination present in some trusts.They can also issue more common units, take on debt, and incur operating expenses in ways that royalty trusts cannot. While these make aggregators appear to be the better option, trusts by nature have beneficial tax treatment, and their yields tend to be higher and relatively more predictable given their distribution requirement, which mineral aggregators could decide to forego.A table summarizing the primary differences between a royalty trust and a mineral aggregator is included below:Market Data for Trusts and AggregatorsTo gain a better insight into how these factors play out in the public marketplace, we should analyze the data. The following tables gives some critical market data for valuation purposes:
[caption id="attachment_27589" align="aligncenter" width="868"]Source: Capital IQ[/caption]
While these trusts are predominantly focused on natural gas, many also have oil and NGL reserves. These natural gas trusts have the lowest market caps and relatively high dividend yields. Compared to the crude oil trusts, these exhibit more diversity in product mix including notable amounts of NGLs.
[caption id="attachment_27615" align="aligncenter" width="867"]Source: Capital IQ[/caption]
[caption id="attachment_27609" align="aligncenter" width="860"]Source: Capital IQ[/caption]
Compared to natural gas focused trusts, crude oil trusts tend to have relatively higher market caps with similar yield and pricing multiples, despite being based on a different commodity. The levels of operating expenses are comparable as well. For this post, we have further delineated between perpetual and terminal crude oil trusts. The latter have a specified end date, while the former do not. However, both groups ultimately will receive distributions related to crude oil prices and declining production, regardless, whether there is a statutory termination or not. Going forward, we do not plan to group these separately.Mineral AggregatorsAs noted previously, mineral aggregators have been the apple of certain investors’ eyes lately. They are not bound by distribution requirements, which allows aggregators to gobble up additional acreage. This provides investors an element of growth in what has historically been a declining, yield-only return play. Despite no statutory requirements to distribute, the below aggregators have offered an attractive yield to investors.
[caption id="attachment_27591" align="aligncenter" width="859"]Source: Capital IQ[/caption]
When compared to the trusts, aggregators are significantly larger in terms of market cap and have notably more operating expenses and product diversity. Also, they tend to trade at higher revenue multiples, with lower yields. While mineral aggregators may present an attractive option for investors, they are less functional as comparables for mineral interest owners. The lower yield, influenced by potential for return from future growth, and higher operating expenses render aggregators less comparable to traditional mineral interests.Other Valuation ConsiderationsNow that we have the data to back up the differences between trusts and aggregators, one must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest. While tempting, drawing valuation conclusions simply by selecting the appropriate commodity mix would be shortsighted. There are plenty of other considerations and judgments that need to be made such as:Timing quirks related to market pricing and dividendsIdiosyncratic issues with the operatorRegion/basin
Dividends are a product of production and commodity pricing over the past year, whereas stock prices tend to be based on expected future commodity prices. WTI crude prices are expected to remain below $60/bbl for the rest of 2019, but dividends in the past year include those from back in late 2018, when some floated the possibility of crude oil returning to $100/bbl. Contrast this to a recent declaration that oil could conceivably drop to $30/bbl. With dividends paid out monthly, the numerator of the yield is impacted by stale prices that do not typically inform future expectations. These expectations, however, are a critical driver for the denominator, so bearish sentiment leads to higher yields. Higher yields inform current market sentiment about relative risk factors, however simply taking the prevailing dividend yield is not advisable.One must delve deeper into the subject characteristics of the individual trusts to determine how one might use these to value their own private royalty interest.Case in point(s): San Juan Basin Royalty Trust has not paid a dividend in the past year. That doesn’t mean there is no risk in their cash flows, it means there are no cash flows. On the opposite end of the spectrum, Whiting USA Trust II has a yield north of 77% as its quarterly dividends have nearly matched its prevailing market price. Again, this should not imply to a private mineral owner that their potential future revenue checks will carry this level of risk.Another important consideration for utilizing trusts as comparables is the operator of the subject interests. Take the three SandRidge trusts for example. Trust distributions are a function of both production and price, and SandRidge has struggled to maintain production given its various woes. Comparing the risk of a private mineral interest to one whose operator is hemorrhaging is not prudent.Finally, one must consider the region or basin. Geological factors distinguish the commodities produced in different plays and basins, and regional transportation dynamics also play a role. As a result, investors may pay a premium to be in a basin such as the Permian. SandRidge Permian Trust bears many of the idiosyncratic issues as the SandRidge Mississippian Trusts, but it is in a more desirable location and therefore is expected to command a higher multiple. Again, production and price determine the distributions, and certain basins such as the Eagle Ford may provide the opportunity for premium prices while others like the Permian may be more attractive for other reasons.How These Factors Impact ValuationsTo value a currently producing royalty interest under the income approach, a valuation professional must determine some indication of projected future cash flows and discount these back to the present. Given the declining nature of the production, total return comes almost exclusively from the yield. Thus, we can use yields on public royalty trusts to discount the projected future cash flows of the subject interest back to the present. As noted above, judgment is required in determining the relative risk and return characteristics of the subject interest. As we noted in our last post, the SEC prices reserves based on a present value factor of 10%. While this is less applicable to PUDs and similarly more risky assets, private mineral interests that have been delivering consistent cash flows in the form of monthly royalty payments are more likely to be around this 10% discount rate, even if current yields indicate something higher.ConclusionWhen investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The commodity mix, operator/sponsor, region, termination (or lack thereof), and other key aspects make each of these investment vehicles unique. Further analysis is required to verify these provide meaningful valuation indications.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Actual IPO of entity holding Falcon Minerals occurred in 2017, but it discontinued its Special Purpose Acquisition Company (“SPAC”) in 2018.2 Viper and Kimbell have both elected to be taxed as C-corporations.
Bank M&A 2019 Mid-Year Update
Through late July, M&A activity in 2019 is on pace to match the annual deal volume achieved in the last few years. Since 2014, approximately 4%-5% of banks have been absorbed each year via M&A. According to data provided by S&P Global Market Intelligence, there were 136 announced transactions in the year-to-date period, which equates to 2.5% of the 5,406 FDIC-insured institutions that existed as of year-end 2018.In the first seven months of the year, aggregate deal volume reached $41.3 billion, which surpasses the $30.5 billion in announced deals in all of 2018 as shown in Figure 1. The increase primarily reflects the $28 billion BB&T-SunTrust merger that was announced on February 7 and represents the largest deal since the 2007-2009 financial crisis. While deal value is up, multiples are down relative to 2018 with the average P/TBV multiple declining from 174% to 161% and the median P/E multiple declining from 25.3x to 17.1x as shown in Figure 2, although the price/earnings multiples from the 2018 period may be distorted by the effects of tax reform.
The tables below provide a more detailed look at deal activity and the change in multiples in 2019 relative to 2018. For banks with assets less than $500 million, P/TBV multiples declined approximately 5%. While deal volume in the $500 million to $1 billion size group somewhat limits the meaningfulness of comparisons, it’s interesting to note that the median P/TBV multiple increased for this group relative to 2018 while the median buyer size increased from $3.1 billion in assets to $6.8 billion.
As shown in Figure 3 below, the landscape of buyers has shifted somewhat in favor of bigger banks over the last decade. Deal activity among the smallest group (buyers with assets less than $500 million) peaked in 2015 with 95 announced deals. In 2018, this group announced 56 acquisitions. In contrast, buyers with total assets between $10 billion-$50 billion announced a 10-year high, 28 deals in 2018 and are on pace to reach a similar level in 2019. In May 2018, the SIFI threshold was increased to $250 billion, providing immediate relief to banks with assets between $50 billion and $100 billion. For those with assets between $100 billion and $250 billion, regulatory relief will phase in after 18 months. This change is expected to encourage additional M&A activity among bigger players.
The theme of the story hasn’t changed; consolidation of the banking industry continues at a pace on par with the historical average. Target banks with less than $500 million in assets continue to comprise 75%-85% of total deal volume, but the composition of the buyer universe does seem to be shifting. In addition to the move towards larger buyers, another trend that appears to be gaining speed is the acquisition of commercial banks by credit unions. In 2015, three of such transactions were announced. In 2018, nine deals by credit unions were announced, and an additional ten have been announced through late July of this year.
As to be expected, pricing trends over the last few years have also further cemented the value of a stable and low-cost customer base. As shown in Figure 4 below, as interest rates increased from the end of 2015 through 2018, pricing diverged in favor of banks with the highest percentage of noninterest-bearing deposits to total deposits.
Mercer Capital has been providing transaction advisory and valuation services for over 30 years. To discuss a transaction or valuation issue in confidence, please contact us.
Originally published in Bank Watch, July 2019.
Community Bank Valuation (Part 1): Financial Performance, Risk, and Growth
This article begins a series focused on the two issues most central to our work at Mercer Capital: What drives value for a depository institution and how are these drivers distilled into a value for a given depository institution?We leave the more technical valuation discussion for subsequent articles. At its core, though, value is a function of a specified financial metric or metrics, growth, and risk.Financial MetricsMany industries have a valuation benchmark used by industry participants, although this metric does not necessarily cohere with benchmarks used by investors. In the banking industry, “book value” fills this role. In fact, there are several potential measures of book value, including:Stated shareholders’ equity, as indicated in the institution’s financial statementsTangible book value, which deducts purchase accounting intangible assets from stated shareholders’ equityTier 1 common equity, which is a regulatory capital measure that is less commonly used as a valuation metric
The most commonly used book value metric is tangible book value (or TBV). Like most industry benchmarks, simplicity and commonality are reasons industry participants embrace TBV as a valuation metric. Strengths of TBV as a valuation metric include:It is reported frequently and comparable from institution to institution.TBV is subject to less pronounced volatility than net income; thus, valuation multiples computed using TBV may be less prone to exaggeration when, for example, earnings are temporarily depressed. TBV can be used to capture the mean reversion tendencies of return on equity (ROE). For example, consider an institution with an ROE exceeding its peer group. Over time, as competitors understand and replicate its business model, these excess returns may diminish. An analyst could use TBV multiples to model potential mean reversion in ROE, which is more difficult to capture using a current period price/earnings multiple.
While TBV has its place, investors focus primarily on an institution’s earnings and the growth therein. This earnings orientation occurs because investors are forward looking, and TBV inherently is a backward-looking measure representing the sum of an institution’s common stock issuances, net income, dividends, and share redemptions since its inception. In addition to being forward-looking, investors also appreciate that earnings ultimately are the source of returns to shareholders. With earnings, the institution can do any of (or a combination of) the following:1Reinvest (i.e., retain earnings), with the goal of generating higher future earningsPay dividends to shareholdersRepurchase stock, which supports the per share value by reducing the outstanding sharesAcquire other companies. Because goodwill and intangible assets are deducted when computing regulatory capital, earnings offset the TBV dilution created in these transactions
More bluntly, investors like growing earnings and cash returns (dividends or share repurchases), which are difficult to provide without a sustainable base of strong earnings. Investors will tolerate some near-term drag on earnings from expansion or risk mitigation strategies, but their patience is not limitless.
In many industries, earnings before interest, taxes, depreciation, and amortization (EBITDA) or a similar metric is the preferred earnings measure. However, banks derive most of their revenues from interest spreads, and EBITDA is an inappropriate metric. Instead, bank investors focus on net income and earnings per share. When credit quality is distressed, investors may consider earnings metrics calculated before the loan loss provision, such as pre-tax, pre-provision operating income (PPOI).
While earnings-based analyses generally should have valuation primacy in our opinion, TBV multiples nevertheless serves as an important test of reasonableness for a valuation analysis. It would be foolhardy to develop a valuation for a depository institution without calculating the TBV multiple implied by the concluded value. Analysts should be able to reconcile implied TBV multiples to public market or M&A market benchmarks and explain any significant discrepancies.
Occasionally, analysts cite balance sheet-based metrics beyond TBV, some of which have more analytical relevance than others. The most useful is a multiple of “core” deposits, a definition of deposits that excludes larger deposits and deposits obtained from wholesale funding markets. Core deposits are time consuming and costly to gather; thus, a multiple of core deposits aligns a bank’s value with its most attractive funding source. A less useful multiple is value as a percentage of total assets, the use of which would implicitly encourage management to stockpile assets without regard to their incremental profitability.GrowthInvestors like growth and accelerating growth even more. Without demonstrating the mathematics, higher expected growth rates produce higher valuation multiples. Further, price/earnings multiples expand at an increasing rate as growth rates increase, as indicated in the following chart. The opposite is true, too, as slowing growth reduces the price/earnings.
Banks report innumerable metrics to directors and investors, but what are the most relevant growth indicia to investors? Usually, investors focus on growth in the following:
Balance sheet components like loans and deposits, which ultimately drive revenue growthAsset quality and capital adequacyPre-tax, pre-provision operating income, which smooths earnings fluctuations caused by periodic volatility in provisions for loan lossesNet income per shareDividends per shareTangible book value per share
Valuation is inherently forward-looking, and historical growth rates are useful mostly as potential predictors of future growth. Further, most investors understand that there is some tradeoff between earnings today and investing for higher earnings in the future. While some near-term pressure on earnings from an expansion strategy is acceptable, strategic investments should not continually be used to explain below average profitability. After all, a bank’s competitors likely are reinvesting as well for the future.
How does growth affect value? As a thought experiment, consider a bank with no expected growth in earnings and a 100% dividend payout ratio. Should this bank’s common equity value increase? In this admittedly extreme scenario, the answer is no. This bank’s common equity resembles a preferred stock investment, with a shareholder’s return generated by dividends. That is, for value to grow, one (or preferably more) of the preceding factors must increase.
Should a bank prioritize growth in earnings per share, dividends per share, or another metric? The answer likely depends on the bank’s shareholder base. In public markets, investors tend to be more focused on earnings per share growth. If an investor desires income, he or she can sell shares in the public market. For privately-held banks, though, investors often are keenly aware of dividend payments and emphasize the income potential of the investment. Of course, sustaining higher dividend payments requires earnings growth.
Growth creates a virtuous cycle – retained earnings lead to higher future net income, allowing for future higher dividends or additional reinvestment, and so the cycle continues. One important caveat exists, though. This virtuous cycle presumes that the retained earnings from a given year are invested in new opportunities yielding the same return on equity as the existing operations. If reinvestment occurs in lower ROE opportunities – such as liquid assets supported by excess capital beyond the level needed to operate the bank safely – then growth in value may be diminished.
This discussion of growth segues into the third key valuation factor, risk.RiskMore than most industries, risk management is an overarching responsibility of management and the board of directors and a crucial element to long-term shareholder returns. Banks encounter the following forms of risk:Credit risk, or the risk that the bank’s investments in loans and other assets may not be repaid in full or on a timely basisLiquidity risk, or the risk that arises from transforming liabilities that are due on demand (deposits) into illiquid assets (loans)Interest rate risk, or the risk attributable to assets and liabilities with mismatched pricing structures or durationsOperational risk, such as from malevolent actors like computer hackers
While growth rates are observable from reported financial metrics, the risk assumed to achieve that growth often is more difficult to discern – at least in the near-term. Risk can accumulate, layer upon layer, for years until a triggering event happens, such as an economic downturn. Risk also is asymmetric in the sense that a strategy creating incremental risk, such as a new lending product, can be implemented quickly, but exiting the problems resulting from that strategy may take years.
From a valuation standpoint, investors seek the highest return for the least risk. Given two banks with identical growth prospects, investors would assign a higher price/earnings multiple to the bank with the lower risk profile. Indicia of risk include:The launch of new products or business lines » Expansion into new geographic marketsHigher than average loan yields coupled with lower than average loan losses
None of the preceding factors necessarily imply higher risk vis-à-vis other banks; the key is risk management, not risk avoidance. However, if an investor believes risk is rising for any reason, then that expectation can manifest in our three pronged valuation framework as follows:Financial Metric. The investor may view a bank’s current earnings as unsustainable once the risk associated with a business strategy becomes evident, leading to reduced expectations of future profitability.Growth. An investor may assess that a bank’s growth rates are exaggerated by accepting too much risk in pursuing growth. In this event, earnings growth expectations would be tempered as the bank realigns its growth, risk, and return objectives.Risk. Valuation multiples are inversely related to risk. By increasing the investor’s required return, the investor increases his or her margin of safety in the event of unfavorable financial developments.
An old adage is that risk can be quantified and uncertainty cannot. This observation explains why stock prices and pricing multiples can be particularly volatile for banks in periods of economic uncertainty or distress. If investors cannot quantify a bank’s downside exposure, which often is more attributable to general economic anxieties than the quality of the bank’s financial disclosures, then they tend to react by taking a pessimistic stance. As a result, risk premiums can widen dramatically, leading to lower multiples.ConclusionThis article provides an overview of the three key factors underlying bank stock valuations – financial performance, risk, and growth. While these three factors are universal to valuations, we caution that the examples, guidance, and observations in this article may not apply to every depository institution.At Mercer Capital, valuations of clients’ securities are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. These important influences on a valuation analysis cannot be gleaned solely from reviewing a bank’s Call Report. Future editions of this series will describe both the quantitative and qualitative considerations we use to arrive at sound, well-reasoned, and well-supported valuations.1 In theory, a bank could accomplish the preceding without earnings, but eventually that well (i.e., the bank’s TBV) will run dryOriginally published in Bank Watch, June 2019.
Is 16x Pro Forma EBITDA a Realistic Valuation for Mercer Advisors?
Pre-season Soccer and the Mercer Price Tag are Likely More About Form Than Substance
I was initially intrigued by this match-up. Two of Europe’s greatest soccer clubs and intra-city competitors squaring off in front of a packed crowd on American soil for the first time in their storied history. Fittingly, the game was played in a football stadium because it was that kind of score. The New York Giants and Jets fans that typically frequent the grounds probably appreciated all the action, but Real Madrid supporters and other soccer enthusiasts had a different impression. Despite all the hype leading up to the game, only one team had any interest in being there, and the match itself has been widely panned by most (non-Atleti) observers.The Real/Atleti debacle is perhaps a microcosm for the broader International Champions Cup (“ICC”) in which it is played. The pre-season tournament has been criticized for the lack of quality competition and blatant apathy of the players despite broad participation by most of Europe’s top clubs. Blame the heat, injury aversion, or American nightlife, but it hasn’t been pretty. Like most pre-season affairs, there’s even talk of cancelling it all together, but that probably doesn’t make sense from an economic perspective. The real culprit is the lack of meaning to the games since they have no implications for the teams’ league status and no (direct) impact on the players’ compensation levels. There have been discussions of playing regular season European matches in America (much like the NFL and MLB are doing in London) to remedy this issue, but no definitive decisions have been made yet.I was similarly intrigued (and skeptical) of the recent reports that RIA aggregator Mercer Advisors was looking to fetch a $700 million-plus price tag in a prospective sale by its PE backers at Genstar Capital. A 15-16x multiple on an estimated pro-forma, run-rate EBITDA of approximately $50 million results in a $750 million to $800 million enterprise value for the business, which certainly got my attention. Still, this figure could be as meaningless as the ICC if it’s an unlikely appraisal of Mercer Advisor’s current market value. We’ll address our opinion from a fair market value and strategic value perspective in this week’s blog.The Fair Market Value of Mercer AdvisorsDespite the similar name, we have no relation to Mercer Advisors. On the one hand, this means that our opinion is not conflicted, but it also means that we are not privy to its financial situation, so we’ll have to opine in general terms. The 15-16x multiple feels a bit rich (we’ll address this later) but may not be nearly as big of a stretch as the “pro forma, run-rate EBITDA estimate” to which it is applied. We don’t know what adjustments were made to get from reported EBITDA to pro forma, run-rate EBITDA, but in our experience, they can be substantial and unsubstantiated.Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range.The context of fair market value, according to most definitions, is a transaction between a hypothetical willing buyer and a hypothetical willing seller, both having reasonable knowledge of the facts and circumstances. The word hypothetical precludes any consideration for what an actual, specific buyer would pay for the business. This means that certain synergies that could be realized by a strategic buyer are typically not considered in a fair market value appraisal. Since the pro forma adjustments likely include such synergies, they are probably not relevant from a fair market value perspective.The 15-16x EBITDA multiple is probably also a stretch. Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range, and this has actually ticked lower over the last few years. Even though Mercer Advisors isn’t really an RIA, it is in a similar line of business, so we can’t totally ignore the market’s current pricing of these companies. On balance, an inflated multiple on a stretched earnings estimate is likely outside a reasonable fair market value range for this business as a stand-alone entity. Especially since RIA aggregators market prices have declined over 30% over the last twelve months leading multiples to fall.The Strategic Value of Mercer AdvisorsSince many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price.Unlike fair market value, strategic value considers the particular motivations of a specific buyer and the synergies that could arise in a contemplated transaction. Since many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price. In this context, pro forma EBITDA estimates become more relevant, and we can look to recent transaction evidence for perspective on what strategic buyers are paying for these businesses. The most recent transaction in the space involved Goldman Sachs’ purchase of RIA aggregator United Capital for $750 million or an estimated 18x EBITDA. This price tag may be a bit rich for Mercer Advisors, which, at $16 billion in AUM, is quite a bit smaller than United’s $25 billion in client assets. Mercer’s pro forma EBITDA estimate may also be more heavily adjusted, so $750 million and/or 18x is probably a bit optimistic.The Focus Financial IPO last Summer offers additional guidance. The IPO price implied a total enterprise value of $2.8 billion or 16x (heavily) adjusted EBITDA. While Focus is much larger than Mercer and United, the 16x multiple may be more applicable here since it is on top of an adjusted EBITDA figure and is reasonably in line with current pricing. Overall, there does appear to be some support for a 16x multiple from a strategic buyer perspective, but we’d like to know more about the pro forma adjustments before validating the $800 million offering price.Where Do We Think this Deal Will Land?Providing a reasonable range of value for this business is nearly impossible without knowing the acquirer or anything about Mercer’s financial situation, but we’ll take a stab at it. If we back off the multiple a bit and revise our pro forma earnings estimate, we get something closer to a $450 million to $650 million transaction value. This estimate is purely speculative, and if $50 million in incremental EBITDA is truly achievable from a buyer’s perspective, then the $700 million-plus price tag looks very achievable especially since Mercer is one of the few independent RIA aggregators of this size left. Overall, we think the $700 million-plus headline value is a bit rich but certainly more meaningful than an ICC trophy.
2019 AAML/BVR National Divorce Conference Recap
On May 8-10, 2019, Chris Mercer, Scott Womack, and I attended the 2019 AAML/BVR National Divorce Conference in Las Vegas. This was the first biannual National Divorce Conference on cutting edge tax, valuation, and financial issues co-sponsored by the American Academy of Matrimonial Lawyers and Business Valuation Resources, LLC.In attendance were family law attorneys, general practice attorneys, CPAs, business valuators, and other financial professionals. Total attendance was approximately 300 individuals, split about 50/50 between attorneys and financial professionals. Sessions covered topics including updates on standards of value, cryptocurrencies and their impact on divorce, tax law changes and their impact on family law, and how to best present your case to the courtroom, among others.We have chosen four sessions that we thought would be of interest to this newsletter’s audience.Blockchain/Crypto: Dividing Digital AssetsEdward L. Kainen, Senior Managing Partner of Kainen Law Group, PLLC & Richard West, Principal & Shareholder of West Family Law Group
In “Blockchain/Crypto: Dividing Digital Assets,” Ed Kainen and Richard West provided a brief history of money– from the development of various forms of currencies and eventually to Bitcoin and other cryptocurrencies. In addition to providing a comprehensive glossary of essential terminology, the speakers also covered how Bitcoin and cryptocurrencies are transacted and explained the mechanics of Bitcoin technology upon which cryptocurrencies rely. A history of Bitcoin, as well as the benefits, determinants and consequences associated with the use of these cryptocurrencies was addressed. The session also covered how all of the foregoing impacts divorce and family law litigation, both issues of valuation and essentials of discovery, as well as the potential for malpractice pitfalls and how to avoid them.How to Present Complex Finance to Judges: K.I.S.S.Z. Christopher Mercer, FASA, CFA, ABAR, Founder and CEO of Mercer Capital
In “How to Present Complex Finance to Judges: K.I.S.S.,” Chris Mercer addressed the question of how to K.I.S.S. (keep it simple, stupid) in a litigation setting, as the K.I.S.S. principle is one of the key ideas of effective communication. Mr. Mercer drew on over 30 years of experience in presenting complex valuation and damages issues to judges and juries while sharing the techniques and templates necessary to communicate one’s position and the opponent’s position in such a way that judges can understand key information and why it is important.How to Rig a Valuation in a Marital DisputeJames R. Hitchner, CPA, ABV, CFF, ASA, Managing Director of Financial Valuation Advisors
In this session, Jim Hitcher posed the question: Have you ever read a business valuation report where you knew the valuation was rigged to obtain a higher or lower value? During his session, he provided tricks of the trade to identify how some valuation analysts can manipulate the process in order to please their client and/or win at all costs. Mr. Hitchner also provided tips on how to attack biases including three areas with the most frequent biases such as multiples, growth factors, and the specific company risk premium/risk factor.Splitting Compensation Equity Awards & Options – Splitting Up is Hard to DoPeter L. Gladstone, Principal & Shareholder of Gladstone and Weissman & Robert A. Stone, CPA, CFF, ABV, Principal at Kaufman Rossin
In this session, Peter Gladstone and Robert Stone provided background on equity awards and options as the increase of startups precipitated by the tech boom of the 1990s has led to increasing popularity of stock options, restricted stock units (“RSUs”), and similar types of equity-based compensation. These forms of executive compensation have become common in both privately held and publically traded companies.
Designed to both reward and retain talented employees, these benefits can be difficult to understand and value, particularly at a random moment that, while relevant to one’s divorce, might seem arbitrary in the context of a business. Just as the value of closely held businesses presents challenging issues over which business valuation experts often disagree, equity-based compensation plans and their values (or future income stream) represent ground for a divergence of opinions among forensic accountants supporting counsel on behalf of their divorce clients.
During the session, the speakers examined the various characteristics of stock options, RSUs, both vested and unvested; their tax implications; and the challenges typically encountered in valuing and equitably distributing these valuable and highly guarded assets of a marital estate.
All the sessions were well-received, and we recommend these presentations and their authors’ publications to anyone interested. We’re looking forward to next year’s event and hope to see you there.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2019.
Return on Invested Capital: Digging a Little Deeper
The best performance metrics address not just “what” performance has been in the past, but reveal the “why” behind that performance and give direction for “how” to improve performance in the future. In last week’s post, we introduced return on invested capital (ROIC) as a comprehensive performance measure for family businesses. In this week’s post, we will dig a little deeper with ROIC, demonstrating how we can use ROIC to answer the “what,” “why,” and “how” questions for your family business.What Has Historical Performance Been?Return on invested capital correlates income statement performance (in the form of net operating profit, or NOPAT) with the balance sheet resources used to generate that performance (in the form of invested capital). The basic calculation of ROIC describes how much NOPAT the business generates per dollar of invested capital:
ROIC measures the efficiency with which management is using family resources to generate income for the family. Because it is expressed in the form of a return, ROIC facilitates comparison to the performance of alternative investments that may be available to the family. Because ROIC is scaled to the size of the company, it also facilitates comparisons with available peer benchmarks.
Why Has Historical Performance Been What it Has Been?Return on invested capital is valuable enough as a free-standing metric. But if we take a quick peek under the hood, we can learn a lot more about why ROIC is what it is. As shown on Exhibit 2, by inserting revenue into our calculation of ROIC, we end up with two distinct components that each have a story to contribute to the overall ROIC narrative.
When we look at it this way, we can see that ROIC is the product of turnover and profit margin.
Turnover measures how much revenue each dollar of invested capital generates. In other words, how well have management and the directors allocated family resources to a portfolio of business assets that produce revenue? All else equal, the more revenue generated per dollar of invested capital, the higher return on invested capital will be.Profit margin reveals how efficiently the family business converts revenue to profit. Revenue is essential, but only profits fuel family returns. All else equal, higher profit margins result in a higher return on invested capital.
Examining ROIC through the lens of turnover and profit margin begins to lay bare how the family business’ industry and strategy influences financial performance. For example, Chapter 4 of Mercer Capital’s 2019 Benchmarking Guide for Family Business Directorspresents turnover and profitability data by industry for a group of publicly traded companies. Exhibit 3 compares the various components for large companies in the health care and industrials sectors.
Relative to industrial companies, health care providers are very asset-intensive (real estate and expensive medical diagnostic equipment). However, health care providers tend to wring more profitability out of each dollar of revenue (medical care tends to be expensive). As a result, the median ROICs for the two sectors are broadly comparable despite the sectors’ having very different individual return components.
Breaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry.Breaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry as well. Our example company, Blue Corp., earned a 10.0% return on invested capital on the basis of its turnover (2.0x) and profitability (5.0%). Assume that Blue Corp.’s primary competitor, Red, Inc., also generated a 10.0% ROIC. However, Red, Inc.’s higher turnover (2.5x) was offset by a lower profit margin (4.0%).Relative to Red, Inc., Blue Corp. has a less efficient mix of assets, but more profitable operations. With this knowledge in hand, the directors of Blue Corp. can begin to formulate some probing questions for their next meeting:Do the performance differences revealed by ROIC correspond to our stated corporate strategy? In other words, given how our family business has elected to position itself in the market, do the components of ROIC make sense?Given our corporate strategy, is a 100 basis point premium in profit margin to Red, Inc. sufficient? Does the market perceive our family business to be a premium provider? If so, are we pricing our services appropriately, or are we leaving money on the table?Or, does our corporate strategy really necessitate that we have lower turnover than Red, Inc.? How does our strategy influence the manner in which we allocate family resources to productive assets?How Can We Improve Performance in the Future?Assessing why our past performance looked the way it did naturally leads us to the final and most pressing question: how can we improve our return on invested capital in the future? What operating changes or strategic adjustments will be required of our family business today if our goal is to enhance ROI tomorrow?The component analysis we introduced in the prior section is instructive here as well. ROIC cannot improve unless one or both of the components of ROIC improve. Exhibit 4 illustrates how we can “map” current performance and the available options for increasing ROIC.
The dotted lines on Exhibit 4 represent different combinations of turnover and profitability that result in the same ROIC. So, for example, both Blue Corp. (2.0x turnover and 5.0% margin) and Red, Inc. (2.5x turnover and 4.0% margin) generate the same ROIC. Suppose that Blue Corp.’s goal is to improve ROIC to 15%. If turnover remains unchanged, NOPAT margin will need to increase to 7.5%. On the other hand, if profitability remains constant, turnover will need to increase to 3.0x. Of course, there are limitless possibilities in between and on either side of the current parameters. To take an extreme example, if Blue Corp. has a strategy to double profit margins to 10.0%, it can withstand a decrease to turnover to 1.5x and still meet the 15.0% ROIC goal.
What operating changes or strategic adjustments will be required to enhance ROI tomorrow?Once the current set of components for your family business have been plotted on the map, along with available peer benchmarks, managers and directors can begin to evaluate what operational or strategic levers represent the best path to increasing ROIC (i.e., moving away from the origin in Exhibit 4). The challenge is to drill down from a broad goal, such as “Improve ROIC to 15.0%”, to concrete objectives that will drive improvements in either turnover or profitability. Here are some examples of concrete objectives that a family business may identify to boost ROIC:Reduce cash holdings to 2% of annual revenueIncrease inventory turns from 5x per year to 6x per yearImprove gross margin from 42% to 44%Reduce manufacturing overhead by 1%
Directors and managers should set these concrete objectives in the context of relevant market dynamics, corporate strategy, and operating capabilities, and be informed when doing so by quality benchmarking data.ConclusionReturn on invested capital is a powerful tool for not just evaluating how your family business has performed in the past, but also for charting a course for future improvement. Once your family shareholders and fellow directors get a feel for it, ROIC is likely to become a go-to tool for developing, refining and evaluating corporate strategy.
Comstock’s Acquisition of Covey Park
A Valuation Analysis of the Multibillion-Dollar Haynesville Deal
On July 16, 2019, Comstock Resources, Inc (NYSE: CRK) finalized its acquisition of Haynesville operator Covey Park Energy LLC. Announced on June 10, 2019, the companies entered into an agreement under which Comstock would acquire Covey Park in a cash and stock transaction valued at approximately $2.2 billion, including assumption of Covey Park’s outstanding debt and retirement of Covey Park’s existing preferred units (totaling approximately $1.1 billion). Covey Park is a natural gas operator with core operations located in the Haynesville Shale Basin and is backed by private equity firm Denham Capital. This acquisition is the latest addition to the continuing resurgence of the Haynesville Shale Basin.For the purposes of this post, we will be examining this deal from a few different vantage points and reviewing the fair value of the various components that make up total deal value. We’ll also look at how this transaction compares to industry valuation metrics and what kind of strategic advantages Comstock may have a result of the deal.Deal OverviewThe transaction is structured in multiple layers, including a substantial investment from Dallas Cowboys owner and Comstock majority stockholder, Jerry Jones. Details behind the total deal consideration are outlined below:
As a result of the finalized deal, Comstock’s holdings in North Louisiana and East Texas comes out to a total of 374,000 net acres with over 1.1 bcfe/d of net production. The company also holds assets in North Dakota.
The chart below maps the acreage of Comstock and Covey Park prior to the merger and where it fits into the Haynesville Shale:
As the various components of the deal are considered, we then begin to analyze the assets actually purchased by Comstock. Analysts, accountants, and investors alike look at fair value of the parts that make up the total purchase, and allocating fair value among the components begins to paint a clearer picture of how we get to deal value.
Allocation of Assets and Liabilities to Fair ValueThe table below outlines the allocation for both the assets acquired and the liabilities assumed. The calculation is management’s estimate from the Definitive Proxy Statement that Comstock had filed with the SEC on June 24, 2019.
For an E&P company, most of its asset fair value naturally derives from its property and equipment. It’s no surprise that of the assets acquired an estimate of nearly $2.2 billion is in the property and equipment camp. We can then take a step further into understanding the value of these assets by diving into the proven resource reserves that are contained within these properties.
The SEC has clear rules and regulations regarding oil and gas reserve reporting (more commonly known as PV-10), and while these summaries of reserves under SEC pricing may not be accurate for determining fair market value, they do provide a general ballpark figure. Below is the summary of proved reserves for Covey Park from the Definitive Proxy Statement:
Under the standardized measure, the total value of the proved reserves (both developed and undeveloped), totals around $2.3 billion. What is interesting is this amount is north of the purchase price by Comstock and may have some investors wondering if this falls into the territory of a bargain purchase.
As we mentioned above, SEC pricing may not be the best indicator of fair value. It’s not unusual for fair value to vary 10-20% from PV-10 value, and most of that generally comes from the developed and undeveloped (PUD) reserve mix. The valuation of PUDs can be tricky at times, and they generally have a fair value that trades at a haircut. Given the mix of the total proved reserves is fairly PUD heavy, it makes sense as to why the management estimated value of properties comes in under the SEC PV-10 amount.
Other assets of note that typically are glossed over are the derivative financial instruments. E&P companies often hold futures and other derivative contracts for hedging purposes, and these contracts are marked to fair value for the purposes of the allocation. These are relatively less important given the magnitude of the other assets, but they certainly merit consideration, particularly for companies that may have significant hedging practices.
How Do Reported Valuation Multiples Compare to the Industry?Below is a list of comparable companies that Comstock identifies in their latest 10-K as competitors, excluding non-gas players, and common valuation multiples (such as EV to Production) used for relative industry analysis.
In comparison to other operators, the acquired assets come in slightly above the median values for EBITDA multiples but are generally close to direct competitors such as Cabot and Antero. The lower acreage multiple observed in the deal compared to the industry group makes sense given our analysis above of the sizable amount of PUDs in the proved reserves.
After analyzing the structure of the deal and how it compares to other valuation metrics, we will take a look at some of the competitive advantages available to Comstock as a result of the deal.
Large Footprint, Established Infrastructure, and Low Gathering CostsWhile the company already owns over 500 miles of gas gathering infrastructure, it also enjoys many locational benefits: limited basis risk due to proximity to Henry Hub, lowest in-basin gathering, treating, and transport costs (approx. 26¢ per Mcfe), and even twelve approved LNG export terminals located in the Gulf Coast.The Houston Ship Channel and other gathering and transportation pipeline infrastructure already present in the Louisiana and East Texas regions mitigate the risks of capacity constraints and bottlenecking unlike those that historically, up until recently, plagued Northeast gas production in the Marcellus/Utica Shale.The Competitive Edge: Capital AdvantageBeing the largest operator in the Haynesville Shale provides Comstock with a strategic advantage due to sheer size of acreage owned. Just as importantly though, Comstock has another major advantage that competitors have been struggling with for some time: access to capital.E&P companies have been facing headwinds in the public markets for some time. The major uptick in U.S. production over the past several years has triggered the need for upstream companies to increase capital expenditures to keep up with demand. However, investors have been unwilling to participate in the upstream sector because free cash flow has been directed to these capital expenditures and additional acreage as opposed to returns in the form of payouts. Consequently, investors have shifted into the realm of mineral rights aggregators because of the immediate returns in the form of dividends and returns on capital. As a result, access to capital markets (both equity and debt) has proved difficult for E&P companies in general.Comstock, however, appears to have bypassed this hurdle before having to cross it. Jerry Jones’ large stake (75% ownership) and his deep pockets can facilitate large capital raises should the need arise. However, Mr. Jones isn’t Comstock’s sole non-public capital raising option. The aforementioned Denham Capital owns 16% ownership interest, and Comstock just renewed its bank credit facility to $2.5 billion concurrent with the transaction. This gives the company the ability to raise any needed funds before having to jump into the public markets.ConclusionAs a result of the transaction, Comstock is now the largest operator in the Haynesville Shale. While it may seem that Comstock managed to acquire Covey Park’s large amount of acreage at a bargain, the examination of the components of the fair value allocation show that the heavy mix of PUDs in the reserves account for much of the estimated fair value by management, even though it came out lower than the calculated PV-10 valuation. This seemed to be confirmed in our comparisons to industry multiples. However, given the advantages Comstock now has as a result of the deal, the company has positioned itself to be a strong player in the Haynesville Shale Basin.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
One Year Later: The Focus IPO Reshaped the RIA Industry
Attention Drives Activity
Whether or not the road tests and sales figures confirm it, the new Corvette is already a success. It’s only been two weeks since the car debuted, and I can’t remember another new model launch that generated as much conversation. Last Thursday I had complete strangers asking me what I thought about it on the elevator ride up to the office in the morning and down that afternoon. One told me he had already put down a deposit.Unlike previous iterations, the eighth generation Corvette sports a mid-engine configuration, and if you squint it looks like a Ferrari 488. The Stingray is no Prancing Horse, however. With a 6.2 liter normally-aspirated (no turbo) V-8 generating 495 hp, GM is eschewing the high compression engines favored by European manufacturers (the Ferrari produces more than twice as many horsepower per liter). Corvette faithful will appreciate the old-school iron under the hood, if they can accept the “hood” being behind them, an automatic transmission, and a dizzying number of character lines in the bodywork.Focus Got People Talking, and MovingIt’s been a year since the Focus Financial IPO generated a similar level of conversation in the RIA community – and the transaction dominos have been falling ever since. In that same year, Victory Capital pulled off a major acquisition, Affiliated Managers Group got back into the acquisition game following a two-year hiatus, United Capital was acquired by Goldman Sachs, and Mercer Advisors is soliciting bids.I was thinking about all of this on a road trip across the southeast last week, in-between blasting Tom Petty on satellite radio and dropping in on a few clients. At one of my first stops, a client asked if I saw a lot of M&A activity in the RIA space. Yes, I replied, but I see even more headlines about it. Plenty has changed in the RIA community in the last twelve months, but even more has not.The Focus IPO was a Watershed MomentThe Focus management team is to be congratulated for surviving their first year as a listed company. Serving private equity masters is no walk in the park, but public company life means enduring the unexplained ups and downs of daily trading activity, the tedium of analyst calls, and half-informed commentary from armchair quarterbacks such as myself. It must weigh on Rudy Adolf and his colleagues, but they made it this far. Their share price has been volatile but mostly resilient, and the analyst calls are becoming routine. The question is: now what?The Voting Machine and the Weighing MachineBenjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine (a popularity contest) and in the long run, like a weighing machine (based on sustainable profitability). It’s a useful way to look at Focus, as well as the overall RIA consolidation movement. Headline activity attracts capital and acquisition opportunities, and headlines begat headlines as others rush to join a crowded trade. At least for now. Eventually, all of these consolidators will have to demonstrate they can do something productive with their acquired businesses, and that’s when the robustness, or lack thereof, of the different rollup models will show.Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine and in the long run, like a weighing machine.The IPO gave Focus an edge in vying for attention among RIA sellers. As a quick reminder, Focus Financial is not an RIA. It is a leveraged investment enterprise that accumulates preferred stakes in RIAs, encouraging their growth with best-practices coaching and sub-acquisition financing. It is not unlike the European Union: financial bonds without much consolidated governance. Nevertheless, Focus is viewed as a bellwether for acquisition behavior in the RIA community, and rightfully so.United Capital and Mercer Advisors are more typical consolidation models: national platforms with cohesive branding, marketing, management structure, compliance, and investment products. Focus’s de-consolidated model probably guarantees independence. Goldman Sachs, which recently acquired United Capital, could never have fit Focus into their framework.Now that Mercer Advisors has put a for-sale sign in the yard, it will be interesting to see who wants their franchise. One would expect Goldman to consider the possibility of rolling Mercer into their United Capital unit, which could be awkward because Goldman is running the book, but it could happen anyway. Goldman also led the Focus IPO, and anyone who doubts David Solomon’s commitment to building an investment management franchise hasn’t been paying attention. My contacts within the Goldman partner network say 1) Solomon is committed to transforming Goldman Sachs and 2) they are impressed with what he’s doing - a powerful endorsement from a tough audience.For Now, It’s a Land GrabIn the near term, Focus will be judged as an acquisition model, which is much more difficult than it sounds. Acquisition activity is difficult to sustain. Focus announced eight transactions in the second quarter. Skimming the ADVs of the acquired entities, these eight firms came with just under $10 billion in AUM and 83 employees. That’s not insubstantial, although nearly half of that workforce and 70% of that AUM came from one deal. The other seven transactions averaged about $400 million in AUM and six employees.When you’re the size of Focus Financial ($100+ billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals. Focus claims thousands of potential acquisition targets, but a realistic assessment is far fewer. Their model won’t appeal to every would-be seller, and firms that work much outside of the advice and planning space won’t suit Focus.As Focus grows, the pressure will build to do larger transactions. The rise of competing acquisition platforms will drive up the competition and the multiples, and limit the opportunities for arbitraging the cost of capital. Deals will still be accretive in the future, but less so than in the past. All of the consolidators will face this.How Will Things Look in Ten Years?In the longer term, Focus will be judged as an operating model. Since Focus allows their partner firms to run independently, they have limited opportunities to widen margins with scale. Monitoring marketing and compliance activities may become more labor-intensive. Seeing hundreds of firms through succession issues could prove daunting. Ultimately, the parent organization will have to justify its considerable overhead by helping partner firms grow faster (organically) or become more profitable (than they would be independently) – otherwise the whole will be worth less than the sum of its parts.As for the more integrated consolidation models, the future of Goldman Sachs’s mass-affluent wealth management practice would be easier to forecast if Joe Duran’s acquisition chief, Matt Brinker, had stayed. Brinker left on the eve of the Goldman deal closing, perhaps to avoid a non-compete. While he hasn’t said so, it’s hard not to imagine Brinker resurfacing in a similar role elsewhere. With Brinker out, will Goldman try to grow this platform organically, or draw on other internal resources to hunt for acquisitions? We’ll know more when Mercer Advisors announces their acquirer. If Mercer flips to another PE firm, we’ll see more of the same from them. Word is strategic acquirers are looking at the deal. In any event, RIA sellers will have several acquisition models from which to choose.Who’s Paying for All of This?The equity multiples being bandied about for RIA consolidators are dizzying. We know Focus went public at a high-teens multiple of adjusted EBITDA. Similar multiples were rumored (and remain unconfirmed) for the Goldman/United transaction, and many have suggested the ask for Mercer Advisors is just as high. RIAs cannot sustain those valuations, so either the pricing is overstated, the pro forma adjustments are substantial, the expected growth is steep, or these really are the end times.One of the earliest lessons I learned in finance was that labor-intensive businesses don’t handle debt well because all they can really mortgage is future compensation.We can only speculate about much of this. However, much of this activity is financed with borrowed capital rather than equity, and because leverage is more formulaic, the behavior surrounding it is more transparent. To that end, we’re puzzled about Focus’s debt burden. In their Q1 2019 filings, Focus reported term debt of almost $800 million and another $290 million on their revolver. Management reported that this represented a bit less than 4.0x a defined measure of cash flow. Focus recently announced consolidating $300 million of revolver debt under the term loan, and then quietly filed an 8-K on Friday that upped that amount to $350 million.Term debt is generally more expensive, but freeing up the acquisition line offers flexibility. With a $650 million revolver in place, Focus could expand their indebtedness considerably – in sharp contrast to what we’re accustomed to seeing.Most RIAs have unremarkable balance sheets. One of the earliest lessons I learned in finance was that labor-intensive businesses (such as professional service firms) don’t handle debt well because all they can really mortgage is future compensation. When leverage ratios get stretched and operating conditions dim, the analyst community becomes agitated. Until then, with a sympathetic Federal Reserve on tap and a land-grab strategy to execute, it’s going to be tempting for Focus management to lever up. We expect to hear more about this during the earnings call next week.As For Everyone ElseAt one-quarter the price of a new Ferrari, the new Corvette will attract a lot of buyers for Chevrolet. GM would probably be satisfied with a lot of lookers. The Corvette is what is known as a “halo-car," designed to showcase what the automaker can do and get people into the showrooms to look at all of their models (less than 5% of Chevy sales in 2018 were Corvettes). Attention drives activity.I haven’t touched on Hightower or Victory or Captrust or Fiduciary Network or any of the other consolidation platforms. And I haven’t talked about the PE platforms like Kudu Investment Management that are making headway in the RIA space. It’s been an active year since the Focus IPO, and the domino effect that comes from transactions completed at seller-friendly pricing and terms sends ripples throughout the industry. Whether you plan to jump into the fray in the foreseeable future or not, the marketplace around your firm is caught up in it, and it affects you.
And Now You Know… The Rest of the Story
The management team at your family business has been hard at work growing revenue and profits by 50% over the past five years, so the value of your shares must have increased, right? Not necessarily.Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware that Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital, because it tells you the rest of the story.What is Return on Invested Capital?Return on invested capital (ROIC) relates the operating performance of a business to the amount of capital used to support the operations of the business. In other words, it measures the efficiency with which family capital is used in the family business. In last week’s post on capital budgeting, we likened the directors and managers of a business to stewards responsible for selecting the capital projects in which to invest family resources.
Return on invested capital measures how well directors and managers are handling their stewardship of family resources. ROIC allows family shareholders to see how much income is being generated per dollar of investment.
How is Return on Invested Capital Calculated?Exhibit 2 illustrates how to calculate ROIC for your family business.
We need to unpack a couple of the terms in Exhibit 2 that may not be familiar.
Net Operating Profit After Tax (NOPAT) is a measure of earnings that excludes interest expense. Analysts often segregate interest expense from the other expenses of the business for at least two reasons. First, interest does not directly relate to the operations of the business. In other words, interest expense does not fluctuate with revenue and does not compensate employees, pay vendors or suppliers, or otherwise contribute to the operations of the business. Second, interest expense is a function of financing decisions that are often made by someone other than the person bearing operating responsibility. As a result, it is not appropriate to evaluate performance with respect to that expense.Since interest expense is not deducted, NOPAT is like the more common measure of EBIT, or Earnings Before Interest and Taxes. The difference is that NOPAT is reduced for taxes. NOPAT is therefore equal to EBIT less taxes at the effective tax rate. Sadly, Uncle Sam is the first one in line for returns, and NOPAT takes the tax burden into account. Some analysts like to make additional adjustments to derive NOPAT, such as adding back research & development costs. Such adjustments may have merit in certain circumstances, but they do add complexity to the calculations that aren’t essential to gaining the primary insights offered by ROIC.Invested Capital is the sum of all capital provided by shareholders (both common and preferred) and lenders. Since the purpose of ROIC is to measure the efficiency of management’s stewardship of family resources entrusted to the business, invested capital is traditionally measured with respect to book values rather than market values. The average balance for the year in question is the preferred denominator since NOPAT is earned over the course of a year, and a point-in-time snapshot of invested capital may not fully capture the family’s true investment over the course of the year. As with NOPAT, some analysts propose a laundry list of custom adjustments to invested capital. These adjustments may have their place for some companies, but the basic calculation is generally a sufficiently reliable guide.Why is ROIC Important?Now we’re ready for the rest of the story. Management has worked diligently to increase operating income by 50% over the past five years. Yet, the value of your family shares has been stuck in neutral over that same period. What gives?Focusing on profit alone will not reveal the answer. But a quick calculation of ROIC shows us what has gone wrong. Exhibit 3 presents the ROIC calculations for 2013 and 2018.
As revealed in Exhibit 3, the 50% increase in profitability did not boost the share value because the amount of invested capital used in the business also increased by 50%. In other words, the return on invested capital was unchanged. Since the weighted average cost of capital for your family business is also 10.0%, the incremental earnings did not boost per share values. Knowing that profitability has improved is not enough to know whether the value of the shares in your family business has increased. Earnings are critical but are only half of the story when it comes to management performance and shareholder value. As a director, it’s your responsibility to know the rest of the story when it comes to the financial performance of your family business, and ROIC is the perfect tool to do so.
Stay tuned for a future post in which we will dig a bit deeper into the individual components of ROIC and learn about some additional insights that are available from this measure.
Challenges in Appraising Refinery Businesses
The appraisal of businesses involved in the refining of crude oil entails a number of challenges. Some are unique to the industry, and others are more common. The challenges arise primarily in two areas – assessing the level of uncertainty inherent in the entity’s future cash flows and forecasting the entity’s future operating results.The greater the range of future cash flows, the greater the rate of return an investor will require to invest in the business.Assessing the level of uncertainty for a particular business’ future cash flows is a key part of any business valuation. Basic economics tells us that the present value of an expected future cash flow is greater if the possible range of the cash flow is +/-10% from the expected level, compared to the possible range of the cash flow being +/-30% from the expected level. Investors aren’t willing to pay as much for an expected future cash flow with a potentially high divergence from expectations than for an expected future cash flow with a potentially low divergence from expectations. The greater the range of future cash flows (the degree of uncertainty of the future cash flows), the greater the rate of return an investor will require to invest in the business.In addition to the challenges posed in the risk (uncertainty) assessment, the appraisal of an oil refinery business also carries particular challenges in forecasting future operating results. Oil refining entails not only a commodity input (feedstock), but also commodity products - gasoline, diesel, liquefied petroleum gases, jet fuel, residual fuel oils, still gases, lubricants, and waxes. Complexity increases in these product markets since they are significantly influenced by international, domestic and local supply and demand, heavy regulation, domestic politics and international politics. Add to those enormous capital requirements and high barriers to entry and you have an industry rife with forecasting complexity.Assessing UncertaintyAssessing the level of cash flow uncertainty for a particular crude oil refining business requires a thorough analysis of the subject company’s internal operations. This analysis includes its facilities, suppliers, customers, level of integration, and use of hedging. Additionally, external factors, such as infrastructure availability and limitations, feedstock and product supply and demand, government and environmental policies, geopolitical matters, and currency exchange rates must be considered. Some potentially key uncertainty assessment considerations are addressed as follows:ConfigurationConfiguration refers to a facility’s ability to accept a range of crude oils (light-sweet crude, or heavy crude) as feedstock. Refineries with limited feedstock abilities lack the flexibility of shifting from one type feedstock oil to another, thereby exposing the business to uncertainties regarding particular feedstock supply and demand. For example, refineries that were specifically designed (configured) to process heavy crude would be exposed to the negative economics of an unexpected decrease in heavy crude availability. On the contrary, refineries configured for greater feedstock flexibility would potentially avoid the negative impact of a reduced supply of heavy crude by shifting to a light crude feedstock.Secondary Processing SystemsSecondary processing capabilities refers to the ability to engage in processing crude oil beyond initial distillation to processes involving catalytic cracking and reforming. These secondary processes allow a refinery to shift between maximizing distillate production in the winter months when heating oil is in higher demand and gasoline production during the summer months when automotive fuel is in demand. Without secondary processing systems, a refinery is more vulnerable to the negative economics of seasonal product supply and demand shifts.Feedstock Source ConstraintsFeedstock source constraints refer to the refinery’s ability to economically choose between feedstock sources. Facilities that are located along the U.S. coastline have the option of using either the WTI (inland U.S. produced) or the Brent (North Sea produced) varieties of crude oil. As such, they have the ability to favorably respond to shifts in WTI versus Brent pricing (the Brent-WTI spread). Refineries located in the U.S. interior have a much lower economic ability to utilize Brent and are therefore subject to the impacts (positive or negative) of pricing variations between the two varieties.Inventory ExposureRefineries typically hold significant levels of inventory (feedstock and product inventory) with these inventories comprising 13% to 17% of total assets. Due to the potential for material swings in the market price for the feedstock inventories (crude oil) and end products, refiners face a significant level of uncertainty regarding their profits. Market-driven increases/decreases in crude prices can raise/reduce the value of feedstock holdings, while market-driven increases/decreases in end product prices can raise/lower revenues and profit margins. While protection against the negative impacts of such market changes is available through commodity price hedging, refining businesses vary in the degree to which they utilize hedging strategies. In appraising a particular oil refining business, the appraiser must gain a clear understanding as to the commodity price risks that are hedged and those that remain unhedged.Ability to Pass-on CostsThe ability to pass-on the higher feedstock costs is often dependent on the current conditions in the local and international end product markets.When crude oil prices are rising, oil refinery businesses may be able to pass those higher feedstock prices on to customers in the form of higher-end product prices and thereby maintain margins. The ability to pass-on the higher feedstock costs is often dependent on the current conditions in the local and international end product markets. If the petroleum product market is experiencing particularly high supply, or low demand, the refiner’s ability to pass-on higher crude oil prices may be significantly limited. However, in situations of lower supply, or higher demand, higher crude prices may more readily be passed through to customers. As such, an appraiser must not only be aware of near-term expectations for crude prices, but also near-term expectations for the various end products of the particular refining business in order to correctly assess the level of uncertainty that should be factored into the appraisal analysis. In performing this part of the analysis, the appraiser must take into consideration the degree to which the uncertainty would be expected to be avoided by the subject company’s use of hedging.IntegrationSome oil refiners are integrated in that they are also involved in the ownership/control of crude oil reserves, or as with many larger refineries, they also own the petrochemical plant customer of the refiner. Such integrated refineries can allow for the shifting commodity price risks between the refinery and the entity that owns the crude reserves or the petrochemical producer. As such, an important part of the refinery appraisal involves a careful assessment of how the commodity price risk is being handled between the entities involved, and how such handling of the risk should be incorporated into the appraiser’s assessment of future cash flow uncertainty.Infrastructure ChangesInfrastructure changes can have a significant impact on a refinery’s profitability. Changes in the availability of the necessary infrastructure for bringing crude oil “to market” (to local refineries, more distant refineries, or to a port for export) can have a significant impact on the refinery’s profitability. For example, for years various market forces (high international demand for Brent, high WTI supply and interior U.S. pipeline capacity deficiencies) maintained a Brent-WTI spread that was advantageous to U.S. refineries. However, more recently shifts in market forces, including improvement of U.S. pipeline capacity, has contributed to a significant narrowing of the Brent-WTI spread. These shifts have resulted in the loss of a considerable portion of the crude supply cost advantage for U.S. refineries. A particular refinery’s exposure to potential changes in crude transportation infrastructure must be considered by an appraiser as part of the analysis in determining the relative uncertainty of the refinery’s cash flows.Facility EfficiencyThe efficiency of a particular refinery can be a material contributor to cash flow uncertainty. The oil refining industry is subject to a large number of market forces that can have a material impact on profitability. In considering the refinery’s ability to successfully adjust to changes in those many market forces, one must consider the facility’s efficiency. In an environment where the number of facilities is expected to downsize and consolidate in the short-term, facilities with lower levels of efficiency are more subject to having their utilization trimmed back, or even being shut-down.Government RegulationThe oil refining industry is subject to an extensive array of both federal and state regulations, which can be changed, delayed, or accelerated, depending on the political climate. While some of these regulations are static, others have restrictions that are implemented over time. For example, MarPol 2020 represents a significant, albeit long foreseen, change beginning January 1, 2020 where the allowable sulfur for fuel used in ocean-bound vessels is reduced from 3.5% to just 0.5%. U.S. refiners with the ability to produce a higher proportion of lighter, low-sulfur fuels from each barrel of oil will stand to profit from the change in legislation, particularly if supply is low in the short term following the change.One must be aware of potential regulatory changes and the facility’s ability to conform.In the appraisal of a refining business, one must be aware of potential future regulatory changes and the particular facility’s ability to conform to such regulations. In some cases, this flexibility may be tied to the configuration of the plant, and in others may be tied to technology-related efficiency. Any factors that create a question as to the ability or willingness from a financial perspective to comply with potential regulatory changes must be considered in assessing the uncertainty of future cash flows.Forecasting Operating ResultsForecasting future operating results can present a challenge for many industries. With the number of market forces in play, several considerations in the forecasting process deserve special attention when appraising a business in the oil refining industry. Some of the areas for particular attention include commodity pricing considerations on volumes and margins, and capital intensity considerations.Commodity Pricing ConsiderationsThe commodity nature of refinery feedstock (crude oil) makes the forecasting of future revenues worthy of particular attention. International, domestic and local supply and demand, heavy regulation, domestic politics and international politics all come into play in the oil refining industry and the uncertainty as to the impact of these various factors is why hedging plays such a significant role within the industry. While careful analysis can identify pertinent short-term and long-term trends, the future direction of feedstock prices always remains uncertain to some degree. As such, the appraiser of a refinery business must be familiar with the mix of factors that can impact future feedstock prices and accurately factor the “knowns” and “unknowns” into projections of future revenue levels.The factors that come into play in forecasting future refinery revenues can also impact future operating margins, but not necessarily. As previously mentioned, the ability to pass-on changes in feedstock prices can vary over time based on supply and demand dynamics regarding the refinery’s products. Similar to the refinery’s crude oil feedstock, the end products are also commodities and are therefore subject to pricing changes that are well beyond the control of the refinery operator. In some cases, those dynamics may allow for changes in crude oil prices to be passed on to the refinery’s customers, thereby maintaining operating margins. However, end product market dynamics may create an environment where increases in crude oil prices can’t be passed-on such that future operating margins would be expected to be trimmed.Capital IntensityCapital expenditures in the oil refining business can be much more significant and much less steady in magnitude than in other industries.Petroleum refining is a capital intensive process requiring large investments in property, plant, and equipment (PP&E). While machinery and equipment maintenance expenses are often somewhat steady over time, certain aspects of such expenses can be much more irregular. In contrast, capital expenditures in the oil refining business can be much more significant and much less steady in magnitude than in other industries. Short-term capital expenditures expectations can vary widely depending on past maintenance expenditures and the facility’s past acceleration, or delaying, of major expenditures. Longer-term capital expenditures, or periodic expenditures, are typically significant and quite large. A detailed discussion with facility management is often necessary in order to gain a clear understanding as to both timing and cost expectations for such expenditures. With the high level of industry regulation, often environmentally focused, the timing and magnitude of some capital expenditures may well be outside of facility management control.In addition to the more direct impact of oil refinery capital intensity on maintenance and capital expenditures is the impact on tax expenditures from the depreciation of the machinery and equipment. With PP&E assets totaling hundreds of millions, or even billions of dollars, tax depreciation of those assets can have a significant impact on expected cash flows. The difference of results between a simplified straight-line depreciation modeling and a more detailed accelerated (MACRS) tax depreciation modeling can be significant even before incorporating potential bonus depreciation and Section 179 immediate expensing of qualifying property.While appraisers may be provided with detailed tax depreciation schedules for existing machinery and equipment, it may be within the appraiser’s scope of service to develop the expected tax depreciation scheduling for machinery and equipment that will be put in place during the forecast period. The detailed tax depreciation forecasting may not be particularly pertinent in less asset-intensive industries, but it can have a material impact in the appraisal of more asset-intensive businesses such as oil refining.Mercer Capital has a breadth and depth of experience in the appraisal of businesses in the oil and gas industry that is rare among independent business appraisal firms. Our Energy Team is led by professionals with 20 to 30+ years of experience involving upstream businesses (E&Ps, oilfield product manufacturers and oilfield service providers), midstream (gathering systems, pipeline MLPs, pipeline processing facilities), and downstream (refining, processing, and distribution). Feel free to contact us to discuss your valuation needs in confidence.
Q2 2019 Asset Manager M&A Trends
Asset and Wealth Manager M&A Keeping Pace with 2018’s Record Levels
Through the first half of 2019, asset and wealth manager M&A has kept pace with 2018, which was the busiest year for sector M&A over the last decade. M&A activity in the back half of 2019 is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends, which have driven the uptick in sector M&A in recent years, have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.Total deal count during the first half of the year is on pace to slightly exceed 2018’s record levels. Reported deal value during the first half of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.
Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator, United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model.
If there was any doubt of that fact, just a few weeks ago it was reported that Mercer Advisors (no relation), an RIA consolidator managing $16 billion, is up for sale by its PE backer, Genstar Capital. Mercer could fetch an estimated $700 million price tag, putting it in a similar size bracket as the United Capital acquisition.
These RIA aggregators have been active acquirers in the space themselves, with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first half of 2019.
The wealth management consolidator Focus Financial Partners (FOCS) has also been active since its July 2018 IPO, although acquisitions slowed during the second quarter of 2019. Focus announced a total of eight transactions during the second quarter, most of which were smaller sub-acquisitions by partner firms, except for the acquisition of William, Jones & Associates, a New York-based RIA managing $7 billion.
The prospect of using buyer resources to facilitate their own M&A may be a key motivation.Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are a growing M&A driver for the industry. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation RationalesThe underpinnings of the M&A trend we’ve seen in the sector include the lack of internal succession planning at many RIAs and the increasing importance of scale against a backdrop of rising costs and declining fees. While these factors are nothing new, sector M&A has historically been less than we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and a size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm, while allowing it to retain its own branding and culture. Other acquires take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactIn 2019, equity markets have largely recovered and trended upwards.Deal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will in turn drive further M&A activity.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.
A Guide to Corporate Finance Fundamentals
Part 3 | Finance Basics: Capital Budgeting
This post is the third of four installments from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure?
These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #2: Capital BudgetingExtending the image of the company as a portfolio of capital projects, senior management’s role can be conceived of as managing investments on behalf of the shareholders, allocating available capital to selected projects.
As depicted in Exhibit 1, management discharges its stewardship role by selecting capital projects for which the expected return equals (or, ideally, exceeds) the cost of capital. On this view, management acts as an intermediary, matching investors with capital projects. There is a symbiotic relationship between the returns required by investors and the riskiness of the capital projects identified by management. Viewed from one side, management that has the responsibility of stewarding high- cost capital will rationally seek out risky projects with corresponding high returns. Viewed from the other side, a portfolio of risky, high-return projects will attract risk-seeking capital. This relationship underscores the importance of management and directors communicating realistic and transparent expectations to capital providers. For public companies, this occurs through quarterly earnings calls and SEC filings; for private companies, it is no less important, but is often ignored since the regulatory mandate is absent.
While specific techniques of capital budgeting are beyond the scope of our discussion, the goal of the capital budgeting process is to identify potential capital projects and evaluate whether the expected return from such projects meets or exceeds the hurdle rate.
When reviewing the results of a capital budgeting process, directors and shareholders should acknowledge the tension, or conflict, that may naturally emerge between management and shareholders. Recall that, from the perspective of shareholders, systematic risk (the contribution of a given project to the overall risk of a diversified portfolio) is more relevant than absolute risk (the dispersion of potential outcomes on a standalone basis). Careers are not readily diversifiable, however; as a result, it may be natural for managers to evaluate a project from the perspective of absolute risk. In a private company, shareholder portfolio diversification may be limited, so the absolute risk perspective may well accord with the shareholders’ risk preferences. In any event, directors and shareholders need to be aware of the different risk perspectives and be able to reconcile them.
Topics for Board DiscussionDetailed capital budgeting is the responsibility of management; for significant projects, the board should evaluate management’s analysis and recommendations.What are the relevant cash inflows and outflows? The relevant cash flows for capital budgeting are those at the margin – what revenues will the company earn and costs will the company incur upon completion of this project that would not be earned/incurred in the absence of this project? For example, fixed operating costs that will be incurred whether or not the project is undertaken are not relevant to the capital budgeting decision.How are available capital projects ranked? Available capital for investment is always constrained at some level. Beyond a simple thumbs-up/thumbs-down evaluation of individual projects, how has management prioritized the available opportunities?What non-financial constraints does the company face? In addition to limited financial resources, companies have limited managerial, human capital, and other resources. Will undertaking the proposed capital project violate any of the non-financial constraints? If so, do the relevant cash flows include the financial cost of dealing with such constraints?What is the strategic rationale for the proposed project? With the “right” inputs, a capital budgeting spreadsheet can always generate a positive net present value. Going beyond the mere numbers, does management have a compelling strategic narrative for why the project “fits”? Is the project an extension of the company’s current strategy, or does it supplement or reverse the strategy in some way? How does the project contribute to efforts to differentiate the company from competitors?What returns have prior projects earned? In a strict sense, historical results are not relevant to the capital budgeting decision. However, a program for monitoring actual performance relative to projections on prior projects is a key element of a sustainable capital investment process, highlighting potential “blind spots” or biases with regard to the projected financial results for the project under consideration. Capital projects that increase the size of the company may be attractive to management without being beneficial to shareholders. A process of calculating realized returns on projects can help ward off capital project bloat.
WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper
Are Trust Companies Changing for the Better?
Trust Company Sector Update
Trust law dates back to the 12th century when landowners who left England to fight in the Crusades retitled their property to another trusted individual to manage the property until the crusader returned home. Upon returning home, however, the land title holder (the “trustee”) often refused to return the property to the crusaders (the “beneficiary”). The Lord Chancellor typically ruled in favor of the returning crusader, requiring the title holder to return ownership of the land to the original holder. Hence, the foundation for modern trust law was formed.Trust companies are changing to meet clients’ evolving needs.Trust law has evolved over time, most recently with modern trust laws in the 1980s and 90s established by certain states such as Delaware, Nevada, and South Dakota. Other states, such as Tennessee, have developed compelling trust statutes in more recent years. Just as trust law has changed with the regulatory environment, trust companies are changing to meet clients’ evolving needs.As demand for trust company services increases with the generational transfer of wealth from baby boomers to their successors, trust companies are competing for new business by changing their model to better serve their clients and altering their marketing strategies to attract new assets.A Fiduciary Minded ModelAs depicted in the illustration below published by Wealth Advisors Trust Company, trust companies have traditionally managed the distribution, administration, and investment of trust assets. However, more trust companies are shifting to a directed trustee model, which allows an investment advisor to be named on the account so that investment decisions are made by the appointed advisor rather than the trust company. This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management.
The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.
Increased Marketing EffortsTrust companies have historically relied heavily on referrals for new clients. While the directed trustee model protects these referral relationships, many referral sources have been lost to industry consolidation. This has led trust companies to increase their online marketing efforts. Many of our clients have seen a reduction in referrals from their traditional referral sources and have responded by increasing spending on website upgrades and digital marketing.Not only do marketing efforts generate new clients, but those clients tend to stick around.According to Forbes, 80% of trust company clients keep the same trustee for the life of the trust. This makes effective marketing essential for trust companies, because trust clients are sticky, and once with another provider, a potential client has likely been lost for good.Industry Tailwinds Demand for trust company services has increased over the first half of 2019 as “high-net-worth families re-evaluate[d] their personal exposure to the market and follow[ed] through on any big moves they’ve been putting off.” This momentum in the industry is driving increased awareness of trusts as an important component of the financial planning process.Additionally, industry participants generally believe that a large portion of the impending wealth transfer from baby boomers to gen X-ers and millennials will be left through real estate holdings, individual retirement accounts, and trusts; thereby providing a tailwind for the trust company industry.Market MultiplesThe market for asset and wealth management firms can offer some insight.While there are no pure-play publicly traded trust companies, analysis of the public markets can lead to a better grasp of trust company valuations. Even though trust companies are increasingly outsourcing investment management, there are still a number of underlying similarities between the business models of trust companies and asset and wealth managers—the most notable being that revenue for all of these businesses is a function of assets under management. Because of the similarities, the market for asset and wealth management firms can offer some insight into valuation trends affecting trust companies.Investment manager valuations have started to recover after stumbling in the first quarter following a rocky Q4 across the entire market. P/E multiples averaged approximately 15.3x LTM earnings as of the end of 2Q 2019, up from 14.1x at the end of the 1Q 2019. The positive movement in asset and wealth manager multiples is likely to translate, to some extent, to trust companies as well, given the similarities between revenue models.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes. In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry. We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Natural Gas Takeaway Constraints
A Tale of Two Basins
Appalachia and the Permian are responsible for much of the United States’ surging natural gas production, resulting in relatively low benchmark prices.
However, difficulties capturing, storing, and transporting natural gas mean that large regional price differentials can occur.
While Appalachia price differentials have narrowed significantly, Permian pricing differentials have widened, often resulting in $0 or sometimes negative realized prices.[1] Going forward, futures prices imply a modest widening of the Appalachia basis over time, while the Permian basis will not stabilize until 2021.
Appalachia Takeaway Constraints Easing – Northeast Supply Constraints, Not so MuchAppalachia natural gas takeaway capacity constraints have eased significantly over the past several years as new pipelines have come into service. RBN Energy estimates the total excess takeaway capacity out of Appalachia at approximately 4 bcf/d. However, the new pipelines are largely moving volumes to the Gulf Coast and Midwest rather than nearby population centers in the Northeast.
Proposed pipelines that would connect the gas-rich Marcellus and Utica plays to East Coast cities have faced intense pushback. The PennEast Pipeline would transport natural gas from northeast Pennsylvania to New Jersey, but has been targeted by multiple environmental and community groups and still awaits approval from various regulatory bodies, including the New Jersey Department of Environmental Protection. A federal appeals court vacated permits issued by the U.S. Forest Service for the Atlantic Coast Pipeline, slated to cross two national forests and the Appalachian Trail in order to transport up to 1.5 bcf/d of natural gas from West Virginia to Virginia and North Carolina. The pipeline’s primary backer, Dominion Energy, has appealed the ruling to the Supreme Court. And The Williams Cos. has battled with the state government of New York for years over water quality certifications needed to move forward with the 125-mile Constitution Pipeline, which would transport gas from northern Pennsylvania.
These various hurdles mean that cities are struggling with supply during winter and some natural gas utilities are not accepting new customers, as recently reported by the Wall Street Journal. Without the ability to hook into natural gas lines, certain new real estate developments are on hold or being shelved. And those customers with access to natural gas sometimes pay dearly, with Transco Zone 6 (servicing New York and New Jersey) prices exceeding $140/mmbtu in January 2018.
The recent infrastructure build-out has helped Appalachian E&Ps, but Northeast end-users will likely continue to be subject to significant seasonal spikes until connectivity to Marcellus and Utica production is improved.
Permian Natural Gas Takeaway Capacity to Remain Constrained in the Near TermWhile Appalachia takeaway constraints have largely been alleviated, the same cannot be said for the Permian. Much of the infrastructure build-out designed to service surging hydrocarbon production in the Permian Basin was focused on higher-value crude, with a significant amount of associated natural gas production simply flared. However, with increasing scrutiny on flaring and Waha natural gas prices falling as low as negative $8.50/mmbtu, midstream companies are finally starting to build meaningful takeaway capacity out of the basin.
And while the political and regulatory environment in Texas is much more amenable to pipeline construction, new pipelines have not been unchallenged. A group of landowners sued Kinder Morgan over the route of the company’s Permian Highway Pipeline. However, the lawsuit, filed in April 2019, was thrown out by a Texas court only two months later.
The new takeaway capacity should help with pricing, as indicated by Waha basis futures, but differentials will remain elevated until 2021.
ConclusionAppalachian takeaway constraints have largely been alleviated, though incremental capacity largely takes volumes to the Gulf Coast and Midwest. As such, Northeast cities will likely still face supply issues despite being located just a few hundred miles from prolific natural gas production. Permian natural gas takeaway constraints remain, and will likely continue until 2021.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs.[1] Appalachia basis reflects Dominion South pricing. Permian basis reflects Waha pricing.
Innovation and Family Wealth
“The arrogance of success is to think that what you did yesterday will be sufficient for tomorrow.”We don’t know whether 19th century English clergyman William Pollard had family business in mind when he penned those words, but their application to successful family businesses is undeniable.If everyone recognizes that innovation is a desirable trait for family businesses, what family and business attributes are most conducive to fostering an innovative culture? Recently published academic research from Vasiliki Kosmidou and Manju K. Ahuja highlights the relationship between innovation and family wealth. Their article, “A Configurational Approach to Family Firm Innovation” appears in the June 2019 issue of the Family Business Review. Our goal in this post is to introduce some of the authors’ most relevant findings to family business directors, translating, as we do, into a less academic idiom.What is Innovation?In order to draw statistical conclusions regarding a concept as potentially nebulous as “innovation,” the researchers asked the following question of the family business owners in their sample:
To what extent has your company placed emphasis on the following activities over the past 3 years?
a - Developing radically new products
b - Introducing radically new products
c - Incrementally upgrading existing products
d - Leading the industry in introducing breakthrough products to the market
What about your family business? If you were responding to the authors' survey, how would they assess your family business’s innovation? As a director, what are you doing to foster an innovation culture at your family business?From a more quantitative perspective, many of our clients measure and track their vitality index. When measured over time, the vitality index, calculated as the ratio of new product revenue to total revenue, provides a gauge of how successful prior innovation efforts have been. Current innovation efforts can be measured by calculating research & development expense as a percentage of revenue.For all but the sleepiest industries, the question is not whether innovation will occur, but rather whether your family business will be leading – or reacting to – trends in innovation. Your family business’s overall strategy should determine its posture toward innovation. Do your family shareholders understand how innovation fits in with your corporate strategy? Do your innovation priorities align with what the business means to the family?What is Family Wealth?Not all forms of family wealth can be measured in dollar terms. Recognizing this reality, academic researchers emphasize the concept of socioemotional wealth (SEW). In this study, the authors evaluated SEW along three separate dimensions: family continuity, family enrichment, and family prominence. The diagnostic questions used to measure SEW are fascinating, and family business directors would do well to think about how they would respond along the various dimensions.Family Continuity Dimensiona - How important is it that the business gives the members of your family an opportunity to work as a unit? b - How important is it that the business gives the members of your family an opportunity to make decisions together? c - How important is it that the business gives the members of your family an opportunity to work toward agreement? d - How important is it that the firm remains in the hands of the family and that the business decisions are directed at developing and motivating future generations toward taking over control of the firm? e - How important is it that the company serves as a vessel through which your family values are maintained and promoted to younger generations of family members? Is your family business a unifying force for your family? For non-enterprising families, there is often very little connection to relatives beyond the range of first cousins. In contrast, multi-generation enterprising families often maintain robust connections at the level of second cousins and beyond. How much value does your family ascribe to continuity?Family Enrichment Dimensiona - How important is it that through operating a business enterprise, you can ensure the enhancement of happiness of your family not directly involved in the business? b - How important is improving the family life and the relationships among family members through operating your business? c - To what extent do the needs of your family, such as the need for employment, affect the business-related decisions? d - To what extent do the needs of your family, such as the need for financial stability, affect the business-related decisions? e - To what extent do the needs of your family, such as the need for belonging, affect the business-related decisions? f - To what extend do the needs of your family, such as the need for intimacy, affect the business-related decisions? What constitutes success for your family business? Do you and your fellow directors identify success in the same way as your family shareholders? If you are an independent director, to what extent do you consider the non-financial perspectives on success implied by the family enrichment questions? Or should you even attempt to do so?Family Prominence Dimensiona - If it is important that the family gain recognition and appreciation in your community, as a company you will engage in actions that have the greatest potential to benefit the family in this regard. b - How important is it that the family can benefit from social relationships developed through your business? c - How important is it that the business can benefit from your family relationships? d - If family reputation is important, as a family you will strive to conduct business in ways that do not jeopardize the family's reputation (i.e., ethically, honestly, respectfully) How closely is your family identified with your family business? Are family members visible in marketing and promotion efforts? Or, does your family prefer to remain “out of the spotlight?” Are your family members aware of/accept the potential link between personal behavior and business performance?The SEW factors are a great reminder to family business directors that family wealth is broader than simply the size of the family checkbook or investment account.Family Wealth as a Predictor of InnovationThe heart of the research paper is an attempt to correlate innovation in family businesses to family wealth and other potentially explanatory attributes (generational involvement, presence of non-family senior executives, and the operating and competitive environment).The researchers identified six “causal configurations,” or unique factor combinations, that characterized high innovation family businesses. We can summarize their results as follows:When SEW is not present in any of its forms, innovation is high only when the operating environment is adverse. In other words, in the absence of SEW, family businesses pursue innovation only when “forced to” by the external environment.When SEW is high, family businesses are innovative in favorable external environments. In other words, “wealthy” families appear to be motivated/willing to pursue innovation proactively, even when it does not appear that there is any immediate “need” to do so.For family businesses that score high on the family prominence dimension, innovation seems to follow even when the family continuity and family enrichment dimensions are weak and the environment is adverse. In other words, securing and maintaining reputation is a powerful motivator for corporate innovation.When the family prominence dimension is weak, but the family continuity and enrichment dimensions are strong, innovation can actually be impaired, especially if senior, non-family managers are not present. In other words, an emphasis on the internal dimensions of family wealth and a desire to keep management of the business in the family can actually inhibit innovation.ConclusionWell, so what? Why should family business directors care about the link between family wealth and innovation? We think the paper is noteworthy for a few reasons. First, it reminds directors of the importance of innovation in sustaining the family business. Second, the broader definition of family wealth, and the diagnostic questions regarding SEW provide thoughtful directors with plenty to chew on. Finally, the findings help directors critically evaluate how perceptions of family wealth and other factors may be influencing the innovation culture of the family business.
Valuations In The Permian
Gearing Up For The Long Haul Or Running In Place?
When it comes to the oil patch, the word “growth” can be a vague term. It’s a word that can be masqueraded around to suit the perspective of whomever utters it. What does it mean in an industry whose principle resources are constantly in a state of decline? When it comes to the Permian Basin these days, growth applies to resources, drilling locations and production. Unfortunately, the same can’t be said for profits, free cash flow or new IPOs. Don’t misunderstand, the Permian is the king of U.S. oil plays and by some measures could be taking the crown as the biggest oil field in the world. However, various economic forces are keeping profits and valuations in check.Permian Reserves: A Behemoth and Getting BiggerFrom a macro perspective, the Permian Basin is, and will continue to be, a record setting engine of hydrocarbon extraction. The Permian has been and will continue to make new production records in the U.S. and globally. In 2018, the U.S. accounted for 98% of global production growth (there’s that word again). Despite alternative energy sources and climate change policies being in vogue, global oil demand has increased for nine straight years, and the Permian has led the way to fill this demand gap. In May 2019, with a mix of productivity gains and drilled but uncompleted (DUC) well drawdowns, Texas’ crude oil production topped 5 million barrels per day for the first time. Shale output, the leading force for this production continues to rise. This will not stop for decades to come. In fact, a USGS survey covering the Wolfcamp and Bone Spring formations estimates an additional 46 billion barrels of oil (enough to supply the world for half a year) and 280 trillion cubic feet of gas (enough to supply the world for two years) are technically recoverable. For context, total U.S. proved oil reserves (which must be technically and economically recoverable) totaled 39.2 billion barrels at year-end 2017, according to the EIA. It’s an amazing growth story.Pipeline Capacity (Finally) ArrivingOne of the biggest constraints for the Permian over the past 15 months has been a lack of pipeline capacity. For months on end, local prices in the Permian suffered huge differentials to NYMEX prices due to the bottleneck issues that plagued the area. Transportation came at a premium and so did costs; however, that's in the process of changing. According to the American Petroleum Institute, the Permian Basin is expected to get 1.5 million barrels a day of new crude capacity. This includes expansions of the Grey Oak, Cactus II and Seminole Red pipelines, taking crude to the Gulf of Mexico for refining or export. Natural gas, which has been flared in many cases, is also getting a reprieve. Almost 5.0 bcf per day of new gas capacity additions are expected to go live by the end of 2019. See the map below made by RBN Energy.[caption id="attachment_27170" align="aligncenter" width="468"]Source: RBN Energy[/caption]
These capacity additions should cut transportation costs for many producers, and none too soon because every dollar and penny count when it comes to profitability in the Permian these days.
Tight Breakeven Spreads and Negative Cash FlowAmid these positive big picture developments in the Permian, most shale producers are struggling to keep up cash balances. According to one analysis for Q1 2019, only 10% of shale companies had a positive cash flow from operating activities, and other studies have shown similar results. Shale producers are spending more than they are making. How can this be with such a plethora of resources and the means to transport it? The answer lies in two conundrums: (i) expensive fracking and completion costs; and (ii) steep production decline curves. Getting to the oil is expensive, and once a producer finds it, the tight well formations drain quickly. The only way to get more production and associated revenues is to drill more. Investing skeptics describe this as a treadmill effect.This wouldn’t be too much of a problem in a $65 or $70 oil environment, but when oil is in the mid $50s, there’s not much profitability cushion and it shows. The April issue of Oil & Gas Investor includes a table showing median breakeven prices in the Permian. In the Delaware Basin median breakevens range between $42.50 and $45. In the Midland Basin median breakevens range between $44.30 and $53.00. Keep in mind – these are medians. Half of producers can produce it cheaper, but half are more expensive too.[caption id="attachment_27171" align="aligncenter" width="600"]Source: Oil & Gas Investor[/caption]
This kind of narrow profit cushion has soured many investors and made financing new drilling more expensive for producers. Investors have demanded austerity and are either charging bigger financing premiums or are cutting off financing altogether. IPOs for producers have been anemic in the past several quarters. Cost control and economies of scale are becoming increasingly important, and thus, the answer has been in the form of consolidation.
Valuation Winners: Low Cost Producers & Royalty HoldersM&A in the Permian has been consistently healthy amid the aforementioned challenges. Values from an acreage and production perspective are generally the highest of any major U.S. basin. With Oxy’s acquisition of Anadarko as the most recent flagship example, producers are scrambling to amass contiguous acreage and drilling synergies, coupled with reduced overhead to create more consistent profitability. This kind of rationale is driving mergers, acquisitions and dispositions. It is also attracting the majors such as Exxon and Chevron to the region. See the table below.[caption id="attachment_27172" align="aligncenter" width="800"]Source: Shale Experts[/caption]
However, this is easier said than done, and not everyone is a believer. Carl Icahn isn’t as he recently opened a shareholder lawsuit in relation to Oxy’s acquisition. Oxy’s price has slid since the announcement. Perhaps the best investment strategy is not to take operating cost risks at all. Enter the mineral and royalty sub-sector, which has been among the most successful areas of energy in the past several years. While producers can’t get access to public equity, royalty companies have had numerous IPOs in the past couple of years. Getting access to the production boom, without exposure to fracking costs, has been the attraction and it appears to be gaining momentum.
Lower costs are the key to creating value in the Permian. Whoever can master this kind of fiscal discipline will move to the top of the heap and finally growth in profits will follow.
Originally appeared on Forbes.com.
Unsolicited Offers for Your RIA
Is the First Bid the Best?
When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer?
“Price” is a sticky wicket that we’ve covered in many posts, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes. The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer. And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller. In many cases, though, the initial offer is above what the buyer ultimately wants to pay (“bid it to get it”) and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller. If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms. We don’t want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements? Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionThe offer gets the process started, but it’s the process that creates the deal. Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place. The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy. As with most things in life, if something looks too good to be true, it usually is.
Q&A: Five Questions with Edward Jackson
From time to time, Family Business Director will interview family business leaders or experienced advisors to get their perspective on important questions common to family businesses. In this second installment, we talk with Edward Jackson, a fourth-generation family member and director of H.G. Hill Realty Company.1. Give us a brief overview of your family and business.Our family business was started in 1895 by my great-grandfather, Horace G. Hill. The business was originally a one store cash and carry grocery operation. As the grocery operation grew, Mr. Hill started buying land on the right-hand side of the road on major thoroughfares going away from downtown Nashville. The belief was that people would not want to cross traffic to get to a store on the way home in the evening. All grocery stores were accompanied by a drug store and hardware store. Today, the grocery stores have all been sold and the remaining properties are being redeveloped with grocery-anchored retail, office, and multi-family opportunities.Senior management is composed of my first cousin, a G4 member as Chairman/CEO and an outside non-family President/CFO. There are also four other G4 members on the board.2. What roles in the family business have you fulfilled over your career?I am a G4 born-in family member and hold a seat on the board. Also, I am the Co-Chair of our company's strategic planning committee that is tasked with numerous objectives to include: capital needs, shareholder liquidity, dividend policy, and succession planning.3. Do you offer an ongoing share redemption program? If so, how long has it been in place, and what do you perceive the primary benefits of the program to be?Within the past two years, we have developed a share redemption program. It is my belief that having a liquidity option in place for family shareholders is extremely important. Family members may not ever participate in the plan; however, just having the opportunity to redeem a few shares makes people more comfortable. Also, if you do not like the direction the company is going or how it is being run, you can opt out. In a way, if no one redeems their shares, then management knows they have buy-in from the family on how things are going. Our board approves a pool of funds to be used for redemption at our spring board meeting, and the pool is then presented at the shareholder meeting. Shareholders then have approximately ninety days to submit any shares for redemption.4. Does your family business have any independent (non-family) directors? If so, when did you first add an independent director? What are the challenges/benefits of having independent directors?Yes, we have had independent directors involved with our business since 2003. I think that outside directors, who understand your family culture and are experienced with some aspect of your business, are invaluable resources. In my opinion, their value depends on your board structure. Is the board advisory in nature or is it a true fiduciary board that can hold management accountable for the operations of the business? Advisory board members are usually not making strategic decisions for the business. They do, however, give the family comfort knowing that someone other than family members are watching over the organization. On the other hand, a fiduciary board needs to have independent members that can help the company achieve its overall vision. They are experts in the fields that can assist management in achieving the company and family vision.In our case, our current board is advisory in nature. Our independent directors are friends of the family that are in related business fields that complement our business model. These board members know our family, are in tune with what the family needs, and are good stewards of the business. They have been an invaluable resource and lend credibility to decisions being made at the board level.One of the toughest challenges to having independent board members is board compensation. It is not as big an issue for an advisory board; however, as you move to being more of a fiduciary it might become more of an issue. I think it is important for the directors to share in the benefits of decisions that they are making at the board level. Our company has begun to look at different scenarios to accomplish this goal. Another challenge for the independent director is to get away from the question of “what does the family want to do?” This is where having a clear vision for the company that the family buys into is so important. This vision allows decisions at the board to be made freely as long as the decision moves the company in a direction to achieve the stated vision. As you can tell, I am a true believer in a strong independent board in a family business.5. What is your best advice for other family business leaders?The best advice for family business leaders is to know all you can about your shareholder base and to communicate tirelessly with them. Through our family council and Mercer Capital, we have surveyed our shareholders on a number of topics over the years and have found the surveys to be a good tool. Knowing how the family feels about certain topics i.e. selling the business or being family owned vs family controlled can give leaders valuable insight. Also, twice a year we bring in experts in different fields that relate to our business to speak to the family. These experts help explain the various market influences that can impact us both in a positive and negative way. Educating your shareholders on the business goes a long way.
Q2 2019 RIA Market Update
Asset Management Stocks Find Some Relief After Year-End Rout
Broad market indices generally increased over the last quarter, and publicly traded asset and wealth manager stocks followed suit.Publicly traded traditional asset and wealth managers ended the quarter up 6.2%, beating out the S&P 500, which rose 2.6%. Alt managers were the bright spot in the sector, up nearly 18%. Aggregators and multi-boutique model firms did not fare well, despite all the hype about consolidation pressures in the industry and the high-profile deals in the aggregator space. These businesses ended the quarter down more than 14%.
Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally, for the simple reason that higher AUM leads to higher revenue and an even greater increase in profitability with the help of operating leverage.
This was the case during the second quarter when multiples continued to recover from December lows, and profitability remained steady to improving. As a result, asset and wealth management stocks saw positive performance relative to the S&P 500 during the second quarter, as shown in the chart above. Expand the chart over the last year, however, and the story for traditional asset and wealth managers looks less upbeat.
Over the last year, traditional asset and wealth managers have trailed the market significantly. While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%.
While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%.The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees. Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last year. Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down.The aggregator and multi-boutique index has declined over 30% during the last twelve months. Several firms in this category have contributed to this decline, but the largest driver has been Focus Financial’s major pullback from its lofty IPO price.The performance of asset and wealth management stocks over the quarter was supported by an improving price to earnings multiple. Multiples for publicly traded asset managers fell considerably near the end of 2018 as the broader equity markets pulled back. While there has been some rebound so far in 2019, multiples remain below the typical historical range.[caption id="attachment_27075" align="aligncenter" width="394"]Source: SNL Financial[/caption]
Implications for Your RIAThe multiple expansion in the public markets combined with the expectation for stable-to-improving earnings, given the movement in broad market indices, suggests an improving outlook for privately held RIAs. If the public markets have relaxed a bit in pricing the industry headwinds, resulting in a higher multiple, then it is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs. Depending on the growth and risk prospects of a particular closely held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs. Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market. Their product is, after all, the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations.On balance, the outlook for RIAs appears to have improved since the end of 2018. The market has recovered following the Q4 correction, and multiples have trended upwards, although they remain below historical norms.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal making. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.
Q2 2019 Macro Overview
Uncertainties Engulf Global Oil Amid Political Tensions
Brent crude prices began the quarter around $69 per barrel and peaked at nearly $75 in late-April before declining to just below $60 on June 12, 2019. Prices have since increased to $65, with WTI continuing to trail by about $8 per barrel. In this post, we will assess global supply and demand factors that have caused these price fluctuations.Global SupplyOriginally founded by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela in 1960, OPEC now stands at 14 members, after Qatar terminated its membership at the beginning of the year. OPEC is still a significant organization when assessing global supply, but it has undergone considerable changes. While OPEC only has 14 statutory members, an alliance known as OPEC+ has added 10 non-OPEC member countries headlined by Russia and including Mexico and Kazakhstan. This group agreed in December 2018 to a production decline with the goal of balancing global inventories and stabilizing the oil market (read: raising prices). With churn in its members and inclusion of allies in its production cuts, people may not know exactly who OPEC+ is, but the oil cartel’s mission remains clear (even if oil and cartel are not the O or C in the group’s amorphous acronym).OPEC+ has thus far been successful in reducing output, though for countries like Iran and Venezuela, decreased output hasn’t necessarily been intentional. In May, OPEC members produced 29.9 million barrels per day (b/d), the lowest for any month since July 2014. It remains to be seen if these production cuts set to expire this month will remain intact, and if so, for how long. Saudi Arabia’s energy minister Khalid al-Falih expressed absolute confidence that an agreement would be reached to extend the oil production cuts after “very constructive discussions” with Russian energy minister Alexander Novak. Falih also said,Our intent is to make sure that we continue to work together closely, not just bilaterally, but with all other members of the OPEC+ coalition – and that the good work we have done over the last two and a half years continues to the second half of 2019, maintaining supply constraints to bring balance to the global inventories of oil.The bilateral comment is telling. In April, the planned meeting was cancelled to reportedly have more time to analyze market data. However, the second delay, though only for a week, has shown heightened tensions, as decisions have increasingly been driven by Saudi Arabia and Russia, who combine for over 40% of OPEC+ oil production. Falih said all but one OPEC member nation has agreed to delay the group’s meeting until after the G20 summit, and the holdup figures to be Iran, who has been increasingly perturbed by its diminishing influence. Production cuts rely on all members to stick to their word, as each individual country would be economically incentivized to increase production to reap the benefits sown by those who withhold production.IranAlongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently. In April, the U.S. reinstated its sanctions on importers of Iranian oil. The sanctions were initially implemented to ramp up “maximum pressure” on Iran as oil is a significant revenue source for the Iranian government. The U.S. is pressuring Iran to curtail its nuclear program and return to the negotiating table on a nuclear deal.Waivers were granted last November to allow countries time to find other sources of supply and three of these countries (Greece, Italy, and Taiwan) have done so as they no longer import any oil from Iran. China and India are the largest importers of Iranian oil whose waivers have been rescinded, which should ramp up pressure on Iran and could have spill-over effects on trade discussions as China expressed displeasure with the U.S.’s decision to reinstate sanctions.Alongside voluntary declines from Saudi Arabia and Russia, Iran has been one of the key reasons for lower production recently.These sanctions are not the only concerns related to Iran. The recent crude price rebound following its 5-month low is due in part to Iran shooting down a U.S. drone, raising already heightened tensions. This comes after attacks in May on two tankers near the Strait of Hormuz, which the U.S. blames on Iran. The Strait of Hormuz, described by the EIA as the world’s most important oil choke point, separates UAE, Oman, and Iran and a significant amount of world oil supply passes through this relatively narrow shipping route.The White House has put out two statements in the past few days, seeking to set the record straight and with Saudi Arabia, UAE, and the UK jointly condemn these attacks. The situation remains fluid and volatile and continues to threaten the flow of oil, as President Trump began the week by announcing new sanctions on Iran.Rising U.S. ProductionProduction cuts from OPEC+ (intentional or not) have been able to raise prices since the lows seen at the end of 2018, and the U.S. has been one of the prime benefactors. The U.S. has been able to increase its global market share, increasing production to fill the void left by OPEC+ production. Additionally, any elevated prices caused by these production cuts have also increased top line revenues for American producers, a fact not lost on OPEC.According to the EIA’s latest Short Term Energy Outlook (“STEO”), U.S crude oil production increased 17% in 2018, peaking at an all-time rate of 10.96 million b/d. This was capped by a December that saw 11.96 million b/d, the highest monthly level on record, despite crude prices sliding considerably in the fourth quarter. The EIA expects this growth to continue with production reaching 13.3 million b/d on average by 2020.Slowing Global DemandAccording to the STEO, the EIA is projecting lower crude prices for 2019 due to uncertainty about global oil demand growth. In late May, President Trump announced the potential for tariffs on Mexico, which would have particularly negative impacts on the energy industry as the U.S. exports more fuels to Mexico than any other country. Easing continental trade concerns, Mexico became the first country to ratify the USMCA (new NAFTA), though approval has yet to come from Canada or the U.S., and there is no timetable for its passage.Concerns about the U.S.-China trade relations picked up in the second quarter as increased tariffs have been threatened by both sides.Concerns about the U.S.-China trade relations have also picked up in the second quarter as increased tariffs have been threatened by both sides. Expected industrial activity, as measured by the manufacturing Purchasing Managers’ Index (PMI) declined across several countries in May, and the U.S. PMI fell to its lowest level since 2009. These contribute to concerns that future economic growth could be lower than expected, which would, in turn, curb oil demand. However, there was optimism on June 20, related in part to hopes that U.S.-Chinese relations would improve when President Trump meets with President Xi at the G20 Summit.Interest RatesOptimism on June 20 wasn’t restricted to trade with China as the Federal Reserve also met the prior day. The Fed Funds rate has been increased 9 times since December 2015 to a target range of 2.25%-2.50%. However, it has become increasingly clear that the next change is more likely to be up than down. For the first time in Jerome Powell’s tenure as Fed Chairman, a dissent was cast, which advocated for a rate cut. James Bullard, President of the Federal Reserve Bank of St. Louis, said cutting rates now “would provide insurance against further declines in expected inflation and a slowing economy subject to elevated downside risks. Even if a sharper-than-expected slowdown does not materialize, a rate cut would help promote a more rapid return of inflation and inflation expectations to target."In theory, interest rate hikes tend to be negative for risk assets such as equities and commodities such as energy. Conversely, a rate decrease should make holding these products more attractive and raise the price. More important, however, is the overall message it sends to the economy. If the Fed were to cut rates, even if it cited its inflation target as the reason (and not a global economic slowdown), this would be viewed by the market as a bearish signal, likely sending equities and crude oil prices downward.ConclusionWith the G20 Summit occurring June 28 and 29, we’ll close the quarter with a more informed outlook on global demand going forward. OPEC and OPEC+ meetings are expected to occur July 1 and 2, so we’ll have to wait until the beginning of the third quarter for a decision on increased, steady, or reduced production cuts on the supply side. Even with an announcement at the beginning of the quarter, it will take more time to determine how this production will be further impacted by individual country circumstances, particularly from Iran. In the meantime, the U.S. will likely continue its production to capitalize on the shortfall, even if global demand slows or is already slowing. While interest rate hikes or cuts will likely continue to play a role in market sentiment, it is unlikely we see a change on this front in the near-term.At Mercer Capital, we stay current with our analysis of the energy industry both on a region-by-region basis within the U.S. as well as around the globe. This is crucial in a global commodity environment where supply, demand, and geopolitical factors have various impacts on prices. We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and internationally. Contact a Mercer Capital professional to discuss your needs in confidence.
Fidelity’s Latest Move to Stay on Top of RIA Trends
Fidelity’s Partnership with Merchant Investment Management
On June 10th, Fidelity Clearing & Custody Solutions and Merchant Investment Management announced a new partnership to increase wealth managers’ access to capital for acquisitions and growth initiates.With the average transaction size in wealth management M&A increasing 30% in the past year, Fidelity Clearing & Custody Solutions will work with Merchant Investment Management to help firms drive growth and scale in an increasingly concentrated market.Overview of Strategic AllianceFidelity Investment Management, one of the largest discount brokers in the U.S., began offering more customized products and solutions to wealth managers over the last few years through Fidelity Clearing & Custody Solutions, which provides a comprehensive clearing and custody platform to RIAs. While it is typical for custodians to maintain loose affiliations with specialty lenders in order to address the capital needs of RIAs, Fidelity has taken this to the next level by formalizing a strategic relationship with Merchant Investment Management.The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on additional selling points to entice M&A-minded RIAs.Merchant provides growth capital to wealth and asset managers looking to grow or take advantage of strategic opportunities. The company provides capital in the form of minority, non-controlling equity investments and credit solutions. Additionally, Merchant offers management resources, such as regulatory and compliance assistance, as well as outsourced CIO services.
As part of the partnership, Merchant will offer Fidelity’s custody clientsdiscounted loan origination fees, as well as discounted rates to some of Merchant’s products, such as Advisor Assist, which offers a suite of compliance solutions, and Compass, which provides outsourced CFO and accounting services for advisory firms. The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on a few additional selling points to entice M&A-minded RIAs.Fidelity’s MotivationThe last 18 months have been busy for investment manager M&A. Several trends are driving the uptick in sector M&A, including rising fee pressures, increasing compliance and technology costs, and organic growth strains. Wealth management consolidators such as Focus Financial, Hightower, and now, Goldman Sachs have capitalized on these trends, and Fidelity seems to be throwing its hat in the ring as well.David Canter, head of the RIA segment at Fidelity Clearing & Custody Solutions, explained Fidelity’s interest in this partnership:Today’s most competitive and future-ready firms are achieving scale through M&A. By our count, there are over 700 RIAs that manage over $1B, and they’re often doing so with national footprints. But it takes capital to create scale—and with the average deal size increasing three-fold in the past five years, access to that capital can sometimes be a roadblock. Lending solutions like this one are a game-changer for firms looking to make strategic acquisitions to create long-term, sustainable value.Chasing TrendsAs one of the largest RIA custody platforms, it certainly makes sense for Fidelity to keep its finger on the pulse of the RIA industry. Fidelity has strived to keep up with RIA trends over the last decade, and the partnership with Merchant appears to be the latest in a series of moves aimed at staying on top of the industry.As part of its efforts to keep pace, Fidelity launched a Robo-advisor platform in 2016. Just a few years later, Fidelity Go was named theTop Robo Advisor in the 2019 winter edition of The Robo Ranking Report from Backend Benchmarking.As passive products have proliferated, Fidelity has backed away from its former strategy ofavoiding low-margin products. In 2018, Fidelity gathered $64 billion in passive products, compared to active product outflows of $17 billion, according to Morningstar estimates. Fidelity was the first discount broker to offer a no-fee index fund.In August of last year, Fidelity “fired major shots in war over fees” when it launched two zero-fee mutual funds and reduced fees for 21 of the firm’s indexed mutual funds. Fidelity was the first discount broker to offer a no-fee index fund—beating out the likes of Vanguard, Schwab, and iShares. And now, with the Merchant partnership, Fidelity appears to be positioning for further consolidation and M&A activity in the industry. Assuming recent M&A trends continue, the Merchant partnership may provide a meaningful incentive for RIAs to use the Fidelity platform.Outlook for Strategic PartnershipsWe expect RIAs to continue to seek bolt-on acquisitions that offer scale and known cost savings from increased operating leverage. Firms struggling with organic growth and margin compression will likely continue using acquisitions to expand distribution footprints and product offerings. Against this backdrop, we expect to see more strategic partnerships involving RIA capital providers going forward.
A Guide to Corporate Finance Fundamentals
Part 2 | Finance Basics: Capital Structure
This post is the second of four installments from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure?
These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #1: Capital StructureFrom a corporate finance perspective, a family business can be thought of as a portfolio of capital projects. The portfolio must be financed with a combination of debt and equity. The specific combination of debt and equity used is called the company’s capital structure.
As noted in Exhibit 1, lenders are entitled to a contractual return and have a priority claim on the company’s assets. Shareholders, in contrast, benefit from the potential upside of growth opportunities, but have only a residual claim on the company’s assets. Since return follows risk, the expected return for debt holders is lower than that for equity holders.
The analysis of capital structure is complicated by the iterative nature of the risks facing debt and equity holders. For any given proportion of debt and equity, the cost of debt will be lower than the cost of equity.
However, increasing the proportion of debt in the capital structure increases the risk of both the debt and the equity, which in turn raises the cost of each. As illustrated in Exhibit 2, at some point the benefit of using a greater proportion of lower-cost debt is eventually offset by the escalating cost of both capital sources.
The optimal capital structure minimizes the overall cost of capital. As shown in Exhibit 2, the optimal capital structure for a company is likely a range rather than a single point, since the underlying measurements are naturally imprecise.
Topics for Board DiscussionWhile the optimal capital structure cannot be defined with precision, the deliberations of an informed family business board and shareholders will focus on the following:What is the company’s current capital structure? The first step is estimating the value of the business enterprise as a whole. What multiple of EBITDA (or some other performance measure) does management believe is appropriate for the Company? What is the basis for that multiple (public companies, transactions, or some rule of thumb)? How do the risk and growth characteristics of the company compare to the selected benchmark?How does the company’s capital structure compare to peers? Capital structure is often related to the nature and intensity of a company’s asset requirements, sensitivity to economic cycles and other industry attributes.What is the availability and cost of marginal sources of capital? If the company anticipates growth, the supporting capital can come through retention of earnings, issuance of new equity, and/or borrowing. Given the company’s current capital structure, what effect would the various marginal financing decisions have on the overall cost of capital?What is the company’s target capital structure? How, if at all, does it differ from the current capital structure? How does it compare to peers? What factors contribute to the differences from peers? Such factors could include differing strategic focus, unique elements of the company’s business model, or shareholder risk preferences.
WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper
Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity
When an exit event is not imminent, the appropriate models to measure the fair value of a company with a complex capital stack are the Probability Weighted Expected Return Method (PWERM), the Option Pricing Method (OPM), or some combination of the two. While the choice of the model(s) is often dictated by facts and circumstances – for example, the company’s stage of development, visibility into exit avenues, etc. – using either the PWERM or the OPM requires a number of key assumptions that may be difficult to source or support for pre-public, often pre-profitable, companies. In this context, primary or secondary transactions involving the company’s equity instruments, which may or may not be identical to common shares, can be useful in measuring fair value or evaluating overall reasonableness of valuation conclusions.For companies granting equity-based compensation, transactions are likely to take the form of either issuances of preferred shares as part of fundraising rounds or secondary transactions of equity instruments (preferred or common shares, as part of a fundraising round or on a standalone basis). Fundraising rounds usually do not provide pricing indications for common shares (or options on common) directly. However, a backsolve exercise that calibrates the PWERM and/or the OPM to the price of the new-issue preferred shares can provide value indications for the entire enterprise and common shares. While standalone secondary transactions may involve common shares, facts and circumstances around those transactions may determine the usefulness of related pricing information for any calibration or reconciliation exercise. Calibration, when viable, provides not only comfort around the overall soundness of valuation models and assumptions, but also a platform on which future value measurements can be based.This article presents a brief discussion on evaluating observed or prospective transactions. Not all transactions are created equal – a fair value analysis should consider the facts and circumstances around the transactions to assess whether (and the degree to which) they are useful and relevant, or not.1Fair ValueASC 718 Compensation-Stock Compensation defines fair value as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” ASC 820 Fair Value Measurement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” While some of the finer nuances may differ slightly, both definitions make reference to the concepts of i) willing and informed buyers and sellers, and ii) orderly transactions.Notably, ASC 820 includes the directive that “valuation techniques used to measure fair value shall maximize the use of relevant observable inputsÉand minimize the use of unobservable inputs.” We take this to mean that pricing information from transactions should be used in the measurement (valuation) process as long as they are relevant from a fair value perspective.Willing and Informed PartiesA fundraising round involving new investors, assuming the company is not in financial distress, tends to involve negotiations between sophisticated buyers (investors) and informed sellers (issuing companies). As such, these transactions are relevant in measuring the fair value of equity instruments, including those granted as compensation.When a fundraising round does not involve new investors, the parties to the transaction are not necessarily independent of each other. However, such a round may still be relevant from a fair value perspective if pricing resulted from robust negotiations or was otherwise reflective of market pricing.Secondary Transactions – Orderly Transactions?As they give rise to observable inputs, secondary transactions can be relevant in the measurement process if the pricing information is reflective of fair value. Pricing from transactions in an active market for an identical equity instrument would generally reflect fair value. In other cases, orderly transactions Ð those that have received adequate exposure to the appropriate market, allowed sufficient marketing activities, and were not forced or distressed Ð can give rise to transaction prices that are reconcilable with fair value. Orderly secondary transactions that are relatively larger and those that involve equity instruments similar to the subject interests are more relevant.Strategic ElementsSome fundraising rounds involve strategic investors who may receive economic benefits beyond just the ownership interest in the company. The strategic benefits could be codified in explicit contracts like a licensing arrangement. Consideration paid for equity interests acquired in such transactions may exceed the price a market participant (with no strategic interests) would consider reasonable. However, even as the pricing indication from such a transaction may not be directly relevant, it can be a useful reference or benchmark in measuring fair value. For example, it may be possible to estimate the excess economic benefits accruing to the strategic investors. Any fair value indication obtained separately could then be compared and reconciled to the price from the strategic fundraising rounds.In other instances, strategic rounds may result in the company and investors sharing equally in the excess economic benefits. The transaction price could then be reflective of fair value, and a backsolve analysis to calibrate to the transaction price would be viable.More Complex StructuresA tranched preferred investment may segment the purchase of equity interests into multiple installments. Pricing for such a round is usually set before the transaction and is identical across the installments, but future cash infusions may be contingent on specified milestones. Value of a company usually increases upon achieving technical, regulatory, or financial milestones. Even when future installments are not contingent on specified milestones, value may increase over time as the company makes progress on its business plan. Pricing set before the first installment tends to reflect a premium to the value of the company at the initial transaction date as it likely includes some expectation of potential economic upside from future installments. On the other hand, the same price may reflect a discount from the value of the company at future installment dates as the investments are (only) made once the economic upside is realized. Accordingly, a reconciliation to pricing information from these fundraising rounds may require separate estimates of the expectation of future upside (for the initial transaction date) and future values implied by the initial terms of the transaction (for later installment dates).Some fundraising rounds involve purchases of a mix of equity instruments across the capital stack (i.e. different vintages of preferred and/or common) for the same or similar stated price per share. Usually, common shares involved in mixed purchases represent secondary transactions. From a fair value perspective, the transaction could be relevant in the aggregate and provide a basis to discern prices for each class of equity involved (considering the differences in rights and preferences among the classes). In other instances, either the company or the investor may have entered into a transaction for additional strategic benefits beyond just the economics reflected in the share prices. Depending on whether the buyer or the seller expects the additional strategic benefits, reported pricing may exceed the fair value of common shares or understate the value of the preferred shares. In yet other instances, mixed purchases at the same or similar prices may indicate a high likelihood of an initial public offering (IPO) in the near future. Typically, preferred shares convert into common at IPO and only one class of share exists subsequently.Timing of Transactions and Other EventsPerhaps obviously, for both secondary and primary transactions, more proximate pricing indications are generally more directly useful for fair value measurement. Older, orderly transactions involving willing and informed parties would have been reflective of fair value at the time they occurred. If a more recent pricing observation is not available, current value indications could still be reconciled with the older transactions by considering changes at the company (and general market conditions) since the transaction date.Planned future fundraising rounds could also provide useful information. In addition to the factors already addressed, a fair value analysis at the measurement date would need to consider the risk around the closing of the transaction.Besides the usual transactions, other events that occur subsequent to the measurement date could still have a bearing on fair value. Future events that were known or knowable to market participants at the valuation date should be considered in measuring fair value. Events that were not known or knowable, but were still quite significant, may require separate disclosures.Special Case – IPOsAn example of a special event on the horizon is an impending IPO. An IPO is usually a complex process that is executed over a relatively long period. At various points during the process, the company’s board or management, or the underwriter (investment banker) may project or estimate the IPO price. These estimates may change frequently or significantly until the actual IPO price is finalized. Even the actual IPO price may be subject to specific supply and demand conditions in the market at or near the date of final pricing. Subsequent trading often occurs at prices that vary (sometimes drastically) from the IPO price. For these reasons, estimates or actual IPO prices are unlikely to be reflective of fair value for pre-IPO companies.Setting aside the uncertainties and idiosyncrasies around the process, an IPO provides ready liquidity for investors and access to public capital markets for the company. The act of going public ameliorates the risks associated with the lack of marketability of investments in a company. Easier access to public markets generally lowers the cost of capital, which would engender higher enterprise values. Accordingly, fair value of a minority equity interest prior to an IPO is generally perceived to be meaningfully different from (estimates of) the IPO price.ConclusionIncorporating information from observed or prospective transactions can help calibrate the PWERM or the OPM (or other valuation methods), along with the underlying assumptions. However, a valuation analysis should evaluate the transactions to assess whether they are relevant. Even when they are not directly relevant, transactions can help gauge the reasonableness of valuation conclusions.Valuation specialists are fond of thinking their craft involves a blend of technique and judgment. The specific mechanics of models and methods, and related computations, represent the technical aspect. There is certainly some judgment involved in developing or selecting the assumptions that feed into the models. Judgment plays a bigger role, perhaps, in weaving together the models, assumptions, valuation conclusions, and other facts and circumstances, including transactions, into a coherent and compelling narrative.Contact Mercer Capital with your valuation needs. We combine technical knowledge and judgment developed over decades of practice to serve our clients.1 The discussion presented in this article is a summary of our reading of the relevant sections in the following:Valuation of Privately-Held-Company Equity Securities Issued as Compensation, AICPA Accounting & Valuation Guide, 2013Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Working Draft of AICPA Accounting & Valuation Guide, 2018
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
Measuring Up: Sorting Through the Puzzle of Dealership Metrics and Performance Statistics
This article explains dealership metrics and performance statistics–what they mean, how to evaluate them, and where a particular store stacks up. As always, performance measures are relative.
Middle Market Transaction Update First Quarter 2019
Overall transaction value and volume in the middle market dropped in the first quarter of 2019 from levels seen at the end of 2018.
M&A in the Permian
Big Deals and Bigger Opportunities
The Permian Basin is one of most prolific oil basins in the world and is the engine driving the resurgence of U.S. energy output. According to the latest EIA Drilling Productivity Report, anticipated oil production for June 2019 in the U.S. is almost 8.5 million barrels per day with the Permian alone accounting for nearly 4.2 million. The importance and impact of this basin to U.S. energy cannot be overstated.Operators in the play have had to pay a premium to access the black gold mine, and companies are still lining up for a chance to get in on the action. While the industry as a whole has been moving into a period of rapid consolidation, a substantial portion of this acquisitive activity has been in the Permian, far more than any of the other major basins.Targets with highly contiguous holdings and acreage have been of particular note to acquirers in the Permian. While acreage continuity has not always been the most important aspect of a potential deal, it has certainly become more of a focal point recently.Recent Transactions in the Permian BasinDetails of recent transactions in the Permian Basin, including some comparative valuation metrics are shown below.Oxy to Acquire Anadarko in $38 Billion DealOn May 10, 2019, Anadarko Petroleum signed a deal to be acquired by Occidental Petroleum (“Oxy”) in a cash/stock deal worth $38 billion. This deal was by far the largest and most newsworthy to come out of the Permian Basin, or any other region, for the year.The transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production.The agreement concludes one of the most closely-watched bidding wars in recent history with Oxy battling with Chevron to acquire the Permian assets of Anadarko. A month earlier, Chevron announced an agreement to purchase Anadarko for $33 billion in a cash/stock deal. Oxy soon joined the fray with a deal that was more accretive to Anadarko shareholders. The price ultimately became too much for Chevron, who received a $1 billion termination fee as part of the initial deal struck with Anadarko. Some lauded Chevron for not raising their offer and potentially overpay for the assets, but as it stands, Oxy is the big winner of the prized Permian assets which present plenty of synergies with its existing acreage portfolio.According to Occidental, the transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production. The company also said the deal provides “compelling strategic and financial rationale for all stakeholders.”Oxy is expected to fund the cash portion of the consideration through a combination of cash and fully committed debt and equity financing, which also includes a $10 billion equity investment by Berkshire Hathaway, Inc in the form of 100,000 shares of cumulative perpetual preferred stock at $100,000 per share. The investment from Berkshire comes at a steep cost though with a warrant to purchase up to 80 million common shares at $62.50 per share as well as a preferred stock dividend of 8% annually.Potential for TakeoverAlthough the Permian is far and away the most covered oil patch in the U.S. by analysts and journalists alike, the Occidental and Anadarko deal has brought some increased scrutiny to the basin particularly in assessing what other potential big deals could be out there. And the analysis seems to point to quite a few.DrillingInfo produced the map below (as of April 30, 2019) of acreage by major operators within the Permian. An interesting observation here is that several of these operators have assets and land that is largely connected.
Concentrated assets and contiguous acreage make several of these companies very attractive targets for takeover. Pioneer Natural Resources, for example, has been hard at work becoming a pure-play Permian Basin operator. With the April 26 announcement that it is to sell off the remaining assets in the Eagle Ford, the company has made itself a more attractive takeover target because of its concentrated asset base in the Delaware Basin within the Permian.
Contiguous acreage allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.There are several benefits in owning such contiguous acreage. First, operators can take advantage of economies of scale, as contiguous acreage provides access to subsurface minerals with fewer well pads required, reducing costs. Logistically, mineral rights considerations are also simplified by consolidation. Contiguous acreage also potentially allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.Costs are further streamlined as the oilfields are less encumbered by multiple operators each bringing in their own drilling crews. Additionally, armies of tanker trucks for hauling away wastewater for various operators in a crowded field are replaced with efficient networks of surface pipes for wastewater disposal. Companies such as those with adjoining acreage to Pioneer could consider the advantages and synergies of such networks and efficiencies, especially if the infrastructure is already in place.EOG Resources, one of the largest independent operators, owns acreage that borders against Chevron and Occidental in multiple areas. Given the recent loss in the bidding war with Occidental for Anadarko’s assets, Chevron has additional cash (set aside for the prior merger attempt as well as the break-up fee) that could be used for another takeover attempt, and EOG would be an attractive target for the reasons described above.Other pure-play companies such as Diamondback or Concho Resources also have highly contiguous acreage adjacent to large companies who could take advantage of these economies of scale and efficiencies. These companies have been active consolidators in the basin, with Diamondback’s 2018 acquisition of Energen and Concho’s takeover of RSP Permian earlier in that year.ConclusionThe trends for the Permian are apparent. Companies have been working to establish firm footholds in this basin and are willing to pay premiums to get in and stay in. The basin is also in an interesting position that due to the layout of operator acreage and assets, large takeovers of neighboring operators with contiguous acreage and established efficiencies create the opportunity for higher return on investment.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Are Value Managers Undervalued?
Growth Investing Has Outperformed Value for Quite Some Time Now, and the Market’s Taking Notice
Looking BackIf you’re an asset manager, then you’re probably aware of growth investors’ dominance over their value counterparts for the last ten or fifteen years. Since the Financial Crisis, it’s been all growth, which tends to outperform during sustained bull market runs and periods of monetary easing.As most value and growth managers’ clients are primarily (performance chasing) institutional investors, this recent disparity has been particularly challenging for value investment firms looking to grow (or even maintain) their AUM balances. The market has clearly picked up on these issues, especially over the last couple of years – two out of the three public (and predominantly) value-oriented investment firms (Gabelli and Diamond Hill) are in bear market territory while the S&P is up nearly 20% since the Summer of 2017:
The economics behind the sector’s fall-out are relatively straightforward. Underperformance leads to outflows and contractions in AUM with corresponding declines in management fees and earnings. Even if the multiple doesn’t slip, the drop in profitability is enough to weigh on share prices. Unfortunately, the multiple did slip, and Gabelli and Diamond Hill have lost a third of their market cap during relatively favorable market conditions. As we’ve noted before, this multiple is a function of risk and growth, so the market either believes their growth prospects have diminished or their risk profile has elevated. In all likelihood, it’s a little bit of both, as growth will likely be adversely affected by lower demand for value products, while the risk of continued outflows remains high.
Looking at the MultiplesAgainst this backdrop, we address this post's original question as to whether or not value managers are indeed undervalued at the moment. A quick glance at the P/E graph below reveals that two of these businesses are priced at less than 10x trailing twelve month (after-tax) earnings, while their RIA peers trade at 15.7x (on average) and the broader market is closer to 20x.
This is definitely at the lower end of a reasonable range, and is, once again, likely attributable to a particularly high-risk profile and lower growth prospects. The ten-plus year slough of relative underperformance versus growth investing and expectations for continued outflows are the likely culprits.
Still, some might contend that this is overblown, or at least short-sighted, if you believe in mean reversion or question the sustainability of the current trend. The last time growth dominated value by this margin was during the tech bubble when the Russell 2000 Growth Index outperformed its value counterpart by 68% (annualized) from October 1, 1998 to March 1, 2000 before giving it all back (and then some) over the next couple of years. The problem for value managers is most of their institutional clients emphasize relative performance over the prospect for mean reversion, so they’re going to have to improve their track records to recover lost AUM. That’s not always a given.
Even the world's greatest value investor is struggling.Even the world’s greatest value investor (and perhaps the greatest investor of all time) is struggling to keep pace with the market. Warren Buffet’s Berkshire Hathaway is up just 2% so far this year compared to just over 15% for the S&P 500 and 25% (on average) for the FANG stocks. Fortunately, this hasn’t curtailed Buffet’s ability to raise money for a good cause, as the current bid for his annual charity lunch currently resides at $4.6 million.
Buffet’s current predicament is not nearly as dire as 1999 during the Dot Com Crash when the S&P and NASDAQ appreciated 20% and 87%, respectively, while Berkshire lost 22%. Worth noting, however, is BRK-A gaining 32% the following year when the S&P and NASDAQ shed a respective 9% and 45%. We’re not forecasting that level of mean reversion but do want to emphasize how quickly relative outperformance can swing the other way.
Looking ForwardThere are very good reasons why value managers’ stocks have performed so poorly over the last few years.The bottom line is that there are very good reasons why value managers’ stocks have performed so poorly over the last few years. Significant underperformance relative to both the market and growth alternatives has led to continued outflows from institutional investors, which in turn has hampered AUM, revenue, and earnings growth despite relatively favorable market conditions. Since the multiple has also slid for these businesses, it appears that the market is anticipating more of the same. That’s probably true since their one, three, five, and ten year track records are lagging, which is what most institutional investors base their hiring and firing decisions on.Regardless, we’re skeptical that this growth-over-value outperformance will persist much longer, given the cyclical nature of investment performance. It’s probably only a matter of time, and if it’s any time soon, that would make value managers (and Berkshire stock) very attractive investments. Otherwise, current valuation levels are justified, and it could be a very long time before the sector regains investor confidence.
Planning for Estate Taxes To-Do List
In last week’s post, we explored how the estate tax works and how family business shareholders are uniquely burdened by the prospect of having a substantial estate tax liability despite potentially having most of their wealth tied up in illiquid stock. This week’s to-do list includes important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises with regard to the estate tax. While the estate tax is an obligation of the shareholders rather than the family business itself, if the shareholders are not adequately prepared to manage their emerging estate tax liabilities, there can be adverse consequences for the sustainability of the family business.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry. Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability? Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers. If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here). You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).When you are reading the valuation report, you should be able to recognize your family business as the one being valued.The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support. You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value. If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest. Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value. In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public. Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest. In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business. If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest. Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post.
We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better. This belief is short-sighted and potentially costly. For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable. Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions. The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory. While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseThe most advantageous time to secure financing commitments from lenders is before you need the money.With the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved. Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations? If so, does the family business have the financial capacity to support such activities? The most advantageous time to secure financing commitments from lenders is before you need the money. What is the risk that an estate tax liability could force the sale of the business as a whole? If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business. If there was no estate tax, what evolution in share ownership would be most desirable for your family and business? The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions. Give one of our professionals a call to help you get started on knocking out your to-do list today.
How to Present Complex Finance to Judges
Originally presented at the 2019 AAML/BVR National Divorce Conference in Las Vegas, in this session, Z. Christopher Mercer, FASA, CFA, ABAR delves into more than 30 years of experience presenting complex valuation and damages issues to judges and juries. One of the key ideas of effective communication is the KISS principle, or “keep it simple, stupid.” The question is, how can we do that? Chris provides the techniques and templates necessary to communicate your position, and your opponent’s position, in such a way that judges can hone in on and understand the most important information and why it’s important.
The Ultimate Investment Vehicle
Is the Value of your RIA More a Function of Risk or Growth?
On Mother’s Day several years ago I gave my wife a pale blue t-shirt that read “I used to be cool” on the front; on the back it said “Now I drive a minivan.” Such was her lament until an absent-minded motorist in a Tahoe shortened the rear end of her Honda Odyssey by a couple of feet, and we replaced it with a BMW. Unsurprisingly, the manufacturer of the Ultimate Driving Machine doesn’t offer a minivan.Automakers have been trying to square the circle of fun with function, and vice-versa, since they started inviting their marketing departments to engineering meetings. Sometimes this quest has produced absurd results. In the 1990s, the folks at “boxy but good” Volvo put an intercooled, turbocharged motor in their mainline station wagon and created a rocket with room for seven. Kind of a cool idea, but hard to answer the “why?” question.The Ultimate Investment VehicleThe analogous tradeoff between fun and function in the valuation world is risk and growth. Unlike fun and function, risk and growth aren’t so much a dichotomy as they are co-present, and often in direct proportion to each other. Treasuries pay a modest but reliable coupon – they are essentially a no-risk, no-growth investment vehicle. On the other end of the spectrum, seed stage venture capital investing offers supernormal growth rates, and high expected returns to match. The ultimate investment vehicle is the profitable, high-growth, low-risk security: the Registered Investment Advisor.Valuation orthodoxy holds that value equates to cash flow priced for risk (downside exposure) and opportunity (growth or otherwise upside exposure). All else equal, the greater the cash flow, the lower the perceived risks associated with that cash flow, and the greater the likelihood of growth or other upside associated with that cash flow, the higher the value. The reverse is also true.On paper, the RIA model is a value generating machine: a reliable stream of distributable cash flow resulting from sticky, recurring revenues and growing effortlessly with the investment returns available in a diversifiable variety of financial markets. The reality, of course, is more nuanced.Cash is (Still) KingAt a core level, the most attractive feature of the RIA business model is a steady stream of distributable cash flow. This would be true in any market environment; given the low rate circumstance of the past decade-plus, it’s even more so. Unlike many businesses, investment management is not capital intensive, so EBITDA is more or less equivalent to distributable cash flow if an RIA is structured as a tax pass-through entity. RIAs offer the potential for double-digit yields and future growth. There are no fixed income instruments that look anything like that. And it’s for this reason that every week we read a new announcement about capital chasing the RIA space.You can’t value a revenue stream based on unrealistically high fees.The catch is that an RIA’s margin needs to be a real margin. By that I mean that you can’t value a revenue stream based on unrealistically high fees, nor is a profit margin reliable when owner compensation is so low that distributions are really being used as a substitute for wages. Segmenting returns to labor (compensation) and returns to capital (profits) can be difficult, but the value of an RIA is necessarily based on cash flows to the capital providers, as if they were not also part of the firm’s leadership.De-Risking Your FirmBusiness risk is inevitable, even for the best RIAs. Markets tumble. Clients die, and their heirs choose different advisors. Investment committees punish outperformance by rebalancing.Many risks seem avoidable, though. Just look at the headlines. Last week’s announcement that First Republic lost a team responsible for $17 billion in client assets is a potent reminder that revenue producers who see more upside on their own won’t stick around forever, especially if they have a track record of chasing opportunity. And Creative Planning’s breakup with Tony Robbins is a keen reminder of the sort of personality risk that can come with celebrity endorsements, or – thinking back a bit – with founders who want to be celebrities. A lot of times, it seems the big risks that come to bite firms are born out of a growth strategy that soured.Put another way, when evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.When evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.But it’s not just the usual business risks that bear consideration (client concentration, key manager risk, etc.). These days, I’m thinking more about how prominent the business communities in which RIAs operate have become: consolidators, IBDs, partnerships, and custodians. In a sense, whether you’re talking about Focus Financial, LPL, Fidelity, Raymond James, Goldman Sachs, Charles Schwab, or others, all of these communities act as eco-systems that present support and guardrails to RIAs. Some of these communities will be a better environment for your RIA than others. The biggest risk you face may be the opportunity cost of choosing the wrong one.Growth as an Offset to RiskMathematically, a given increment of growth can mitigate certain business risks. Many years ago we cautioned a buy-side client that they were overpaying for an RIA to tuck into its bank trust department. They wanted the acquisition and did the deal anyway. We weren’t wrong, but the bull market that followed made most of our concerns about the target irrelevant as the growth in the acquired firm gave the bank a handsome return on their investment.You can’t count on bull markets to bail out bad investments, but (even in a cash flowing business) growth matters because it provides part of the expected return on investment. If a given RIA is valued with a discount rate in the mid-teens, say 15%, and the growth expectation associated with the firm’s model is only a modest premium to inflation, say 3%, then the capitalization rate (also known as earnings yield) is 12% (cost of capital of 15% minus the growth rate of 3%). The earnings multiple is the inverse of the earnings yield, or 1/12%, or 8.5x. That’s an after-tax multiple, and the pre-tax equivalent is roughly equal to an EBITDA multiple, or about 6x. At a 5% growth rate, the earnings yield of 10% converts to an after-tax earnings multiple of 10x, or an EBITDA multiple of roughly 7.5x.You can’t count on bull markets to bail out bad investments.That march through the math of cap rates is admittedly dry, but if you’d like to think about how the market values growth, just look at how Focus Financial, an aggregator of mostly wealth management firms, stacks up against Affiliated Managers Group, an aggregator of mostly asset management firms. Since their IPO almost a year ago, Focus has been one of the most, if not the most, acquisitive of the consolidators, and is currently trading at a mid-teens multiple of EBITDA. AMG just announced their first acquisition in two years and has had a tough time growing earnings in these choppy markets. AMG trades for a little less than 10x reported EBITDA, a big discount to Focus.Just Because You Can, Doesn’t Mean You ShouldWe get asked, regularly, what we think the best value-maximizing model is for an RIA. We can tell you that there are approximately 20 thousand RIAs, hybrid IBDs, independent trust companies, and unregistered investment management firms in the United States. Any one of them can be very successful, and we’ve had the pleasure of working with many that do very well. There is no one size fits all model or strategy. We can tell you that value is directly proportionate to cash flow and growth, and inversely proportionate to risk. Any strategy or model can be evaluated in terms of these three levers, and all are available as a way to increase the value of your RIA.Just be careful before you mix and match strategies. Checking the lap time of a carpool carrier is a little like measuring the towing capacity of a Lamborghini. Ridiculous, but some have tried:One of a series of similar advertisements for Volvo
Forecasting Future Operating Results for an Oilfield Services Company
In our prior two Energy Valuation Insights blog posts, we detailed the specifics of “what is” and “what are the characteristics of” an oilfield equipment/services company (“OFS”), and detailed the typical approaches and methodologies utilized in valuing OFS companies. This week, we’ll address some of the special considerations that must be given attention in the appraisal of OFS companies. Specifically, the challenges in forecasting the future operating results for an OFS company.In the appraisal of an OFS company, the application of the income approach often includes the application of a discount cash flow (“DCF”) methodology. Actually, one might make the argument that the application of the income approach in appraising an OFS company should nearly always include the application of a DCF methodology, as opposed to relying solely on a capitalization of earnings methodology (“capitalization method”). While application of a capitalization method can provide a reasonable indication of value for companies in many industries, doing so for an OFS company can be problematic due to the inherent cyclicality of the OFS industry. One can attempt adjustments to a capitalization method indication of value to account for future deviations in cash flow growth rates (such as those caused by OFS industry cyclicality), but doing so can involve unnecessary subjectivity, resulting in an indication of value that may lack reliability. Typically, the better, and often more reliable, option is to utilize a DCF method using a forecast of future operating results rather than a capitalization method with imprecise adjustments.Understanding Industry Cyclicality is an Important Factor in Valuing an OFS CompanyIn applying the DCF method, the starting point is, of course, the development of a forecast of future cash flow for the subject company, which typically begins with a forecast of future revenues. Here we run into the first of several challenges in the appraisal of OFS companies. The OFS industry is of the most cyclical of industries that analysts can cover. Not just cyclical with the general economy of the region, nation or world, but cyclical in a way that is much more difficult to predict fluctuations in the price of oil (or natural gas) tied to a whole host of factors including technological, political, and even geopolitical factors can make forecasting complicated very quickly.Several varying forces can make predicting the future demand for oil from a particular region, and therefore, the demand for OFS products/services, quite difficult.Demand for oil and gas, and therefore demand for OFS products/services, can be as simple as the fact that in a robust economy more goods are being bought by end users and consumers. More purchases of goods, means more goods have to be transported to the end user/consumer, which requires more fuel to facilitate that transportation. Technology can impact the supply side of the equation as oilfield technology advances can lower the cost of oil production, thereby encouraging greater production even when oil prices are stable, or possibly even in decline, all else being equal. Local and national politics can impact demand as well. In the U.S., recent differences in positions on the use of coal as a power source have inserted a new dynamic into the economic demand for oil. In the geopolitical realm, bans on the importation of oil from certain countries (Iran or Venezuela, for example) have created shifts in demand for oil from other oil-producing countries.These varying forces can make predicting the future demand for oil from a particular region, and therefore, the demand for OFS products/services in that region, quite difficult. As indicated in the chart below, the timing and magnitude of cycles in the OFS industry can vary significantly.[caption id="attachment_26698" align="alignnone" width="812"]Note: Median year-over-year revenue change among the smaller publicly-traded OFS industry participants.[/caption]
Forecasting OFS Company RevenuesIn forecasting OFS company revenues, one must distinguish between the short-term forecast and the long-term forecast. The short-term forecast will be primarily focused on the current direction of industry revenues, the typical length of industry cycles in estimating the timing of a current down-cycle bottom (or current up-cycle peak), and expectations for the subject company’s revenue cycle relative to that of the OFS industry as a whole (lagging or leading). The long-term forecast for the subject company will be more focused on the expected timing of a return to the mid-cycle level of revenues and the subject company’s particular expected mid-cycle level of revenue, with a potential adjustment for possible changes in the subject company’s market share.In performing the company level analysis, it’s always important to be aware of past transaction activity, changes in product/service, mix, or changes in markets served.In support of both the short-term and long-term forecasting considerations, an analysis of past OFS industry cycles and of the subject company’s past revenue cycles is warranted. With access to certain specialized databases, a detailed analysis of industry cycles (or industry participant cycles) can be readily performed. The same cycle analysis regarding the subject company is possible if the company has a long-enough operating history. In performing the company level analysis, it’s always important to be aware of past transaction activity (acquisitions, or divestitures), changes in product/service, mix, or changes in markets served, that might influence the results.Based on these analyses, the appraiser must determine reasonable estimates for the following:The time until the then current up-cycle will peak, or current down-cycle will bottomThe revenue level at the current up-cycle peak, or current down-cycle bottomThe time to reaching the next mid-cycle point, or mid-cycle level of revenue
Estimates based on a sound analysis of historical industry and subject company data will result in a reasonable revenue forecast.Forecasting ConsiderationsBeyond the industry-wide considerations necessary in developing the OFS company forecast, one must also consider a number of more specific, non-industry-wide factors. These may include the target market (geographic), the subject company’s specific product/service offerings, the mix of product/service offerings, and the subject company’s ability to weather a current industry down-cycle.Geographic Target MarketUnlike participants in many other industries, OFS industry participants expect that future operating results can be significantly impacted by the geography of their target market, or, more specifically, the geology of their target market. The cost of extracting oil/gas can vary significantly depending on the basin being served. Similarly, the cost of processing (refining) oil from different basins can vary significantly, based on the quality of the oil being produced. For example, according to a 2016 EIA study, lower production costs were more prevalent in the Delaware Basin and Appalachian Basins while higher production costs were more standard in the Eagle Ford and Midland Basins1.The differences in production costs were partially a factor of the geology of the basins, which impacts the specific processes necessary in order to extract the reserves. In the Marcellus Basin, shallow formations and pad drilling techniques allow for lower cost production, while in the Eagle Ford Basin, deeper and more technically challenging formations tended to result in higher production costs. This changes over time with experience and technology accelerators, as the Eagle Ford’s costs have come down for several producers in the past year.Cost differentials can result in potentially significant differentials in drilling and production activities across the various basins, depending on prevailing oil prices.These cost differentials can result in potentially significant differentials in drilling and production activities across the various basins, depending on prevailing oil prices. Proximity to refiners also plays a role as transportation costs can add up. Prices at $60/bbl, for example, may spur activity in one basin while another basin remains at markedly lower activity levels, often captured in “break-even” prices. As such, in estimating future operating activity levels of an OFS company, one must be aware of the expected oil prices and the level of activity that would be expected in conjunction with those prices in the basins served by the subject company.OFS companies can mitigate some of the cyclicality by diversifying across basins. Operating in multiple markets can spread costs over more operations as well. OFS companies concentrated in one particular basin, on the other hand, would likely experience more volatile swings, particularly if they operate in a high-cost basin.Specific Product/Service OfferingsThe specific products and services offered by the subject OFS company must also be considered, as some services will only experience increased demand at higher oil price points, that justify the operator incurring the additional expense. For example, even in a period of rising production, a provider of services related to more expense stimulation techniques may not see a significant increase in the demand for its services until a certain price point is achieved. On the other hand, providers of services that are necessary for more general production activities would be expected to experience cyclical demand for its services more in-line with the general OFS industry. Some may even be insulated from price declines as E&P companies will continue to demand certain services regardless of price.Mix of Product/Service OfferingsSimilar to the impact of diversification of basins served, diversification across products and services offered can potentially contribute to reduced cycle extremes. An OFS company might see greater cycle extremes for certain exploration and production services. However, offering multiple services not tied to those same exploration and production activities can provide needed diversification which may mute cycle highs and lows.Financial Condition of the Subject CompanyThe subject company’s financial condition is often given inadequate consideration in forecasting future operating results; however, it can be critical when appraising companies in industries that commonly experience more significant cycle highs and lows, such as the OFS industry. This is particularly important when the subject industry is facing a material downturn in activity in the early portion of the forecast period.Consideration of a company's financial condition can be critical when appraising companies in industries that experience significant cycle highs and lows, such as the OFS industry.During an industry downturn, certain expenses can’t be avoided, and the subject company may generate negative cash flows until demand returns. As such, an analysis of the company’s financial condition is important in determining its ability to weather the downturn and participate in the expected improved conditions as the industry cycle swings back to more favorable conditions.Companies that have ample cash reserves, low levels of debt, or a significant ability to reduce fixed costs will be more likely to overcome the impact of the down cycle. Companies that have little cash reserves, substantial leverage, or are less able to cut costs may have to take more significant actions to weather the downturn. Such actions may impact the degree to which they’re able to participate in the industry’s next upswing in demand. In forecasting future operating results, one must include an analysis of the subject company’s financial condition and consider what actions may be necessary in order for the company to deal with the short-term cash outflows. Those actions may, if more extreme, result in the subject company participating to a lesser degree in the eventual industry recovery.Forecasting OFS Company Cash FlowNext, is the task of deriving a cash flow forecast from the revenue forecast, through the forecasting of cost of sales and operating expenses. In both cases, a greater level of analysis is warranted for OFS industry participants than for participants in industries less subject to large cycles. The reason being that depending on the relative level of fixed and variable expenses in cost of sales and operating expenses, those expenses, as a percentage of revenues may fluctuate significantly over the course of the industry’s cycle. As demand for labor, materials, and products will be high near the peak of the industry cycle, their cost will potentially increase relative to revenues, resulting in higher cost of sales relative to revenue and lower gross margins. The opposite would be expected for time periods near the bottom of the cycle, with demand at a low point and cost of sales lower relative to revenues, resulting in higher gross margins. Operating expenses can be tied to these peaks and valleys in the industry cycle as well, but the impact may not be as severe, since they have a larger ratio of fixed versus variable components relative to the cost of sales expense.Unlike companies participating in less cyclical industries where it may be reasonable to forecast cost of sales and/or operating expenses as a static, or near static, percentage of revenues, forecasting OFS company expenses (cost of sales and operating) typically requires an analysis of past operating results in order to identify cycles and ranges of company expenses relative to revenue. The question to be addressed is essentially, what will my cost of sales percentage (of revenues) be at the level of revenue forecasted for each discreet period in the forecast and what will my operating expense percentage be at the level of revenue forecasted for each period in the forecast? Note that due to the likely presence of a greater fixed/variable expense ratio in operating expenses (than cost of sales), the change in operating expenses as a percentage of revenues over the forecast period will likely be more pronounced than for cost of sales.Extreme Industry Condition ImplicationsRare indeed is the industry that is subject to the potential cyclical extremes of the OFS industry. As indicated in the chart below, in 2008 oil prices surged to unprecedented levels for several months (that haven’t been seen since) resulting in a significant spike in OFS product/service demand. Shortly thereafter, in 2009, oil prices dropped sharply to levels that hadn’t been seen since 2003, only to be followed by a sharp increase to a level generally in-line with the price trend that had been established during the 2004 to 2007 period.[caption id="attachment_26700" align="alignnone" width="740"]Source: EIA[/caption]
Due to these fluctuations in commodity prices, and therefore OFS activity levels, one must be cautious in applying the DCF method. While typical cycle highs and lows can be dealt with through an analysis of historical industry cycles, periods of extreme highs, or extreme lows, create unusual challenges for OFS forecasting. No matter the level of industry experience, extreme industry activity (high or low), can easily lead to forecasts that result in unreliable indications of value. In such instances, while application of an income approach DCF methodology may be warranted and appropriate, it may be the case that reliance on the indication of value derived from this methodology should be afforded less weight relative to the weight afforded indications of value from other valuation methods - likely a market approach guideline company methodology.
ConclusionAs indicated, the unpredictable cyclicality of the OFS industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results. While consideration of such factors should be part of the analysis in the appraisal of businesses in all industries, the impact of these considerations is magnified in highly cyclical industries such as that served by OFS businesses.Mercer Capital has a breadth and depth of experience in the appraisal of businesses in the oil and gas industry that is rare among independent business appraisal firms. Our Energy Team is led by professionals with 20 to 30+ years of experience involving upstream businesses (E&Ps, oilfield product manufacturers and oilfield service providers), midstream (gathering systems, pipeline MLPs, pipeline processing facilities), and downstream (refining, processing, and distribution). Feel free to contact us to discuss your valuation needs in confidence. 1 EIA: Trends in U.S. Oil and Natural Gas Upstream Costs – March 2016
A Taxing Matter for Family Businesses
Family business owners cite different motives for investing their time, energy, and savings into building successful businesses. Some have entrepreneurial zeal, while others are creators who see problems in the world that they can solve. Others are natural leaders who are inspired by the job opportunities and other “positive externalities” that successful enterprises generate for employees and the communities in which they operate. But common to nearly all family business owners is the desire to provide financially for their heirs. As a result, one of the most common concerns such owners cite is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The estate tax is a tax on your right to transfer property at your death.The Internal Revenue Service defines the estate tax as follows: “The estate tax is a tax on your right to transfer property at your death.” The amount of tax is calculated with reference to the decedent’s gross estate, which is the sum of the fair market value of the decedent’s assets less certain deductions for mortgages/debts, the value of property passing to a spouse or charity, and the costs of administering the estate.As with all taxes, things are not as simple as they seem. Before calculating the estate tax due, two adjustments are made. First, all taxable gifts previously made by the decedent (and therefore no longer in the estate) are added to the gross estate. Second, the sum of the gross estate and prior taxable gifts is reduced by the available unified credit. The unified credit for 2019 is $11.4 million. The following table illustrates the calculations for the taxable estate of an unmarried individual.
To complicate things a bit further, estates have benefited from the introduction of “portability” to the estate tax regime in 2011. Portability refers to the ability of an individual to transfer the unused portion of their available unified credit to a surviving spouse. The ultimate effect of portability is that for married family business owners, the total available unified credit is slightly more than $22 million.
Taxes are never fun, but what proves to be especially vexing about the estate tax for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock. Going back for a moment to our prior example, if the decedent’s assets consist primarily of a portfolio of marketable securities, it is relatively easy to liquidate a portion of the portfolio to fund payment of the tax. If, on the other hand, the decedent’s assets are primarily in the form of shares in the family business, liquidating assets to pay the estate tax may prove more difficult (estate taxes are payable in cash and may not be paid in-kind with family business shares). As a result, family businesses may be sold or be forced to borrow money to fund payment of a decedent’s estate tax liability.
Attorneys who specialize in estate taxes have devised numerous strategies for helping families manage estate tax obligations. Strategies range from relatively simple, such as a program of regular gifts to family members, to complex, such as the use of specialized trusts. While the finer points of various potential strategies is beyond the scope of this post, the concept of fair market value is essential to understanding and evaluating any estate planning strategy.
What is Fair Market Value?As noted above, fair market value is the standard of value for measuring the decedent’s estate, and therefore, the estate tax due. The IRS’s estate tax regulations define fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”So far, so good.The fair market value of family business shares depends not just on the fundamentals of the business but also on the relevant level of value.But how does all this work for a family business? To understand the underlying rationale for much estate planning, we need to explore how the standard of value intersects with what is referred to as the level of value. In other words, the fair market value of family business shares in an estate depends not just on the fundamentals of the business (expected future revenues, profits, investment needs, risk, etc.), but also on the relevant level of value.If an estate owns a controlling interest in a family business (in most cases, more than 50% of the stock), the fair market value of those shares will reflect the estate’s ability to sell the business to a competitor, supplier, customer, or financially-motivated buyer, such as a private equity fund. In contrast, the owner of a small minority block of the outstanding shares of a family business has no ability to force the business to change strategy, seek a sale of the business, or otherwise unilaterally compel any action. As a result, the owner of the shares is limited to waiting until the shareholders that do have control decide to sell the business or redeem the minority investor’s shares. In the meantime, they wait (and, potentially, collect dividends). If there is a willing buyer for the shares, they may elect to sell, but that buyer will be subject to the same illiquidity, holding period risks, and uncertainties, so the price is unlikely to be attractive.Business appraisers often describe the levels of value with reference to a chart like the following:
The levels of value chart captures two essentially common-sense notions regarding value. First, investors prefer to have control rather than not. The degree to which control is valuable will depend on a whole host of case-specific facts and circumstances, but in general, having control is preferred. Second, investors prefer liquidity to illiquidity. Again, the magnitude of the appropriate marketability discount will depend on specific factors, but not surprisingly, investors prefer to have a ready market for their shares. Fair market value is measured with respect to both of these common-sense notions.
Estate Planning ObjectivesMinimizing taxes is only one possible objective of an estate planning process.As a result, one objective of most estate planning techniques is to ensure – through whatever particular mechanism – that no individual owns a controlling interest in the family business at his or her death. Of course, minimizing taxes is only one possible objective of an estate planning process, which might include asset protection, business continuity, and providing for loved ones.Therefore, family businesses should carefully consider whether an estate planning strategy designed to minimize estate taxes will have any unintended negative consequences for the business or the family.For example, an aggressive gifting program that causes the founder to relinquish control prematurely may increase the likelihood of intra-family strife, or jeopardize the family’s ability to make timely strategic decisions on behalf of the business.Or, adoption of an unusually restrictive redemption policy in an effort to minimize the fair market value of minority shares in the company may lead to inequitable outcomes for family members having a legitimate need to sell shares.
In short, families should be careful not to let the tax tail wag the business dog. Families should consult legal, accounting, and valuation advisors who understand their business needs, family dynamics, and objectives to ensure that their estate plan accomplishes the desired goals.
Net Interest Margin Trends and Expectations
Since Bank Watch’s last review of net interest margin (“NIM”) trends in July 2016, the Federal Open Market Committee has raised the federal funds rate eight times after what was then the first rate hike (December 2015) since mid2006. With the past two years of rate hikes and current pause in Fed actions, it’s a good vantage point to look at the effect of interest rate movements on the NIM of small and large community banks (defined as banks with $100 million to $1 billion of assets and $1 billion to $10 billion of assets).
As shown in Figure 1, NIMs crashed in the immediate aftermath of the financial crisis, primarily because asset yields fell much quicker than banks could reprice term deposits. NIMs subsequently rebounded as the asset refinancing wave subsided while banks were able to lower deposit rates. A several year period then occurred in which asset yields grinded lower at a time when deposit rates could not be reduced. This period was particularly tough for commercial banks with a high level of non-interest bearing deposits.
Since rate hikes started, the NIM for both small and large community banks have increased about 20bps through year-end 2018 before experiencing some pressure in early 2019. The nine hikes by the Fed to a target funds rate of 2.25% to 2.50% amounts to a 225bps increase.
At first pass, the expansion in the NIMs is less than might be expected; however, there are always a number of factors in bank balance sheets that will impact the NIM, including:
Loan Floors. Many Libor- and prime-based commercial loans had floors that required 100-150bps of hikes before the floors were “out-of-the-money.”Competition. Intense competition for loans in an environment in which bonds yielded very little resulted in pressure in the margin over a base rate as bank and non-bank lenders accepted lower margins in order to make loans.Asset Mix. Community banks located in rural and semi-rural areas tend to have low loan-to-deposit ratios and, therefore, have not benefited as much as peers located in and around MSAs that are “loaned-up.” Nonetheless, net loans as a percentage of assets among community banks increased by an average of 15bps each quarter since year-end 2016 while bond portfolios declined.Loan Mix. Community banks tend to have somewhat more of their loan portfolios allocated to residential mortgages and CRE than regional banks. As a result, it will take much longer for these mostly fixed-rate assets to reprice than Libor-based C&I portfolios.Deposit COF. In recent quarters the marginal cost of funds (“COF”) has become expensive as depositors who came to accept being paid essentially nothing for their money began to demand more competitive rates once the Fed Funds rate approached 2%.Deposit Mix. In addition to depositors demanding higher rates, a mix shift from non-interest bearing and very low-yielding transaction accounts into higher paying money markets and time deposits has pushed the COF higher, too, in recent quarters.Fed to Cut Rates?Recent incremental pressure on NIMs notwithstanding, community banks’ balance sheets were poised to take advantage of rising rates the past several years. The outperformance of bank stocks beginning in November 2016 reflected several factors, including an economic and regulatory backdrop that would allow the Fed to raise rates further and faster, and thereby support NIM expansion.The underperformance of bank stocks since last fall reflects investor concern that this tailwind is ending in addition to more general concerns about what a possible economic slowdown implies for credit costs. Telltale signs include the inversion of the Treasury yield curve and yields on the two-year and five-year Treasuries that, as of the date of the drafting of this article, are below the low-end of the Fed Funds target range.
Also, the spot and forward curves for 30-day Libor imply the Fed will cut the Funds target rate and other short-term policy rates one or two times by early 2020 (or stated differently, the December rate hike was a mistake).
The Federal Funds rate, the predominant influence on short-term interest rates, has remained unchanged since year-end 2018 at a target range of 2.25%–2.50% due to concerns about lower inflation figures and what they may forewarn about future economic growth as reflected in falling U.S. Treasury yields. The FOMC reiterated its wait-and-see approach on May 1. However, the sand appears to be shifting beneath the Fed’s feet.
The Wall Street Journal’s most recent Economic Forecasting Survey revealed an increasing belief that the Fed’s next move will be to cut rates. 51% of respondents said that a rate cut would be the next move, up from 44% in April. 25.5% replied that the next rate raise would occur in 2020 or later. Fed officials have maintained their stance that a rate move in either direction will not occur soon.
The Importance of Deposits and Next StepsAs deposit costs initially lagged, but more recently moved with short-term interest rate hikes, the composition of a bank’s deposit base and funding structure has become increasingly important. As shown in Figure 4, the percentage of banks experiencing a rising cost of interest bearing deposits has steadily increased. Total funding costs have nearly doubled since year-end 2016 as depositors have reoriented funds toward accounts offering higher rates. Banks searching for funding either must engage in intense deposit competition or tap into higher-cost sources such as wholesale funding.
Going forward community banks may face a modest reduction in NIMs because the yield curve is flat and the cost of incremental funding is expensive. Some community banks will choose to slow loan growth in order to protect margins; others will accept a lower margin. The predicament demonstrates yet again why deposit franchises are a key consideration for acquirers as banks with low cost deposit franchises and excess liquidity are particularly attractive in the current market.
Originally published in Bank Watch, May 2019.
Why Has the Public Market Soured on RIA Consolidators?
Recent Capitulations for AMG and Focus Suggest Investors are Starting to Question Their Business Model
While it’s no secret that the last year has been especially challenging for the RIA industry, Affiliated Managers Group (AMG) and Focus Financial (FOCS) have underperformed most of their peers by a fairly significant margin in the last few months. AMG is down nearly 50% over the last year, and Focus has lost over 50% of its value since peaking last September. For this post, we’ll offer our take on the driving forces behind this decline.1) AMG and Focus’ Underlying Investments Have Likely Depreciated with the Industry, and These Losses Have Been Amplified by LeverageIf the RIA sector has underperformed the broader market by 10-15% in the last year (per above), it stands to reason that businesses that invest in this industry would experience a similar decline. Then you have to factor in leverage. Both AMG and Focus employ debt financing to make acquisitions, which magnifies losses when things go bad. Even though the balance sheet isn’t a focal point for most RIAs, AMG and Focus both have growing debt obligations and deficit tangible equity. Their income statements aren’t much better as Focus remains unprofitable (on a reported basis), and AMG is battling margin compression.Asset managers, in particular, have struggled over the last year, which may explain AMG’s underperformance relative to Focus during this time. Fee compression, poor investment performance, and continuous asset flows from active to passive products are largely to blame for the sector’s recent woes.2) Market Declines Can be Particularly Damaging to High Beta Securities like AMG and FOCSA quick perusal of the graph above shows how sensitive these businesses are to market gains and losses. The fourth quarter and recent weeks show significant declines as the market pulls back. Volatility has likely compounded this issue as nervous investors shun active managers and look to products designed to mitigate losses.
While Focus Financial CEO Rudy Adolf contends that Focus is relatively well insulated from market downturns, the reality is that this business (and AMG) levers up to buy companies that invest primarily in stocks or equity funds. This dynamic creates an inherently volatile and market sensitive security that will almost certainly underperform the market in a downturn or correction. The opposite is also typically the case, but not always.3) Goldman Sachs’ Recent Entry in the RIA Consolidation Space Means More Competition for Buyers and Possibly Lower ReturnsGoldman’s acquisition of RIA consolidator United Capital could be a game changer for M&A in the wealth management space. A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals. Hightower also intends to ramp up RIA acquisitions in an already crowded space. AMG and FOCS’s correction over the last couple of weeks may be attributable to these developments.A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.The public market seems concerned about AMG and Focus’ ability to find deals at attractive valuations (and returns). While Focus has strung together over 20 acquisitions so far this year, keeping up that pace may be a tall order—especially if competition for deals increases. AMG, on the other hand, has had a two-year acquisition dry spell that recently ended with the acquisition of Garda Partners.For aggregators like AMG and Focus, acquisitions are a key part of the growth strategy. While these firms try to foster organic growth as well, acquisitions are still the fastest path to scale. If the public market’s reaction to AMG and Focus is any indication, the outlook for this strategy appears to be facing some challenges.Don’t Read Too Much Into This…Focus and AMG are often regarded as bellwethers for financial advisory firms and asset managers, respectively. We disagree. They’re both in fundamentally different lines of business.AMG and Focus use debt financing to buy RIAs of one kind of another. They’re not managing assets on behalf of clients (at least not directly). They have huge balance sheets and debt obligations, unlike most investment managers. They’re monitoring their own investments, not their clients’. As publicly traded firms, they’re probably more concerned with the beating the Street and appeasing a much broader ownership base.Sure, the fortunes of AMG and Focus are tied to the fortunes of the firms they invest in over the long run. But the business of acquiring RIAs is not the same as the RIA business. So, while AMG and Focus may have lost half of their value in recent months, your business probably hasn’t.…But You Should Still Pay AttentionWe don’t think you should panic because publicly traded consolidators have struggled in recent months. We do think it’s important to recognize the challenges they’re facing, especially if you’re starting to think about an exit strategy. The RIA acquisition model isn’t dying, but investors seem to be anticipating a market share shift away from AMG and Focus.We don’t think you should panic over publicly traded consolidators' recent struggles, but we do think it’s important to recognize the challenges they’re facing.It’s also worth noting that these acquirers often use their own stock as part of the total consideration. For AMG and Focus, you know exactly how much that’s worth. For closely held aggregators like Hightower and Captrust, their stock price is not readily apparent. Given what’s happened to AMG and FOCS over the last year, it’s probably reasonable to assume that other consolidators are not worth as much as they once were. Even if they are publicly traded, you should be wary of any lock-up provisions since their stock prices are so volatile.In all likelihood, these businesses and other consolidators will continue to drive industry M&A. RIA aggregators like AMG and Focus are just one of many exit options for RIA owners, but we’ll likely see their share of overall transaction volume increase with Goldman backing United Capital, and Hightower changing course to compete with Focus et al. As the industry ages, these businesses are poised to play an increasingly important role in resolving the succession dilemma. A few years ago, many of our clients had never heard of AMG or Focus. That has definitely changed.
How to Value an Oilfield Services Company
When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries)
[caption id="attachment_26635" align="alignnone" width="790"]Source: Energy Education[/caption]
Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value.
Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As we discussed last week, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns.
While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed. Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers. A widely diversified customer base is typically worth more than a concentrated one. Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied. The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry. In our next post, we plan to delve deeper into these special valuation considerations beyond the framework established in this post. Stay tuned…[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.
Why Your Family Business Has More Than One Value
It is understandably frustrating for family business directors when the simple question – what is our family business worth? – elicits a complicated answer. While we would certainly prefer to give a simple answer, the reality a valuation is attempting to describe is not simple.The answer depends on why the question is being asked. We know that sounds suspect, but in this post, we will demonstrate why it’s not. Let’s consider three potential scenarios that require three different answers.What Is Our Family Business Worth to Our Family?This is the most basic question about value, and the answer revolves around the expected cash flows, growth prospects, and risk of the family business on a stand-alone basis. This does not mean that the status quo is assumed to prevail indefinitely, only that a combination with a strategic buyer's business is not anticipated. The family business may have plans for significant changes to operations or strategy, and if it does, the value should reflect such changes.The value of the family business to the family depends on three principal factors: expected cash flows, growth prospects, and risk.This perspective on value is especially important to family business directors weighing long-term decisions regarding dividend policy, capital structure, and capital budgeting. The value of the family business to the family depends on three principal factors:Expected Cash FlowsIdentifying the expected cash flows of the business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business. Revenue and earnings are important, but future cash flows also depend on how much the business will need to spend on capital expenditures and working capital to execute on the business plan.Growth ProspectsAll else equal, the faster a business is expected to grow, the more valuable it is. Cash flows can grow because of increasing market share, a growing market, or improving profitability. The assessment of growth prospects should take into account each of these potential factors and the sustainability of each.RiskThe value of a business is inversely related to the risk. Investors crave certainty, and risk is just another word for not knowing what the future holds. The wider the range of potential outcomes for your family business, the riskier it is, and the less enthusiastic investors will be about committing capital to the business. When investing in riskier businesses, investors pay less. Risk is evaluated relative to comparable investments or businesses.Whether using a discounted cash flow method or using methods under the income approach, the value of the family business to the family is a function of these three attributes of the business itself. This measure of value is often likened to the perspective of stock market investors or private equity buyers that look to the operations of the business to drive return apart from a strategic combination with another business.If this first question deals with the value of the family business assuming it continues being a family business, the second question addresses the value of the business once it stops being a family business. In other words, what is the value of the family business to a strategic buyer?What Is Our Family Business Worth to a Strategic Buyer?Families occasionally decide they don’t want to own the family business anymore. Families can reach this decision for different reasons. Sometimes, the family friction associated with managing the family business has reached an unsustainable level. In other cases, the family may be approached by a buyer of capacity with what appears to be a very enticing offer. Or, perhaps, an enterprising family decides that a “fresh start” with proceeds from the sale of the legacy business could unlock new opportunities for the family. In any event, when the decision to sell, or at least consider selling, has been made, directors naturally turn their attention to maximizing the sales price.A strategic buyer is one that will combine the operations of the target company with their existing operations.A strategic buyer is one that will combine the operations of the target company with their existing operations in a bid to increase the earnings and cash flow of the target and/or the newly combined entity as a whole. Strategic buyers are most commonly competitors of the target, but they could also be suppliers or customers. The essential attribute is that a strategic buyer has the ability to change how the target operates, resulting in either higher earnings, better growth prospects, or reduced risk (or some combination thereof).Exhibit 1 illustrates potential earnings enhancements available to a strategic buyer (in this case a competitor).
By combining the target with their existing operations, the larger strategic buyer will be able to achieve purchasing efficiencies, which will contribute to a higher gross margin. In addition, there are redundant general and administrative expenses, which can be eliminated by the buyer. As a result, the strategic buyer anticipates generating an EBITDA margin of 22%, compared to the 16% EBITDA margin available to the target company on a stand-alone basis. Stated alternatively, the strategic buyer anticipates EBITDA that is 38% higher.
Does that mean that the target company is worth 38% more to the strategic buyer? Not necessarily. The amount that a strategic buyer will, in fact, pay for the target company depends on how many other strategic buyers they are likely bidding against and how unique the target company opportunity is.
The magnitude of strategic benefits available and the likely negotiating dynamics for a family business tend to be very fact-specific. So, assessing the value of your family business to a strategic buyer will require that you and your fellow directors consider the following questions:
Who are the competitors, suppliers, or customers with whom our family business would provide the most compelling strategic “fit”?What opportunities would such buyers have for increasing earnings and cash flow, improving growth prospects, or reducing the risk of the family business?How unique is our family business? Are there other similarly situated businesses that can provide comparable strategic benefits to buyers?
A potential strategic sale is not the only context in which family business directors need to think about the value of the family business. We’ll consider the final variation on the question of value in the next section.What Is a Share of Stock in Our Family Business Worth to an Investor?The final question relates to the value of an interest in the family business, rather than the family business itself. Minority shares in a family business are often considered unattractive from an investment perspective for a number of reasons. As a minority shareholder, one has no direct influence or control over business strategy or other long-term business and financial decisions: one is simply along for the ride and subject to decisions made by others. Furthermore, since it is a family business, there is likely no ready market for the shares. As a result, one is effectively stuck, and, potentially, for a long time.So, from this perspective we need to think about all the things that influence what the family business is worth to the family plus some additional considerations that relate to the unique position of being a minority shareholder in a private company. This perspective is critical for gift and estate tax planning.Are There Any Dividends?Regular cash flow dulls the pain of illiquidity. If there is a reasonable expectation that investors will receive dividends while owning the shares, that helps to mitigate the burden of being unable to sell the shares. Since many family businesses are set up as S corporations, it is important to clarify that the dividends that matter are those in excess of any tax liabilities that are passed through to shareholders.What are the Prospects for Liquidity?Even though there is no ready market in which to sell minority shares in a family business, there are still opportunities to sell the shares from time to time. For example, the family business could be sold, the company may repurchase shares from select shareholders, or other family members may be willing to acquire the shares at a favorable price. While future liquidity opportunities cannot be predicted with precision, it is possible to establish a range of likely holding periods by analyzing relevant factors. The longer the period until a liquidity event can be anticipated, the less attractive the investment.What are the Growth Prospects for the Investment?When liquidity does come, what proceeds can be reasonably expected? In other words, at what rate would one anticipate the value of the business to the family to grow from the current level? If the family business has a track record of reinvesting earnings in attractive capital projects, investors will view the growth prospects more favorably than if management has a propensity to accumulate large unproductive stockpiles of cash or other assets in the business.What are the Relevant Risks?As with the business itself, the value of a minority share is inversely related to the attendant risks.As with the business itself, the value of a minority share is inversely related to the attendant risks. The risks of a minority share include all the risks associated with the family business plus those associated with the illiquidity of a minority interest. In other words, the focus is on identifying those risks (including, potentially, lack of access to financial statements, uncertainty as to the ultimate duration of illiquidity, uncertainty regarding future distribution decisions, and the like) that are incremental to the risks of the family business itself.The combination of expected dividends, holding period, expected growth, and risk factors determine the value of a share in the family business relative to the corresponding pro rata portion of the value of the business as a whole to the family.ConclusionThere is no simple answer to “What’s our family business worth?” because the question is never quite as simple as that. The answer depends on exactly how and why the question is being asked. From transaction advisory services to gift and estate tax compliance to corporate finance decisions, our valuation professionals have the experience and expertise to help you ask the right questions about the value of your family business and get the right answers. Call us today.
A Guide to Corporate Finance Fundamentals
Part 1 | Finance Basics: Return & Risk
This post is the first of four installments from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make.
In our experience, an informed and engaged shareholder base is the most important ingredient for preserving family harmony. The purpose of this short review of basic finance principles is to promote productive engagement by equipping family business shareholders with a conceptual framework and vocabulary for communicating their financial needs and preferences to the board. While family businesses face many important questions, the scope of this guide is limited to the three inter-connected financial decisions of capital budgeting, capital structure, and distribution policy. Our goal is to enable family business directors and shareholders to understand the manner in which these decisions are linked together and how they interact with corporate strategy to generate shareholder returns and value.
In this series, we start with a brief overview of return and risk, the two basic building blocks of corporate finance. Having laid that foundation, we proceed in future posts to address the three big financial questions facing corporate directors. Following a quick overview of the key finance concepts relating to each decision, we will offer a list of related discussion topics for boards and shareholders. We will conclude by reviewing how each of the three questions relates to, and depends upon, each other.Finance FundamentalsThe first fundamental axiom of corporate finance is the time value of money: a dollar today is worth more than a dollar tomorrow. In other words, the passage of time has a corrosive effect on wealth. The essence of investing is deferral; one elects to defer consumption today in hopes of having more tomorrow. Corporate managers are engaged in a race against the clock, knowing that their stewardship of family resources will be evaluated by the degree to which they offset and overcome the corrosive effect of passing time on the family’s wealth.Investment returns have two components. Yield measures the current income (interest or distributions) generated by an investment. Capital appreciation measures the increase in value during the period. As shown in Exhibit 1, total return is the sum of yield and capital appreciation. There are no other sources of financial return to investors. There is an inherent tradeoff between these two components – higher current income limits future upside, and faster growth usually comes at the expense of current income.
Families must select their investments from a large, but limited, menu of potential alternatives. Investors uniformly desire higher returns. However, in the process of competing with one another, investors bid up the price on less risky investments. For a given financial outcome in the future, a higher price today results in a lower return over the holding period. As a result, the more desirable investments offer lower expected returns. The second fundamental axiom of corporate finance, the risk-return relationship, follows from this. As shown in Exhibit 2, return follows risk.
The diagonal line illustrates some of the more common risk-return combinations available to investors. In order to achieve a higher expected return, investors must be willing to accept greater risk.
Peter Bernstein defined risk succinctly: “Risk doesn’t mean danger – it just means not knowing what the future holds.” As depicted in Exhibit 3, the most common basis for measuring financial risk is the dispersion, or variability, of potential financial outcomes.
The charts in Exhibit 3 plot an equal number of outcomes for two investments. The one on the left has a tighter range of potential outcomes and is, therefore – on an absolute basis – the less risky of the two.
However, the absolute riskiness of an investment is less important than the contribution of that investment to the overall risk of a diversified portfolio. The rational response to risk is to diversify. Diversification is effective to the extent that the components of a diversified portfolio respond differently to common economic factors. Dividing one’s investment portfolio among multiple assets is a waste of time if those assets all behave in the same way. Correlation is a measure of the “co-movement” of returns. The more similar two investments are, the higher the correlation between them; highly correlated investments do not contribute much to diversification. Exhibit 4 illustrates the risk-reduction benefit of less-than-perfect correlation among assets in a portfolio.
The two investments in Exhibit 4 (the blue and orange bars) have equal risk on an absolute basis. However, the returns are not perfectly correlated with one another, making them well-suited diversification partners. As a result, an equal-weighted portfolio of these two assets exhibits is less risky than either investment by itself. Since diversification is relatively easy, most people do it. As a result, the relevant measure of risk that corresponds to return (Exhibit 2) is the asset’s contribution to the overall riskiness of a well-diversified portfolio. This is called systematic risk. So, we can supplement our risk axiom as follows: return follows systematic risk.
Quick ReviewBecause a dollar today is worth more than a dollar tomorrow, investors evaluate investment performance by calculating returns. Investment returns are the sum of yield (current income) and capital appreciation (future upside). Higher expected returns can be achieved only by accepting higher risk. From a financial perspective, risk is simply the dispersion of the variability of future outcomes. Since diversification reduces risk, the most relevant measure of risk to investors is systematic risk, or an asset’s contribution to the risk of a well-diversified portfolio. WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper
What is an Oilfield Service Company?
The oilfield equipment and services (or OFS) industry refers to all products and services associated with the oil and gas exploration and production process, i.e. the upstream sector of the energy industry. In general these companies are engaged in the manufacturing, repair, and maintenance of equipment used in oil extraction and transportation.Products such as seismic testing, transport services, and directional services for horizontal drillers in addition to well construction, and production and completion services are generally what most would typically think when an oilfield services company comes to mind.However, the range of products and services under the OFS umbrella is wide and include many technology-based services that are vital for successful field operations. Such services include locating energy sources, energy data management, drilling and formation evaluation, geological sciences, and many others.
Technological innovation over time has led to increased efficiencies in resource extraction and management, and larger OFS companies such as Schlumberger and Halliburton have capitalized on technology-based services to meet the increasing demand in this subsector. Other OFS companies such as Helmerich & Payne continue to specialize in legacy services, including rigs and equipment manufacturing, drilling services, and products.
How Do Oilfield Services Companies Fit in the Industry?OFS providers in their modern form arose through a combination of factors dating back to the oil price slump in the late nineties and the mega-mergers of BP-Amoco in 1998 and Exxon-Mobil in 1999. Mergers of this size allowed for synergies of logistics and allowed for restructuring and optimization of assets.While the advantages of these mergers were clear in the downstream segment, the impact for upstream was not so apparent. In fact, the in-house ownership of these various types of services created inefficiencies and redundant cost centers that made it expensive to provide necessary upstream services without impacting the bottom line.These factors and segment trimmings enabled the development of a specialized oilfield service industry, which today provides the majority of the technology (primarily assets and people) and innovation essential across the life cycle of an oil and gas development.The rationale for the outsourcing of service capability can be summarized in three key points:Economies of scale – Specialization of companies in the service chain allows for intense competition among suppliers while also facilitating technical innovation. In-house ownership of services might not have provided the rapid rise of such competition and technology advances that the industry has seen over the last couple of decades.Capital efficiency – A service company able to supply a wide range of clients (large/small public, government-owned, independents, etc.) would expect to be able to achieve higher rates of utilization for their assets and therefore better return on capital employed than could an E&P company limited by their own inventory.Accountability – Third-party service providers arguably allow for increased accountability and efficient creation of reward structures between operator/contractor. However outsourcing may lead to greater operator risk, execution delays, and even contract mispricing.Key Drivers and Indicators of the Oilfield Services IndustryAt its core, the revenue of the OFS companies is a function of the capital and operating expenditure of the E&P companies, which is in turn governed by current and future expectations of the price of oil & natural gas.There are of course several other factors that come into play (advances in technology, climate, seasonality of spending, availability of financing, political factors, etc.), but ultimately it is the supply and demand balance and market fundamentals which determine incentives for investment by these companies. Below is a non-exclusive list of leading indicators that are used to gauge the outlook and demand across the OFS sector:E&P Capital Expenditure Budgets – Size of capex budgets will ultimately determine how the OFS industry will perform as whole. E&P companies will typically begin drafting capex budgets for the next year in the final quarter of the current year. Many will then announce their forward spending plans, strategy, and quarterly/annual results to the market through quarterly earnings calls and press releases. These calls and news releases tend to be closely watched as a leading indicator of future demand. However, historical trends before the oil collapse in 2014 showed that large companies tended to overspend whereas companies at year end 2018 have been tight on capex budgets, even in rising oil price environments. Lean budgets will push the use of third party services down the priority list resulting in hard hits to an OFS company’s revenue stream.Rig and Well Counts – Historically, one of the most closely followed measures of the level of demand for the OFS industry is the active rotary rig count. Baker Hughes began publishing the North American active rig count on a weekly basis since 1944 and initiated the monthly international rig count in 1975. Rig counts have historically been treated as a business barometer for the drilling industry and its suppliers. The thought is when drilling rigs are active, they consume products & services produced by the OFS industry; however, well counts have been trending towards being the primary leading indicator of profits. The reason is in part due to “pad drilling”, in which multiple wells are drilled from one site. Combined with technological advances and logistical efficiencies, having multiple wells per pad in a shale play has a greater effect on performance in a given area. In essence, fluctuating well counts on a seemingly stagnant overall rig count provide a different picture of the health of the sector. Therefore tracking well counts in the last decade has improved predictive power than indications provided solely by rig counts.Day-rates - Day rate refers to all in daily costs of renting a drilling rig, and roughly makes up half of the cost of an oil well. The operator of a drilling project pays a day rate to the drilling contractor who provides the rig, the drilling personnel and other incidentals. The oil companies and the drilling contractors usually agree on a flat fee per contract, so the day rate is determined by dividing the total value of the contract by the number of days in the contract. Although less easily observable, it is also possible to track trends through day rate announcements for other less ‘liquid’ marine sectors, such as seismic vessels, supply boats, support vessels and installation/heavy-lift vessels. Analyzing day rates in combination with metrics like rig utilization allows investors to gain insight into the overall supply and demand picture of the OFS industry at large. When day rates increase, this implies decreased supply of OFS providers or increased demand for their services.Equipment orders – A steady stream of new orders is critical of any manufacturing company, and it is no different with OFS sector. It is customary for OFS companies to announce major equipment orders, i.e. rig orders, floating production storage and offloading (FPSO) orders, underwater equipment orders, drilling packages, etc. and these announcements provide useful insights as to the level of demand across various parts of the service lifecycle.Backlogs – Similar to engineering and construction companies, many OFS companies announce backlogs as a snapshot of the health of their businesses. Since backlog is not an audited measure and its definition can vary from company to company, it is not a hard and fast figure that should be taken at face value. While a sufficient backlog typically means the company is busy, there is give and take for backlogs that extend too far out. Unless specified by management, the timing of backlogged projects can be fairly unpredictable with durations as short as a few months to as long as a few years. But the general thought in analyzing company backlog is to provide an indication of value of revenue not yet recognized and demand for services to be rendered in the future.
In our next post, we'll explore valuation issues relevant to oilfield service companies. Stay tuned.
Will Goldman Sachs Pay 18x EBITDA for Your RIA?
No. But Goldman’s United Capital Buy Suggests the Consolidation Winds are Shifting
Brand value is difficult to create, hard to measure, and easy to ruin.In the late 1960s, Porsche and Volkswagen found themselves trying to develop similar cars. Porsche needed a replacement for the 912, a Carrera look-alike with a smaller engine and a cheaper price, and VW needed an updated version of its top-of-the-range (for Volkswagen) Karmann Ghia coupe. The two automakers combined forces to joint-venture what became the 914 model for Porsche and the new Karmann Ghia for VW. Since the bodies and powertrains of the two cars were going to be very similar, Porsche faced the balancing act of preserving its exclusive image while taking advantage of the economy of working with the maker of “the people’s car.” The automakers resolved this conundrum by deciding that only the Porsche would be sold in North America. This marketing alchemy worked, and while the 914 is not regarded as the best performing or most beautiful Porsche ever developed, it did become their best-selling product, by far, during its seven-year run.Subsequent “down-market” Porsches like the 924 through today’s 918 series have produced the sales volume necessary for Porsche to be efficient while maintaining the pricing power conferred by a premium marque. This combination has delivered higher margins for Porsche than other German automakers with a more consistent top line than the more upmarket strategies followed by rivals from Italy. If you do it right, extending your reach can support your brand, not dilute it.Goldman Sachs Extends Brand to Wealth ManagementSome may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital. We don’t think so.Some may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital. We don’t think so.The announcement last week that Goldman was buying United Capital for $750 million caught many people by surprise, but the more I think about it, the more it makes sense. The opportunity of consolidating the wealth management industry is well publicized: a highly fragmented and inefficient community of small firms in need of effective ownership transition strategies. Several different approaches to this consolidation have emerged, not all of which would have suited Goldman. Some industry consolidators leave acquired firms with their own brands and SEC registrations, which theoretically maintains their sense of entrepreneurship - but also makes national marketing impossible, regulatory compliance more expensive, and may not ultimately govern the ownership transition process reliably. Joe Duran’s approach was different: bring everyone under the United Capital brand and sell it, coast to coast, as a homogenous wealth management platform with a local presence in nearly 100 markets.If there is one consistent story in these RIA rollups, it’s that building them takes longer than anybody expects. Duran worked on building United Capital for nearly 15 years. Some things require scale that cannot be acquired in one lifetime, however, and that’s where the CEO of Goldman Sachs, David Solomon, saw an opportunity.This Really Starts with David Solomon, not Joe DuranImagine you’re David Solomon. You’ve got a really good job heading a global organization known for producing innovative financial products, outsized profits, and Treasury secretaries. Your predecessor, Lloyd Blankfein, became a public figure by building Goldman in the wake of a crisis that took down several major competitors. But the financial universe never stops changing, and despite their high-brow successes, one thing Goldman Sachs doesn’t have is much reach beyond the very wealthy.Solomon inherited a business that did well on large and risky trades but needed to transition into an era that is more staid and regulated. In this environment, he’s looking to bring Wall Street to Main Street. The opportunities Solomon sees are not upmarket, they’re mass-market. Even as it celebrates 150 years of success as a powerhouse that profitably caters to the well-heeled, Goldman Sachs has plunged headlong into commercial banking, corporate cash management, and even a branded credit card, so it makes sense to prepare to court the mass-affluent through a wealth management advisory practice. Goldman could have started from scratch, but buying United gives Goldman an established platform for outreach to the RIA community to seek other acquisitions, which it will undoubtedly begin to do.Will Goldman Sachs Pay 18x EBITDA for Your RIA?So, what does all this mean to you?It has been suggested that the $750 million Goldman paid for United represents something on the order of 18x EBITDA. The actual multiple isn’t public, but given United Capital’s AUM of $25 billion, total revenue including management fees should be between $200 million and $250 million on an ongoing basis. A multiple of 18x EBITDA suggests an EBITDA margin in the mid-teens to just over 20%. That’s a bit thin, so perhaps Goldman Sachs sees opportunities for margin enhancement that buy-down the multiple. At a 30% margin and midpoint revenue estimate of $225 million, Goldman would have only paid 11x EBITDA. On a pro forma basis, at least, that makes more sense.United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.In any event, David Solomon probably didn’t reach his bid on a spreadsheet – at least not looking at United Capital on a standalone basis. The opportunity is to get a substantial but manageable RIA with consistent branding and systems across a national footprint that puts Goldman Sachs in a position to test the platform and grow it accordingly. Plus, the deal comes with Joe Duran. United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort. Goldman will need a front-man to pitch their narrative to skeptics and prospects in the RIA community. Duran will have more credibility than someone who didn’t grow up in the independent channel.This is Not Wirehouse 2.0Some of the early backwash I’ve heard on the deal is that Wall Street money is sucking another example of entrepreneurship into the machine. I think that’s flat wrong. If Goldman just wanted to build a new mass-market wirehouse to push investment products, they could have paid much less for many, many broker-dealers with far more FAs than United Capital. All signs suggest that Goldman is looking for distribution for existing GSAM products (no doubt to upper end clients of United) and also to develop new ones for the more typical mass-affluent client. But this is not simply a distribution play. The decision to do this through a fiduciary practice suggests that this isn’t about Wall Street infecting the RIA community, but that RIA culture has finally come home to infect Wall Street. If Goldman puts its might behind the effort and builds a national brand investment advisory practice, it will be a game changer.Focus + High Tower + Cap Trust + AMG + … + Goldman Sachs = More options for RIAsAlmost lost in the Goldman/United deal was that AMG recently announced their first acquisition (Garda Partners) in a couple of years. And it was just earlier this month that a rebooted Hightower announced a plan to grow through investments in new RIAs. With AMG back in the game, and Hightower muscling in on Focus Financial’s territory, the Goldman Sachs deal suggests that buyer competition is going to be heating up in the money management space – much to the benefit of sellers. It further suggests that RIAs seeking an exit through a consolidation strategy are going to have a number of options depending on their perspective and needs.Even if you’d rather stay independent, stay tuned. As we all know, an option has value, even if you don’t exercise it.
What We’re Reading on the RIA Industry
M&A and Practice Management
Much of the sector’s recent press has focused on the current M&A environment as well as practice management issues for RIA firms, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the investment management industry.Goldman Sachs Readies Splashy RIA Retail Debut as it (Likely) Adds $24-Billion United Capital to $35-Billion AUM Ayco for $59-Billion 82 Office Behemoth; Months After Buying RIA Lure From S&PBy Oisin Breen, RIABiz
Goldman Sachs recently completed its acquisition of United Capital for $750 million, marking a major expansion into the RIA space for Goldman and a significant endorsement of the RIA aggregator model. The deal value represents approximately 3% of United Capital’s $24 billion AUM and a little over 3x revenue of $230 million.M&A Gains Drive Focus’ 33% Revenue GrowthBy Jessica Mathews, FinancialPlanning
RIA aggregator Focus Financial reported 33% year-over-year revenue growth in the first quarter. The growth comes primarily from new partner firms acquired over the last year. In its IPO filings last year, Focus management outlined a growth strategy based on continued M&A and organic growth at Focus’s partner firms. While organic growth has faltered somewhat (partly due to market conditions), Focus has clearly executed on the M&A component of its growth strategy. So far this year, Focus has acquired 21 firms, with 12 of those acquisitions taking place in the first quarter.Bye-bye Broker Protocol: HighTower Exits in Identity MakeoverBy Charles Paikert, FinancialPlanning
HighTower Advisors has exited the broker protocol, the industry agreement which allows advisors switching employers to take basic client contact information with them. Exiting the protocol reflects the evolution of HighTower’s business model from recruiting wirehouse teams to focusing on RIA acquisition activity. For some, the decision to exit the protocol is seen as a way to increase retention — perhaps in preparation for a future liquidity event. With recent liquidity events from the other two major roll-up firms, Focus Financial and United Capital, now may be a good time to exit for PE-backed HighTower.U.S. Wealth Management Becomes Hotbed of M&A By Chris Flood, Financial Times
Private equity interest in wealth management has continued to increase, given the industry’s growth opportunities and stable cash flows. The wealth management industry remains highly fragmented but is poised to consolidate.Merger Mania: Why Consolidation in the RIA Space is About to ExplodeBy Jeff Benjamin, InvestmentNews
Some industry players see the pace of consolidation picking up. Ron Carson, CEO of Carson Group, predicts that in seven years there will be a third less firms than there are today. Historically, there has been less consolidation than we would expect given the size and fragmentation of the industry. However, given the current dynamics of aging ownership, PE interest in the space, and consolidators offering scale and back office efficiencies, the pace of M&A may accelerate significantly.Kitces: The Ratios That Determine Advisory Firm SuccessBy Michael Kitces, FinancialPlanning
Tracking productivity, identifying its drivers, and understanding how to improve are important aspects of managing a successful advisory firm. Michael Kitces offers his take on some of the key performance metrics for advisory firms.
In summary, consolidation and M&A continue to be major trends in the investment management industry. RIAs continue to receive interest from PE investors due to the recurring revenue and growth potential that wealth management firms offer. Aging ownership bases have also contributed to the consolidation tailwind. The RIA aggregator model has now been endorsed by Goldman Sachs with its acquisition of United Capital, as well as the public markets with Focus Financial’s IPO last year. Whether HighTower’s PE backers will seek an exit in the near term remains to be seen, but given the interest in the Focus IPO and the attractive multiple offered by Goldman for United Capital, it is clear that market interest in the aggregator model is strong.
Tailoring Financial Decisions to the Meaning of Your Family Business
In a previous post, we identified the four basic economic meanings that a family business can have. For some families, the business is an economic growth engine for future generations. For others, the family business is a store of value. Alternatively, the family business can be a source of wealth accumulation or a source of lifestyle for family members.
As noted in our prior post, there are certain family and business characteristics that can help family members discern what meaning “fits” their circumstances best. The meaning of the family business, in turn, has implications for the dividend policy, reinvestment, and financing decisions for the family business.
In this post, we examine how the meaning of the family business influences these corporate finance decisions.
Family Business as an Economic Growth EngineFor some families, the purpose of the business is to grow the family’s wealth for the benefit of future generations. Sustaining or growing per capita business value as the family grows biologically often requires deferring current returns. The following table summarizes how this first meaning influences major corporate finance decisions.
For this meaning to “stick,” family shareholders need to be willing to fund their household expenses and lifestyle choices with other sources of income, whether in the form of wages (inside or outside the family business) or returns on other investments.
The principal risk of adopting this meaning is that, since truly attractive investment opportunities are scarce, the pressure to reinvest may result in the business making increasingly risky investments. Such investments may offer returns high enough to meet growth objectives, but only at the expense of an unattractive risk level.
Family Business as a Store of ValueFor other families, the business may serve as a store of value. By store of value, we mean that the role of the family business is to mitigate the volatility that may be present in other elements of the family’s wealth. In contrast to the public equity markets, which can experience dramatic short-term swings in value, the family business functions as a steadying force on the family’s collective balance sheet. In other words, the emphasis for these families is on preserving rather than increase the value of the family business over time.
When the business serves as a store of value for the family, the different generations of the family need to understand that the emphasis on capital preservation may result in an erosion of per capita business value over time (especially on an inflation-adjusted basis). Investing is about tradeoffs: families can’t expect to have both safety and enviable growth. There’s nothing inherently wrong with pursuing safety, but family members need to understand the (opportunity) cost of doing so.
The principal risk of this meaning is the increased likelihood that the family business may accumulate low-yielding non-operating assets that create a drag on future shareholder returns.
Family Business as a Source of Wealth AccumulationOthers, wary of putting all of the family eggs in a single bucket, view the family business as a source of wealth accumulation for the family. Rather than the family business itself being the direct engine of economic growth through reinvestment and capital appreciation, the family business instead provides the “seed capital” for family shareholders to accumulate wealth outside the family business. These families seek to foster an entrepreneurial culture in which the most substantial reinvestment activities occur outside the legacy family business.
When families adopt this meaning, there is a chance that the business will no longer provide a unifying center to family life. If individual family shareholders are reinvesting dividends from the legacy family business, differing investment outcomes can lead to significant wealth disparities among the various branches of the family tree over time. In an effort to counteract this potential outcome, some families elect to pursue reinvestment through a common family fund. This helps ensure that family wealth remains balanced, but also limits the ability of family members to tailor a wealth accumulation plan to their unique needs, preferences, and risk tolerances.
From the perspective of the family business, a risk of this meaning is that the business may lose existing competitive advantages if profitable reinvestment opportunities are foregone in favor of distributions.
Family Business as a Source of LifestyleProlonged capital appreciation may be what makes a family wealthy, but predictable dividend checks are often what make family members feel wealthy. In accord with this reality, the final meaning that a family business can have is that of an ongoing source of lifestyle for family shareholders. This does not require that dividends be sufficient to fund a source of idle leisure, but does require that dividends be regular and predictable. With predictability, family shareholders have assurance that other sources of income will be supplemented by dividends from the family business. Depending on the size of the business, these dividends may be sufficient to fund automobile, vacation, housing, or education choices that would not otherwise be attainable by family members.
Families adopting this meaning need to understand the inherent tradeoff between realizing the lifestyle benefits of the family business in the present and preserving that benefit for future generations. If the biological growth of the family is above average, it may be difficult for the family to maintain the lifestyle to which it has grown accustomed on a real per capita basis in the next generation.
Since reinvestment takes a backseat to the predictability of dividend payments, the family business faces two mirror-image risks. When the business performs well, low-yielding assets may accumulate if retained earnings exceed attractive investment opportunities. On the other hand, in lean years, the dividend may crowd out needed capital investment in the business.
ConclusionA clear understanding of what the business means to the family is essential if decisions about dividend policy, capital budgeting, and capital structure are to be made in a coordinated, rather than disjointed, manner. Consensus regarding these critical long-term decisions will be fleeting and unpredictable without prior consensus about what the family business means to the family. Our professionals are eager to help your family discern what your family business currently means and assess whether that meaning will provide a proper “fit” going forward.
Royalty and Mineral Value Proposition Highlights Otherwise Underperforming Energy Sector
The burgeoning mineral market is leading the way for an energy sector that has lagged in returns for several years now. This was one of the themes from the DUG Permian Basin Conference in Fort Worth last month. Among the discussion, presenters including Scott Noble, CEO of Noble Royalties and Rusty Shepherd of RBC Capital Markets highlighted the ascension of the estimated $400 to $600 billion onshore mineral market in the U.S., depending on who’s doing the estimating.The interest in the segment has been undergirded by the attractive cash returns coupled with fewer risks and burdens.The interest in the segment has been undergirded by the attractive cash returns coupled with fewer liability risks, operating risks, and expense burdens. In addition, royalty owners retain ownership rights to perpetuity. These characteristics of royalty and mineral plays have drawn investors in as compared to the market’s negative response to upstream management teams merely seeking to beef up the size of their reserve reports.Overall, the energy market’s returns have been subpar. As a sector, energy has lagged all other major sectors over the past several years. In 2018, the returns were again at the bottom of the heap.
[caption id="attachment_26449" align="aligncenter" width="940"]Source: Company filings and FactSet[/caption]
However, there is an energy sub-sector that has been an emerging bright spot: public mineral aggregators. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years. Brigham began trading on April 18 at $18.00 per share on the New York Stock Exchange. Brigham became the fifth mineral company to go public since 2014, far outpacing the energy sector in general.
[caption id="attachment_26456" align="aligncenter" width="885"]Source: Company filings and Brigham S-1[/caption]
The attraction and growing appetite for mineral aggregators lies in its asset level economics. Several presenters at the conference touched on various factors that are driving returns and valuations. While current producing wells bring in monthly cash flow, they also demand the lowest returns. According to B.J. Brandenberger of Ten Oaks Energy Advisors, producing minerals are commonly purchased on expected returns of 8% to 10%, whereby DUC wells and permitted wells currently have expected returns around 12% and 15%. Undeveloped properties are often valued at over 20% expected return profiles depending on various factors such as the hydrocarbon producing layers in the ground (or “benches” as the industry sometimes calls them). Most of the uncertainty and intrigue has to do with undeveloped properties. The reasons that expected returns are so much higher than producing properties lies in unknowns such as drilling timing, operator quality and expertise, production assumptions, and pricing differentials to name a few.The mineral segment is representing an economic bright spot in a sector that, while improving, has resided in the dark from a stock return perspective.This kind of uncertainty comes with the opportunity for outsized returns resulting in market attraction. According to Oil and Gas Investor’s reckoning, there were 12 companies listed in their mineral company directory in 2015. In 2019, this has ballooned to 140.Public momentum has grown as demand for these investment vehicles is high. Given most new entrants in the market are private equity funded with exit expectations in upcoming years, the chances are high that we see an increase in the number of IPOs from mineral aggregators in the future compared to upstream and E&P companies. Time will tell. In the meantime, the mineral segment is representing an economic bright spot in a sector that, while improving, has resided in the dark from a stock return perspective.
Q1 2019 Call Reports
RIAs Respond to the Changing Industry Landscape with Varied Measures
During Q1 2019, most classes of RIA stocks underperformed the market despite its relatively sharp increase through the first three months. Investors still seemed concerned about the RIA industry’s prospects in the face of fee compression and continued asset outflows. RIAs are responding to this pressure in different ways. Some are actively expanding product offerings to meet clients’ changing demands; others are staying true to the traditional RIA model and responding to revenue pressure by developing cost efficiencies.As we do every quarter, we take a look at some of the earnings commentary of investment management pacesetters to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Industry consolidation has been spurred by a challenging revenue environment for RIAs, but firms are going about this in different ways.Consolidation is driven by a need for succession planning.RIAs are also increasingly seeking options to address succession planning, which is another catalyst of M&A. Industry research indicates that over one-third of all RIAs will transition within the next 10 years, putting $2 trillion of client assets in motion. In our expertise in continuity planning, Focus is well positioned to lead the industry in this area, which will be another important driver of our growth. – Ruediger Adolf, Founder, Chief Executive Officer, and Chairman, Focus FinancialConsolidation is driven by cost savings.We expect to recognize roughly 50% to 55% of the cost synergies by the end of the third quarter. Additionally, by the end of 2019, we'll anticipate capturing approximately 85% of the synergies or more than $400 million in the run rate savings. – Loren Starr, Chief Financial Officer, Invesco (on Invesco’s acquisition of Oppenheimer)Consolidation is driven by the expansion of product offerings to include advanced tech platforms and alternative investments.Last month, we announced the binding offer and exclusive agreement to acquire eFront, the world's leading end-to-end alternative investment management software and solutions provider. As clients increasingly add to their alternatives allocations, the ability to seamlessly manage portfolios and risk across public and private asset classes on the single platform will be critical. The combination of eFront with Aladdin will set a new standard in investment and risk management technology and reinforce Aladdin's value proposition as the most comprehensive investment operating system in the world. – Gary S. Shedlin, Chief Financial Officer, Black RockTheme 2: RIAs see flows back to fixed income after a volatile 2018.We saw strong re-risking for those who were in cash that allocated back into fixed income. We saw that predominantly a lot of investors were believing that interest rates are going to go higher, central banks really continue to tighten and, obviously the change in central bank forward forecast and their behaviors many investors were underinvested and put duration to work across the board. – Laurence D. Fink, Chairman and Chief Executive Officer, Black RockIn general, investors continue to pursue more defensive strategies, such as fixed income at the expense of international and higher beta domestic equity strategies. Outflows for our international core equity and science and technology strategies, remain somewhat elevated during the quarter. While our emerging market equity and high income strategies, also continued to experience outflows, it was at a significantly reduced rate from the previous quarter. – Ben Clouse, Chief Financial Officer, Waddell & ReedOn fixed income, generally, I would say that […] I think we're interested in fixed income. We like the differentiated strategies within fixed income, the kind of core kind of bond U.S. and global. [….]. We've seen substantial appetite from institutions for fixed income relative value. – Jay C. Horgen, President and Chief Financial Officer, AMGTheme 3: RIAs continue to respond to the demand for responsible investing.Clients are increasingly attracted to our Responsible and Impact investing portfolio offerings. Assets in a diverse array of responsible equity and fixed income services totaled $1.9 billion at quarter-end, a 23% increase since year-end. – Seth Perry Bernstein, Alliance BernsteinLast week, we launched a Liquid Environmentally Aware Fund or LEAF, as a prime money market fund with an environmentally focused investment strategy. The fund will use 5% of its net revenues to purchase and retire carbon offsets and direct a portion of the proceeds to OUR conservation efforts. Increasingly, clients want sustainable strategies that provide financial returns and target a measurable social or economic impact. BlackRock's goal is to make those strategies more accessible to more people. Beyond dedicated sustainable investment funds, we're also integrating environmental, social, and government risk factors across all our investment processes. – Laurence D. Fink, Chairman and Chief Executive Officer, BlackRock
Asset managers saw some improvement in performance in Q1 2019, but performance fees remained depressed as products worked back up to their previous watermark. RIAs are still experiencing headwinds and are responding in various ways. Under the assumption that fee pressure is the new norm, we are still seeing increased spending on technology in order to lower costs. Others are expending into higher margin products such as illiquid alternative investments. Overall, RIAs are well positioned to have a stronger second quarter.
We will continue to follow the key drivers of consolidation in the industry, as well as changes in fees and asset mixes during the rest of 2019.
Case Study: Second-Generation Shareholders Achieve Long-Term Sustainability
Since 1982, we have been observing and working with successful family companies. Over that period, there aren’t many family business scenarios the professionals at Mercer Capital haven’t seen.We bring that accumulated experience to bear in our assignments advising family businesses.In the following case study, we summarize a recent engagement.
We received a call from a shareholder in a successful, second-generation family business as result of our publications regarding dividend policy. The four second-generation owners had purchased the business from their parents a number of years earlier.Shareholders had differing views regarding the business, the future outlook, and dividend policy.The Company was in uncharted territory. The Company had been growing, the acquisition debt was nearly paid off, and the shareholders had differing views regarding the business, the future outlook, and the appropriate dividend policy.The second-generation owners had done some planning of their own, and the CEO, who had led the first-generation buyout and had run the Company for years, was looking to transition into a board and owner role after bringing on a non-family CEO.The EngagementIn addition to the three shareholders (each of whom served as directors), the Company had two outside board members with diverse operating and financial experience. So there were two questions for the shareholders and the board, from their differing perspectives.What portion of shareholder returns should come from dividends and what portion from expected capital appreciation?What dividend policy would be reasonable for the Company, given the development of outside management and the need for and opportunities for the Company to grow?
Mercer Capital was retained to help the shareholders and directors address these questions. The engagement was divided into two phases.Phase I: Financial Discussion and EducationUnderstanding the Needs of All StakeholdersFirst, we met with the shareholders collectively and individually. The purpose was to understand their differing perspectives regarding future dividends from the business. We also spent time talking about the purpose of dividend policy and the various ways in which it could be implemented in a company like theirs.As the discussions ensued, it became clear that the four shareholders had differing personal perspectives and had followed differing personal investment plans leading to the current point.One of the shareholders had built a significant, multi-million dollar investment portfolio based on the small, incremental dividends that had been paid over the years that the Company was repaying acquisition debt to the parents. The other two shareholders had modest portfolios outside the business.There was a disparity in the level of shareholder liquidity outside the Company. We realized that, given the then-current profitability of the business and the retirement of acquisition debt, the Company had substantial free cash flow and substantial value.We also met with the board of directors, which included the shareholders and the outside members.Recommendations to Address Shareholder Liquidity Now and in the FutureIn the first meeting, we suggested that it might be reasonable to consider a leveraged dividend recapitalization. The purpose of the recapitalization was to provide a substantial, after-tax nest egg of liquidity outside the business for the three shareholders, who owned the business equally.Dividends would rise or fall based on changes in value, which all the shareholders could agree was a reasonable benchmark.The discussion then turned to dividend policy on a going forward basis. Since the Company was a tax pass-through entity, the first policy consideration was that the Company should make quarterly distributions to the shareholders to pay for their pass-through tax liabilities. The question then shifted to identifying the appropriate policy for “economic distributions,” or dividends in excess of pass-through taxes.We explained that there were a number of potential policies for consideration. The policies would have to be adjusted to consider the magnitude of the leveraged dividend recapitalization and the prospects for growth. The potential policies included:Constant dividend payout ratio. This policy would call for a constant percentage of “net income” (after pass-through taxes) to be paid to shareholders.Constant dividend yield. The board could set a target dividend yield (usually based on beginning value) to establish the annual dollar dividend. The yield could be determined based on reference to similar, publicly traded companies or through some other decision-making process.Annual dollar dividend. The dividend could be based on board judgment each year. This was not attractive to a couple of the shareholders who did not want to be in annual discussions with management regarding “dividends versus growth.”
Upon reviewing our recommendations, the board elected to set a constant dividend yield target. Dividends would rise or fall based on changes in value, which all the shareholders could agree was a reasonable benchmark.Phase II: ImplementationGiven the Company’s history of profitable growth, the Company was able to obtain bank financing for a significant (but not reckless) leveraged dividend recapitalization. All debt coverage ratios were easily attainable on a pro forma basis. No shareholder guarantees were required. The financing was straightforward and completed with little difficulty.The Company established a dividend yield for future economic dividends. The yield was adjusted to account for the debt service on the recapitalization debt and to allow for adequate reinvestment for future growth.Outcome for the Shareholders and the CompanyThe engagement accomplished a number of important objectives.Shareholder Harmony: The shareholders worked together to develop a policy that was reasonable for each of them given their differing personal situations and objectives.Shareholder Diversification and Liquidity: The leveraged recapitalization enabled each shareholder to set aside a significant nest egg of liquidity independent of his or her ownership of the Company.Shareholder/Management Harmony: The new, non-family CEO had marching orders from the board regarding expectations for debt service and for shareholder distributions. His “allowance” for capital expenditures was the residual cash flow after debt service and shareholder distributions.Long-Term Sustainability: The Company and the shareholders had agreement regarding the outlook for the future. With a non-family CEO, this second-generation family business had transitioned to a more sustainable footing with three shareholder directors who were not active in management of the business.ConclusionWe were excited by the opportunity to help this family secure the sustainability of its growing and successful Company. By addressing and listening to the different perspectives of the three shareholders, we were able to promote a balanced financial course of action that addressed each party’s concerns and avoid the rancor and distrust that plagues too many family businesses.
The Importance of Fairness Opinions in Transactions
It has been 34 years since the Delaware Supreme Court ruled in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) and thereby made the issuance of fairness opinions de rigueur in M&A and other significant corporate transactions. The backstory of Trans Union is the board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.Why would the board approve a transaction without extensive review? Perhaps there were multiple reasons, but bad advice and price probably were driving factors. An attorney told the board they could be sued if they did not approve a transaction that provided a hefty premium ($55 per share vs a trading range in the high $30s).Although the Delaware Supreme Court found that the board acted in good faith, they had been grossly negligent in approving the offer. The Court expanded the concept of the Business Judgment Rule to include the duty of care in addition to the duties to act in good faith and loyalty. The Trans Union board did not make an informed decision even though the takeover price was attractive. The process by which a board goes about reaching a decision can be just as important as the decision itself.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties; however, once any of the three duties is breached the burden of proof shifts from the plaintiffs to the directors. In Trans Union the Court suggested had the board obtained a fairness opinion it would have been protected from liability for breach of the duty of care.The suggestion was consequential. Fairness opinions are now issued in significant corporate transactions for virtually all public companies and many private companies and banks with minority shareholders that are considering a take-over, material acquisition, or other significant transaction.When to Get a Fairness OpinionAlthough not as widely practiced, there has been a growing trend for fairness opinions to be issued by independent financial advisors who are hired to solely evaluate the transaction as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a fairness opinion.While the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:There is only one offer for the bank and competing bids have not been solicitedCompeting bids have been received that are different in price and structure (e.g., cash vs stock)The shares to be received from the acquiring bank are not publicly traded and, therefore, the value ascribed to the shares is open to interpretationInsiders negotiated the transaction or are proposing to acquire the bankShareholders face dilution from additional capital that will be provided by insidersVarying offers are made to different classes of shareholdersThere is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all partiesWhat’s Included (and What’s Not) in a Fairness Opinion
A fairness opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar banks. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders (particularly minority shareholders) provided the analysis leads to such a conclusion.
The fairness opinion is a short document, typically a letter. The supporting work behind the fairness opinion letter is substantial, however, and is presented in a separate fairness memorandum or equivalent document.
A well-developed fairness opinion will be based upon the following considerations that are expounded upon in an analysis that accompanies the opinion:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreementThe subject company’s capital table/structureFinancial performance and factors impacting earningsManagement’s current year budget and multi-year forecastValuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction priceThe investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, accretion/dilution to EPS, TBVPS, DPSAddress the source of funds for the buyer and any risk funding may not be available
It is important to note what a fairness opinion does not prescribe, including:What the highest obtainable price may beThe advisability of the action the board is taking versus an alternativeWhere a company’s shares may trade in the futureHow shareholders should vote a proxyThe reasonableness of compensation that may be paid to executives as a result of the transaction
Due diligence work is crucial to the development of the fairness opinion because there is no bright line test that consideration to be received or paid is fair or not. Mercer Capital has nearly four decades of experience in assessing bank (and non-bank) transactions and the issuance of fairness opinions. Please call if we can assist your board.
Originally appeared in Mercer Capital's Bank Watch, April 2019
Ignoring the Obvious: What the Market isn’t Telling us About RIA Valuations
Classic car collecting has probably reached its apex, with stories touting old iron as an alt-investment and giving tips for beginners to the space. Have muscle cars finished their run? Are 90s cars next to rise? Are Ferraris and Porsches on the downslope? And so forth. The chatter is interesting but mostly misses the point. Collecting old cars is about nostalgia and stories and traveling to auctions in beautiful locations and very occasionally about making money. About the only thing you can guarantee by investing in classic cars is that it is cheaper than owning horses.Private Markets for RIAs Have Diverged from the Public MarketsOver the weekend, the Financial Times published an article touting the rising merger and acquisition activity in the U.S. wealth management industry. The piece echoed much of the typical commentary on the RIA industry’s prospects for deal activity: a large, profitable, but fragmented community of firms needing scale to develop the necessary technology infrastructure and serve sophisticated client needs. The article talked to leaders in several PE-backed consolidators and some M&A specialists in the space, all of whom talked their book in general agreement that valuations were strong and consolidation was on. What the article didn’t address is that while private equity has indeed been actively pursuing the investment management industry, the public markets seem to have lost interest.What Goes Down, Can Go Down FurtherIt’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Last July, Barron’s ran an article talking up the investment management industry that looked at six firms with depressed valuations and strongly suggested there was a lot of upside there for the taking. I’ll admit that I nodded my head in agreement, because many publicly traded investment management firms had double-digit losses, and we knew from talking to our clients that business was actually pretty good. It’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Fortunately, I didn’t execute on the idea. In the nine months since the article came out, valuations for this group have generally declined further, with four of the six names covered in the Barron’s piece down even more (Legg Mason and Franklin Resources are up, barely).Public RIA Multiples are Following the Trend LowerOne of my colleagues at Mercer Capital, Zach Milam, has been keeping an eye on EBITDA multiples for smaller money managers. He updated the chart below through the end of April.The chart mimics what we’re seeing in the pricing of public investment management houses. Most of the time over the past ten years, money managers traded at high single-digit or low double-digit multiples of EBITDA – a metric that should not surprise anyone. But last year the group took a nosedive toward the mid-single digits. Valuations bounced back a bit in the first part of 2019, but it’s hard to say they’ve truly recovered, despite record highs being set by many major equity indices and bond prices firming. Given the improvement in pre-tax returns yielded by the late 2017 Tax Cuts and Jobs Act, this down leg in EBITDA multiples is alarming.When the Trend is NOT Your FriendEven Warren Buffett is not having much luck with investors, having spent this last weekend facing down questions about the pace of Berkshire Hathaway’s succession planning and why the company has underperformed the S&P 500 over the past decade. And as I wrap up drafting this, the market is generally reeling from the renewed threat of tariffs on China. Whether you believe Buffett’s difficulties are isolated, part of a broader transformation in investment management, or a contra-indicator, it’s a tough time to be an active manager.So What Explains the “Red Hot” M&A Pace?What would M&A activity look like if a few of the major consolidators were not pursuing a landgrab strategy?In contrast to the headlines, first quarter M&A activity should probably be characterized as “normal.” DeVoe’s first quarter transaction review shows 31 transactions, down one from the same quarter last year, and with the average size of the deal (sellers reporting just over $600 million in AUM) well down from last year. The trend in deal size has fallen consistently since 2016, and one wonders what it would look like if a few of the major consolidators, like Focus Financial, were not pursuing a landgrab strategy.The push from the private equity backed rollups has definitely improved liquidity opportunities for sub-$1 billion RIAs, but we suspect that opportunities for larger firms are mostly unchanged. Wealth management firms and independent trust companies have many options, whereas buyers of asset management firms are more selective.EpilogueIf you missed the article last week in the Wall Street Journal on Charles Schwab’s ascent, mostly at the expense of wirehouse firms, go read it now. Just as discount brokers revolutionized the retail investment industry and indexing took on asset management, a myriad of forces are trying to figure out how to capture what are perceived to be outsized profits in the wealth management space. There’s no Schwab-like trend in place yet, even though everyone is trying to claim there is.For all the talk, the deal volume of the consolidators trumpeted in all the headlines is a drop in the ocean compared to the number of RIAs and the assets they manage. So far, the model of an independent firm with five to fifty employees billing 100 basis points to manage the investible wealth of mass-market millionaires is proving to be highly resilient. Many of the trends supposedly driving consolidation, like technology, make independence more sustainable. And while some smaller RIAs are joining industry roll-ups, other wealth management groups are fleeing wirehouses to go independent. In the end, it’s business as usual.
Five Takeaways for Family Business Directors from Kress v. U.S.
A recent federal court decision in a tax dispute represented a significant victory for family business shareholders. The case (Kress v. U.S.) revolved around the value of a multi-generation family business, Green Bay Packaging (“GBP”). Our colleague Chris Mercer wrote an extended review of the technical appraisal issues in the case which can be found here.The plaintiffs, family shareholders in GBP, had made a series of gifts of minority shares of GBP based on contemporaneous appraisals from 2006 to 2008.In August 2014, the IRS assessed additional tax and interest on the gifts, claiming that the fair market value of the gifted shares was approximately over twice the amount claimed by family shareholders.In response to the IRS deficiency notice, the taxpayers paid the assessed tax and interest and filed suit in federal court for a refund.In its ruling, the federal district court sided with the taxpayers, concluding that the fair market value of the gifted shares was nearly identical to the amounts originally claimed.
While we generally think family business directors have more important things to think about than tax-related judicial decisions, the Kress decision is one with which family business directors should be familiar. In this post, we identify five important takeaways for family business directors from Kress.1. Contemporaneous Appraisals Are More PersuasiveThe business valuation reports that were ultimately vindicated by the Court were those prepared in real-time in the ordinary course of business. GBP had a legacy of regular appraisals that were apparently used for a variety of purposes. In the Court’s eyes, the contemporaneous appraisals prepared by a qualified professional having a long history of familiarity with the company were more reliable than the valuations prepared long after the fact and rendered in the context of an already existing dispute.Does your family business have a program of regular appraisals performed by a reputable and qualified business appraiser? Do the appraisals reflect a consistent valuation methodology, adapted to the unique circumstances and economic conditions at each valuation date? Are the conclusions of these appraisals used in contexts other than tax compliance (i.e., corporate planning, shareholder redemptions, etc.)?2. S Corporations Are Not Worth More Than C CorporationsFor decades now, the IRS has maintained that S corporations – since they do not pay corporate income tax –are inherently worth more than otherwise comparable C corporations. Observers have long noted that this position defies common sense as S corporations have to make distributions to shareholders each year in amounts sufficient for the shareholders to pay their personal tax liabilities on S corporation earnings. In other words, S corporations are burdened by taxes on income the same way as C corporations; the only difference is that S corporation income tax payments flow through the hands of shareholders before reaching the IRS coffers.If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporation?The IRS’ stubbornness on this issue has been a nuisance to family shareholders more than anything. Most experienced business appraisers, understanding the economic rationale summarized above, have ignored the preferred IRS position in measuring fair market value. However, in so doing, all parties understood that they were inviting a potential challenge from the IRS.GBP is organized as an S corporation, but the company’s appraiser opted to follow economic logic and treat the company as if it were a C corporation for purposes of the valuation. In accepting the resulting valuation conclusion, the Kress Court effectively acknowledged the propriety of that treatment. While the appraiser retained by the IRS applied corporate taxes as if GBP were a C corporation, he then increased the conclusion of value by adding an S corporation. The Kress Court rejected that premium.How is your family business structured for tax purposes? If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporationThe Tax Cuts and Jobs Act of 2017 has shifted the calculus on whether the S election is beneficial – have your tax advisors helped you assess whether S corporation treatment remains optimal for your family business?3. Economic Conditions MatterThe gifts that were at the heart of the tax dispute were made in the years leading up to and at the start of the Great Recession. The Kress Court criticized the report of the appraiser retained by the IRS for failing to give adequate consideration to the impact of the Great Recession on the fair market value of family businesses.By preparing contemporaneous valuations, GBP’s appraiser was necessarily attuned to the economic dislocations of the time and how the value of the business was affected. In particular, the contemporaneous appraisals assigned significant weight to indications of value derived under the market approach, which examined the observable pricing behavior for a representative group of comparable public companies. Developing indications of value under the market approach for consideration in the overall conclusion helps to ensure that the valuation effect of current economic conditions is not overlooked or minimized.Does your family business operate in a cyclical or counter-cyclical industry? How does your valuation take into account signals from the market? Is your family business ready for the next recession?4. Know Your Appraiser, and Make Sure Your Appraiser Knows YouGBP’s appraiser, John Emory, has had a long and distinguished career in the valuation profession. Perhaps more important, it is evident from the Court’s decision that Mr. Emory had a thorough understanding of GBP’s business based on years of interviews with management.In contrast, the Kress Court noted that the appraiser retained by the IRS had not spoken with GBP management beyond attendance at a deposition. While much can be learned about a company from careful study of its financial statements, some aspects of the business are much easier to understand by being on-site and speaking with management.Does your family business have an ongoing relationship with an experienced and qualified business appraiser? Has your business appraiser developed a thorough understanding of how your family business operates and the factors that make your family business valuable?5. Don’t Get GreedyToo often, family business shareholders think about valuation only from the perspective of minimizing gift and estate taxes. While the Kress decision does not provide sufficient financial data from GBP to make relative value assessments, the Court’s adoption of the taxpayer’s appraisal suggests that the valuation was a valid determination of fair market value rather than a “low-ball” estimate intended to minimize tax payments.Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?This is particularly evident in the marketability discounts applied in the taxpayer appraisals. The taxpayer’s appraiser applied marketability discounts between 28% and 30%. While the appropriate marketability discount depends on the specific facts and circumstances pertaining to the subject interest, the marketability discounts applied often correspond to the underlying economics of minority shares in the family business. The marketability discount is not a tool for reducing taxes, but is instead a reflection of the economic reality of owning illiquid shares in a family business.In short, while gift and estate tax compliance may be an important application of the valuation of your family business, it is not the only application. As noted above, valuation conclusions will generally be more persuasive if they are used in multiple contexts beyond just tax compliance. An aggressive valuation for tax compliance may carry unintended negative consequences elsewhere in your family business.As directors, how do you use appraisals of your family business? Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity? Does your family business have a redemption policy or buy-sell agreement? If so, does it specify the “level of value” to be used?ConclusionThe Kress decision is a welcome one for family businesses. Our valuation professionals are eager to talk with you about how the lessons from Kress noted above affect your family business. Call us today.
Brigham Minerals IPO Brings Spotlight to Oil & Gas Market
Mineral Aggregators are Leading the Forefront in an Underwhelming Energy Sector
Initial public offerings in the upstream and midstream sectors of the oil and gas market have been lackluster at best for quite some time, and the trend has continued through the first quarter of 2019. Despite the rebounds in the energy sector and broader market to start the year, there has been a scarcity of energy equity capital markets activity, thus resulting in fewer IPOs in the E&P and upstream and is exacerbated by the fact that companies in this space have been underperforming relative to the broader market.
This continued lack of activity has made this market fundamentally “underweight” due to the disproportionally small size of available public equities relative to the immense use and value of oil and gas in the national economy.
However, in the midst of an underperforming energy market, there is a sector that has been an emerging bright spot: public mineral aggregators. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years. Brigham began trading on April 18 at $18.00 per share on the New York Stock Exchange.
While we have addressed trends in the mineral aggregators and royalty MLPs, we are taking a closer look into what these companies have to offer the investing public and why they have been so popular in recent years. We continue to see an uptick in IPO activity in this sector as the value of these companies addresses the current wants and needs of energy investors, i.e. high yield cash returns with low-risk characteristics. The timeline below shows how some of the major players in this space have appeared only within the last five years.
[caption id="attachment_26224" align="aligncenter" width="680"]Source: Company filings and Brigham S-1[/caption]
In this post, we will review the continued IPOs and valuation implications for the mineral aggregators market as well as examine Brigham’s operations and placement in this sector.Energy IPOs Slide While Minerals ShineIn the wake of the oil crash in 2014, there have been a total of 33 IPOs in the U.S. oil and gas market from 2015 through Q1 2019, excluding mineral aggregators. This contrasts sharply with the average of approximately 23 IPOs per year from 2011 – 2014. This decline is illustrated in the chart below, which tracks deal volume by year in various subsectors of the energy market.[caption id="attachment_26223" align="aligncenter" width="892"]Source: Gibson Dunn Presentation "IPOs and Capital Markets Developments in the Oil and Gas Industry," February 26, 2019[/caption]
The declines of IPO activity in recent years has been consistent with overall investor sentiment in the upstream and E&P space in that investors have been eager for current yield, not the future growth that these companies have been pedaling. These companies have been reinvesting into additional acreage and capital expenditures, leaving next to no free cash flow and little in the form of dividends to investors.
While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing.Since many of these newer companies are typically in the high growth and investment phases, they have achieved the capital necessary for growth through private funding rather than through public channels. So why have mineral aggregators been so popular in the public capital markets in a sector that has been so unimpressive from an IPO standpoint?Mineral aggregators have the ingredients investors have been craving for some time. They are cash flow positive, high margin, and have dividend yields that provide healthy returns straight to the investor’s pocket. They also do not carry the typical risk profile of traditional E&P and upstream companies as mineral aggregators provide opportunities to be exposed to mineral plays and benefit from technological advances without taking operator risk.While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing, currently averaging around four per year and are continuing at an increasing rate going into 2019.Valuation ConsiderationsBased in Austin, Texas, Brigham Minerals had initially set out to raise $100 million in their IPO, but then increased the amount to be raised to $261 million at $18 per share in an updated S-1 filed on April 9 due to higher than expected demand. Current holdings for Brigham are shown below:[caption id="attachment_26211" align="aligncenter" width="755"]Source: Company filings and Brigham S-1[/caption]
[caption id="attachment_26212" align="aligncenter" width="1000"]Source: Company filings and Brigham S-1[/caption]
Brigham is averaging approximately 4,579 boe/d of production on approximately 68,800 net royalty acres as of 12/31/2018, pro forma, with a little more than half of the production being oil. Net income attributable to common shareholders was $0.66 per share, and adjusted EBITDA per share came out to approximately $1.11 per share attributable to common. The large gap here is due to depreciation and depletion rates nearly doubling in 2018 due to higher depletion because of the significant increase in production volumes in the current year and a revised depletion rate after evaluation of current reserve reports.
By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.After going public, Brigham will have an influx of cash which it can use to acquire more mineral interests, leading to increased production and free cash flow. At first glance, this might appear to be similar to the reinvestment cycle for E&P companies, but there are important differences. The mineral interests acquired are a revenue stream that can almost immediately be paid out as dividends to investors because the investment is in properties that are already producing and the mineral aggregators receive a portion of the proceeds. Contrast this to an E&P company that reinvests its cash flows into new projects where it must purchase property, equipment, infrastructure, etc. There are large upfront costs that eat into this capital and frequently require taking on debt as well. Before their investors start to realize a return, E&P companies aim to recoup their expenses first, not to mention servicing the debt. By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.Market cap at the time of the IPO launch was approximately $377 million, and accounting for cash and debt on the books as of the 12/31/2018 financials, we arrive at an estimated enterprise value of approximately $514 million.Below is a table of selected multiples using these calculated metrics as well as other comparable mineral aggregators:
Compared to other competitors in the mix, it would make sense for multiples for Brigham to come in under the peer group given the lower production figures. However, utilizing proceeds from the IPO to continue to acquire additional royalty acreage could push the Brigham into a position that is comparable in size and value to those like Falcon and Kimbell, so as long as it can produce free cash flow to pay out high dividends that investors have become accustomed to receiving from these other companies.
Location and Production MixBrigham’s operations and focus are semi-diversified compared to other publicly traded mineral aggregators and has the most in common with Kimbell in this respect. What do we mean by this? While Brigham is not as concentrated in a single basin like Viper (Permian focus) and Falcon (Eagle Ford focus), it’s more focused than Black Stone which is by far the most diversified in its class with approximately 89% of holdings falling into the “other” category due to being scattered across multiple, non-traditional plays. There are benefits and drawbacks to both concentrated versus non-concentrated strategies. Consider the table below:
Brigham sets itself apart by its presence in the DJ and Williston basins. No other mineral aggregator has a concentrated or material focus there. As well activity picks up in this area, Brigham will benefit. However, it also misses out on activity in the Eagle Ford as well as gas driven plays such as the Haynesville and Appalachia.
ConclusionAs we’ve noted before, this market has been frequently discussed among industry professionals for some time and has been featured regularly at oil and gas conferences. The vast market of the public royalty aggregators has been gaining momentum as investor demand for these investment vehicles is high. Given these factors, the chances are high that we see an increase in the number of IPOs from mineral aggregators in the future compared to upstream and E&P companies.In an industry that has seen a decline in public market activity that coincided with the steep drop in oil prices, mineral aggregators like Brigham have emerged as an attractive opportunity for investors looking to gain exposure to the industry with an opportunity to participate in the benefits sooner rather than later.At Mercer Capital, we have valued mineral and royalty rights located across the country. We understand how the location of your assets affects value and work to monitor transactions in each region to understand the state of the current market. Contact a Mercer Capital professional today to discuss your valuation and transaction advisory needs in confidence.
2019 Eagle Ford Shale Economics
Challenging For Valuation Title Belt
Investors and boxing fans have some things in common. First, they both prefer champions. Second, there tends to be attention on heavyweights, when the best fighters may be in a different class.Several attributes put the Eagle Ford among the most profitable shale basins in the U.S.In the oil patch’s proverbial basin battle of economics and relative value, the Eagle Ford Shale is coming on strong. Granted, the Eagle Ford Shale may not reside in the same heavyweight class as the Permian Basin. Indeed, the Permian is in a class of its own and even may be winning over Saudi Arabia’s behemoth Ghawar field in a battle for the title of the largest oil field in the world. However, from a pound for pound well economics standpoint, the Eagle Ford Shale is currently a formidable challenger to the Permian due to several advantages in key areas: breakeven prices, well costs, certain productivity metrics and proximity. These attributes put it among the most profitable shale basins in the U.S. Some well-known operators such as BP and Chesapeake have noticed and are putting big money behind this play.Ranked Contender Or Forgotten Champion?Although the Eagle Ford is a relatively mature basin compared to some other U.S. shale plays, the area has experienced a valuation resurgence over the past twelve months, and it’s not being driven by just the uptick in oil prices. Consider the transaction activity in the table below:[caption id="attachment_26150" align="aligncenter" width="1000"]Source: Shale Experts, Company Reports, EIA [/caption]
Activity, dollars and commitment have all swelled. This activity was anchored by two deals: (i) BP’s purchase of BHP Billiton and (ii) Chesapeake’s Wildhorse acquisition. WildHorse and Chesapeake were the fourth and fifth largest drillers in the region, respectively in 2018. Chesapeake appeared to pay a little more attention to current production, while BP’s acquisition appeared more geared towards future acreage. It’s also worth noting that although BP bought assets in other areas such as the San Juan Basin, Wamsutter area and Anadarko Basin, it’s shedding those assets to focus, in part, on the Eagle Ford. Regardless, the relative Eagle Ford acreage prices more than doubled while production values increased generally in lockstep with commodity prices.
In a time where oil and liquid production (as opposed to reserve accumulation) is the energy industry’s focus, the Eagle Ford Region is, according to the EIA, the second most prolific oil region in the United States from a myriad of standpoints: (i) overall oil production, (ii) per rig production and even (iii) DUC well count. Additionally, it is home to some of the lowest breakeven prices in the country, certainly from the standpoint of shale plays. Why are costs low? The answer lies in shallower wells, lower cost drilling, higher cuts (meaning there’s more oil and less water produced) and resultant premium commodity pricing near the Gulf Coast. In a time where Permian differentials were particularly wide in 2018, this pricing advantage was helpful to Eagle Ford shale producers.
Why are costs low? The answer lies in shallower wells, lower cost drilling, higher cuts and resultant premium commodity pricing near the Gulf Coast.Producers are encouraged by this. At an industry conference last fall, Conoco Phillips’ Greg Leville said that there were certain areas where breakevens were as low as between $20 and $30 per barrel. EOG has noted that they can make money at $30 per barrel on some of their leases. This enthusiasm was characterized according to Marathon’s CEO Lee Tillman at another recent industry conference: “I would compare the returns in the Eagle Ford to anything,” he said, given its $4-5 million/well completion costs, oiliness and Louisiana light sweet pricing. “There's really nothing today on a zone-by-zone basis that can touch the Eagle Ford.” Costs can be particularly lower for operators in 2019 that will be focused on producing from existing DUC wells such as Murphy Oil.Other less choice areas of the Eagle Ford do have higher breakevens, but overall the play, particularly its oil window, boasts among the lowest costs in the country challenging the Permian in this respect. A picture of the generalized spread of breakeven prices in the play can be seen in the chart below.[caption id="attachment_26151" align="alignnone" width="1000"]Source: Company Reports & Investor Presentations[/caption]
Fighting For Capital EfficiencyThe trends show that key producers (EOG, BPX and Chesapeake) are working towards consolidating their acreage. More money is going into the basin overall, but operators, wary of overspending, are being more strategic about their capex use. The trend is towards the fewest dollars and the most wells. Note particularly the well count below. It’s becoming a more relevant leading metric than rig counts these days. Rig counts can be somewhat misleading when it comes to well count and productivity as the ratios have changed with technology. The key takeaway is that these producers are all growing well counts significantly.[caption id="attachment_26152" align="aligncenter" width="1000"]Source: Company Reports & shaleexperts.com[/caption]
In addition to this group, SM Energy’s capital plan is overall down from last year, but it is increasing its Eagle Ford spending. The hope is that with more experience than other basins, being longer in the tooth will pay off in the near and intermediate term. It also helps that gas produced in the basin will be very competitive in the oncoming LNG market growth on the Texas coast.
Get Stronger Or Get Out Of The RingThe prognosis for the Eagle Ford is not all positive. The play struggles (as do other basins) with steep decline curves and production replacement, thus impacting rates of return. Economic critics of the shale plays warn of the “treadmill” effect of replacing production and the costs to do so. There is validity to this. Follow on wells in pad drilling have had productivity problems known as parent-child well interference. Carrizo and Equinor have changed their frac designs to attempt to counter this, and the downside risk to BP’s Eagle Ford bet is that they will be able to flatten their declines enough to keep Eagle Ford wells economical for longer periods of time. Many companies have questioned where Eagle Ford assets fit in their long-term plans. Encana, a reputable Canadian producer, has recently characterized their Eagle Ford acreage as “non-core.” Pioneer Resources has been selling their Eagle Ford positions over the past year, and Earthstone Energy is leaving the play. A long time region producer, Sanchez Energy, was recently delisted from the NYSE.Pound For Pound – A Strong Challenger For The Valuation TitleThese issues can be warnings to investors to be sure, but they can also be interpreted as a natural part of the consolidation cycle in the play as top producers commit and smaller or less successful operators step out of the proverbial ring. The good news for these exiting producers is that they are getting better prices as they leave. Where they cashed out around $8,000 per acre a year or more ago, many are getting closer to $18,000 per acre now. Even gas-heavy producers are more optimistic as the Eagle Ford is the single most proximate play to many oncoming LNG facilities in South Texas.Will the Eagle Ford win the profitability fight with other basins? It may not have the scale or heft of the Permian, but its profitability punches are as strong as anyone's.Originally appeared on Forbes.com.
RIAs Still Reeling from Last Year’s Sell-Off
Despite Recent Uptick, Investment Managers are Underperforming
Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally. As the broader indices creep up, so does AUM and revenue. Higher top-line growth typically leads to even greater gains in profitability with the help of operating leverage. Assuming no change in the P/E multiple, RIAs stock prices should outpace the market in a bull run.This isn’t always the case though. So far this year, most classes of RIA stocks have underperformed the market despite its relatively sharp increase through the first three months.
The explanation isn’t necessarily obvious. Investors are likely concerned about the industry’s prospects in the face of fee compression and continued asset outflows. Alternative asset managers were the sector’s sole bright spot as hedge funds tend to do well in volatile market conditions. However, expanding this graph over the last year shows that they too have underperformed the market over this time.
The fallout over this time is primarily attributable to the decline in the (historical) earnings multiple.
Since this multiple is a function of risk and growth, at least one of those factors is weighing on investors. We believe it is a combination of the two. Rising fee pressure and continuing demand for passive products have heightened the industry’s risk profile while dampening growth prospects. The forward multiple has recovered some this year, but that’s likely attributable to analysts’ downward revisions of forward earnings estimates in Q1 after the market decline from the prior quarter.
As noted a couple of weeks ago, traditional asset managers have felt these pressures most acutely. Poorly differentiated products have struggled to withstand downward fee velocity and increased competition from ETF strategies. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules.
Implications for Your RIA Your company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with.In all likelihood, your investment management firm is much smaller than the public RIAs, many of which have several hundred billion in AUM and thousands of employees across the country. It’s also probably unlikely that your business lost 20% of its value last year like most of the public “comps.” The market for these businesses was particularly volatile in 2018, and year-end happened to fall at the low end of the range. So far this year, most publicly traded RIAs have recovered some of these losses during more favorable market conditions.Still, we can’t totally ignore what the market is telling us about RIA valuations. We often get pushback from clients for even considering how the market is pricing these businesses (typically as a multiple of earnings) given how large these companies are relative to theirs. The reality though is that your subject company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with. If investors have turned particularly bullish or bearish on the industry’s prospects, we have to consider that in our analysis.A (Less) Bearish OutlookThe outlook for these businesses is market driven—though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic, but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.On balance, the outlook for the rest of 2019 doesn’t look great given what happened to RIA stocks at the end of 2018, but the recent uptick suggests that it’s not as bad as it was a few months ago. The market is clearly anticipating lower revenue and earnings following the Q4 correction, which could be exacerbated if clients start withdrawing their investments. On the other hand, more attractive valuations could also entice more M&A, coming off the heels of a record year in asset manager dealmaking. We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.
Three Questions to Consider Before Undertaking a Capital Project
From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.What are the most important qualitative factors to consider when evaluating a proposed capital project?Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects. While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second. To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.1. Market OpportunityThe market opportunity question is simply this: Why does the proposed capital project make sense? Management must be able to provide a simple, straightforward, and compelling answer to this question. The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need. Under no circumstances should the answer to this question reference a net present value or internal rate of return. If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.2. Strategic FitOnce the market opportunity has been demonstrated and vetted by the board, the next question is this: Why does the proposed capital project make sense for us? In other words, how does the proposed capital project relate to the family business’s existing strategy? Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable. Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities. If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved. If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.
This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders. Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.” If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business.
Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.3. ConstraintsThe final question is this: Can the proposed capital project be done by us? Management's time and attention, infrastructure and systems, and human resources are limited. Will undertaking the proposed capital project divert scarce resources away from other areas of the business? In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business. While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run. Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.Does your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible? If it does, that’s great. But the approval process cannot end with a green light on the financial side. Family business directors need to be diligent to answer the qualitative questions identified in this post.
Q1 2019 Asset Manager M&A Trends
On the Heels of a Record Year, Will Asset Manager M&A Trends Continue to be Strong in 2019?
Last year marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019 as business fundamentals and consolidation pressures continue to drive deal activity.Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during the first quarter of 2019 was flat compared to the same period in 2018, while deal count was up 35% for the twelve months ending March 31, 2019, compared to the comparative period ending March 31, 2018. Reported deal value during the first quarter of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.2018 marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019.Consolidation has been a driver of many of the recent large deals, as exemplified by the largest deal of last year, Invesco’s (IVZ) acquisition of OppenheimerFunds. IVZ announced plans in the fourth quarter last year to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the US. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’s products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call in 2017:"Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan – President and CEO, Invesco Ltd. 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. So far in 2019, FOCS has announced 11 deals (including acquisitions by its partner firms). Just last week, Silvercrest Asset Management announced the acquisition of Cortina Asset Management, a $1.7 billion small cap growth equity manager based in Milwaukee, Wisconsin.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Another emerging trend that has been driving deal volume is the rise of minority interest deals by private equity or strategic buyers. These deals solve or mitigate many of the problems associated with acquisitions of what are normally “owner operated” businesses (at least for smaller RIAs). Minority interest deals allow sellers to monetize a portion of their firm ownership (often a significant portion of their net worth). From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.
Basics of Financial Statement Analysis
Part 4: Telling the Company’s Story
This post is the fourth and final installment from our Basics of Financial Statement Analysis whitepaper. In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.Telling the Company’s StoryHaving reviewed the primary financial statements individually, we review in this section how the statements relate to one another. A comprehensive view of how items on one financial statement relate to items on another financial statement is necessary to discern the underlying story or narrative of the company.Exhibit 1 below summarizes the principal components of the three financial statements. We address the most important relationships in the following numbered sections corresponding to Exhibit 1.#1: Balance Sheet and Income StatementThe balance sheet and income statement link up with each other at a few key points that are important for analysis.Total assets and revenue. Assets are valuable to the extent that they generate (profitable) revenue. Measuring the efficiency with which the company’s assets generate revenue can be a helpful way to evaluate the success of a company’s strategy over time and to compare its performance to that of peer firms. Decreasing asset efficiency may be a sign that the company is accumulating excess, or non-productive, assets when distributing a greater proportion of earnings would be more optimal.Revenue and accounts receivable. For companies that sell on credit, correlating the balance of accounts receivable to revenue over time can reveal changes in normal credit terms, and/or provide a proxy for the financial health of the company’s customers. As the average time receivables are outstanding increases, collectability becomes more difficult, and the wedge between reported earnings and operating cash flow widens.Cost of goods sold and inventory. The relationship between cost of goods sold and inventory is akin to that between revenue and accounts receivable. If inventory balances are growing disproportionately to cost of goods sold, there may be concerns regarding production inefficiencies, market demand for the company’s products, and an increasing likelihood of inventory obsolescence.Depreciation and net fixed assets. As noted previously, the amount of depreciation expense incurred on the income statement is determined by the net fixed assets on the balance sheet.Amortization and intangible assets. As with depreciation, amortization charges are a function of intangible assets recognized on the balance sheet. The presence of intangible assets and the resulting amortization expenses indicate that the company has grown – in part, at least – through acquisition rather than organically.Interest expense and debt. The interest expense reported on the balance sheet is a function of the average amount of debt outstanding during the period and the effective interest rate on the debt. Interest expense on the income statement will prompt an experienced financial statement reader to consult the notes to learn about the relevant terms of the debt.#2: Income Statement and Statement of Cash FlowsIn addition to reconciling reported earnings to operating cash flow, the statement of cash flows can provide leading indicators for the income statement.Net income and operating cash flow. Two of the three primary components of the reconciliation of net income and operating cash flow are found on the income statement. While non-cash charges to earnings do not consume cash in the current period, they do correspond to cash outflows in prior (depreciation and amortization) or future (equity-based compensation) periods.Capital expenditures and depreciation expense. Acknowledging that capital expenditures can be lumpy, the relationship between capital expenditures and depreciation expense is worth examining. Capital expenditures in excess of depreciation should correspond to revenue and profit growth. If capital expenditures consistently lag depreciation, that may be a signal that some expenditures have been deferred and will need to be made in the future to maintain productive capacity.Acquisitions and operating income. Acquisitions on the statement of cash flows should be a leading indicator of operating income growth. A history of acquisitions without corresponding increases in operating income may suggest that the company’s capital budgeting process is not functioning well.Transactions with lenders and interest expense. If the company is a net borrower, interest expense will be expected to grow in future periods. If so, is operating income sufficient to sustain a higher degree of financial leverage? If the company is repaying debt, interest expense will decrease, although potentially at the cost of slowing earnings growth on a per share basis.Transactions with shareholders and earnings per share. One motivation for companies to repurchase shares is to stimulate growth in earnings per share. If attractive investment opportunities are scarce, repurchasing shares at an appropriate valuation may be an effective tool to augment growth in earnings per share.#3: Balance Sheet and Statement of Cash FlowsThe statement of cash flows analyzes cash flows by tracing changes in balance sheet accounts.Working capital and operating cash flow. Changes in accounts receivable, inventory, and accounts payable are key elements of reconciling reported net income to operating cash flow. While often not accompanied by the same degree of intentional deliberation, investment in working capital is no different than investment in fixed assets or business combinations.Capital expenditures and net fixed assets. To the extent capital expenditures exceed depreciation charges, the balance of net fixed assets will increase. If the incremental assets are not productive, investment returns will suffer.Acquisitions and intangible assets. Devoting capital resources to acquisition activity will increase the balance of intangible assets. The degree to which an acquisition is accretive to returns depends, in large part, on the negotiated pricing of the deal.Transactions with lenders and interest-bearing debt. Net borrowing or repayment of debt will reconcile to changes in the balance of interest-bearing debt. As noted previously, financial leverage increases both potential returns and risk. Changes in debt should be evaluated relative to the overall market value-weighted capital structure of the company.Transactions with shareholders and shareholders’ equity. The decision to issue new shares or return cash to shareholders through dividends and share repurchases should be evaluated with regard to the availability of attractive investment opportunities and the marginal costs of debt and equity capital.DuPont Analysis – Dissecting the Plot
The classic example of cross-financial statement analysis is DuPont analysis. As illustrated in Exhibit 2, this technique breaks return on equity into its component parts using elements from the balance sheet and income statement. DuPont analysis is a simple tool for helping to uncover the narrative underlying the company’s operating performance.
Return on equity is a measure of the efficiency with which the shareholders’ investment in the business generates net income. All else equal, shareholders prefer more net income per dollar of investment. Using DuPont analysis, this aggregate measure of financial performance is disaggregated into three components, each of which can be correlated to the company’s overall strategy and compared to other firms.
Profit margin. Profit margin measures the profitability of the company per dollar of revenue. Profit margin reflects the relative competitive strengths of the company and the degree to which barriers to entry exist to limit competition.Asset turnover. Asset turnover measures the efficiency with which the company employs its assets to generate revenue. Asset turnover can reflect strategic decisions such as whether to lease or purchase facilities. Non-operating or excess assets reduce asset turnover.Financial leverage. Financial leverage measures the degree to which the company uses OPM (“other peoples’ money”) to fund operations. Financial leverage can have a multiplicative effect on return on equity, although it also increases risk.
DuPont analysis can be used both to evaluate the company’s performance over time and to compare the company’s performance to peers. The underlying conceptual framework can also be helpful in evaluating the effect of potential changes to the company’s strategy.Assessing Projected Financial StatementsUnderstanding historical financial performance is important, but the ultimate objective of financial statement analysis is to develop expectations regarding the amount and timing of future cash flows. In this section, we review the key elements of a financial forecast.Revenue growth. Revenue is the starting point for nearly any financial projection model. For most companies, a revenue forecast will be more credible if the analyst can distinguish between unit volume growth and anticipated changes in pricing. Unit volume growth can then be compared to expectations for the broader industry, and pricing assumptions can be evaluated for reasonableness in light of inflation expectations and the competitive dynamics in the industry.Gross margin. Gross margin projections should be supportable with reference to key commodity inputs and other elements of the production process (direct labor, fixed overhead). Deviations from historical performance or available peer data should be reconciled to differences in strategy or projected market conditions.Profitability. Forecasts of profitability are best evaluated by calculating the implied margins. EBITDA is often an appropriate measure of profitability for forecasting, since a discrete depreciation and amortization forecast can be calculated separately. Comparison of fixed and variable costs can add texture and credibility to the forecast, particularly if margins are projected to change. The concept of reversion to the mean is important to keep in mind when reviewing projected profitability; competitive and market forces can have a corrosive effect on above-peer margins over time.Capital expenditures. The forecast of capital expenditures should be evaluated relative to the projected revenue stream and existing capacity utilization. Since capital expenditures are often lumpy, the year-to-year relationship to depreciation will not necessarily be predictable. However, over the long-run the two amounts should be comparable in the aggregate.Working capital. Working capital can be the “silent killer” of cash flow forecasts. The reasonableness of projected working capital balances can be assessed either in the aggregate (generally as a percentage of revenue) or at the level of the individual components. In either case, working capital assumptions should be compared to historical trends for the company, peer averages, and anticipated strategy shifts.Interest-bearing debt. When projecting cash flow to shareholders, anticipated borrowings are cash inflows, while the repayment of debt is a cash outflow. Interest expense should be forecast with reference to average projected debt balances and assumed interest rates. For companies that rely on floating rate debt, it may be appropriate to examine forward LIBOR curves to estimate future interest expenses.
The critical touchstones for evaluating projected financial performance are the historical results of the company itself and relevant peer data, when available. For the forecast as a whole (and each of the primary components), the projected inputs and results should be consistent with the company’s overall story, as revealed in the analysis of the historical financial statements.The Notes to the Financial StatementsAudited financial statements contain detailed notes. Reading and understanding these notes is an integral part of reading the financial statements. The notes relate valuable information that cannot be presented on the face of the actual financial statements. While the content of the notes will vary, general categories of interest will generally include the following:Accounting policies. Management often chooses between multiple potential accounting treatments for a given transaction. Understanding when revenue is recognized, what depreciation pattern/life is used, and how inventory is accounted for is important when comparing financial statements for different companies.Asset detail. The composition of inventory (raw materials, work in process, and finished goods), net fixed assets (land, buildings, rolling stock, leasehold improvements), and intangible assets (customer relationships, tradenames, goodwill) helps to reveal the company’s strategy.Debt terms. For companies with financial leverage, the notes to the financial statements will provide important information regarding the rates and maturities of the company’s outstanding debt, all of which are critical to assessing the company’s financial flexibility.Remaining lease payments. Although multi-year lease agreements do not currently appear on the balance sheet as financial obligations, such agreements are in many ways similar to debt in that they represent fixed obligations that are payable regardless of the future operating results of the business. The notes to the financial statements detail the annual lease payments the company is obligated to make in coming years.Pension and benefit liabilities. The accounting for defined benefit pensions and other post-retirement benefits is complex. The notes to the financial statements summarize the most important assumptions management has made regarding the amount of benefits to be paid and the expected return on plan assets.Acquisitions. The notes to the financial statements generally include discussion of significant business combinations, including pricing, allocation of purchase price to assets acquired, and occasionally, pro forma financial results for the acquired business.Equity-based compensation. Many companies use equity-based compensation plans to incentivize management. While the accounting treatment of such plans can be somewhat arcane, the notes to the financial statements include informative schedules that help to quantify the potential dilution from such plans.Material subsequent events. There is a lag between the issuance date and the as-of date for the financial statements. If a significant corporate event (acquisition, divestiture, refinancing, lawsuit, etc.) has occurred during that interim period, it will be disclosed in the notes to the financial statements.
Astute readers of financial statements know how essential the notes are. There is no shortcut to a careful reading of the notes.ConclusionReading financial statements is an essential part of evaluating the performance of management, corporate strategy, and plans for the future. The balance sheet, income statement, and statement of cash flows each provide an indispensable vantage point on the company’s performance. Understanding what the different statements do and how they fit together enables the reader to uncover the company’s narrative or story, with a view to developing expectations for future performance and evaluating how different strategy options will affect future cash flows.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper
An Overview of Salt Water Disposal
Over the last 12 years the oilfield waste water disposal industry has grown exponentially, both on an absolute basis, and by rank of its importance/size among the oilfield services. This growth has been largely driven by the increased volumes of waste water generated in the production of oil from shale plays. This post discusses the basics of salt water disposal which has become so important given the rise of hydraulic fracturing.The Impact of the Shale BoomThe shale revolution, starting in the Bakken formation in 2007 and ramping-up in the Eagle Ford and Permian basins beginning in 2011, was largely propelled by the combination of horizontal drilling and hydraulic fracturing (commonly, “fracking”).Over the last 12 years the oilfield waste water disposal industry has grown exponentiallyBecause shale hydrocarbon deposits are located in tight-rock formations, the naturally occurring produced water (water that is naturally present in oil and gas formations, referred to as “formation water”) to oil ratio is lower than in conventional reservoirs that have increased pore space and connectivity. To economically produce oil/gas from unconventional reservoirs composed of shale or tight (low permeability) rock, the reservoir must be stimulated by a process such as fracking.Fracking increases the hydrocarbon flow capacity by creating cracks (fractures) that are then filled with a permeable media (proppant) that allows oil/gas to move out of the rock formation and into the wellbore. Fracking requires very large volumes of water to be pumped into the reservoir to carry proppant and other fluids into the fractures. That water flows back after the frack is complete. When added to naturally occurring produced water, and produced water resulting from other stimulation operations (water flooding and/or steam flooding), fracking results in water/oil production ratios that can exceed 10:1. This results in enormous volumes of produced water (tens of billions of gallons each year), some of which is utilized in additional stimulation activities, but much of which must be disposed of.The Need for Disposal and MeansProduced water (also referred to as “brine”) contains a number of contaminants, both naturally occurring (salt, oils/grease, and organic/inorganic chemicals) and chemical additives utilized in the drilling and operation of the well. Even after treatment to extract some of the impurities, the resulting water (referred to as “salt water”) contains significant contaminants and must be handled carefully and disposed of properly.The method of salt water disposal depends on a number of factors: geology, technology, area infrastructure, and the prevailing climate in the areaThe method of salt water disposal depends on a number of factors, notably the geology of the formation from which the water is produced, as well as the technology and infrastructure available in the area and the prevailing climate in the area. While some particularly arid regions allow for disposal via evaporation from large holding pits, most salt water is disposed of at specialty disposal sites where the salt water is injected by way of a disposal well (salt water disposal, or SWD wells) into natural underground formations.Geographic DistributionA large portion of the U.S. SWD facilities are located in Texas due to the disproportionate amount of shale acreage in the state and the SWD conducive geology in Texas. Far fewer SWD facilities are located in other shale areas, such as the Marcellus and the Bakken, due to less favorable geological formations in those areas. The Marcellus in particular lacks favorable formations for disposal purposes with the number of recent operating SWD wells in Pennsylvania at less than 100, compared to more than 12,000 SWD wells in Texas.Location SelectionWhen siting a SWD facility, a number of factors come into play, including demand, proximity, and geology.DemandDemand might seem to be an easy consideration – just locate the facility in an area where oil and gas operators are generating large volumes of waste water. However, oil production and, therefore, waste water production, in particular areas can vary widely over both short and long periods of time.When siting a salt water disposal facility, a number of factors come into play, including demand, proximity, and geologyProduction in a particular field naturally declines over time as reserves are depleted, but can increase again with technology advances. Oil prices dictate if it’s economically viable for continued production in a particular field, with oil prices being notoriously unstable compared to many commodities due to supply and demand, country-specific political forces and even geopolitical forces.ProximityProximity to the area of waste water disposal demand is important. Proximity can be viewed both as distance and as the availability of the appropriate infrastructure (roads) to efficiently transport the waste water from the production site to the disposal site. Transporting oilfield waste water is a significant expense and for obvious reasons is tied directly to the transport distance. Many oil and gas wells are located in remote areas where the existence of roads, or lack thereof, plays into the SWD location decision.GeologySurface location isn’t the only consideration when choosing a SWD facility site. The location’s geology is just as important.A porous and permeable, non-hydrocarbon bearing zone that is not considered an aquifer under the UIC program is one possible geological formation appropriate for salt water disposal. A second possibility would be a previously depleted oil and gas zone, that is both porous and permeable.For either option, a clear barrier must exist between the target zone and all underground sources of drinking water ("USDWs"), and the drill area needs to be generally clear of any significant geologic faults.ConstructionSalt water disposal wells have very specific construction requirements in order to ensure that there will be no contamination of the area USDW or the environment in general. For example, in Texas, salt water disposal wells are constructed with three layers of casing to ensure that groundwaters are not impacted. The surface casing (the first layer) is a cement encased steel pipe that extends from ground level to a specific minimum distance below the deepest USDW level. The production casing, a pipe that is permanently cemented in the wellbore, is the second casing layer and runs the length of the well. The third protection layer contains the injection tubing string that guides the injected water to the bottom of the well for discharge into the target formation. This construction provides the most secure means of disposing of salt water developed to date in that all three pipes would have to fail at the same time for surrounding groundwater to be contaminated.RegulationRegulation of SWD facilities is significant and thorough. The 1974 Safe Drinking Water Act required the U.S. Environmental Protection Agency ("EPA") to set minimum requirements for salt water injection wells, along with many other wells utilized in disposing of various hazardous and nonhazardous wastes. These EPA established requirements are generally referred to as the Underground Injection Control ("UIC") program. Since the inception of the UIC program, wells classified for injection of oilfield waste liquids have been used to inject over 30 trillion gallons of oilfield salt water without endangering USDWs.Regulation of salt water disposal facilities is significant and thoroughThe UIC program established the necessary requirements for a state to enforce the program within their jurisdiction. In order to assume primacy, the states must demonstrate that their program for UIC enforcement meets the minimum requirements established by the UIC program. At the current time, 33 states and three U.S. territories have primacy for the UIC wells in their jurisdiction. Seven states share primacy with the EPA with the state typically handling one or more classifications of wells and the EPA overseeing the remaining classifications. The EPA maintains primary enforcement of the UIC programs in the remaining ten states and three U.S. Territories.EconomicsA commercial SWD well operator will typically charge between $0.50 and $2.50 per barrel of salt water. The wide range is a simple result of supply and demand. In areas where disposal demand is low, where SWD wells are abundant and have significant capacity availability, the per barrel rate trends towards the lower end of the range. That contrasted with areas where demand for salt water disposal is strong, but the disposal infrastructure, or capacity, is lacking, or the geology places limits on the injection of oilfield waste water, the commercial SWD operators are able to charge fees in the upper end of the range.A commercial salt water disposal well operator will typically charge between $0.50 and $2.50 per barrel of salt waterAnother consideration associated with disposal of oilfield waste water is the cost of transporting the salt water from the well site to the disposal site. Typically the transportation of waste liquids will cost the operator $1.00 per barrel per hour of transport time. In an area of SWD facility abundance, such as the Barnett shale, transport expense might only add $0.50 per barrel to salt water disposal expenses. However, in areas with few SWD facilities, such as some Pennsylvania locations, oilfield waste fluids have to be trucked to disposal facilities in Ohio or West Virginia, with the cost adding $4.00 to $6.00 per barrel.ConclusionWatch this space for future blog posts addressing the valuation issues faced by companies operating in this space.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry. Because drilling economics vary by region, as touched on above, it is imperative that your valuation specialist understand the local economics impacting your company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas related valuations have been used to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Sourceshttp://www.oilandgas360.com/water-handling-in-oilfield-operationshttp://www.tech-flo.net/salt-water-disposal.htmlhttp://www.producedwatersociety.com/produced-water-101http://aqwatec.mines.edu/produced_water/intro/pw/http://www.epa.gov/sites/production/files/documents/21_McCurdy_-_UIC_Disposal_508.pdf
Kress v. U.S. Denies S Corporation Premium and Accepts Tax-Affecting
The issue of a premium for an S corporation at the enterprise level has been tried in a tax case, and the conclusion is none.In Kress v. United States (James F. Kress and Julie Ann Kress v. U.S., Case No. 16-C-795, U.S. District Court, E.D. Wisconsin, March 25, 2019), the Kresses filed suit in Federal District Court (Eastern District of Wisconsin) for a refund after paying taxes on gifts of minority positions in a family-owned company. The original appraiser tax-affected the earnings of the S corporation in appraisals filed as of December 31, 2006, 2007, and 2008. The court concluded that fair market value was as filed with the exception of a very modest decrease in the original appraiser’s discounts for lack of marketability (DLOMs).Background on GBPThe company was GBP (Green Bay Packaging Inc.), a family-owned S corporation with headquarters in Green Bay, Wisconsin. The company experienced substantial growth after its founding in 1933 by George Kress. A current description of the company, consistent with information in the Kress decision, follows.Green Bay Packaging Inc. is a privately owned, diversified paper and packaging manufacturer. Founded in 1933, this Green Bay WI based company has over 3,400 employees and 32 manufacturing locations, operating in 15 states that serve the corrugated container, folding carton, and coated label markets.Little actual financial data is provided in the decision, but GBP is a large, family-owned business. Facts provided include:Although GBP has the size to be a public company, it has remained a family-owned business as envisioned by its founder.About 90% of the shares are held by members of the Kress family (a Kress descendant is the current CEO), with the remaining 10% owned by employees and directors.The company paid annual dividends (distributions) ranging from $15.6 million to $74.5 million per year between 1990 and 2009. While historical profitability information is not available, the distribution history suggests that the company has been profitable.Net sales increased during the period 2002 to 2008.Hoovers provides the following (current) information, along with a sales estimate of $1.3 billion:Green Bay Packaging is the other Green Bay packers’ enterprise. The diversified yet integrated paperboard packaging manufacturer operates through 30 locations. In addition to corrugated containers, the company makes pressure-sensitive label stock, folding cartons, recycled container board, white and kraft linerboards, and lumber products. Its Fiber Resources division in Arkansas manages more than 210,000 acres of company-owned timberland and produces lumber, woodchips, recycled paper, and wood fuel. Green Bay Packaging also offers fiber procurement, wastepaper brokerage, and paper-slitting services. (emphasis added)The court’s decision states that the company’s balance sheet is strong. The company apparently owns some 210 thousand acres of timberland, which would be a substantial asset. GBP also has certain considerable non-operating assets including:Hanging Valley Investments (assets ranging from $65 – $77 million in the 2006 to 2008 time frame)Group life insurance policies with cash surrender values ranging from $142 million to $158 million during this relevant period and $86 million to $111 million net of corresponding liabilitiesTwo private aircraft, which on average, were used about 50% for Kress family use and about 50% for business travel
GBP was a substantial company at the time of the gifts in 2006, 2007, and 2008. We have no information regarding what portion of the company the gifts represented, or how many shares were outstanding, so we cannot extrapolate from the minority values to an implied equity value.The Gifts and the IRS ResponsePlaintiffs James F. Kress and Julie Ann Kress gifted minority shares of GBP to their children and grandchildren at year-end 2006, 2007, and 2008. They each filed gift tax returns for tax years 2007, 2008 and 2009 basing the fair market value of the gifted shares on appraisals prepared in the ordinary course of business for the company and its shareholders. Based on these appraisals, plaintiffs each paid $1.2 million in taxes on the gifted shares, for a combined total tax of $2.4 million. We will examine the appraised values below.The IRS challenged the gifting valuations in late 2010. Nearly four years later, in August 2014, the IRS sent Statutory Notices of Deficiency to the plaintiffs based on per share values about double those of the original appraisals (see below). Plaintiffs paid (in addition to taxes already paid) a total of $2.2 million in gift tax deficiencies and accrued interest in December 2014. It is nice to have liquidity.Plaintiffs then filed amended gift tax returns for the relevant years seeking a refund for the additional taxes and interest. With no response from the IRS, Plaintiffs initiated the lawsuit in Federal District Court to recover the gift tax and interest they were assessed. A trial on the matter was held on August 3-4, 2017.The AppraisersThe first appraiser was John Emory of Emory & Co. LLC (since 1999) and formerly of Robert W. Baird & Co. I first met John in 1987 at an American Society of Appraisers conference in St. Thomas. He is a very experienced appraiser, and was the originator of the first pre-IPO studies. Emory had prepared annual valuation reports for GBP since 1999, and his appraisals were used by the plaintiffs for their gifts in 2006, 2007, and 2008.The Emory appraisals had been prepared in the ordinary course of business for many years. They were relied upon both by shareholders like the plaintiffs as well as the company itself.The next “appraiser” was the Internal Revenue Service, where someone apparently provided the numbers that were used in establishing the statutory deficiency amounts. The court’s decision provides no name.The third appraiser was Francis X. Burns of Global Economics Group. He was retained by the IRS to provide its independent appraisal at trial. As will be seen, while his conclusions were a good deal higher than those of Emory (and Czaplinski below), they were substantially lower than the conclusions of the unknown IRS appraiser. The IRS went into court already giving up a substantial portion of their collected gift taxes and interest.The fourth appraiser was hired by the plaintiffs, apparently to shore up an IRS criticism of the Emory appraisals. Nancy Czaplinski from Duff & Phelps also provided an expert report and testimony at trial. Emory’s report had been criticized because he employed only the market approach and did not use an income approach method directly. Czaplinski used both methods. It is not clear from the decision, but it is likely that Czaplinski was not informed regarding the conclusions in the Emory reports prior to her providing her conclusions to counsel for plaintiffs.While the court did not agree with all aspects of the work of any of the appraisers, the appraisers were treated with respect in the opinion based on my review. That was refreshing.The Court’s ApproachThe court named all the appraisers, and began with an analysis of the Burns appraisals (for the IRS). In the end, after a thoughtful review, the court did not rely on the Burns appraisals in reaching its conclusion.After reviewing the essential elements of the Burns appraisals, the court provided a similar analysis of the Emory appraisals. The court was impressed with Emory’s appraisals, and appeared to be influenced by the fact that the appraisals were done in the ordinary course of business for GBP and its shareholders. The court surely noticed that the IRS must have accepted the appraisals in the past since Emory had been providing these appraisals for many years. Other Kress family members had undoubtedly engaged in gifting transactions in prior years.The court then reviewed the Czaplinski appraisal. While the court was light on criticisms of the Czaplinski appraisals, it preferred the methodologies and approaches in the Emory appraisals.Interestingly, the entire analysis in the decision was conducted on a per share basis, so there was virtually no information about the actual size or performance or market capitalization of GBP in the opinion. We deal with the cards that are dealt.Summary of the Court’s DiscussionAs I read the court’s decision, there were ten items that were important in all three appraisals, and an additional item that was important in the December 31, 2008 appraisal. Readers will remember the Great Recession of 2008. It was important to the court that the appraisers consider the impact of the recession on the outlook for 2009 and beyond in their appraisals for the December 31, 2008 date.In the interest of time and space, we will focus on the appraisals as of December 31, 2008 in the following discussion. The summaries of the other appraisals are provided without comment at the end of this article. The December 31, 2008 summary follows. We deal with the eleven items that were discussed or implied in the subsections below.There are six columns above. The first provides the issue summary statements. The next four columns show the court’s reporting regarding the eleven items found in the 2008 appraisal based on its review of the reports of the appraisers. Note that there is no detail whatsoever for the rationale underlying the IRS conclusion for the Statements of Deficiency. The final column provides the court’s conclusion. To the extent that items need to be discussed together, we will do so.Items 1 and 2: The Market Approach and the Income ApproachAll the appraisers employed the market approach in the appraisals as of December 31, 2008 (and at the other dates). They looked at the same basic pool of potential guideline companies but used different companies and a different number of companies in their respective appraisals.The court was concerned that the use of only two comparable companies in the Burns report was inadequate to capture the dynamics of valuation. In fact, Burns used the same two guideline companies for all three appraisals, and the court felt that this selective use did not capture the impact of the 2008 recession on valuation (Item 7). He weighed the market approach at 60% and the income approach at 40% in all three appraisals.Czaplinski used four comparable companies in her 2008 appraisal and weighted the market approach 14% (same in her other appraisals). Her income approach was weighted at 86%.Emory used six guideline companies in the 2008 appraisal. While he used the market approach only, the court was impressed that “he incorporated concepts of the income approach into his overall analysis.” This comment was apparently addressing the IRS criticism that the Emory appraisals did not employ the income approach.Items 3 and 4: The S-Corp Premium/TreatmentThe case gets interesting at this point, and many readers and commentators will talk about its implications.At the enterprise level, both Burns and Emory tax-affected GBP’s S corporation earnings as if it were a C corporation. This is notable for at least two reasons:Emory’s appraisals were prepared a decade or so ago. That was the treatment advocated by many appraisers at the time (and still), including me. See Chapter 10 in Business Valuation: An Integrated Theory, Second Edition, (Peabody Publishing, 2007) and the first edition published in 2004. The economic effect of treatment in the Emory appraisals was that there was no differential in value for GBP because of its S corporation status.The Burns appraisals also tax-affected GBP’s earnings as if it were a C corporation. This is significant because the IRS’ position in recent years has been that pass-through entity earnings (like S corporations) should not be tax-affected because they do not pay corporate level of taxes. Never mind that they do distribute sufficient earnings to their holders so they can pay their pass-through taxes. There was, therefore, no differential in GBP’s value because of tax-affecting.
The Czaplinski report avoided the S corp valuation differential issue by using pre-tax multiples (without tax-affecting, of course). Since the Czaplinski report used pre-tax multiples, there was no differential in value because of the company’s S corporation status.
The Burns report, however, did apply an S corporation premium to its capitalized earnings value of GBP. The decision reports neither the model used in the Burns report nor the amount of the premium. Let me speculate. The premium was likely based on the SEAM Model (see page 35 of linked material), published by Dan Van Vleet, who was also at Duff & Phelps at the time (like Czaplinski). I speculate this because it is the best known model of its kind.
If my speculation is correct, based on tax rates at the time and my understanding of the SEAM Model, it was likely in the range of 15% – 18% of equity value (100%), or a pretty hefty premium in the valuation. Nevertheless, Burns testified to the use of a specific S corporation premium at trial.
Again, if my speculation is correct, the facts that Czaplinski and Van Vleet were both from Duff & Phelps and that Czaplinki did not employ the SEAM Model likely provided for some colorful cross-examination for Czaplinki. If so, she seems to have survived well based on the court’s review.
The court accepted the tax-affected treatment of earnings of both Burns and Emory, and noted that Czaplinski’s treatment had dealt with the issue satisfactorily. The court did not accept the S corporation premium in the Burns report.
What do these conclusions regarding tax-affecting and no S corporation premium mean to appraisers and taxpayers?The court accepted tax-affecting of S corporation income on an as-if C corporation basis in appraising 100% of the equity of an S corporation. This is good news for those who have long believed that an S corporation, at the level of the enterprise, is worth no more than an otherwise identical C corporation. It should pour water on the IRS flame of arguing that there should be no tax-affecting “because pass-through entities do not pay corporate level taxes.”The court did not accept the specific S corporation premium advanced by Burns. This is a second recognition that there is no value differential between S and C corporations that are otherwise identical. After all, the election of S corporation status is a virtually costless event. The fact that the court considered testimony regarding an S corporation premium model and did not agree with its use is a very significant aspect of this case.Kressv. U.S. will be quoted by many attorneys and appraisers as standing for the appropriateness of tax-affecting of pass-through entities and for the elimination of a specific premium in value for S corporation status.Item 5: Non-Operating AssetsThe treatment of non-operating assets by the appraisers is less than clear from the decision. What we know is the following regarding the substantial non-operating assets in the appraisals:The Burns report treated the non-operating assets at “almost full value.” This treatment was disregarded by the court.The Emory report did not provide for separate treatment of non-operating assets, noting that it considered them in the book value of the business. Since book value was not provided or weighted in the Emory report (or any of the others), it would appear that the court was satisfied that the non-operating assets had little value, since minority shareholders could not gain access to their value until the company was sold. That could be a long time given the desire of the Kress family to maintain family control over the company.The Czaplinski report provided for some discounting of the non-operating assets in the marketable minority valuation, and then allowed for further discounting through the marketability discount. Details of her treatment were not provided in the opinion.
Since the court sided primarily with the overall thrust of the Emory report, we see little guidance for future appraisals in the treatment of non-operating assets in this decision.Item 6: Management InterviewsThe court noted that Burns had not visited with management, but had attended a deposition of GBP’s CFO. The court was impressed that Emory had interviewed management in the course of developing his appraisals, and had done so at the time, asking them about the outlook for the future each year. It is not clear from the decision whether Czaplinski interviewed management.Item 7: Consideration of the 2008 Recession (in the December 31, 2008 Appraisal)The Burns report was criticized for employing a mechanical methodology that, over the three years in question, did not account for changes in the markets (and values) brought about by the Great Recession of 2008. Specifically, it did not consider the future impact in the year-end 2008 appraisal of the recession’s impact on expectations and value at that date.Both the Emory and Czaplinski reports were noted as having employed methods that considered this landmark event and its potential impact on GBP’s value.Item 8: Impact of Family Transfer Restrictions on ValueThe court’s opinion in Kress provided more than four pages of discussion on the question of whether the Family Transfer Restriction in GBP’s Bylaws should have been considered in the determination of the discount for lack of marketability. This is a Section 2703(a) issue. Ultimately, the court found that the plaintiffs had not met their burden of proof to show that the restrictions were not a device to diminish the value of transferred assets, failing to pass one of the three prongs of the established test on this issue.Neither the Burns report nor the Czaplinski report considered family restrictions in their determinations of marketability discounts. The Emory report considered family restrictions in a “small amount” in its overall marketability discount determination.In spite of the lengthy treatment, the court found that the issue was not a big one. In the final analysis, the court deducted three percentage points from the marketability discounts in the Emory reports as its conclusions for these discounts.Item 9: Marketable Minority Value per ShareWith this background, we can look at the various value indications before and after marketability discounts. First, we look at the actual or implied marketable minority values of the appraisers. For the December 31, 2008 appraisals, the Emory report concluded a marketable minority value of $30.00 per share. Czaplinski concluded that the marketable minority value was similar, at $31.33 per share. The Burns report’s marketable minority value was 50% higher than Emory’s conclusion, at $45.10 per share.The Court concluded that marketable minority value was $30.00 per share, as found in the Emory Report. That was an affirmation of the work done by John Emory more than a decade ago at the time the gifts were made.Item 10: Marketability DiscountsThe Emory report concluded that the marketability discount should be 28% for the December 31, 2008 appraisal (where previously, it had been 30%). The discount in the Czaplinski report was 20%. The marketability discount in the Burns report (for the IRS) was 11.2%.There were general comments regarding the type of evidence that was relied upon by the appraisers (restricted stock studies and pre-IPO studies that were not named, consideration of the costs of an initial public offering, etc.). Apparently, none of the appraisers used quantitative methods in developing their marketability discounts. The court criticized the cost of going public analysis in the Burns report because of the low likelihood of GBP going public.Based on the issue regarding family transfer restrictions, the court adjusted the marketability discounts in each of Emory’s three appraisals by 3% – a small amount. Emory concluded a 28% marketability discount for 2008. The court’s conclusion was 25%.Item 11: Conclusions of Fair Market Value per ShareAt this point, we can look at the entire picture from the figure above. We replicate a part of the chart to make observation a bit easier.
It is now possible to see the range of values in Kress. The plaintiffs filed their original gift tax returns based on a fair market value of $21.60 per share for the appraisal rendered December 31, 2008 (Emory). The IRS argued, years later (2014), for a value of $50.85 per share – a huge differential. The plaintiffs paid the implied extra taxes and interest and filed in Federal District Court for a refund.
The expert retained by the IRS, Francis Burns, was apparently not comfortable with the original figure advanced by the IRS of $50.85 per share. The Burns report concluded that the 2008 valuation should be $40.05 per share, or more than 21% lower. Plaintiffs went into court knowing that they would receive a substantial refund based on that difference.
Plaintiffs retained Nancy Czaplinski of Duff & Phelps to provide a second opinion in support of the opinions of Emory. Her year-end 2008 conclusion of $25.06 per share, although higher than the Emory conclusion of $21.60 per share, was substantially lower than the Burns conclusion of $40.05 per share.
The court went through the analysis as outlined, noting the treatment of the experts on the items above. In the final analysis, the court adopted the conclusions of John Emory with the sole exception that it lowered the marketability discount from 28% to 25% (and a corresponding 3% in the prior two appraisals).
The court’s concluded fair market value was $22.50 per share, only 4.2% higher than Emory’s conclusion of $21.60 per share.
Based on this review of Kress, it is clear that Emory's appraisals were considered as credible and timely rendered. Kress marks a virtually complete valuation victory for the taxpayer. It also marks a threshold in the exhausting controversy over tax-affecting tax pass-through entities and applying artificial S corporation premiums when appraising S corporations (or other pass-through entities).
Kress will be an important reference for all gift and estate tax appraisals that are in the current pipeline where the IRS is arguing for no tax affecting of S corporation earnings and for a premium in the valuation of S corporations relative to otherwise identical C corporations.
When all is said and done, a great deal more will be written about Kress than we have shared here, and it will be discussed at conferences of attorneys, accountants and business appraisers. Some will want to focus on the family attribution aspect of the case, but, as the court made clear, this is a small issue in the broad scheme of things.
Summary of Other Appraisal DatesFor information, below is a summary of the appraisals as of December 31, 2006 and December 31, 2007.
Family Business Industry Spotlight: Beverage Wholesalers
This week’s post is the first in a periodic series of “Family Business Industry Spotlights.” In these posts, we will share conversations with our family business advisory professionals who have deep experience working with family businesses in a particular industry. We think the conversations promise to be of interest to family business directors regardless of their industry. This week, we talk with Tim Lee about the challenges and industry trends facing families in the beverage wholesaling industry.1. How have beverage wholesalers performed over the past decade?This is a good-news-bad-news answer. For context, we need to describe the structure of the industry. Beverage wholesalers occupy the middle tier of a three-tier regulatory system in the alcoholic beverage industry. With very few exceptions, virtually all alcoholic beverages must be delivered through the wholesaler channel which connects beverage producers and suppliers with the various retail licensees that sell goods to consumers.Let’s tackle the bad news for malt beverage wholesalers – the major domestic brands, while still commanding considerable market share, are experiencing decreasing volume as consumers clamor for new choices. Ironically, despite the ongoing search for something new, prime consumer demographics have become saturated with an overabundance of beverage categories and choice, as attested by the peaking or shrinking volumes of some well-known craft brewers. Boomer consumption patterns, particularly in high-density markets, no longer provide a safe haven for the major domestic brands. Low-density markets still survive on the fading market share glory of legacy brands, but small territories with costly windshield times are exhibiting declining volumes due to an aging consumer base lacking/lagging in new product adoption. Additionally, in gentrified high-density markets, wine & spirits and alternative choices abound, eroding brewers’ share of mouth.The short answer is – many wholesalers are doing fine, some better than ever.Despite the challenges on the malt side of the beverage world, innovation in craft, imports, and new categories, coupled with premium pricing across the spectrum have generally kept malt wholesalers cash flowing and profitable, albeit middle-tier consolidation has left fewer family wholesalers banking the dividends. Wine & spirit wholesalers are doing quite well as many states liberalize previously restrictive retail licensing laws and an aging demographic pushes consumption patterns toward presumably less filling, higher alcohol-content beverage choices. As with the malt side of the industry, the increasing dominance of large wine & spirit wholesalers has thinned the ranks of independent operators.So, the short answer is – many wholesalers are doing fine, some better than ever. Others are facing certain absorption as the middle tier of the industry consolidates and hybridizes with other beverage categories.2. In your experience, how do families in the beverage wholesaling industry deal with ownership and management transition?Suppliers in the alcoholic beverage industry generally require their wholesalers to demonstrate ownership stability and commitment through direct business involvement. In general, owners are required to be active participants in their businesses and to have approved succession and contingency plans. As with other closely held businesses, familial continuity plans often evolve, promoting or mandating mergers or outright sales in order to facilitate the liquidity needs of departing owners whose wealth is often concentrated in their family businesses. In cases where continuing family ownership is desired and feasible, we see varying approaches for transitioning ownership that range from conventional trust and estate strategies to thoughtfully designed and funded buy-sell agreements. Regardless of the strategy employed, an acute understanding of how “fair market value” reconciles to strategic market value is vital to buyers and sellers in the transaction process.3. What are the biggest risks facing families in the beverage wholesaling industry today?The elephant in the room for family transition planning is consolidation and the ever-encroaching specter of professionalized capital upon the industry. Families with the talent, capital, and risk tolerance to mimic the deep-pocketed players in the industry should fare well. Those without the resources may be forced to bid farewell sooner than later.The elephant in the room for family transition planning is consolidation and the ever-encroaching specter of professionalized capital upon the industry.Risk for families in this industry is a very situational and subject to personal perspective. The industry is, in my view, relatively low in execution risk under the prevailing regulatory platform. It seems a virtual certainty that consumers will consume a certain amount of alcohol in one variety or another for the foreseeable future just as they have over the course of human history. However, middle-tier operators are getting squeezed from both sides of their industry. Disruption by way of regulatory change and the commercial interests that compel such changes seem a risk to the wholesaler industry as a whole. In the interim, the risk is that smaller wholesalers will continue to get pushed out.On the bright side, unlike virtually all other industries where going out of business is economically punitive, laws in most states oblige suppliers and consolidators to compensate exiting wholesalers for the value of their brand rights. Wholesalers who lack a fundamental understanding of transaction finance and brand rights valuation run the risk of leaving money on the table in those transactions. Likewise, families electing to prune their shareholder base need a proper understanding of the options and challenges that accompany inter-family transactions.4. What is the most important industry trend that will affect families in the coming decade?At the risk of oversimplifying: consolidation, consolidation, consolidation. Apologies – that was three most important trends. The trends that affect consolidation are varied and complex, and the characteristics of transaction participants can have a direct bearing on deal values. Families must get informed or risk being on the wrong side of a zero-sum equation.If your distributorship is healthy but stagnant, the industry is serving notice to either grow or exit. Simply put, growth means deploying capital and/or deferring liquidity in an evolving market with emerging risks - selling out means harvesting business value and reallocating family wealth to other assets. Big consolidators appear convinced that the legacy system will eventually experience a meaningful shake-up. Mergers among global producers and the downstream consolidation of wholesalers suggest that, with the stroke of a regulatory pen, the historically distinct tiers of the U.S. alcoholic beverage system could be dramatically re-ordered.5. If you could add one agenda item to a beverage wholesaler’s next board meeting, what would it be?As a valuation and litigation practitioner and a transaction intermediary, I’d be remiss if I didn’t advise directors and major shareholders to get familiar with the myriad of value drivers in the industry. There’s only one way to do that, which involves retaining an expert. Also lacking for many wholesalers is a proper understanding of how tax reform has altered longstanding rules of thumb that many use to gauge their brand and distributorship valuations. Get informed or risk getting out maneuvered by the deeper pocketed and growing oligarchy of beverage operators.
Valuations of Asset Managers Are Slow to Recover
Is the Decline in Active Management a Result of Increased Competition or Mediocre Performance?
Over the last year, the stock price declines of publicly traded asset managers were generally more significant than other investment managers and the broader stock market.As mentioned in our latest whitepaper, How to Value a Wealth Management Firm, wealth managers are more resistant to market volatility as shown by their superior performance to asset managers over the last year. Their resilience stems from the fact that client assets are correlated with the market, but client relationships are not.Asset management firms are more susceptible to market volatility, however, because during periods of volatility or market declines, asset management firms risk losing assets from both downward market movements and client outflows. Downward market movement clearly has a direct negative impact on AUM, but it can also lead to outflows and lower revenue as clients de-risk or reallocate to lower fee fixed income products.While market declines are a threat to the profitability and valuations of any asset management firm, active managers face the additional threat of relative underperformance driving outflows, even in periods of rising markets. Low fee passive strategies have become increasingly popular due in part to both the perceived underperformance of active managers and an increasing focus on fees. But to what extent have active fund outflows been driven by mediocre performance versus competition from passive strategies, and what is the impact on asset management firm valuations?Fund OutflowsIn general, asset managers are experiencing an industry-wide shift away from actively managed investment products. Over the last 15 years, more than half of all U.S. equity funds have merged or liquidated. According to MorningStar, 2018 was the “worst year for long-term fund flows since 2008.” Inflows were less than half the $350 billion average for the prior year, and outflows approximated 4% of beginning assets.At year-end, Morningstar predicted that if current trends in asset flows continued, passive U.S. equity funds would likely catch up with active funds’ market share in the next few months of 2019. Most of our clients expect this trend will continue for a few more years before stabilizing and ultimately reversing. January 2019 brought a more positive outlook for actively managed funds which “for the first time in five years outshone their passive counterparts.”Mediocre PerformanceHeadlines have recently brought attention to the mediocre performance of many active managers (“Active fund managers trail the S&P 500 for the ninth year in a row”). One of the primary reasons for active funds’ lackluster performance is the number of active funds who participate in closet indexing. Closet indexers claim to manage a unique portfolio designed to generate active returns while their active share (percentage of holdings that differ from the benchmark) is actually quite low. Last year, thirteen active fund managers agreed to voluntarily disclose their active share in order to increase transparency. Actively managed funds charge higher fees in exchange for the promise of excess return. Closet indexers typically generate returns in line with the benchmark but at a higher cost than a passive investment in the underlying benchmark.Competition from Passive AlternativesAccording to Morningstar’s semiannual Active/Passive Barometer (published in February), “just 38% of active U.S. stock funds survived and outperformed their average passive peer in 2018, down from 46% in 2017.” For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year, while the average equity fund investor earned a return of only 5.19%. There has been much written about the shift from active to passive investing, and high costs and active manager underperformance are largely to blame.ValuationsOn average the stock prices of asset managers fell 17% year-over-year. Trailing valuations fell by over 30% from a median of 15.8x trailing earnings in March 2018 to 10.5x trailing earnings in March 2019. The broader stock market has recovered somewhat from the pullback observed at year end, but asset manager valuations have improved more modestly. Forward multiples, however, are more in line with historical norms.Is the decline in active management a result of increased competition or mediocre performance? We think it’s both. In general, clients (especially institutional investors and high net worth individuals) are still willing to pay for superior performance. We think best-in-class asset managers could come out ahead of their passive counterparts in the long run, but the problem is that best-in-class asset managers are, by definition, few and far between.
Considerations for Endowments Divesting Fossil Fuels
Due to the historical popularity of this post, we revisit it this week. Originally published in 2018, the purpose of this post is to educate and advise those who have decided to divest their fossil fuel assets and are unsure of how to proceed.The American Council on Education reported in 2014 that college and university endowments are heavily invested in commodities, natural resources, private equity, and other illiquid assets. In the 1990s, endowments invested over 95% of their assets in traditional stocks and bonds. By 2013, less than 50% of endowment assets were invested in traditional equities. Currently, endowments have approximately 5% of their assets, $22 billion, invested in energy and natural resources.
Over the last few years, many university students and church congregations have urged their trustees to consider divesting their endowments from fossil fuels. The Guardian in January 2018 explained “The divestment movement, primarily consisting of climate activists, is urging private and public institutions to rid their portfolios of all oil, gas, and coal stocks to send a financial and ethical message that fossil fuels are harmful and shouldn't be tolerated. So far, it's estimated that funds totaling $6 trillion have committed to divesting from fossil fuels.”
Due to the favorable tax benefits of gifting assets to endowments upon death, your endowment may hold illiquid fossil fuel assets, such as mineral and royalty rights. You have received an annuity-like stream of payments every month but are now considering divesting. However, the shortage of a well-organized market for illiquid fossil fuel assets can cause a dilemma for trustees of endowments. How do you sell your royalty and mineral rights and what are they worth?
The purpose of an endowment is to provide a permanent source of funding that maintains the operations of colleges, universities, churches, etc. To best serve its fiduciaries, an endowment should achieve the highest return possible. Congruently, when divesting, the endowment must ensure it achieved a fair price for its investments. This post does not weigh in on the discussion of whether endowments should or should not liquidate fossil fuels. Rather, we hope to educate and advise those who have decided to divest their fossil fuel assets and are unsure of how to proceed.The Growth of Illiquid AssetsThe growth of illiquid assets in endowments investment portfolios is not a surprising trend. While illiquid assets garner more downside risk, they also offer the potential for higher returns than those realized in the traditional equity marketplace. A proper fiduciary who weighs the risks and reward of illiquid assets over time will likely like include these assets in their portfolios. However, when it comes time to liquidate these assets, a trustee must act carefully. Selling illiquid assets requires a thorough understanding, and as trustee, it is your fiduciary duty to understand these transactions or seek the advice of someone who does.Divesting publicly traded fossil fuel stocks and bonds is relatively simple. While it can be beneficial to consider the timing of your sale with movements in the market, generally you can contact your portfolio manager or log onto your trading account directly and liquidate these stocks or ETFs within minutes.Unlike public equity investments, mineral interests and royalty rights investments cannot be liquidated at known market prices instantaneously. Rather, the price and the terms of the deal must be agreed to by both the buyer and the seller.What Are Your Mineral and Royalty Rights Worth?One of the most common methods used to value mineral and royalty rights is a discounted cash flow analysis. The holders of royalty rights receive a monthly payment similar to that of a bond holder or commercial real estate lessor. Thus, future payments can be predicted and then discounted back to the present. However, the payments to a royalty holder can drastically increase or cease entirely without the say of the royalty holder. This makes the prediction of future cash flows used to value the asset much more difficult. Future cash flows must consider the current and future oil price environment, future levels of production, decline curves, the financial strength of current operators, and many other factors. As we explain in our whitepaper, How to Value an Oil and Gas Royalty Interest, “To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price. The stream of income (revenue less taxes and deductions) is then discounted back to present value using a discount rate that accounts for risk in the industry.”The guideline transaction approach can also provide a helpful indication of value. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. Acquisition data can be utilized to calculate valuation multiples that take into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. In many ways, this approach goes straight to the heart of value: mineral interests and royalty rights are worth what someone is willing to pay for them.Offer LettersAdding to the uncertainty surrounding the value of royalty rights, the majority of mineral interest and royalty right owners with whom we work receive a couple, if not dozens, of offer letters every year. While offer letters, like transactions, do provide an indication of what someone is willing to pay for the asset, the definition of fair market value includes both a willing buyer and a willing seller. Since these offers are only half of the equation, they should not be used in isolation as an indication of value. As shown in the excerpt from the offer letter below, the distinction between fair market value and offer prices is critical in order to protect yourself from brokers attempting to profit at your expense.Offer letters generally offer a multiple of average monthly cash flow on your revenue checks. These multiples can range widely, often from less than 60x to more than 200x monthly cash flow. Unfortunately, there is not one benchmark that can be applied to monthly cash flows across the nation, or even within one basin, so there is not an easy way to determine if you are receiving a fair price.Especially after the fall in oil prices in mid-2014, we saw many offers that used scare tactics to try to persuade royalty owners to sell their interests at absurdly low prices. Since the crash in oil prices, many royalty owners stopped receiving royalty checks; however, this does not mean their royalty interests are worthless. Even now that oil prices have recovered and production is at an all-time high, some offer letters seek to take advantage of inexperienced royalty owners by suggesting that recent acquisitions, drilling activity, or changes in production have increased the risk, and therefore, decreased the value of their investment. An understanding of royalty and mineral prices is not common to the average and even advanced investor and information about royalty and mineral rights is scare and difficult to find. This, unfortunately, means that these scare tactics often work.A recent offer letter to one of our clients read,“As you may know, Hess Corporation has sold their interest in this unit. But there is another risk factor, as well. While it's hard to see on your revenue checks, from 2015 to 2016 the production declined by 10.1%. The decline over the past 30 years has been 1.7%. While the decline has improved this year, it makes one wonder what the decline will be in the future. As a mineral owner in this unit, it certainly has my attention. I'm making this aggressive offer in the belief it will go back to historical declines.”This offer of 90x monthly cash flow was received in August, following the announcement of the acquisition. By October when the details of the acquisition had been further explained to the investor community, our client had received another offer for approximately 140x monthly cash flow.While there are legitimate online brokers who will buy your royalty interest for a fair price, the best solution is to know and understand the value of your asset before you start searching for a credible buyer.The Value of Mineral Interests and Royalty RightsAs explained in our post "Before Selling Your Oil and Gas Royalty Interest Read This," we believe there are three points you need to understand before selling your mineral interest and royalty rights.Understand what you are sellingRecognize production and price as value driversUnderstand the location’s impact
The responsibility of divesting fossil fuels assets, especially for churches, often falls to a volunteer board that is tasked with much more than overseeing the divestiture of their fossil fuel portfolio. It is the board’s fiduciary duty to ensure that the endowment is operating in the best interest of its beneficiaries which means, they need to ensure they receive a fair price for their assets.
At Mercer Capital we have valued mineral and royalty rights in located across the country. We understand how the location of your assets affects value and work to monitor transactions in each region to understand the state of the current market. Contact a Mercer Capital professional today to discuss your valuation and transaction advisory needs in confidence.
2019 CFA Institute Wealth Management Conference Recap
Last week, Matt Crow, Taryn Burgess, Zach Milam, and I attended the 2019 CFA Institute Wealth Management Conference in Fort Lauderdale. We didn’t get a total headcount, but attendance appeared to be up from last year’s event. There are probably a number of explanations for this, but perhaps the most plausible was the interest in this year’s focus on the psychological side of wealth management, which explored behavioral finance tendencies and how emotional decision-making can impact investment performance. For this post, we’ve elected to summarize some of these presentations and their implications for financial advisors.The Geometry of WealthBrian Portnoy, Head of Education at Magnetar CapitalIn The Geometry of Wealth, behavioral finance expert Brian Portnoy, Ph.D., CFA defines true wealth as “the ability to underwrite a meaningful life” or “funded contentment.” Dr. Portnoy distinguishes this concept from the blind accumulation of assets, which he likens to a continuous (and often unsatisfying) treadmill experience. He contends that living a meaningful life and tending to financial decisions should be complementary, not separate, pursuits and uses three basic shapes to help readers visualize how to adapt to evolving circumstances (circle), set clear priorities (triangle), and find empowerment in simplicity (square). Through this process, Dr. Portnoy maintains that true wealth is achievable for most people but only in the context of a life in which purpose and practice are thoughtfully calibrated. He addresses the following questions to accomplish this goal:How is the human brain wired for two distinct experiences of happiness and why can money ‘buy’ one but not the other?Are the touchstones of a meaningful life affordable?Why is market savvy among the least important sources of wealth but self-awareness is among the most?Can we strike a balance between pushing for more and being content with enough?
Dr. Portnoy advises managers to help clients spend wisely (on experiences, others, and time savers) and hedge sadness as most investors are loss averse.How Client Engagement is Being DisruptedJulie Littlechild, Founder of Absolute EngagementJulie Littlechild’s book, The Pursuit of Absolute Engagement, discusses the trends that are disrupting client engagement and why many advisors aren’t keeping pace with client demands. She recommends that advisors answer these four questions to effectively respond to a client disruption (or at least stay one step ahead):Who are you designing the client experience to support? (Hint: Define an authentic niche, because you can’t design a compelling client experience around the needs of everyone)What does "extraordinary" look like through their eyes? (Hint: Actively involve clients in defining what extraordinary looks like, because you can’t base this on assumption)What is the client’s journey? (Hint: Understand the steps that clients go through and what they think, feel, and do at each stage because that will uncover their real needs)How will you support clients in their journey? (Hint: Define a communications plan that actively reflects the client journey and supports them along the way because that’s where innovation happens)
By answering these questions and anticipating clients’ needs, advisors are able to support their clients on a deeper level by shifting their focus from "good service" to a "meaningful experience."The Behavioral InvestorDaniel Crosby, Chief Behavioral Officer of Brinker CapitalPsychologist and behavioral finance expert Dr. Daniel Crosby emphasizes the importance of understanding human nature and investor psychology in the portfolio construction process. Dr. Crosby contends that only through developing a deep understanding of why humans make decisions can we really ascertain how we should invest. Specifically, he says individuals should avoid making investment decisions while in a H-A-L-T phase, that is Hungry, Angry, Lonely, or Tired. By understanding the context of our decisions and our own behavioral shortcomings, we can become better investors and advisors over time. Similar to Brian Portnoy, Dr. Crosby posits that true wealth encompasses psychological wellbeing not just asset accumulation.Perception is Reality: Defining Your Value Proposition in a Competitive MarketplaceNikolee Turner, Managing Director of Business Consulting at Charles SchwabThis presentation stresses the importance of branding and perception in developing relationships and a strong referral network from existing clients. Nikolee Turner discusses how advisors can fine tune their value proposition to compel action from prospective clients and win new business. One way to accomplish this feat is through the use of firm success stories and concrete examples of helping clients realize their financial objectives. Turner found that such communication is often lacking as her firm’s research indicates that many advisors can’t even articulate their firm’s value proposition to prospective clients. As the competition for client assets intensifies, the need for effective communication and a dedicated referral program has never been greater. Mastering both, Turner contends, is critical for achieving growth goals and gaining market share.All the sessions were well-received, and we’d certainly recommend these presentations and their author’s publications to anyone interested in this topic. We’re looking forward to next year’s event in Seattle and hope to see you there.
Investor Relations for Family Businesses
An Informed and Engaged Shareholder Base is a Strategic Advantage
Family Business Director was in sunny Tampa last week at the spring edition of the Transitions Conference produced by Family Business Magazine. It was a great event, with about 275 attendees representing nearly 100 enterprising families. The perspectives offered from the stage and through intensive workshops highlighted some of the most pressing concerns family business directors have to address, and informal conversations with participants over meals and during breaks confirmed the reality of these issues in day-to-day family and business life.For family shareholders who are not employed in the business, the family business can be a bit of a mystery.The sessions offered fresh insights on perennial challenges around succession planning, conflict management, and communication. But the recurring – if not underlying – theme that impressed us was the challenge of shareholder engagement. For family shareholders who are not employed in the business, the family business can be a bit of a mystery. Despite knowing that the family business is important to them economically, many “outside” shareholders are in the dark about how the company works and how the economic benefits of ownership accrue to them.The advantages of family-owned businesses are well-documented. But consider for a minute the perspective of a minority family shareholder that doesn’t work in the business relative to a minority shareholder in a public company.In view of these comparisons, is it any wonder that “outside” family shareholders are occasionally frustrated? Over time, lack of transparency triggers speculation on the part of shareholders as to what the “real story” must be.Public companies understand that well-informed shareholders contribute to a lower cost of capital. A company’s cost of capital is the economic hurdle rate for a company, or the minimum return needed to satisfy its lenders and shareholders. The cost of capital is a primary driver of business value and stock price. As a result, most public companies are rather obsessive about keeping shareholders informed about the company’s performance, management, and strategy. Yes, many of the disclosures are mandated by the Securities and Exchange Commission, but public companies often go beyond the bare minimum regulatory disclosures, believing that an informed and engaged shareholder base is a strategic advantage. Public companies refer to this management function as “investor relations.”We have long found it a bit ironic that many family businesses do not assign the same importance to investor relations that public companies do. After all, the leaders of family businesses are literally related to their shareholders. We suspect the reluctance of many family businesses to take investor relations seriously stems from some combination of three potential beliefs.First, the family members working in the business may feel that the “outside” family members should simply trust them to do what is best for the business and the family. From this viewpoint, working in the business grants the family managers a measure of “sweat equity” entitling them to a measure of respect and implicit trust from the rest of the family.Second, in contrast to public company shareholders that can take their capital elsewhere, family capital is “captive” capital that cannot easily be reallocated by owners. In other words, some family businesses ignore investor relations because of a perception that they don’t have to.Third, the family members working in the business may believe that the “outside” family members are not capable of understanding detailed financial information regarding the performance of the family business.Family shareholders are most likely to grow suspicious when they perceive that relevant information is being unreasonably withheld from them.In our view, each of these perspectives is short-sighted. The desire of family shareholders to be informed about their investment is not necessarily attributable to some unhealthy mistrust of the family members managing the business. Rather, family shareholders are most likely to grow suspicious when they perceive that relevant information is being unreasonably withheld from them (i.e., “they must be hiding something”). While family capital may indeed by “captive” to the family business, if the family relations become toxic enough, family shareholders may resort to litigation in an effort to liberate their capital. Defending such litigation is not a good use of management time or business resources. Finally, a robust shareholder education program, coupled with tailored disclosures carefully designed to communicate relevant information rather than merely overwhelm recipients with data can overcome nearly any communication barrier.In short, we came away from last week’s conference with a renewed appreciation for the value – and challenge – of investor relations for family businesses. We know that many family businesses are very intentional about maintaining positive shareholder engagement, but we also know that many others are mired in perpetual conflict with one or more disengaged shareholders. Forward-thinking family business directors will want to make investor relations a priority in 2019.
From Enduro to Permianville
A Closer Look at Permianville Royalty Trust
In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners. Many publicly traded trusts are restricted from acquiring other interests, so they have relatively fixed resources, and the value of these trusts comes from generally declining distributions. In many cases, the royalty comes from a related operator, though this is neither required nor characteristic of all trusts. There are also other MLPs such as Kimbell Royalty Partners, Viper Energy Partners, Dorchester Minerals, and Black Stone Minerals that are aggregators consistently gobbling up new acreage. In this post, we explore the subject characteristics of Permianville Royalty Trust, formerly known as Enduro Royalty Trust.Market ObservationsIt’s been a while since we’ve looked at this group, and Permianville Royalty Trust isn’t the only change. Hugoton Royalty Trust voluntarily delisted from the NYSE last August after not being able to sustain a sufficient stock price. Over the previous two years, the performance of the remaining 20 publicly traded royalty trusts and partnerships has varied widely. The table below shows the performance and other key metrics of the 20 main oil and gas-focused entities that are publicly traded, as of March 28, 2019.
[caption id="attachment_25737" align="alignnone" width="940"]Source: Capital IQ [/caption]
Returns are pretty evenly split, with 9 positive and 11 negative. With oil prices rising 23% in the past two years and natural gas declining 8%, it’s not too difficult to pick out which trusts receive royalties from which commodity, though other factors such as timing and operator certainly play a role.For comparison, the chart below shows the two-year returns from Permianville Royalty Trust (PVL), crude oil, natural gas, the O&G150 Index, and a publicly traded E&P ETF called “SPDR S&P Oil & Gas Explore & Prod. (XOP)”. Interestingly, PVL has had little correlation with either crude (+25.9%) or natural gas (-37.0%) prices over the past two years, likely due to its exposure to both commodities and other notable activity specific to the Trust as discussed later.[caption id="attachment_25764" align="alignnone" width="940"]Source: Capital IQ [/caption]
Permianville Royalty Trust Origination and SaleEnduro Royalty Trust was formed in May 2011 to acquire and hold a net profits interest (NPI) representing the right to receive 80% of the net proceeds from interests in certain oil and natural gas producing properties located in Texas, Louisiana, and New Mexico. These underlying properties were held by Enduro Resource Partners and are in both conventional and unconventional plays. The initial IPO occurred in November 2011 issuing 13.2 million units at $22. A second offering occurred in October 2013 issuing 11.2 million additional units at a reduced price of $13.85. No further offerings or redemptions have occurred, leaving the number of Trust Units outstanding at 33 million, including the 8.6 million units originally retained by Enduro.Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas to reflect its holdings in the Permian and Haynesville Shale.On May 15, 2018, Enduro Resource Partners buckled under its debt load and filed for Chapter 11 bankruptcy. This significantly impacted the royalty trust, similarly to how SandRidge’s issues have plagued its royalty trusts. Three days later, the Trust declared a dividend of $1.13 million, down 42.5% from the prior month, further exacerbating the decline. The Trust’s share price declined 12.8% from May 10th to May 17th and fell to almost $3 per share a month after the announcement when it was trading closer to $4. On August 31, Enduro finalized a sale of the underlying properties and its outstanding Trust Units to COERT Holdings 1 LLC. This helped stabilize the stock price of the royalty trust as it increased from $3.4 on August 30th to $3.7 by September 6th. According to footnotes of an SEC filing, COERT Holdings paid an aggregate gross consideration of $35.75 million for the 8.6 million Trust Units held by Enduro. This implies a unit price of about $4.16, significantly higher than the price seen around this time.In connection with the sale, COERT assumed all of Enduro’s obligations (became the “Sponsor” of the Trust) with minimal disruption to unitholders anticipated. Notably, the portfolio consisted primarily of non-operated interests, easing any transition concerns. Seeking to rebrand from its former operator, the Trust opted to capitalize on the hype on opposite ends of Texas, changing its name to Permianville Royalty Trust to reflect its holdings in the Permian and Haynesville Shale. It should be noted, however, that not all of its holdings in East Texas are in the Haynesville.Permian + Haynesville = PermianvilleUnderlying PropertiesThe Permian has dominated shale production in the U.S. over the past year, but Haynesville Shale has made a push of its own recently. It surpassed the Bakken with 58 rigs in the first week of March, which it has only done for a brief period at the beginning of 2018 and before then in 2011 when it also had more rigs than Appalachia and the Eagle Ford. According to the EIA March Drilling Productivity Report, Haynesville only trailed Appalachia in new-well gas production per rig while legacy gas production has declined slower than both Appalachia and the nearby Eagle Ford. Despite these gains, the Permian still dominates in terms of production and the majority of Permianville Royalty Trust’s acreage is in the Permian basin with 88% of net acreage and 92% of net wells.[caption id="attachment_25756" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption]
As seen in the chart below, the majority of the Trust’s proved reserves are developed, oil reserves at 59%. Natural gas makes up approximately 38% of reserves, split between producing and undeveloped. This makes sense as the Permian is the main focus of the Trust, with Haynesville adding a bit of upside in terms of reserves with potential that have yet to begin producing.
[caption id="attachment_25757" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K[/caption]
Operators and CustomersAs noted earlier, Permianville Royalty Trust is operated predominantly by operators other than COERT. Only 17 of 3,748 gross wells (0.5%) are operated by the Sponsor, and these wells are in the East Texas/North Louisiana region. Other operators include Aethon Energy Operating, BHP Billiton, EXCO Resources, and Indigo Resources. The primary operators in the Permian Basin are Apache Corporation, XTO Energy, and Occidental Petroleum. Most drilling activity for the underlying properties in 2018 was focused on the Permian Basin with six gross (0.5 net) wells drilled in 2018. In 2017, roles were reversed as six gross (0.5 net) wells were drilled in the Haynesville Shale. While capex budgets are determined by each individual operator and subject to change (as we saw many operators do in 2018) the Sponsor anticipates capex for 2019 to range between $5 million to $7 million prior to consideration of the 80% NPI.The top purchasers of the oil and gas produced from the underlying properties are displayed in the chart below. The realized prices are also included. Notably, the realized price on natural gas increased in 2018 despite declines on the NYMEX, likely because most of the gas harvested is near the Henry Hub.[caption id="attachment_25758" align="aligncenter" width="500"]Source: Permianville Royalty Trust 10-K*Applicable NPI Period per 10-K[/caption]
Termination of the TrustA traditional royalty interest typically continues into perpetuity. In contrast, many public royalty trusts have a set termination based on a specific date and/or production level. Permianville Royalty Trust differentiates itself as it is not subject to any pre-set termination provision such as time or production. The Trust will dissolve upon the earliest of the following:The Trust sells the NPI (subject to approval from at least 75% of unitholders);The annual cash proceeds received by the Trust attributable to the NPI are less than $2 million for two consecutive years;75% of unitholders vote in favor of dissolution; orThe Trust is judicially dissolved.
Upon dissolution, the trustee would then sell all of the Trust’s assets and distribute the net proceeds of the sale to the trust unitholders. Net profits allocable to NPI have been $15.2 million, $7.5 million, and $9.3 million in the past three years, mitigating concern the Trust would be dissolved in the near-term.Disposal of Interests Related to Permianville Royalty TrustNPI received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets; however, unitholders will be compensated if a sale occurs. Without a vote of approval, the Trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders. The sale also cannot exceed a fair market value of $500,000, and both limits are common features of royalty trusts. COERT sold a couple of producing wells and corresponding acreage in Glasscock County for approximately $62 thousand in January 2019.With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects.To make a larger sale, approval originally required consent from 75% of unitholders. However, at a special meeting in August 2017, unitholders approved amendments to the Trust Agreement decreasing this figure to a simple 50% majority. The next month, the Trust under Enduro’s stewardship divested $49.1 million worth of its underlying properties. Net of transaction expenses, the 80% NPI, and an indemnity holdback, the Trust distributed nearly $38 million to unitholders, a special dividend amounting to about $1.15 per share. By comparison, the Trust has only distributed about 90 cents per share in regular monthly dividends over the past three years. As expected, shares of the Trust spiked upon announcement of the special dividend, then decreased by approximately the amount of the dividend once paid a month later.Divestitures are much more common in the oil and gas industry than the general market as companies seek to develop expertise in core regions. With the large capital outlays required, companies must be conscious of their cost of capital, frequently increasing debt to fund new projects. The need to service this debt sometimes causes E&P companies to divest certain holdings. This is why industry participants frequently refer to transactions as A&D (acquisitions and divestitures) as opposed to M&A (mergers and acquisitions) in other industries.Such disposals, like the divestiture made by Permianville Royalty Trust, can have either positive or negative impacts on unit/shareholders. Ultimately, it depends on the sale price achieved. For royalty trusts, large divestitures lead to special dividends that represent an expedited yield. This could be a positive as such investments are typically seeking a return of their capital with declining distributions. According to the principles of time value of money, it is better to receive cash sooner rather than later. However, such divestitures could lead to different tax treatment and alter the expected return profile for investors. Also, if prices or production turn out to be higher than expected, the upfront sale can have a negative impact in the long-run. This is particularly interesting for Permianville Royalty Trust as it does not have a defined termination date.ConclusionThe performance of Permianville Royalty Trust has varied over the past two years, as it divested assets, changed its name and sponsor, and experienced commodity price volatility. Those who initially sold their units after Enduro filed for bankruptcy may wish they had held on longer. This is certainly true for people who couldn’t wait for oil prices to rebound following the crash in 2014 and likely anyone who sold prior to the announcement of the special dividend in 2017. After the Q4 dip in prices, the Trust also announced its largest monthly dividend since July 2014 concurrent with its 2018 10-K filing, boosting share price further.[caption id="attachment_25763" align="alignnone" width="940"]Source: Capital IQ [/caption]
When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The source of income, region, operator, sponsor, termination (or lack thereof), and other key aspects make each trust unique.
We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
What Does Your Family Business Mean to Your Family?
Mission statements, vision statements, corporate responsibility statements and lists of corporate values abound as managers and corporate directors seek to provide consistent direction for business decisions. While such statements doubtless have their place, they often ignore what we see as a more fundamental question for family businesses: What does the business mean to the family?In our experience, families tend to assign one of four basic meanings to their family business. Identifying what the business means to the family provides managers and directors with a roadmap for long-term strategic decisions regarding the family business.Failing to achieve consensus around what the business means to the family can lead managers and directors to make decisions regarding long-term strategic decisions on an inconsistent, piecemeal, or even contradictory manner. Corporate finance and strategy textbooks tell directors how to make these types of decisions if their shareholders are economically rational robots that evaluate investment decisions from a strictly quantitative perspective. In other words, the long-term strategic decisions are easy unless family shareholders are people who view their investments through a mix of economic, emotional, and practical considerations. And they are. Add family dynamics to that mix, and the easy textbook answers fade to irrelevance.The Four MeaningsThe meaning of a family business is a function of both family and business characteristics. As shown below, the meaning of the family business, in turn, influences the dividend policy, investing, and financing decisions of the company. In this week’s post, we will identify the four potential meanings and correlate family & business characteristics with those meanings. We will explore how the meaning of the family business informs dividend policy, investing, and financing decisions in a subsequent post.
Based on our observations over decades of working with family businesses, we have identified the following four potential meanings for a family business.
1. Economic Growth EngineFor some families, the business exists to drive economic growth for future generations. For these families, the emphasis is not on generating distributable income for the current generation of shareholders, but rather on pursuing growth opportunities so that the business grows along with the family.Family Characteristics: Growing family with each subsequent generation larger than the preceding generation by a factor of two or three (or more). The family has multiple members with entrepreneurial instincts and experience.Business Characteristics: The family business operates in an industry with ample attractive investment opportunities that can be used to spur growth. The management team has experience growing businesses organically or through acquisition. The business has access to financing to make investments when advantageous opportunities arise.Example: A new restaurant concept that is pursuing a rapid geographic expansion strategy to meet consumer demand for its unique combination of flavors, atmosphere, and experience.
When the family business is an economic growth engine for the family, shareholders know that the emphasis is on the future, and make personal financial decisions accordingly.2. Store of ValueOther family businesses serve as a mechanism by which to preserve the family’s capital. In contrast to the often dramatic swings experienced in the public equity markets, the family business is a stabilizing component of the family’s overall balance sheet.Family Characteristics: Family has relatively few shareholders or is growing slowly. The family business makes up a significant portion of the family’s overall wealth.Business Characteristics: The family business operates in a mature or counter-cyclical industry with few attractive reinvestment opportunities. The business owns tangible assets (real estate, manufacturing facilities) with alternative future uses.Example: A manufacturer of generic over-the-counter medications with a mature product portfolio for which sales growth largely tracks population growth.
If the family business functions as a store of value, family shareholders take comfort in the durability of the business, and can make long-term personal financial plans with relative certainty that the family business represents a stable foundation for their overall investment portfolio.3. Source of Wealth AccumulationA family business can also be a source of wealth accumulation. Families that adopt this meaning focus on diversification as a means of managing financial risk. The business is managed to provide significant current distributions that family shareholders are expected to allocate to unrelated investments. The objective is for the legacy family business to constitute a decreasing portion of total family wealth over time.Family Characteristics: Family exhibits diversity with regard to interests, geography, and risk tolerance. The family business may represent a significant portion of the family’s overall wealth at present, but the family’s express desire is for that relative allocation to go down.Business Characteristics: The family business operates in a mature industry and has limited investment requirements. While growth opportunities are limited, the business earns attractive margins attributable to an entrenched strategic advantage.Example: A producer of branded snack foods with a strong regional following that can operate with well-maintained, but old, production equipment.
When the family business acts as a source of wealth accumulation, family shareholders adopt an outward focus, allocating time and resources to evaluating potential investment opportunities.4. Source of LifestyleFinally, a family business can also be a source of lifestyle for family shareholders. These families value the stability of dividend payments as a supplement to wages and other sources of household income. The business is managed to protect the company’s dividend capacity. The objective is for the family business to predictably augment the family’s aggregate income from other sources to help facilitate travel, philanthropy, education, or other pursuits important to the family.Family Characteristics: While the senior generation may be able to rely on dividends as the primary source of income, family members in younger generations rely on wages or other sources of primary income.Business Characteristics: The family business operates in a maturing industry with modest investment opportunities. A primary goal of capital investment activity is to generate some measure of real growth in distributions over time.Example: A developer of a niche enterprise software platform for veterinary practice management.
If the family business is a source of lifestyle, family shareholders may appreciate the financial backstop provided by the value of the business, but ultimately gauge the success and health of the business by the stability, predictability, and growth of the dividend. The predictable dividend may free some family members to pursue meaningful careers that are not especially rewarding financially.So What?Every family business plays a unique variation on one of these themes. The meaning of a family business may shift over time as the family and business evolve. What is the meaning of your family business today? Do your family shareholders agree on the meaning of the family business?In family businesses, alignment and consensus regarding the meaning of the family business can prevent most of the disputes that breed resentment, open conflict, and litigation. Give one of our family business professionals a call today for help with discerning the meaning of your family business.
Buy-Sell Agreements for Investment Management Firms
An Ounce of Prevention is Worth a Pound of Cure
Due to the historical popularity of this post, we revisit it this week. Originally published in 2016, the purpose of this post is to equip ownership to understand the consequences of their buy-sell agreements before a controversy arises, and to make informed decisions about the drafting or re-drafting of the agreement to promote the financial health and sustainability of their firm.The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. Similar to the one pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then, an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well,” we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties.Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long-term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long-term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules of Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule of thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value,” does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level of value," as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of the other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value.Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts.”Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well-known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience.Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long-term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper
Middle Market Transaction Update Fourth Quarter 2018
Transaction volume continued at a reduced pace during 2017 – with most market commentators contributing this diminished activity to business owners “waiting” for the impact of the business-friendly tax and regulatory reforms that had been promised by the Trump Administration.
O(i)l Faithful
Eagle Ford Region Overview
Nearly a quarter of the way through 2019, prices have rebounded somewhat after a tumultuous end to 2018. First quarter energy prices again moved in opposite directions, with crude prices increasing steadily over the period while natural gas prices decreased from $2.94 to $2.80 per Mcf by mid-March despite peaking at over $3.50 in mid-January.Location, Location, LocationBorrowing the mantra of many real estate agents, sometimes it’s all about location, location, location. This is quite clear for oil and gas plays, particularly when looking at the acreage multiples paid across various regions. Eagle Ford Shale has quietly delivered solid results, overshadowed by some of the other shale plays, particularly the Permian to the west. The Eagle Ford’s location provides a distinct advantage, however, as it is closer to higher Brent-related pricing seen on the Gulf Coast. Its higher cut of oil also opens it up to Louisiana Light Sweet pricing. Even though the attention on the Permian has increased both acreage multiples and congestion due to transportation issues, it has been less of a concern in the Eagle Ford because the product has a shorter distance to travel to get to market.While proximity to better pricing is clearly a boon, location within the region also plays a large role.While proximity to better pricing is clearly a boon, location within the region also plays a large role. The Eagle Ford has areas where the cost of supply is as low as $20 to $30 per barrel according to Greg Leveille, Chief Technology Officer of ConocoPhillips. EOG Resources, the largest operator in the region, has noted similar supply costs as well. According to Thomas Tunstall, senior researcher with UTSA’s Institute of Economic Development, “EOG has some of the choicest leases in the Eagle Ford. They have indicated publicly that they can make money at $30 per barrel.” This has a considerable impact particularly with WTI prices currently trading around double that figure.According to Bloomberg, breakeven prices tell a similar story. While the West Eagle Ford has the highest breakeven of these regions, the East Eagle Ford has the lowest. Though it can be difficult to isolate reasons for these differences, Bloomberg’s breakeven prices in the table below do seem to corroborate the assertion that location plays a role as the eastern portion of the Eagle Ford is closest to the Gulf Coast with the Brent and LLS pricing.Free Cash Flow vs Potential — Safe vs SexyAs we noted last week, operators in the Eagle Ford have enjoyed the reliable production inherent in a later life-stage play. Along with the pricing benefits noted above, companies that have operated in the region for a while have been able to benefit from experience. Todd Abbott, Marathon Oil’s VP of Resource Plays South, attributed the company’s success in the region to drilling innovation and efficiency and repeatability of a stable drilling program. He further noted, “We are completing wells in a quarter of the time it took us to complete them in 2012.” This notion was furthered by ConocoPhillips’ CTO Leveille who touted innovations in well-spacing and stacking have allowed the company to achieve a 20% field-level recovery factor in the Eagle Ford Shale.
Technical innovations and experience have led to free cash flow for operators, which is something investors have been seeking. It also allows for diligence in capital spending, where investors have also begun to prioritize capital efficiency over capital expenditure. In fact, according to Marathon’s Abbott, the Eagle Ford has been able to effectively subsidize its efforts in regions such as the Permian and Oklahoma Stack as it is generating the free cash flow that the others are consuming. Still, the Eagle Ford lacks some of the luster of other plays.Valuation ImplicationsTo further understand the current production profile of the Eagle Ford and oil and gas plays in general, we can compare them to a typical company. In the early stages, companies retain earnings to fund growth opportunities as the return on investment can be quite high. As the company matures, however, there are fewer high return investments to be made, and companies tend to pay more dividends. Returns shift from capital appreciation from retained earnings to a yield in the form of dividends paid as a reward for years of investment. The Eagle Ford is in the stage of paying dividends.As has been the case for some time now, operators in the Permian continue to lead the other regions in terms of EV/production multiples, also known as price per flowing barrel. The Bakken was about on par with the Permian at the end of 2018, but it slid back towards the Eagle Ford, which edged up over the past three months. Multiples continue to trail levels seen in the past as enterprise values have been somewhat lower and production figures have increased.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America decreased 4.2% in the last three months, but increased 3.6% over the last twelve months. Eagle Ford Shale had the highest annual increase at 15.5%, but its 82 rigs only represent 8.0% of total rigs in North America. Despite a 4.5% decline in the past three months, the Permian Basin continues to lead the way with 464 rigs, representing about 45% of the total. By comparison, the Eagle Ford has the second most rigs, just outpacing Appalachia at 79 and the Bakken with 56.Despite the increase in rig counts, production increases over the past year for both oil (14.4%) and gas (8.3%) have trailed production gains seen in other regions. This is likely due to the older nature of the play, and its stage in the production cycle. The lack of production growth does not mean there is low production, however. It continues to provide solid production, with crude oil production on par with the Bakken, and significantly above Appalachia, known for its natural gas. The Eagle Ford also leads the Bakken in terms of natural gas production.
Much of the attention, particularly in Texas, has been on crude as opposed to natural gas. Despite this, the graph above shows natural gas production in the Permian has increased significantly in the past year. As noted earlier, the Eagle Ford’s location, specifically its proximity to the Henry Hub in Louisiana, may be a reason why the chasm between the amounts of natural gas produced in the two regions hasn’t increased further than it has. Much like crude, operators focused on natural gas in the Eagle Ford have benefitted from higher pricing as well as lower costs. According to Michael J. Wieland, President and CEO of Laredo Energy VI LP, the economics of dry gas in the Eagle Ford are particularly strong. Wieland further estimated finding and development costs at 50 cents per thousand cubic feet (Mcf) and netbacks of about $2/Mcf. SilverBow Resources’ EVP and CFO, Gleeson Van Riet, said the company has drilled 20 of the top 50 Eagle Ford gas wells and that the play is the best place to be in the U.S. for natural gas because it has best prices, good infrastructure and is located in the demand growth area. SilverBow (formerly Swift Energy) is the Eagle Ford’s only public pure-play in dry gas. Whether an operator focuses on crude oil, natural gas, or both, neither seems to be in short supply in the region.
End of an Era?While there is plenty of current production in addition to cash flow, there are concerns about the longevity of the region. Even regional giant EOG is looking to diversify. On a recent earnings call, EVP of Exploration & Production Ezra Yacob noted expanding exploration in those areas will “help increase the quality of our inventory” and “should hopefully shallow the decline that these unconventional plays are kind of known for.” The company still plans to drill about the same number of wells in the region in 2019, after posting a 9% crude oil production increase. The Eagle Ford represented 43% of EOG’s crude production last year, so diversifying to other regions doesn’t necessarily indicate a bearish view. Instead, it seems to be in line with the strategy alluded by Marathon, using the cash flow generated in the Eagle Ford to pay for growth in other plays.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas.Despite the older nature of the play, many people around the industry believe there is plenty of value still under the subsurface in south Texas. Director at BMO Capital Markets Max van Adrichem called the Eagle Ford a good alternative to “some of the more mature basins which may not have enough running room to get you through 5 to 10 years.” Martin Thalken, Chairman and CEO of pure-play Eagle Ford operator Protégé Energy III, supports this line of thinking. He commented the Eagle Ford “is still in the early innings” on applications like primary EOR and refracturing. John Thaeler, CEO of Vitruvian Exploration IV also employed a baseball analogy, saying “the dry gas Eagle Ford is just in the second inning.” Marathon’s Abbott agrees, “We believe there is a lot of running room left in the Eagle Ford for Marathon and the rest of the industry.”ConclusionCrude prices have rebounded since the turn of the year, while natural gas prices have remained steady. Pricing will always be dynamic in a global commodity environment, but the economics of certain plays tend to be less fluid. While it may not offer the potential of the Permian, the Eagle Ford is poised to leverage its experience and location to deliver solid returns.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
Mercer Capital Attending and Sponsoring the 2019 Transitions Spring Conference
Mercer Capital will be attending and is sponsoring the 2019 Transitions Spring Conference in Tampa Bay, Florida (April 3-5).Attendance at this conference is strictly limited to owners, shareholders, family members, in-laws, and executives of 75 family businesses/enterprises. The conference is designed to facilitate conversation on important family issues among various generations. The common thread among all attendees is a desire to see their family enterprise grow successfully through generational transitions.Travis W. Harms, CFA, CPA/ABV, senior vice president and leader of Mercer Capital’s Family Business Advisory practice, will be attending the conference.If you will also be attending, please let us know!
Basics of Financial Statement Analysis
Part 3: The Statement of Cash Flows
This post is the third of four installments from our Basics of Financial Statement Analysis whitepaper. In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.
An accounting professor of mine referred to the statement of cash flows as the “desert island” financial statement because if he were stranded on a desert island and could have only one financial statement with which to analyze a company, he would want it to be the statement of cash flows. While sincerely hoping never to find myself in such a position, I do believe there is merit to the sentiment.
The statement of cash flows reconciles the change in cash balance during the period by reference to reported earnings, non-cash charges, changes in balance sheet accounts, capital expenditures and other investments, and transactions with lenders and shareholders. While often overlooked, the experienced financial statement reader knows that the statement of cash flows reveals the company’s fundamental underlying narrative more clearly than either the balance sheet or income statement do in isolation.Key Components of the Statement of Cash FlowsThe statement of cash flows is divided into three sections, with all sources of cash flow and uses of cash classified as operating, investing, or financing activities.Operating ActivitiesNet income is not synonymous with operating cash flow. The purpose of the operating activities section of the statement of cash flows is to reconcile the two figures. While the operating activities section often includes a dizzying number of reconciling entries, they generally fall into three categories:Non-cash charges. Some expenses do not correspond to cash outflows in the current year. Depreciation is an allocation of amounts spent in prior years on long-lived assets. Amortization assigns the cost of acquired identifiable intangible assets to the years following the acquisition. Equity-based compensation expense recognizes promised payments to employees in future periods for services rendered in the current period. Since the purpose of the operating activities section is to reconcile reported net income to cash flow, these non-cash charges are added to reported net income.Realized gains and losses. When the company disposes of an asset, the difference between the proceeds received and the net book value of the asset sold is recognized as a component of net income. If the proceeds exceed the net book value, the sale will result in a gain, and if the proceeds are less than net book value, the company will record a loss. While the resulting gain or loss influences reported net income, it does not represent a source of operating cash flow. As a result, gains are deducted from (and losses are added to) reported net income in the reconciliation of operating cash flow.Changes in working capital. When the company sells goods or services on credit, it recognizes revenue despite the fact that no cash has been collected yet. The same potential timing differences apply to the relationship between cost of goods sold, operating expenses, and other components of working capital (principally inventory, accounts payable and various accruals). The accumulation of working capital assets reduces operating cash flow, while growing working capital liabilities increase operating cash flow.
Differences between reported net income and cash flow from operating activities are to be expected. However, persistent accumulations of working capital (beyond that reasonably necessary to support sales growth) may be a signal that the quality and/or sustainability of reported earnings is doubtful. For example, excessive accumulation of accounts receivable or inventory may result in future writedowns if accounts are ultimately uncollectible or if inventory becomes stale or obsolete.Investing ActivitiesOne of the most important tasks of corporate managers and directors is identifying suitable investments that merit allocation of available capital resources. This process, known as capital budgeting, involves comparing the returns expected from potential projects to the firm’s cost of capital and selecting those projects that are financially feasible and consistent with the company’s broader strategy and competitive advantages. The investing activities section of the statement of cash flows summarizes the results of the capital budgeting process. As noted in Exhibit 1, cash flows from investing activities generally fall into one of three buckets.Capital expenditures. Capital expenditures represent amounts paid to maintain or expand the productive capacity of the business. Whereas depreciation expense represents a systematic allocation of the cost of long-lived assets to the accounting periods during the useful life of those assets, capital expenditures represent the cash paid for those assets in the period acquired. The level of capital expenditures should be positively correlated with the availability of attractive investments to support growth.Acquisitions. Business acquisitions are akin to capital expenditures. Rather than investing in new production capacity, acquisitions allow the company to consolidate production capacity that already exists in the industry. Most business combinations are rooted in a belief that there are economic benefits available to the combined business that are not otherwise available to either company on a standalone basis. Capital expenditures may be wise or unwise, but the price of the acquired assets is generally well-known. The amount paid for a business combination, on the other hand, is a matter of negotiation, and often involves competitive bidding among multiple potential acquirers. As a result, there is a risk of overpaying for what would otherwise be a “good” acquisition. The portion of the purchase price paid through issuance of the acquiring company’s shares will not appear on the statement of cash flows, but the attentive financial statement reader will note the corresponding increase in the number of shares outstanding.
Since both capital expenditures and acquisitions represent uses of corporate cash, they appear on the statement of cash flows as negative figures (i.e., cash outflows).Proceeds from sales of assets. The capital budgeting process can also work in reverse, identifying assets that do not promise attractive future returns, no longer align with the company’s strategy, or can be sold for an attractive price. The cash proceeds from the sale or disposition of the asset appear as a positive figure in the investing activities section.
Capital expenditures, acquisitions, and asset dispositions tend to be “lumpy”. In other words, a significant capital expenditure that doubles productive capacity may not need to be repeated for a number of years. As a result, it is often helpful to analyze the statement of cash flows on a cumulative basis (i.e., aggregate cash flows over a multi-year period). This can provide a broader view of the company’s investing strategy and capital budgeting process and reduce undue focus on a single quarter or year.Financing ActivitiesThe final category is cash flow from financing activities. As illustrated on Exhibit 2 below, cash flow from financing activities summarizes the company’s transactions with capital providers during the period.
Transactions with lenders include borrowing and repaying debt. If debt on the balance sheet increases during the period, positive cash flows from borrowing will exceed negative cash flows from repaying debt. Borrowing appears as a positive figure on the statement because the proceeds from borrowing money increase the company’s cash balance. One shortcoming of the statement of cash flows is that interest paid to lenders is not classified as a financing cash flow, but rather is a component of cash flow from operations.
A company has two mechanisms for returning cash to shareholders: share repurchases and dividends.When the company issues new shares to investors, the proceeds from the issuance increase the company’s cash balance and therefore appear as a positive figure on the statement of cash flows. A company has two mechanisms for returning cash to shareholders. The first is to repurchase shares. Share repurchases return cash on a non-pro rata basis to the shareholders electing to sell. If the price paid for the shares differs from the value of the shares, a share repurchase will be either dilutive or accretive to the remaining shareholders. In contrast, dividends provide a pro rata return to all shareholders without the risk of mispricing associated with share repurchases. Among public companies, share repurchases are very common due to advantages under current tax law and the fact that share repurchases do not carry the burden of sustainability that dividends do (failing to repurchase shares is rarely perceived negatively, whereas reducing or suspending dividend payments is a very bearish signal). For private companies, share repurchases are less common, due in large part to the difficulty in identifying a price that is not unduly accretive or dilutive to the remaining shareholders.Analyzing the Statement of Cash FlowsFor an experienced reader of financial statements, the relationships among the primary components of the statement of cash flows reveal the broad contours of the company’s financial strategy, particularly with respect to capital budgeting, capital structure, and distribution policy. As noted previously, investing and financing cash flows are, by their nature, lumpy, so it can be helpful to analyze the statement of cash flows on an aggregate multi-year basis. There are two basic relationships to evaluate.The first is the relationship of operating and investing cash flows. If (the absolute value of) investing cash flow exceeds operating cash flows, management and the directors believe that attractive investment opportunities are readily available. With the allocation of more capital resources to the company’s investment portfolio comes the expectation that future earnings and cash flows will be sufficient to justify the commitment by providing an attractive return on investment.Investing and financing cash flows are, by their nature, lumpy, so it can be helpful to analyze the statement of cash flows on an aggregate multi-year basis.If investing cash flows exceed operating cash flows, financing cash flows must be positive (i.e., net cash inflows from either borrowing money or issuing new shares). If, instead, operating cash flows exceed (the absolute value of) investing cash flows, management and the directors believe that attractive investment opportunities are relatively scarce. Limiting the capital resources allocated to the company’s investment portfolio mitigates the pressure for growth in future earnings and cash flows but exposes the company to the potential opportunity cost of foregone investments that would have provided an attractive return. When operating cash flows exceed investing cash flows, financing cash flows will be negative, as the company will have “excess” funds to return to capital providers.Second is the relationship between transactions with lenders and transactions with shareholders within cash flow from financing activities. This relationship correlates to changes in capital structure at the margin.When aggregate financing cash flows are positive, borrowings will predominate over share issuance when management and the board assess the marginal cost of debt to be less than the marginal cost of equity. While beyond the scope of this whitepaper, note that the marginal cost of debt is not the same thing as the interest rate on newly-issued debt. If the marginal cost of debt is perceived to be higher than the marginal cost of equity, companies will issue new shares to fund investment.When aggregate financing cash flows are negative, management and the board must balance de-leveraging and returning cash to shareholders. If they perceive the marginal cost of debt is less than the marginal cost of equity, they will forego the opportunity to de-leverage the balance sheet, and opt instead to return cash to shareholders through share repurchases or dividends. If, instead, the marginal cost of debt is greater than the marginal cost of equity, the board should emphasize repayment of debt over returning cash to shareholders.
These relationships are summarized in Exhibit 3 below.ConclusionThe statement of cash flows should not be ignored. It provides important perspective regarding the company’s strategy and narrative that cannot be easily gleaned from the income statement or balance sheet in isolation. The reconciliation of reported net income to operating cash flow provides additional insight regarding the nature and quality of reported earnings. Cash flow from investing activities reveals the net results of the company’s capital budgeting process. Transactions with lenders and shareholders summarized in the financing activities section reflect the board’s assessment of the marginal costs of capital.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper
M&A in the Eagle Ford Shale
Over the last twelve months, the Eagle Ford Shale region has experienced steady growth and healthy transaction activity.According to the Society of Petroleum Engineers, crude production from the south Texas play climbed steadily throughout the year and continued to achieve its highest marks ever. New, upstart independents came back to the region, including one led by the former head of Occidental Petroleum, as investors looked beyond the neighboring Permian Basin with its crowded top-tier acreage and pipelines. And operators began joining forces to increase the scale of their operations, headlined by Chesapeake Energy’s merger with Wildhorse Resource Development.The region’s strengths, such as its low cycle times, high oil cuts and Louisiana Light Sweet crude and Brent oil pricing, has facilitated free cash flow and made the area attractive to both investors and operators.As long as entry costs and well costs remain reasonable, the Eagle Ford Shale has strong potential for continued economic growth.Recent Transactions in the Eagle Ford RegionDetails of recent transactions in the Eagle Ford Shale, including some comparative valuation metrics are shown below.Chesapeake Closes Acquisition of WildHorse for Nearly $4 BillionChesapeake has made several major transactions over the last nine months. In the middle of 2018, the company sold its entire stake in the Utica Shale, and experts speculated that the company would put the sales proceeds towards an acquisition in the Eagle Ford or Powder Basin area.Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Chesapeake closed a deal with Houston-based WildHorse Resource Development with a transaction value of $3.977 billion. The consideration for the transaction consisted of either 5.989 shares of Chesapeake common stock or a combination of 5.336 shares of Chesapeake common stock and $3 cash, in exchange for each share of WildHorse common stock. Chesapeake intended to finance the cash portion of the WildHorse acquisition, which was expected to be between $275 million and $400 million, through its revolving credit facility.In a statement, Chesapeake’s CEO, Doug Lawler said: “In 2018, Chesapeake Energy continued to build upon our track record of consistent business delivery and transformational progress through both financial and operating improvements. The addition of the WildHorse assets to our high-quality, diverse portfolio, combined with our operating expertise and experience, provides another oil growth engine with significant oil inventory for years to come and gives us tremendous flexibility and optionality to help achieve our strategic goals.”Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Trends and OutlookInvestor Returns and Free Cash FlowOne of the most attractive features of the Eagle Ford region for the last year has been the returns. The Eagle Ford generates solid economics and cash flow, which operators use to fund exploration projects both nearby and elsewhere. Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Coupled with the fact that the Eagle Ford is one of the lowest costing basins in the U.S., reliable production and capital efficiency in a mid-life stage play has been translating to free cash flow, something investors have been vocal about trying to obtain from the oil and gas industry as a whole for quite some time.Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Todd Abbott, VP of Resource Plays South for Marathon Oil Corp., recently said at the DUG Eagle Ford conference in San Antonio that Marathon is seeing “fantastic” returns with reliable production, capital efficiency, and free cash flow.At the same conference, Stephen Chazen, chairman, president and CEO of Magnolia Oil & Gas, noted “General investors want reasonable growth, earnings per share, and free cash flow.” The recently formed small independent company generated free cash flow in excess of capital on acquisition spending and ended 2018 with $136 million of cash on the balance sheet, an increase of approximately $100 million compared to the end of the third quarter.These kinds of results show that the region has been a cash flow generator for the year and has been a main driver for most of the recent and anticipated transaction activity, especially companies under $1 billion in market capitalization.Anticipated Large Operator Divestitures in 2019In recent reports from Shale Experts, several larger operators in the Eagle Ford area are potential candidates for divestiture. Following Q4 2018 earnings calls, five operators have indicated that they are open to selling all or parts of their Eagle Ford assets in 2019. Collectively, the net acreage under consideration totals to over 100,000 net acres.
Below are four of the company responses to Shale Experts’ questions regarding where Eagle Ford assets fit into their portfolios:Encana Corp. - After purchasing Newfield, Encana now considers the Eagle Ford as non-core.Pioneer Natural Resources - They have been actively selling pieces of their Eagle Ford asset since 2018.Matador Resources - Matador will outspend cash flow this year, and therefore an Eagle Ford asset sale might help plug that gap.Earthstone Energy - Earthstone is trying to convert itself into a Permian-only player. Reports from Shale Experts expect they will be looking to offload their Eagle Ford assets in the near-term.
In addition to the reports above, Norway’s Equinor announced plans to explore the sale of its Eagle Ford assets as well.
Equinor has an ownership interest in the Eagle Ford Shale formation located in south Texas through a joint venture with Repsol. Through transactions in 2013 and 2015, Equinor obtained full operatorship in the joint venture and increased its working interest to 63%.
The company’s net acreage position in Eagle Ford at the end of 2018 was approximately 71,000 net acres and production of 43,000 boe/d.
In a recent interview, Al Cook, the company’s head of strategy, said that Equinor is looking to add to its large position in Appalachia in an attempt to chase natural gas-rich acreage. This move is consistent with trends we identified last quarter in our transaction analysis of the Marcellus-Utica region.
Any divestiture of assets by these operators would pose an interesting opportunity, especially for aforementioned smaller operators to acquire acreage and capitalize on the cash flow generating ability of the region to facilitate growth and increase returns.
We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
What Wealth Managers Need to Know About the Market Approach
The market approach is a general way of determining the value of a business which utilizes observed market multiples applied to the subject company’s performance metrics to determine an indication of value. The “market” in market approach can refer to either public or private markets, and in some cases the market for the subject company’s own stock if there have been prior arms’ length transactions. The idea behind the market approach is simple: similar assets should trade at similar multiples (the caveat being that determining what is similar is often not so simple). The market approach is often informative when determining the value of a wealth management firm.There are generally three methods that fall under the market approach.Guideline Public Company MethodGuideline Transaction MethodInternal Transaction Method
All three methods under the market approach involve compiling multiples observed from either publicly traded guideline companies, comparable transactions in private companies, or prior transactions in the company’s own stock and applying the selected (and possibly adjusted) market multiples to the company’s performance measures.Multiple MultiplesThe most common multiples used when valuing wealth management firms are enterprise value (EV) to EBITDA1, EV to AUM, and EV to revenue multiples. The multiples used are generally categorized into “activity” multiples and “profitability” multiples. Activity multiples are multiples of AUM and revenue whereas profitability multiples are multiples of earnings metrics (e.g. EBITDA).Both profitability and activity multiples have their advantages and disadvantages.Both profitability and activity multiples have their advantages and disadvantages. Activity multiples can provide indications of value for a subject wealth management firm that are only a function of the chosen activity metric—typically AUM or revenue. Such an indication is not a function of the profitability of the firm, which can be an issue because the underlying profitability of a firm is the ultimate source of value, not revenue or AUM. The benefit of activity metrics is that they can be used without explicitly making normalizing adjustments to a wealth management firm’s profitability. The caveat, however, is that applying market-based AUM and revenue multiples to the subject wealth management firm’s activity metrics is essentially transposing the realized fee structures and EBITDA margins of the guideline companies onto the subject firm—an implicit assumption about normalized profitability and realized fees which may or may not be reasonable depending on the specific circumstances.Profitability multiples, on the other hand, explicitly take into account the subject firm’s profitability, which on its face is a good thing. Profitability metrics are not without their drawbacks, however. Differences in risk or growth characteristics will, all else equal, result in different EBITDA multiples. If the risk or growth prospects of the subject company differ from the guideline companies that informed the selected EBITDA multiple, then the appropriate multiple for the subject company will likely differ from the observed market multiple.Subject Company MeasureOnce a market-based profitability multiple is obtained that reflects the risk and growth prospects of the subject firm, the next question is often: which EBITDA (or other profitability metric) is the multiple applied to? Reported EBITDA?Management adjusted EBITDA?Analyst adjusted EBITDA? Wealth management firms frequently require significant income statement adjustments—the largest of which is typically related to normalizing compensation—and so the answer to the question of which EBITDA to apply the multiple to can have a significant impact on the indicated value.It’s often said that “value is earnings times a multiple.” While there is some truth to be had there, the simplicity of the statement belies the reality that the question of the appropriate multiple and the appropriate earnings is rarely straightforward, and buyers and sellers may have very different opinions on the answer.Guideline Public Company MethodThe guideline public company method is a method under the market approach that uses multiples obtained from publicly traded companies to inform the value of a subject company. For wealth managers, the universe of publicly traded firms is relatively small – there are only about two dozen such firms in the U.S.The chart below shows historical EV / LTM EBITDA multiples for publicly traded RIAs with less than $100 billion in AUM (the size range which most of our clients fall in). As can be seen, the public companies have generally traded in a band of 8-11x LTM EBITDA, although the pricing at the end of 2018 had fallen to a historically low multiple of just over 5 times, partly due to increased market volatility observed at year-end.
When valuing small, privately held wealth management firms, the use of multiples from publicly traded companies—even the smallest of which is still quite large compared to most privately held RIAs—naturally brings up questions of comparability. How comparable is a wealth management firm with, say, $1-10 billion in AUM and a few dozen employees to BlackRock, which manages over $6 trillion? The answer is probably not very.
The comparison of the small, privately held RIA to BlackRock is obviously extreme, but it illustrates the issues of comparability that are frequently present when using publicly traded companies to value privately held wealth management firms. In our experience, the issues of comparability between small, privately held companies and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification. These differences point towards greater risk for privately held RIAs versus the publicly traded companies, which, all else equal, suggests that the privately held RIAs should trade at a lower multiple to that observed in the public markets.
The growth prospects for privately held RIAs can differ from publicly traded companies as well. Because small, privately-held RIAs tend to be focused on a single niche, the growth prospects tend to be more extreme, either positive or negative, compared to publicly traded guideline companies. A subject company’s singular niche may be growing quickly or shrinking, whereas the diversified product offerings of publicly traded companies are likely to have some segments that are growing and some that are shrinking, resulting in a moderated overall growth outlook. The growth prospects, of course, impact the multiple at which the subject company should trade. In some cases, we’ve seen RIAs much smaller than the guideline public companies transact at a premium to the then-prevailing observed public company multiples because of the RIA’s attractive growth prospects. More often, however, the higher risk of the privately held RIA dominates, and the justified multiple is lower than the guideline public company multiples. As a general rule, a smaller RIA means a smaller multiple.
Despite the less than perfect comparability between publicly traded companies and most privately held RIAs, publicly traded companies provide a useful indication of investor sentiment for the asset class and thus should be given at least some consideration. However, due to differences in risk and growth characteristics, adjustments to the multiples observed in the guideline companies may need to be made.
Guideline Transactions MethodGuideline transactions of private companies in the wealth management space provide additional perspective on current market pricing of RIAs. The guideline transactions method uses these multiples to derive an indication of value for a subject firm.The transaction data is appealing because the issues of comparability are generally less pronounced than with the guideline public companies. There are caveats to the guideline transactions method, however. One unique consideration for the use of the guideline transactions method in the wealth management industry is that deals in the industry almost always include some form of (often substantial) contingent consideration (earn-out). The structure of such contingent consideration will be tailored to each deal based on the specific concerns and negotiations of the buyers and sellers. In any event, the details of the earn-out payments are often not publicly available. The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.Another important consideration is that deals in the industry occur for unique reasons and often involve unique synergies. It’s not always reported what these are, and the specific factors that motivated a particular guideline transaction may not be relevant for the subject company. The type of buyer in a guideline transaction is another consideration. Private equity (financial buyers) will have different motivations and will be willing to pay a different multiple than strategic buyers.Despite an uptick in sector deal activity over the last several years, there are still relatively few reported transactions that have enough disclosed detail to provide useful guideline transactions multiples. Looking at older transactions increases sample size, but it also adds transactions that occurred under different market conditions, corporate tax environments, and the like. Stale transaction data may not be relevant in today’s market.Internal Transaction MethodThe internal transactions method is a market approach that develops an indication of value based upon consideration of actual transactions in the stock of a subject company. Transactions are reviewed to determine if they have occurred at arms’ length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date. Inferences about current value can sometimes be drawn, even if there is only a limited market for the shares and relatively few transactions occur.However, even arms’ length transactions in the subject company stock occur for unique reasons and often involve unique synergies which means even these implied multiples are not always a clear indicator of value.Rules of Thumb: Where They Come From and Why They (Sometimes) Make No SenseObserved market multiples are often condensed into “rules of thumb,” or general principals about what an investment firm is or should be worth. These rules provide a simple, back-of-the-envelope way of quickly computing an indicated value of a wealth management firm. However, rules of thumb are not one-size-fits-all. Consider the example below, which shows a “2% of AUM” rule of thumb applied to two firms, A and B:
Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile, but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x—a multiple which is unlikely to be considered reasonable in any market conditions.
We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb—even if they made perfect sense at the time the document was drafted—do not have a long shelf life. A lot can change that can make a once sensible rule of thumb seem outlandish due to changes at the firm itself or in the broader market for wealth management firms.
Reconciliation of ValueThe market approach provides useful information about the current market conditions and investor sentiment for wealth management firms, but the method also has limitations and important considerations that need to be made, many of which are specific to the wealth management industry. Any valuation is as of a specific date and should reflect the market and universe of alternative investments as of that valuation date—which ultimately is what market approach indications of value are informed by. On the other hand, the fundamentals of a subject company may suggest a valuation that differs from market-based indications. Whatever the concluded value—it should make sense in light of both the current market conditions and indications of value developed under the income approach.1 Wealth management firms tend to have little “DA”, so EBITDA is typically approximately equal to EBIT and operating income.
Q&A: Five Questions with Dan Hatzenbuehler
From time to time, Family Business Director will interview family business leaders or experienced advisors to get their perspective on important questions common to family businesses. In this first installment, we talk with Dan Hatzenbuehler, the retired Chairman and CEO of E. Ritter & Company. Dan offers great insight that we know our readers will profit from.1. Give us a brief overview of your family and business.E. Ritter & Co. ("ERC") is a fifth-generation family business with approximately 50 family owners from the third through the fifth generations. The company has two primary business divisions: agribusiness and communications. On the ag side, the company owns a significant amount of farmland (growing cotton, soybeans, rice, corn, and wheat), a farms management operation, and a fairly new specialty crops operation raising flowers and fruits for sale to groceries. The communications division operates three rural telephone companies offering voice, video, and high-speed data. It is also developing a robust fiber network across northern Arkansas, selling wholesale and enterprise access and services, as well as sophisticated technology solutions to small and medium-sized businesses. It was started by my wife’s great grandfather in 1886 in Marked Tree, AR. The fourth and fifth generations currently hold leadership positions on the Board of Directors of ERC, and one fourth-generation family member is still employed in the area of community relations.Today, senior management consists totally of non-family employees. Upon my retirement in 2015, the Board of Directors hired our first non-family CEO.2. What roles in the family business have you fulfilled over your career?I’m a married-in family member who joined ERC’s Board of Directors in 1979 and on which I served until 2016. I practiced law for about 25 years before joining ERC’s senior leadership team as Chairman of the Communications Division and Vice-Chair of the Board of ERC. A couple of years after joining, I was elected Chairman and CEO of ERC.3. Does your family business have any independent (non-family) directors? We first added an “independent” director to the board in the early 1980s. Several years later, we added a second. I would characterize these directors as “outside” directors, not “independent” directors because they were vastly outnumbered by the family directors and were selected because of personal relationships they had with one or more of the family directors. In 2008, we transitioned our governance system to one with a majority of independent directors chosen for their industry experience, relevant skill sets, and/or executive expertise.The initial challenges of independent directors are convincing the family that they are not giving up “control” by inviting “strangers” into the board room, coupled with the need to successfully onboard the independent directors who are not familiar with the family and/or business cultures. The benefits far outweigh any discomfort with having non-family members on the board who don’t work in the family business. Independent board members bring varieties of experiences, perspectives and skill sets that family directors don’t have. Also, being independent, they aren’t impacted by the family “baggage” that can inhibit good decision making by the board of a family business.4. Do you offer an ongoing share redemption program? We have had a shareholder agreement that contains a share redemption program since 1990. The program offers shareholders the opportunity to redeem shares during their lifetimes at a price independently determined by a third-party valuation firm. It also has a mechanism which enables the estates of deceased shareholders to redeem shares to pay for estate/inheritance taxes attributable to the value of the ERC shares, not the entire value of the decedent’s estate.Over the years, we’ve had relatively few family members take advantage of the redemption program, but there is tremendous value to the family owners in knowing the mechanism is available should they ever want or need to access it. The fact that the annual valuation is determined by an independent source and not by management also adds tremendous transparency and credibility to the program.5. What is your best advice for other family business leaders?A family business is a tremendous asset and needs to be treated as such. The “business of the family” is just as important as the “business of the business” and takes almost as much energy and attention from a family business leader. Just as good corporate governance is important to the operation of any business, good family governance is equally as important. There are tremendous resources available to family business leaders who are interested in learning more about the “business of the family” and I would encourage family business leaders to utilize those tools, structures, and opportunities for education in this area. The issues of a family business multiply as the family becomes multi-generational, thereby requiring more and more time and attention if both the family and the business are to be successful for the long term.
What Wealth Managers Need to Know About the Income Approach
There are three general approaches to determining the value of a business: the asset-based approach, the income approach, and the market approach. The three approaches refer to different bases upon which value may be measured, each of which may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) based on those most indicative of value for the subject interest. The chart below summarizes the methods typically used to value wealth management firms under each valuation approach.
This week, we take a look at how the income approach is used to value wealth management firms.
What is the Income Approach?The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount. Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce. The income approach requires estimates of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.Methods under the income approach are varied but typically fall into one of two categories:Single period capitalization of free cash flowDiscounted future cash flow model (DCF)Single Period Capitalization ModelThe simplest method used under the income approach is a single period capitalization model. Ultimately, this method is an algebraic simplification of its more detailed DCF counterpart. As opposed to a detailed projection of future cash flow, a base level of annual net cash flow and a sustainable growth rate are determined.
The denominator of the expression on the right (r – g) is referred to as the “capitalization rate,” and its reciprocal is the familiar “multiple” that is applicable to next year’s cash flow. The multiple (and thus the firm’s value) is negatively correlated to risk and positively correlated to expected growth.
There are two primary methods for determining an appropriate capitalization rate—a public guideline company analysis or a “build-up” analysis. The most familiar method applies the P/E ratio from a guideline public company analysis. A build-up analysis can be based upon the Capital Asset Pricing Model (CAPM) or Adjusted CAPM (ACAPM). Both the P/E ratio and the built-up capitalization factor articulate the risk and growth factors that investors believe underlie earnings measures.
Discounted Cash Flow ModelWealth management firms are frequently valued using the DCF method because this method allows for detailed modeling of revenue and expense items over the discrete projection period. A discrete projection period of three to five years is typically employed so that AUM trends, fee levels, and operating expenses can be modeled with reasonable certainty based on the current trends and business model. Beyond the discrete projection period, it is assumed that the business will grow at a constant rate into perpetuity. In circumstances where no changes in the business model or capital structure are expected, a single period capitalization method may suffice.The discounted cash flow methodology requires three basic elements:Forecast of expected future cash flowsDetermination of terminal valueSelection of an appropriate discount rateDCF Element #1: Forecast of Expected Future Cash FlowsA DCF model requires a base level of cash flows to use as a starting point to model future growth and profitability.The base rate of profitability is determined by a wealth manager’s current revenue and cost structure, with possible adjustments made. It is often said that wealth managers generate revenue while they sleep, as revenue is a function of assets under management and is typically not performance or commission based. The fee-based revenue model used by most wealth management firms allows us to determine an ongoing (run rate) level of revenue by multiplying assets under management at any given day by the business’ average realized fee structure.The base rate of expenses for wealth management firms is typically based on reported expenses over the most recent annual period, with adjustments made for various items (the most significant of which typically relates to normalizing compensation).Projecting Cash Flow for Wealth ManagersWe typically view the discounted cash flow method as superior to the single period capitalization approach as it is more dynamic and allows for the discrete forecasting of cash flows. Projections of future cash flows rely on many assumptions as explained below.Assets Under Management Trends in AUM growth should include new business gained and expected market returns based on overall asset allocation. When determining growth in AUM, it is important to ask what has historically driven growth and if it is reasonable to assume that this trend will continue. For example, has a firm’s historical AUM growth been driven by market movement or by new client generation? Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage. As mentioned in a prior post, "Client assets (AUM) do correlate to a great extent with the market, but client relationships do not." Without proper relationship management, assets leave and revenue suffers.Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage.Further complicating new AUM generation, many wealth managers have aging customer bases and are struggling to attract younger clients who are more likely to choose passive alternatives. As managers struggle to gain new clients in light of the competitive environment, effective marketing has become increasingly important.Realized FeesProjected realized fees are typically evaluated in light of historical levels. However, fee compression has plagued the industry in recent years, and in light of increasing fee consciousness among clients, many wealth managers are cutting fees in order to stem outflows.CompensationWealth management is a relationship business, and relationships require the time and energy of a dedicated staff. The majority of a typical wealth management firm’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and owners. Compensation generally tracks revenue closely, making operating leverage more pronounced with non-compensation related expenses than compensation related expenses.Compensation programs tend to evolve in wealth management firms and over time take on a life of their own. Inevitably, compensation programs tend to be intertwined with business models and ownership. The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The compensation structure for owners is often affected by the tax environment. The corporate structure of a firm (C Corp vs S Corp or other pass-through entity), as well as the current federal and state tax environment, frequently determines whether firms pay out profit as bonuses or distributions. For example, in states with high corporate tax rates but no personal income tax, income is more likely to be paid out in the form of bonus compensation rather than distributions in order to reduce taxable income at the corporate level.Non-Compensation Operating ExpensesMarketing expenditures have increased as wealth managers seek to attract new, often younger, clients. We have seen an increased focus on branding as wealth managers seek to connect with clients on a more personal level. Additionally, spending on technology has increased as wealth managers update their platforms to increase transparency and cater to younger clients who prefer to manage their accounts online. This increased reliance on technology has allowed some wealth managers to reduce overhead combatting margin compression.With some exceptions, wealth managers’ non-compensation operating expenses are generally fixed in nature, which allows wealth managers to take advantage of operating leverage over time.DCF Elements #2-3: Terminal Value & Discount RateOnce it is assumed that the business will achieve a constant level of performance, the remaining cash flows are capitalized and represented by a terminal value. An appropriate discount rate is used to discount the forecasted cash flows and the terminal value to the present.The sum of the present values of all the forecasted cash flows (both the discretely forecasted periods and the terminal value) is the indication of value for a specific set of forecast assumptions.Reconciliation of ValueYour firm’s valuation should clearly articulate the observations, assumptions, adjustments, and empirical data upon which the income method is based. If your valuation provider cannot develop and report their analyses in a manner that you sufficiently understand, get clarification or a new appraiser. You may not agree 100% with the conclusion, but you should understand the methods used and recognize your wealth management firm in the report.Additionally, your firm’s valuation should make sense in light of industry trends and valuations observed within the public and private markets.Next week, we will look more closely at the market approach and how it can be used to better understand the value of wealth management firms.
How to Value Your E&P Company
Our whitepaper "How to Value Your Exploration and Production Company" provides an informative overview of the valuation of exploration and production (E&P) companies. Because of the historical popularity of this post, we revisit it this week.There are numerous scenarios under which some form of an ownership transition occurs, and in all scenarios, a business owner must invariably address the question of value. A lack of knowledge regarding the value of a business can be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help to understand how to grow the value of a business and maximize returns when it comes time to sell.Download the full whitepaper or read a brief summary below.WHITEPAPERHow to Value Your Exploration and Production CompanyDownload WhitepaperImportant Industry FactorsA review of the oil and gas industry is important in establishing a credible value for any business operating in this space. Such a review should consider a wide range of issues (far too many to list in full here), with primary considerations as outlined below.Price Volatility. The oil and gas industry is characterized by high price volatility. The size and global nature of the oil and gas market means that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market.Technology. Technology in the oil and gas industry changes rapidly and has the potential to materially impact the market. Adoption of innovative drilling techniques, such as horizontal drilling and hydraulic fracturing, has made oil and gas production quicker, easier, and relatively cheaper.Regulation. The oil and gas industry is heavily regulated by various entities, and regulations on operations can have a costly impact on the industry. The regulatory environment is constantly changing and regulations vary across regions and countries.Variation by Oil and Gas Play. Drilling economics vary by region. There are geological differences between oilfields and reserves that make it harder (thus more costly) to drill in some places than others. Accordingly, the value of any E&P company is strongly influenced by its location, and it is important to consider geological differences when valuing E&P companies.Financial ConsiderationsWhen valuing a business, it is critical to understand the subject company’s financial condition. E&P companies rely on their oil and gas reserves to produce revenue. Understanding the drilling economics is crucial in understanding a company’s value.A break-even analysis is a helpful tool used to analyze drilling economics. A break-even analysis can be used to compare how much it costs to produce one barrel of oil versus the revenue generated per barrel. This can reveal whether a company is losing money through the production process and determine at what price a company can be profitable.An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.To properly consider a company’s current financial position, it is important to understand management’s plan for future development of wells. Since oil is a depleting asset, in order to continue at current levels of production, oil companies must continuously explore for reserves and develop new wells. Thus, when valuing an E&P company in today’s market, it is important to consider the company’s ability to meet its capital needs. An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.E&P companies have extremely high operating costs, in large part due to the magnitude of exploration expenses. Exploration endeavors, although not always successful, are extremely costly. For this reason, many in the oil and gas industry prefer to look at EBITDAX multiples rather than EBITDA multiples. EBITDAX represents EBITDA before exploration expenses and tends to be a better metric to compare E&P companies because it negates the effect of a company’s selected accounting policy.What Does the Valuation Process Entail?There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value.Mineral reserves are an E&P company’s main generator of value, but because they are depleting assets and are often owned through working interests, their value can be tricky to understand. Reserves are typically divided into two groups: proved and unproved reserves. Proved reserves are further classified as proved developed producing reserves (PDP), proved developed non-producing reserves (PDNP), and proved undeveloped reserves (PUDs); unproved reserves are further classified as probable and possible. The valuation methodology used depends on the type of reserve. Generally, the income approach is the most supportable approach for valuing proved reserves and the market approach is generally used to value PUDs and unproved reserves.The Income ApproachThe income approach can be applied in several different ways. For companies operating in the oil and gas industry a discounted cash flow analysis is most common because reserves produce unequal annual cash flows that can be projected by a petroleum engineer in a reserve report. This approach allows for the consideration of characteristics specific to the subject company and their reserves.These future production estimates from reserve reports can be used to project revenue throughout the remaining life of a well. Estimates of future cash flow can be discounted back to the present using an appropriate discount rate (rather than the 10% industry standard used to calculate PV-10).While the income approach is typically a reliable estimate of value for proved reserves, it is not always helpful in determining the value of PUDs and unproved reserves because the production of unproved reserves is ambiguous. Rather, we generally use the market approach.The Market ApproachThe market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.While geography may not factor into the selection of guideline public companies in many industries, the location of an E&P company is one of the most important factors to consider when selecting similar companies in the oil and gas industry. Drilling economics vary across play; thus, it would be inaccurate to select a company operating in the Permian Basin as a comparable company to one operating in the Bakken Shale in North Dakota.Acquisition data from industry acquisitions can be utilized as a multiple on the subject company’s performance measure(s). For unproved reserves in particular, because production is uncertain, the market approach provides the most meaningful indication of value. Using an EV/acreage multiple derived from transactions of similar companies, analysts can gauge the value of a company’s unproved reserves.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.Mercer Capital has long promoted the concept of managing your business as if it were going to market. In this fashion, you promote the efficiencies, goals, and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We encourage you to extend your business planning dialogue to include valuation. For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.
The Anatomy of a Wealth Management Firm
A Closer Look at a Business that Continues to Pivot with Client Needs
From Broker to AdvisorWealth management firms represent a critical link between asset management firms (who develop investment products) and the highly fragmented retail client channel. The dominant model by which the wealth management industry connects retail clients with asset managers has changed significantly over the last several decades. The predecessor to the modern-day financial advisor is the wirehouse stock broker who rose to prominence during the bull market run of the 1980s and 90s. Typically compensated on a commission basis, the broker was as incentivized to churn client assets as he was to grow them because pay was tied to transactions rather than performance – at least directly. The result was often a gradual transfer of wealth from the customer to the broker, whose interest ran counter to most investors. Oversight was minimal, and many regulators were not properly incentivized themselves. Change was desperately needed.Fortunately, the business has come a long way since the Wolf of Wall Street days. Evolving client expectations, increased transparency, and stronger fiduciary standards have expedited the broker-to-advisor conversion in recent years. Brokerage houses fueled by commissions have largely been replaced by wealth management firms whose fee schedules vary with client assets instead of trades executed on their behalf. A financial advisor’s office now bears more resemblance to a law firm than Stratton Oakmont or Gekko and Co. The industry has definitely become more boring, which is good news for those in need of competent financial advice.This evolution has had some obvious benefits for advisors as well. Client attrition rates have plummeted since the broker days as customers are far more likely to stick around when their advisor’s interests are aligned with their own. High retention rates make it easier to retain the employees who service these accounts, enabling partners to build an actual business rather than a collection of brokers that switches firms every few years.Recurring revenue from asset-based fees is also more predictable than commission income. A wealth management firm’s ongoing or run-rate revenue is simply the product of its current AUM balance and effective realized fee percentage. This predictability makes it easier to forecast hiring needs and project future levels of profitability. These apparent financial advantages combined with the fact that the fee-based model is more appealing to clients explains why the number of broker-dealer firms has declined 24% over the last decade, while the number of RIAs has grown by over 20% just in the last five years, according to FINRA and the SEC. Asset flows also demonstrate the apparent advantages of the fee-based, fiduciary model; RIAs as a group are growing AUM at a faster rate than other distribution channels and manage a growing share of total AUM. Look for these trends to continue as investors become more educated on fee structures while regulators crack down on conflicts of interest and suitability concerns.Characteristics of Today’s Wealth Management FirmAccording to ThinkAdvior and a report from Investment Advisor Association (IAA), the typical (i.e. average) SEC-registered investment advisor has the following characteristics:Works with a team of nine employeesHas $359 million in regulatory assets under managementManages 124 client accountsHas at least one pension/profit-sharing plan as a clientExercises discretionary authority over most accountsDoes not have actual physical custody of client assets or securitiesIs organized as a U.S.-based limited liability company headquartered in California, Connecticut, Florida, Illinois, Massachusetts, New Jersey, New York, Ohio, Pennsylvania, or Texas
Even though some of the firms included in the report outlined above are not wealth managers, they are generally representative of the wealth management industry since 94% of their clients are individuals rather than institutions. The report also states that over 95% of RIAs are compensated as a percentage of AUM while just under 4% charge commissions, so it doesn’t include many broker-dealers or RIA/BD hybrids. Perhaps also in contrast to the Wall Street era, 86% of RIAs reported no disciplinary history at all.
The IAA report also states that 57% of RIAs are “small businesses,” employing ten or fewer non-clerical employees, with 88% employing less than 50 people. Unfortunately, this end of the size spectrum is not gaining market share relative to their larger counterparts. The report found that RIAs with over $100 billion in AUM grew at a faster pace than smaller advisors last year both in terms of the number of firms and AUM. The benefits of scale and branding are largely to blame for this discrepancy, and it seems likely that this trend will continue into the foreseeable future.How Does Your Wealth Management Firm Measure Up?According to RIA in a Box’s annual survey, the average advisory fee in 2017 was 0.95%, down from 0.99% in the prior year. A little math (0.95% x $359 million) implies average annual revenue of $3.4 million. According to the InvestmentNewsAdvisor Compensation & Staffing Study, the average operating margin for an RIA was 22.8% in 2017, so here’s how the “typical” advisory firm P&L breaks out:While the numbers for 2018 haven’t come out yet, we suspect they’ll be down across the board. The major indices were down 5% to 10% for the year, and realized fees have been on the skid for quite some time. Declining AUM and revenue combined with generally higher costs associated with rising compensation expenses means margins will likely be compressed as well. Valuations of publicly traded RIAs in 2018 echoed these concerns:[caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption]
The silver lining for wealth management firms is that they (generally speaking) outperformed other classes of RIAs last year and are up so far in 2019. Their superior performance is likely attributable to a more adhesive customer base that won’t jump ship after a few quarters of poor returns. Wealth managers are also generally less susceptible to fee pressure than traditional and alternative asset managers that have struggled to justify their higher rates with the rise of low-cost ETFs and other passive investment products. Wealth management and financial advisory services are primarily based on client service rather than performance relative to a benchmark, so these firms have been able to stave off fee pressure and client attrition for the most part. The ability to keep this up will likely depend on their capacity to continue servicing clients while connecting with their next generation. It’s a tall order, but most wealth managers have learned to cope with this reality for quite some time. We suspect they’ll continue to do so.
Basics of Financial Statement Analysis
Part 2: The Income Statement
This post is the second of four installments from our Basics of Financial Statement Analysis whitepaper. In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.
If the balance sheet is a photograph, the income statement is a movie. It summarizes the activity of a business over a period of time. Whereas the balance sheet caption is “as of” a particular date, the caption for the income statement reads “for the period ending” on a particular date. As its name suggests, the income statement summarizes the revenues, expenses, and resulting income for the company during a particular period.Principal Income Statement ComponentsExhibit 1 summarizes the basic flow of the income statement. We will walk through each of the principal components in turn.RevenueThe concept of revenue is intuitive. It is the amount received from customers in exchange for the goods or services provided by the company. Analysis of revenue should focus on change over time. For many businesses, it may be possible to analyze revenue as the product of some measure of volume sold and effective pricing. Doing so allows the analyst to more clearly evaluate the underlying changes in revenue (i.e., is revenue increasing due to volume growth or higher prices). When looking at revenue over time, the goal should be to identify why revenue has been stable, grown, or decreased. These factors will not be enumerated on the face of the income statement, but the overall trends should prompt further investigation to fill out the narrative more clearly. Ultimately, revenue growth (or decreases) can be traced back to some combination of a few potential factors.Increasing volume with existing retained customers. Does the company have a base of recurring customers that generate revenue each year? If so, the company may piggyback on the growth of its existing customers. If the market for the company’s goods and services is growing, is the company gaining or losing share in relevant markets? If so, why?Volume from new customers is greater than lost volume from customer attrition. Some amount of customer churn is to be expected. Even satisfied, enthusiastic customers are occasionally acquired by non-customers or go out of business. If some degree of churn is inevitable, the company will need to identify and cultivate new customers to take the place of lost customers. What are the trends in customer attrition? Why do existing customers leave, and why do new customers start doing business with the company?Sales of new products/services in excess of sales from obsolete products/services. Whether because of technological advances or other factors, the company’s existing portfolio of products and services may eventually become obsolete. Is the company developing new products or services to take the place of such products? If so, do the new offerings appeal primarily to existing customers or to those who have not historically been prospects?Price increases. Regular price increases are an often-overlooked source of potential revenue growth. Does the competitive environment permit the company to increase pricing on a regular and predictable basis? If price increases are not feasible, is the company’s production efficiency increasing?Cost of Goods Sold & Gross ProfitCost of goods sold (“COGS” for short) is easiest to understand for a retailer or wholesaler, for whom the cost of goods sold is simply the amount paid for the inventory that is then sold to the company’s customers. For a manufacturer, COGS is the sum of the raw materials, direct labor, and production overhead incurred to manufacture the company’s products. Many service companies do not report a distinct cost of goods sold on the income statement.The excess of revenue over cost of goods sold is gross profit. For the purpose of reading and understanding financial statements, gross profit is generally a more enlightening point of analysis than cost of goods sold. Gross profit represents the amount available to pay for the company’s operating expenses and generate operating income. Analysts will generally compute a company’s gross margin by dividing gross profit into revenue. Gross margin is therefore a measure of gross profit per dollar of revenue. Calculating gross margin facilitates comparisons of the subject company’s performance over time and relative to peers.Calculating gross margin facilitates comparisons of the subject company’s performance over time and relative to peers.When analyzing gross margin for the subject company over time, the reader of the income statement should attempt to reconcile observed changes to competitive factors facing the business. If the company’s production inputs include raw materials subject to price volatility, can it adjust prices in response to the changing input prices, or does gross margin fluctuate? Does the company engage in hedging activities to reduce volatility? If gross margins are contracting over time, it may be a result of pricing pressure from low-cost competitors. Conversely, if gross margins are expanding, that may suggest that the company has pricing power due to some competitive advantage relative to competitors or suppliers.Comparing gross margins to those of peers can reveal differences in strategy among firms. A company focused on product differentiation would generally expect to report gross margins in excess of their peers, while one focused on cost advantages may be willing to accept a lower gross margin in the expectation that operating expenses will be lower.Operating Expenses & Operating IncomeOperating expenses include those costs incurred to support the sales & marketing, administration, and research & development activities of the company. These overhead activities are incurred to both service existing customers and to promote the company’s growth through acquiring new customers and developing new products. Deducting operating expenses from gross profit yields operating income. As with gross profit, operating income is best analyzed relative to revenue (i.e., operating margin).Operating income (also referred to as EBIT, or earnings before interest and taxes) is an important point of comparison to other firms because it is the lowest level of earnings that is unaffected by sources of financing. In other words, a company’s operating margin reflects the efficiency with which it converts revenue to profits before taking interest expense into account.Income statements presented in accordance with generally accepted accounting principles (GAAP) do not classify expenses as fixed or variable, even though doing so can be very helpful. Broadly speaking, variable expenses fluctuate with revenue, while fixed expenses remain unchanged over a fairly wide range of revenue levels. Companies with a greater proportion of fixed expenses are said to have operating leverage, meaning that a given change in revenue will have a greater impact on operating income. Exhibit 2 illustrates the concept of operating leverage.Both companies in Exhibit 2 generate the same base revenue and operating profit. However, most of the expenses for the company on the left are variable, while those for the company on the right are predominately fixed. While revenue for both companies increased by 10%, the company on the right experienced a more substantial increase in profitability. A few observations are in order:First, all companies have some degree of operating leverage. To the extent the company has any fixed costs, changes in revenue will trigger disproportionate changes in profitability. So the real question is not whether a company has operating leverage, but rather the degree to which it has operating leverage.Second, an emphasis on scenarios in which revenue is increasing might suggest that operating leverage is inherently good. Yet, that perspective needs to be balanced by the very real possibility that revenue could decline, in which case the company with a greater degree of operating leverage will experience a disproportionate decrease in profitability. Stated alternatively, the company with less operating leverage also has a lower breakeven point. For example, the company on the left in Exhibit 2 breaks even with revenue of $625, while the company on the right would lose $113 at that level of revenue.Finally, the distinction between variable and fixed expenses is imprecise and fluid. The longer the planning horizon, the more variable a company’s cost structure is. Even over a specified time period, whether a given cost is truly variable or fixed is a matter of some interpretation. Yet, the ultimate purpose of such analysis is not absolute precision, but rather a conceptual framework for evaluating strategy and a broad measure of the effect of changing revenue on profitability.Interest Expense & Pre-tax IncomeShareholders receive current returns in the form of dividends, and lenders receive current returns in the form of interest payments. Although conceptually equivalent (both are returns to capital providers), interest payments are recorded as expense on the income statement, while dividends paid to shareholders are not.The amount of interest expense incurred during the period is the product of the average interest-bearing debt balance outstanding during the period and the effective interest rate on the debt. The rate on debt can be either fixed at a set rate for the duration of the instrument, or it may float with reference to a market rate, like LIBOR. In either case, the amount of interest expense is not correlated with the amount of revenue or operating income generated by the company during the period. In other words, even floating-rate interest constitutes a “fixed” cost. Whereas operating leverage describes the change in operating income relative to a given change in revenue, financial leverage describes the change in pre-tax income relative to a given change in operating income. As with operating leverage, financial leverage magnifies both upside and downside returns.Experienced readers of financial statements will correlate interest expense on the income statement to the balance of interest-bearing debt on the balance sheet. This check helps confirm the emerging narrative the financial statements are telling about the company and illustrates how the financial statements are related to one another.Income Taxes & Net IncomeThe final deduction in calculating net income is income tax expense. The first consideration in analyzing income tax expense is the tax structure of the company. Many privately-held family businesses are organized as S corporations or limited liability companies, both of which “pass-through” taxable income to the shareholders. As a result, such companies neither pay income taxes nor report income tax expense. From a cash flow standpoint, however, these companies almost always distribute cash in an amount that would otherwise be reported as income tax expense to fund the income tax liability that accrues to shareholders personally.For taxable entities, income tax expense will ordinarily be proportionate to the reported pre-tax income. In other words, income taxes are perfectly variable with respect to pre-tax income – if the effective tax rate in the relevant jurisdiction is 40%, income tax expense will be equal to 40% of pre-tax income.From a somewhat broader conceptual perspective, net income is the change in shareholders’ equity during the period resulting from the operations of the business.One complicating factor that need not detain us too long here is that the IRS does not use GAAP to calculate taxable income. As a result, the amount of income that the company actually pays tax on during a given year may not match the amount of pre-tax income reported on the company’s financial statements. These differences often relate to different timing assumptions regarding when certain items of revenue or expense are recognized. Eventually, such differences will reverse themselves. If GAAP income exceeds taxable income, income tax expense will be based on the higher GAAP earnings, and the difference between income tax expense and taxes actually due is recorded as a deferred tax liability on the balance sheet. If GAAP income is less than taxable income, income tax expense will still be based on the lower GAAP earnings, but the excess of taxes actually due over income tax expense is recorded as a deferred tax asset on the balance sheet.Net income is the difference between revenue and all expenses. From a somewhat broader conceptual perspective, net income is the change in shareholders’ equity during the period resulting from the operations of the business. This conceptual definition of net income is consistent with the reconciliation of shareholders’ equity summarized in Exhibit 5 in a previous post.Earnings per ShareFor public companies, earnings are expressed on a per share basis. While per share earnings are a less common expression for private companies, the underlying concept remains valid. If the reported earnings are not scaled to the number of shares outstanding, it can be difficult to assess whether earnings growth generated by investments funded through the issuance of new shares has been economically accretive or dilutive. Expressing earnings on a per share basis is also important when evaluating the effect of potentially-dilutive equity-based compensation on shareholders.Normalizing AdjustmentsOur discussion thus far has assumed a very “clean” income statement. Income statements for real companies are often a bit messier and include items such as gains and losses on the sale of assets, currency gains and losses, the results of discontinued operations, extraordinary charges due to changes in accounting principles, and other non-operating sources of income and expense. Consistent with the broad conceptual definition of net income noted in the previous section, the inclusion of such items is entirely appropriate, as these items do have a very real effect on shareholders’ equity.
On the other hand, one common purpose of income statement analysis is to discern the earning potential of the company on a prospective basis. For this purpose, it is entirely appropriate to make “normalizing” adjustments to the reported income statement. Such adjustments are used to convert the income statement from one that is backward-looking to one that is forward-looking. Normalizing adjustments will fall into one of the following three broad categories:
Clean up unusual or non-recurring events. The most obvious adjustments are those that remove the effect of unusual or non-recurring events, such as losses due to unusual weather events, large recoveries in litigation, or unusual transaction costs that obscure the true earning power of the business. One should be wary, however, if management labels every roadbump that the company encounters as “non-recurring” while assuming that every bit of good fortune represents ongoing earning power. A series of annual, non-recurring losses begins to look like a recurring feature of the business. The goal is to normalize earnings, not sanitize them.Remove the effect of discontinued lines of business. Business lines come, and business lines go. To get a clean view of the future prospects of the business, the results of discarded business lines should be excised from the reported income statement. If the discontinued business was profitable, removal will reduce normalized earnings, and vice versa. While sales and cost of goods sold can generally be readily identified, associated operating expenses may be more difficult to estimate. If too much of the expense base is allocated to the discontinued business, earning power will be overstated.Add the impact of recently acquired businesses. For an acquisition made during the fiscal year, the reported earnings of the acquirer will not reflect the full impact of the acquisition on earning power. For example, if the legacy business generates earnings of $10 million, and the business acquired mid-year earns $5 million annually, reported earnings for the year will be $12.5 million. Adjusting reported earnings to reflect a full year of operations for the acquired business will result in a more accurate view of “run rate” earnings. For acquisitive businesses, these adjustments can be significant. Ultimately, such adjustments are appropriate to the degree they accurately reflect the earnings contribution of the acquired business.
In short, earnings adjustments are an appropriate element of financial statement analysis, but the proposed adjustments should be carefully scrutinized to ensure that they do not distort the true earning power of the company.Excursus: EBITDAThe most commonly cited measure of earnings for private companies is EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is an example of a non-GAAP measure of financial performance since it does not appear on the face of most income statements. It is, however, readily calculated by simply following the components of its perfectly descriptive name. When management teams and others focus on adjusted EBITDA, it is important to have a clear reconciliation identifying the normalizing adjustments that were included in the calculation.Why do investors and managers focus on EBITDA? There are essentially two reasons. First, EBITDA is the broadest measure of earnings and cash flow for the firm. As depicted in Exhibit 4, EBITDA is a proxy for the cash flow that is available for a variety of purposes. It is therefore, in one sense, a measure of the discretionary cash flow available to a potential acquirer of the business as a whole, which explains why it is the performance metric of choice for describing and assessing merger and acquisition activity.Second, referencing EBITDA promotes comparability across firms. Working up from the bottom of the income statement, EBITDA provides the most consistent measure of relative operating performance of different companies by “normalizing” for structural features of how different companies are organized, financed, and assembled.Income Taxes. As discussed previously, many private companies are organized as tax pass-through entities and therefore report no income tax expense on the income statement. Since EBITDA is calculated without regard to income taxes, C corporations and S corporations are on equal footing.Interest Expense. The decision to finance operations with debt rather than equity does not directly affect the operating performance of the business. Since EBITDA is calculated without regard to interest expense, the operating performance of highly leveraged companies can be readily compared to that of companies with no debt.Depreciation. Depreciation is a non-cash charge. Annual depreciation charges are influenced by the amount of depreciable assets (some companies own real estate while others rent) and accounting assumptions (depreciable lives and methods). Calculating earnings prior to depreciation charges normalizes for these differences. A note of caution is in order here, however—the comparability benefits break down a bit at this point. If Company A rents facilities while Company B owns facilities, EBITDA will be lower for Company A (rent expense is deducted in computing EBITDA) than for Company B (depreciation is not). However, Company B will presumably have higher capital expenditure needs to maintain the properties that it owns than Company A will as a lessee. All of which is another way of saying that, while it is true that depreciation does not represent a cash outflow in the period recognized, it does represent a real cash outflow in a prior period, and one that will need to be repeated as the asset wears out.Amortization. Companies that grow through acquisition recognize intangible assets on their balance sheets that are subsequently written off through amortization charges on the income statement. Companies that grow organically do not incur amortization charges. Since EBITDA is calculated prior to amortization deductions, the performance of companies that have grown through acquisition is presented on a comparable basis with those that have grown organically. Unlike depreciable fixed assets, amortizable intangible assets generally do not need to be replaced through subsequent cash outflows.ConclusionThe income statement records the revenues earned and expenses incurred by the company during a period of time. Experienced financial statement readers focus on revenue growth and margins (on an absolute basis, with respect to change over time, and relative to peers). Breaking revenue down into its constituent parts (volume and price) can yield insights into the narrative behind changes in revenue over time. Analysis of fixed and variable operating expenses can help form judgments regarding breakeven revenues and the sensitivity of changes in operating income to changes in revenue. Interest and income tax expenses reveal the company’s financing and organizational decisions. Expressing earnings on a per share basis helps assess whether investments in growth have been accretive or dilutive. Normalizing adjustments may be appropriate to develop an estimate of ongoing earnings. EBITDA is a commonly-cited measure because it enhances comparability across firms and serves as a proxy for cash flow available to owners for a variety of discretionary ends.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper
How to Value a Business & Situations That Give Rise to a Valuation
Karolina Calhoun, CPA/ABV/CFF, Vice President, presented "How to Value a Business & Situations That Give Rise to a Valuation" at the Tennessee Society of CPAs West Tennessee Chapter monthly meeting in Jackson, TN.The valuation of a business can be a complex process, requiring accredited business valuation and forensic accounting professionals. This session will take a deep dive into the process and methodologies used in a valuation. Also covered will be the situations that give rise to valuation services such as estate/tax planning, ESOP annual valuation, M&A transactions, GAAP/ financial reporting, family law marital dissolution, buy-sell disputes, and corporate litigation.
Collaborative Divorce: An Alternative to Reduce Tension and Cost
In traditional divorces, each spouse engages a lawyer who fights hard to “win.” Their weapons can include bringing in their own financial professional to value financial assets. Naturally the neutrality of those valuations may be suspect in the other party’s eyes, even if the valuator follows all proper procedures. In collaborative divorce, each spouse still hires a lawyer, but the goal is to reach a settlement that satisfies each party. Neutral consultants, such as financial and mental health professionals, are also frequently involved. The model is “troubleshoot and problem-solve” rather than “fight and win.”How Collaborative Divorce WorksThe collaboration is carried out through a series of meetings in which the couples and their attorneys negotiate over issues such as property division, alimony, child support and custody. The meetings are quarterbacked by the mental health professional, who prioritizes the goals for each session, monitors the emotional climate, and keeps things on track. The attorneys each are responsible to look out for the interests of their clients, but rather than using the law to win, they are more focused on making sure their clients understand the legal issues involved and how a court might view them. The role of the financial professional, who is paid by both parties, is to provide an objective assessment of the financial issues involved. If one of the spouses has a business, the financial neutral provides an arm’s-length valuation and can also serve to educate the other spouse about the business, if needed. After several meetings, the financial neutral produces a marital balance sheet, laying out the couple’s financial landscape.Advantages of Collaborative DivorceWhile collaborative divorce is not for everyone, in the right settings it can have these advantages:A Quicker ResolutionDivorces litigated through the court system can often take a year or more to reach a conclusion. The collaborative process can move faster because there is no waiting for motions to be filed and hearings to be held.Lower ExpenseAttorneys likely will have fewer billable hours since there is less engagement with the courts. There is only one financial consultant rather than two. In addition, because litigated cases tend to take more time, there may be a need for revised valuations as economic conditions change while the divorce makes its way through the process.Less AcrimonyWhile there certainly can be tension between the two spouses during the collaborative process, the temperature tends to be lower when the working model is problem-solving rather than fighting. The addition of a mental health professional to the team also can serve to defuse tensions, and the neutrality of the financial professional can serve to reduce distrust.More ControlWhen divorce cases reach the courtroom, subjective judgments by the judge can come into play. While Tennessee law spells out guidelines for judges in divorces, they still have latitude.More PrivacyDivorce settlements litigated through the courts become public record. Settlements that result from the collaborative process do not. This can be of particular importance when one or both spouses are high-profile.ConclusionCollaborative divorce is not for everyone. Sometimes distrust between the parties has become so intense that litigation is the only way out. However, many divorcing spouses have found that a collaborative process can reduce tensions and cost and provide a result satisfactory to both parties. Attorneys can benefit from numerous services provided by financial professionals in litigated and collaborative divorce matters. At Mercer Capital, we have two professionals who are trained in the Collaborative Practice and provide assistance to attorneys in collaborative and litigated divorce matters. Please contact us if we can be of assistance to you and your clients.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
What Is a Lifestyle Analysis and Why Is it Important?
A lifestyle analysis is an analysis of each party’s sources of income and expenses. It is used in the divorce process to demonstrate the standard of living during the marriage and to determine the living expenses and spending habits of each spouse. It is typically a more in-depth analysis than the financial affidavits required in the divorce process and is prepared by a forensic accountant. The details in the analysis serve as verification of net worth and income, and expense statements submitted by both spouses can help a judge determine the equitable distribution of marital assets as well as alimony needs.The lifestyle analysis pulls together all considerations and provides a visual of income and expenses over the remaining life expectancy. Through illustration of the aggregate sources of income(s) and expenses over time, one can discern what funds are actually required (and if these funds are available) to maintain standard of living, i.e., to fund expenses. The exercise then yields relative analyses (percentage comparisons and trend analyses), and ultimately, an illustration of net worth at a point in time, as well as net worth accumulation over time.Factors Considered for Spousal SupportIn Tennessee, the Decree for support of spouse is under § 36-5-121(i). Careful consideration must be given to the factors listed in the statute when determining historical lifestyle (standard of living) as well as reasonable need into the future. Twelve factors assist in determining whether the granting of an order for payment of support and maintenance to a party is appropriate, as well as determining the nature, amount, length of term, and manner of payment. Refer to § 36-5-121(i) for the full listing.Although each of the factors must be considered when relevant to the parties’ circumstances, the first factor, “the relative earning capacity, obligations, needs, and financial resources of each party, including income from pension, profit sharing or retirement plans and all other sources,” has presented the two most important components: the disadvantaged spouse’s need and the obligor spouse’s ability to pay.Hence arises the “pay & need analysis,” also known as the “lifestyle analysis.”Sources of Financial Information Used in the AnalysisThe following documentation provides financial information used in the analysis and is typically requested during the discovery process.Tax returnsBrokerage accountsRetirement, pension accountsBank, debit card, credit card statementsPersonal financial statementsLoan applicationsInsurance policies (cash surrender value)Mortgage statementsTrusts, willsDeeds to home, vehicles, motorboats, etc.Annuity, stock certificates, deposit boxBusiness valuationsAppraisals of tangible items (artwork, collectibles, etc), among othersThe Process: Building a Lifestyle AnalysisThere are many moving pieces in constructing the lifestyle analysis, and the components can be quite different from case to case. During the preliminary stages, the financial expert/ forensic accountant will obtain pertinent documents from the aforementioned documentation in order to create the marital balance sheet (and potential separate property) and assess historical and current earnings and expenses/spending habits. Additionally, the expert may also assist in building a budget based on historical expenses. The expert will review retirement plans and annual contributions, brokerage accounts, cash & savings accounts, their respective average rates of return as well as varying tax obligations. The risk tolerance of the individuals can even be considered in relation to future rates of return. For example, a person with ample disposable cash may be willing to invest in riskier ventures where the return may be higher, than a person who chooses to invest conservatively due to limited disposable cash.The investigative process may even lead the parties to establish the “true income” of a spouse who is suspecting of perpetrating fraud and determine any possible hidden assets or dissipation of marital assets.Ultimately, the lifestyle analysis illustrates the sources of income, tax obligations, and disposable cash before and after expected expenses. This tool is valuable because it leads to further analyses such as relative analyses of gross earnings comparisons and after-tax disposable cash comparisons, among others. The analysis allows comparison on relative terms not just dollar amounts.Another valuable result of the lifestyle analysis is the ability to assess the parties’ net worth at multiple points in time. The net worth accumulation analysis illustrates the differences of the division of net worth at the date of divorce, and the division of net worth at the date of death. Additionally, it illustrates the net worth accumulation between those two points in time. This process may highlight what appears to be reasonable at a point in time, may or may not be reasonable when extracted over time. When used as trial demonstratives, the illustration can assist the trier of facts in determining the disadvantaged spouse’s need and the obligor spouse’s ability to pay.For a fact pattern and step-by-step illustration, refer to my Lifestyle / Pay & Need Analysis presentation from the 2018 AICPA Forensic & Business Valuation Conference.ConclusionIn financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable. The details in the lifestyle analysis can help determine the equitable distribution of marital assets as well as alimony needs.Because no two cases are alike, all components of the analysis must be carefully assessed. Complexities that may need further consideration include, but are not limited to:Earnings capacity: need for a vocational expert?Differences in retirement plans (such as tax structure & penalties): qualified vs non-qualified, Roth vs Traditional, pensions, etc.Investment risk profiles: risky vs risk averse (hence, annual returns may differ)Alimony requested: duration, dollar amount, typeBusiness ownership: valuations, personal vs. enterprise goodwill, active vs. passive appreciation (i.e., marital vs. separate)Deferred compensation:Stock options and restricted stock (both vested and unvested) • Election 83(b): timing of tax on restricted stockShort-term and long-term incentive plans (bonuses), among others
A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion. For more information or to discuss your matter, please don’t hesitate to contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
Takeaways from AOBA 2019: “It was the best of times, it was the worst of times…”
I ventured into the Arizona desert again this year to Bank Director’s Acquire or Be Acquired Conference (“AOBA”) in Phoenix in late January. This year I was struck by the dichotomous outlook for the banking sector that reminded me of Dicken’s famous line: “It was the best of times, it was the worst of times…”The Best of TimesThe weather was lovely. Phoenix/Scottsdale is the place to be in late January, and this year did not disappoint with sunny weather and a high of around 70 each day. At the same time, much of the country was feeling the effects of a severe polar vortex that caused temperatures to plunge well below zero in the Upper Midwest and Great Plains. Many of the attendees from that area were forced to stay a day or two longer due to airline cancellations.The operating environment for banks reflected a similar analogous dichotomy. Take the market for example. Most banks produced very good earnings in 2018, and many produced record earnings due to a good economy, the reduction in corporate tax rates, and margin relief as the Fed raised short-term interest rates four times further distancing itself from the zero interest rate policy (“ZIRP”) implemented in late 2008.The Worst of TimesNonetheless, bank stocks, along with most industry sectors, were crushed in the fourth quarter. The SNL Small Cap US and Large Cap US Bank Indices declined 16% and 17% respectively. Several AOBA sessions opined that valuations based on price-to-forward earnings multiples were at “financial crisis” levels as investors debated how much the economy could slow in 2019 and 2020 and thereby produce much lower earnings than Wall Street’s consensus estimates.Within the industry the best of times vs. worst of times (or not as good of times) theme extended to size. Unlike past eras when small (to a point) was viewed as an advantage relative to large banks, the consensus has flipped. Large banks today are seen as having a net advantage in creating operating leverage, technology spending, better mobile products for the all-important millennials, and greater success in driving deposit growth.Additionally, one presenter noted that larger publicly traded banks that are acquisitive have been able to acquire smaller targets at lower price/tangible book multiples than the multiple at which the shares issued for the target trade in the public market and thereby incur no or minimal dilution to tangible BVPS.TechnologyThe most thought provoking sessions dealt with the intensifying impact of technology. Technology is not a new subject matter for AOBA, but the increasingly larger crowds that attended technology-focused sessions demonstrated this issue is on the minds of many bankers and directors. While technology is a tool to be used to deliver banking services, I think the unasked question most were thinking was: “What are implications of technology on the value of my bank?”Several sessions noted big banks that once hemorrhaged market share are proving to be adept at deposit gathering in larger metro markets while community banks still perform relatively well in second-tier and small markets. Technology is helping drive this trend, especially among millennials who do not care much about brick-and-mortar but demand top-notch digital access. The efficiency and technology gap between large and small banks is widening according to the data, while both small and large banks are battling new FinTech entrants as well as each other.Not all technology-related discussions were negative, however. Digital payment network Zelle (owned indirectly by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, US Bank, and Wells Fargo) has grown rapidly since it launched in 2017. Payment volume in dollar terms now exceeds millennial-favorite Venmo, which is owned by PayPal. Also, JPMorgan Chase rolled-out a new online brokerage offering that offers free trades for clients in an effort to add new brokerage and banking clients while also protecting its existing customer franchise.Steps to Create ValueIn addition to the best of times/worst of times theme, I picked up several ideas about what actions banks large and small can take to create value.Create a Digital/FinTech Roadmap for Your BankThere was a standing room only crowd for the day one FinXTech session: “The Next Wave of Innovation.” This stood in stark contrast to the first AOBA conference I attended which was during the financial crisis. Technology was hardly mentioned then and most sessions focused on failed bank acquisitions. Clearly, this year’s crowd proved that technology is top of mind for many bankers even if the roadmap is hazy. A key takeaway is that a digital technology roadmap must be weaved into the strategic plan so that an institution will be positioned to take advantage of the opportunity that technology creates to enhance customer service and lower costs. Further, emerging trends suggest that technology may help in assessing credit risk beyond credit scores. To assist banks in creating a FinTech roadmap, Bank Director recently unveiled a new project called FinXTech Connect that provides a tool bankers can use to consider and analyze potential FinTech partners.Become a “Triple Threat” BankDuring our (Mercer Capital) session, Andy Gibbs and I argued for becoming a “triple threat” bank, noting that banks with higher fee income, superior efficiency ratios, and greater technology spending were being rewarded in the public market with better valuations all else equal (see table below). While we do not advocate for heavy tech spending as a means to an ill-defined objective, the evidence points to a superior valuation when technology is used to drive higher levels of fee income and greater operating leverage. For more information, view our slide deck.Plan for the Good and Bad Times, Especially for the Bad TimesWhile there was a lot of discussion about an eventual slowdown in the economy and an inflection in the credit cycle, several sessions highlighted that a downturn will represent the best opportunity for those who are well prepared to grow. The key takeaway is to have a plan for both the good and the bad economic times to seize opportunity. Technology can play a role in a downturn by helping add customers at very low incremental costs.Best Practices around Traditional M&AOn the M&A front, two M&A nuggets from attorneys stood out as well as a note about MOEs (mergers of equals):Sullivan & Cromwell’s Rodgin Cohen suggested that buyers should determine what the counterparty wants and structure the transaction to achieve the counterparty’s objectives. Also, buyers need to “ride the circuit” to meet with potential acquisition candidates well before a decision to sell is made, while sellers need to know what they want to achieve before launching a sales process.Howard & Howard’s Michael Bell, a leading attorney to credit unions, had an interesting session where he noted commercial bankers should actively court credit unions as potential acquirers in a marketing process because credit unions’ lower operating cost structures and tax-exempt status can produce a better cash price for the seller.A few sessions discussed the potential for MOEs to create value for both banks’ shareholders through creating scale and by combining banks with different areas of strength. In addition, MOEs create an opportunity to upgrade technology while addressing costly legacy systems, including extensive branch networks. All three themes were addressed in two large MOEs announced in 2019 by TCF/Chemical and BB&T/SunTrust.ConclusionWe will likely be back at AOBA next year and hope to see you there. In the meantime, if you have questions or wish to discuss a valuation or transaction need in confidence, don’t hesitate to contact us.
Four Themes from Q4 2018 Earnings Calls
We Read the Earnings Calls so You Don’t Have to
Commodity prices exhibited significant volatility to end 2018 with steep declines in crude prices and a spike in natural gas prices that subsequently fell back. The general market also declined over the period, making it difficult to parse reasons for various stock price gyrations. While lower prices aren’t ideal for industry operators, earnings calls remind wary investors that there’s more to price than what trades on the NYMEX. Executives this quarter also note a shift in focus when it comes to capital outlays.We take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Hedging Protects Operators from Lower Crude Prices Our 2019 crude oil hedge positions remain unchanged. We have 95,000 barrels of oil per day hedged for calendar 2019 with $60 WTI put option contracts. We expect option premium amortization will be approximately $29 million per quarter in 2019. –John Rielly, CFO, Hess CorporationIt is notable that we remain the only publicly traded U.S. producer that is 100% hedged on expected natural gas production in 2019. –Glen Warren, President and CFO, Antero Resources CorporationIn order for operators to mitigate risk and volatility in commodities such as crude oil and natural gas, many companies will engage in hedging, mostly by use of derivative instruments. This ability to effectively pay a fixed price over future periods of time, commonly in the form of commodity futures and various option contracts, allows for more certainty and stability in cash flows particularly when prices exhibit volatility. This is particularly important for an industry that requires significant capital outlays and long term budgeting plans. While hedging is certainly beneficial when markets behave as they did in Q4, it is important to realize these contracts come at a cost as noted in the Hess quotation above. In response to analyst questions, Hess Corp’s CEO noted future hedging would be of a similar structure where they “protect the downside but we don’t cap the upside.”Hedging protects E&P companies from adverse price realization, effectively propping up operations when commodity prices fall. These instruments tend to smooth results, so revenue does not drop too severely in bad times, though its costs do lower profits in times of rising prices. When valuing E&P companies, the increased cost would be a calculated reduction in value; however, hedging lowers volatility and risk. If companies sought to save this cost and expose themselves to commodity risk, it could be subject to a higher discount rate to account for these risks. Ultimately, hedging is a form of insurance and is a cost of doing business.Theme 2: Local Pricing and Transportation Issues Also Obscure Prices Achieved by Operators2018 was a volatile year for oil prices, especially in the Permian. As you can see on Slide 4, we successfully navigated a challenging midstream takeaway situation throughout the year and delivered a realized oil price that comfortably outpaced both, our peers and local Midland prices. Even more importantly, our proactive marketing strategy delivered ample flow assurance without burdening our long-term pricing structure. So we would expect to stay near the top of the class on this measure in coming years. –Matt Gallagher, President and CEO, Parsley Energy, Inc.
[caption id="attachment_25161" align="aligncenter" width="459"]Source: Parsley Energy Earnings Presentation, Slide 4[/caption]
Our strategy is to have multiple export markets here to provide us flexibility to move our oil into the highest value market. So, we can get about 70% of our oil to the coast to get the Brent influenced pricing. –John Rielly, CFO, Hess CorporationThe ability to sell this oil at Brent-related pricing has had a very positive impact on both margins and returns in 2018. For instance during the fourth quarter, we moved about 90% of our oil to the Gulf Coast which had the effect of increasing our oil margins by over $9 per barrel. –Rich Dealy, Executive Vice President & CFO, Pioneer Natural Resources Company
[caption id="attachment_25167" align="aligncenter" width="527"]Source: Bloomberg[/caption]
A recurring theme throughout 2018 was the pricing differentials between localized prices and those seen on different exchanges such as the standardized Cushing, Oklahoma. The Brent-WTI spread was also pronounced throughout the year, with an average spread of $6.79 per barrel, peaking at $11.37 in June. Capacity constraints from a lack of infrastructure in place to bring the product to market played a role in this, and operators in all regions dealt with localized pricing differentials. As we see from these quotes, many operators are seeking markets where they can achieve higher pricing, particularly those related to Brent in the Gulf Coast.Higher prices received for a given level of production increases profit for E&P companies, but transporting the product to these markets incurs increased costs too. Ultimately, companies must balance the increased revenue with the incrementally increased costs to make sure returns are realized from this strategy.Theme 3: Lower Prices Reign in CapEx BudgetsLast month we discussed various capital budgets through three different pricing scenarios, but we've decided to limit our full capital spend in 2019 to $4.5 billion. This represents a $500 million or a full 10% reduction from 2018. By maximizing efficiencies, we are reducing spending to adjust to a lower oil price environment. –Vicki Hollub, President and CEO, Occidental Petroleum CorporationIf we get extended in an extended low-price environment and really would have to go really more into 2020, the tail-end of 2019 into 2020, in that case an extended low-price environment we have the flexibility as we mentioned to reduce our annual CapEx by as much as $1 billion and that’s principally by reducing rigs in the Bakken. –John Hess, CEO, Hess CorporationIn an effort to align spending with cash flow projections both Appalachia and Permian producers are reducing 2019 capital budgets, which results in lower supply growth in 2019 with an even more meaningful supply impact in 2020. –Glen Warren, President and CFO, Antero Resources CorporationAntero will remain flexible depending on the commodity price outlook. We will remain disciplined, spending within cash flow in a low case but have the ability to prudently grow production to maximize free cash flow if commodity prices improve ultimately delivering an appropriate mix of return of capital to shareholders and further deleveraging. –Paul Rady, Chairman & CEO, Antero Resources CorporationMany CapEx budgets for 2019 and beyond were revised downward after the steep drop in oil price as it makes less sense for operators to ramp up production under these conditions. As is noted above, CapEx budgets will remain flexible as an increase in prices would induce operators to produce more in the short-term.Higher CapEx spending in the near term increases revenue for E&P companies, though this will ultimately decrease overall return if the operator does not scale back production until prices rise again.Theme 4: Market Not Paying for Growth Without ReturnCapital discipline has been the buzzword in the E&P industry throughout most of 2018, and certainly as we enter 2019. At Marathon, we have a very clear working definition of capital discipline […] It means prioritizing sustainable free cash flow generation at conservative prices over growth for growth sake. We've been very clear that production growth is simply an outcome of our disciplined capital allocation process, and given our commitment to returns and cash flow, we emphasize high-value oil growth to drive both high margins and capital efficiency. And with sustainable free cash flow, capital discipline for us is also a commitment to return capital back to shareholders, through both our peer competitive dividend and thoughtful share repurchases. –Lee Tillman, Chairman, President, and CEO, Marathon Oil CorporationThe steps we took in 2018 will be really important when it comes to 2019 in the sense that we in our 2019 plan can point to a significant CapEx decrease about 11% compared to 2018, while at the same time delivering a strong 15% increase in production. So, we're very excited about what 2019 holds when we can show that kind of capital efficiency gains. –Tim Dove, President & CEO, Pioneer Natural ResourcesWell, I think, first of all, we are slowing down growth, if you look at this year compared to the prior two years, we've been well into the 20s in terms of growth percentages. We have moved this down. We have a range now which centers on 15%. Obviously, we can ratchet within that range at a moment's notice. It's based on how much activity we want to execute on. But fundamentally, we've taken significant steps to increase basically return of capital to shareholders and we wouldn't have a $2 billion share repurchase plan if that wasn't the case. But I think we have to go further. –Tim Dove, President & CEO, Pioneer Natural ResourcesParsley expects to see an 8% to 10% plus year-over-year improvement on capital efficiency during 2019. We expect both productivity gains and CapEx savings to drive this improvement as detailed down the right hand side of the slide. –Matt Gallagher, President and CEO, Parsley Energy, Inc.
[caption id="attachment_25160" align="aligncenter" width="519"]Source: Parsley Energy Earnings Presentation[/caption]
As a consequence to reductions in capital budgets, companies are emphasizing capital efficiency over capital expenditures. The market has indicated that a perpetual cycle of growth not sharing the returns with investors is becoming less appealing. Doug Leggate, a Merrill Lynch analyst and frequent participant on industry earnings call Q&A sessions, posed this question directly to Pioneer, specifically noting the share price had not increased since March 2016 despite production doubling in that time frame. The CEO’s response is our third quotation above. Companies will need to strike a balance between funding their growth operations, paying down debt, and returning capital to investors in the form of dividends and share repurchases.Capital efficiency, that does not negatively impact long-term growth prospects, would increase the value of E&P companies as it focuses on increasing returns. In the typical Gordon Growth model for determining intrinsic value of a stock, it gives investors a return in the form of dividends as opposed to capital appreciation, which is only rewarded if the market is willing to pay for it.
Tax Law Changes Affecting Family Law: 2019 Changes and Recap of 2018 Changes
2019 ChangesBy now, many are familiar with the changes from the Tax Cuts and Jobs Act (TCJA), however, specific changes related to family law and alimony deductibility went into effect in 2019.Alimony Payments. Effective January 1, 2019, alimony payments are no longer deductible to the payer spouse, and are no longer taxed to the recipient spouse. This applies to divorces finalized, by settlement agreement or court order, on or after January 1, 2019. Under the prior law, alimony was deductible to the payer, reducing income and basis for taxes, and taxed to the recipient, increasing income and basis for taxes. The change is permanent and will not sunset, like some of the TCJA amendments.Income from Trusts. Also, under the prior law, income of a (alimony) trust paid to the ex-spouse was taxable to the recipient and not to the grantor. The TCJA eliminated that rule.Existing Agreements and Modification Requests. Existing alimony or marital dissolution agreements, as well as any modification requests, are grandfathered to pre-January 1, 2019 rules as per existing agreements, unless both parties mutually consent and specifically opt to implement new rules. Alimony modification requests made January 1, 2019 and after will require recognition of the changes of the tax law.Recap of 2018 ChangesWe discussed many of these in a prior newsletter. The changes are as follows.Personal Exemptions. Under the new tax law, personal exemptions are eliminated. Previously, personal exemptions were often used during divorce settlement negotiations with the parties splitting these deductions and sometimes one spouse compensating the other spouse to “purchase” the use of this exemption.529 Plans. The new tax law expands the use of 529 plans to include secondary education and other uses, whereas it was previously only available for college and higher education. Often, 529 plan accounts exist in a marital estate and become a topic discussed during settlement negotiations for how/when they will be used.Business Valuation. TCJA reduced corporate income tax rate from 35% to 21%. The valuation of C corporations could be higher simply due to the mechanics of income approaches to value a business, all other factors held equal.Child Tax Credit. The TCJA increased the credit to $2,000 and the income phase-out increased to $200,000 ($400,000 for joint filers).Other Deductions. TCJA repealed legal and accounting fees related to taxable alimony, divorce-related tax planning, and related analysis. The TCJA suspends the miscellaneous deductions through Dec. 31, 2025. This also applies to professional fees related to splitting of Individual Retirement Accounts or ERISA plans (e.g., QDRO fees).
For more information, see this helpful reference.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2019.
Warren Buffett and the Intrinsic Value of Investment Management
A Few Reflections on the 2019 Berkshire Hathaway Shareholder Letter
In a world where non-stop financial commentary is as commonplace as it is tedious, one man’s market insights get an unusual amount of attention: Warren Buffett’s annual shareholder letter. Buffett is an ironic icon of the investment management industry. He’s made his fortune from active investment management, but regularly articulates his skepticism of the same. He’s doubtlessly inspired more people to found RIAs than any other individual, yet his firm, Berkshire Hathaway, is not an RIA. And his annual treatise on the performance of his company is full of common-sense wisdom that, based on Berkshire’s track record, is anything but common.
Buffett’s annual letter may be the most anticipated event of the financial reporting season, and this year’s letter – released on Saturday – did not disappoint. My favorite passage, decrying the use of “adjusted EBITDA” as a proxy for operating earnings, recounted a story from another famous American:Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “Four, because calling a tail a leg doesn’t make it one.” Abe would have felt lonely on Wall Street.The Rap on GAAPAlso common to Buffett’s annual letter was his comparing and contrasting intrinsic value (what assets are “worth”) and market value (how assets are “priced”). Readers of this blog don’t need any further explanation of why he would revisit such a topic each year, but Buffett actually opened this year’s letter with the issue because of a change in accounting rules which requires Berkshire Hathaway to mark the value of its positions in public equities to market on its balance sheet, and report any corresponding gains or losses on the company’s P&L.This new fair value reporting requirement makes sense at first glance (why not use market pricing if available?), but Buffett effectively and emphatically deconstructs this accounting standard by noting that 1) it doesn’t require the company to adjust the value of Berkshire Hathaway’s marketable securities for taxes on embedded capital gains paid at the realization of market value, and 2) it doesn’t have a corresponding standard for the company’s interests in entire businesses which, because they are owned outright by Berkshire, aren’t publicly traded. So while Berkshire Hathaway’s holdings of Apple and American Express are marked to market, GEICO is held at cost.During the volatile fourth quarter of 2018, Berkshire Hathaway’s marketable securities portfolio registered “gains” and “losses” by this standard of $4 billion on several individual days (an amount equivalent to the company’s reported earnings for the entire year). Yet Buffett notes the companies owned by Berkshire Hathaway generated operating earnings in 2018 that exceeded their previous high (in 2016) by 41%! The Oracle’s message is clear: GAAP is actually obscuring Berkshire Hathaway’s performance rather than reporting it.Does the Market Obscure the Value of Investment Management?Market pricing of investment management firms over the recent past has shown a similar level of volatility, such that owners of RIAs, BDs, and trustcos (our clients) may be wondering what the impact of market behavior is on the “value” of their firms. It’s a simple question with a complicated answer.[caption id="attachment_25140" align="aligncenter" width="1000"] It’s been a rough six months for our indices of traditional asset management and wealth management firms. The drop in broader equity indices brought about even greater selling of investment firms, despite the fact that wealth managers usually have a strong allocation to fixed income and are, therefore, less exposed to market downturns. Even as equities recovered, the damage to market pricing for investment management firms has persisted.[/caption]
In the valuation community, there are three traditional approaches to value: asset, income, and market. The asset approach is a basket of balance sheet focused methodologies that aren’t usually considered to mean much to the value of firms where it is commonly stated that the “assets get on the elevator and go home each night” (more on that later).
The market approach can be tricky to apply to the valuation of a closely held asset manager.The market approach can be tricky to apply to the valuation of a closely held asset manager. How does one compare the public pricing of a behemoth like Franklin Resources to, say, a niche institutional equity manager with $3.0 billion in AUM? If BEN is priced at 6x EBITDA or 10x EBITDA, is that relevant to a firm with one strategy and a couple dozen employees? Moreover, if – over the past six months – BEN dropped 15%, appreciated to a recent high, then dropped 20%, and is now priced roughly even with where it was six months ago (which is what has happened), does that mean the value of a closely held asset manager oscillated similarly?Buffett, of course, uses what he perceives as market mispricing to buy securities at a discount to what he thinks they are worth. By “worth,” he means intrinsic value. As illustrated by the discussion above, it’s sometimes difficult to derive intrinsic value from market approaches. The income approach, however, is useful.I won’t drag you through all the numbers, but I modeled a sample wealth management firm through 32 years of market gyrations to see what impact market movements had on the discounted cash flows of the business (a decent empirical estimate of intrinsic value). My inputs were:Starting AUM of $1.0 billionModest accretion of client assets under management (net of client withdrawals and terminations)Aggregate average portfolio returns of 6.5% after feesDistinction between fixed and variable costs (mostly compensation) in the expense baseDiscount rate of 15% and a terminal multiple of 8x net
I ran ten-year DCFs over each year of the model to see 1) if there was a positive buildup of value estimated under this income approach, and, 2) what was the resulting multiple implied in each year of the analysis. With a 32-year time series, this gave me 22 point estimates of value.
The result of this exercise suggests the stability of intrinsic value for investment management firms, regardless of market circumstance. There was a general upward trend in the estimate of intrinsic value over the forecast period, even in bad market conditions, probably because an upward trending market and a successful client acquisition program are more than enough to overcome the inevitable downturns. The multiple implied by these intrinsic value estimates ranged from 7.25x EBITDA to 9.25x EBITDA, with the average and median multiple falling near 8.0x. The multiple derived was, obviously, dependent on the discount rate, but the point is that the range was fairly tight regardless of market circumstance.Narrative over Numbers: What Is the Intrinsic Value of Investment Management?One reason Buffett’s letter is more widely read than this blog is he doesn’t simply bombard his readers with numbers. He also tells the story of his investments in a narrative format which makes sense without reference to margins and the cost of capital. In recent years Buffett has not failed to extol the virtues of his investment in GEICO. He loves the property & casualty insurance business because people give them money (premiums) in advance of them having to give some of it back (claims) and in the meantime they can invest the money (float). That float has helped build Berkshire Hathaway’s investment base into the powerhouse it is today. The story tells the numbers even better than the numbers tell the story.It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night.The narrative of investment management goes a long way to explaining the intrinsic value of an RIA. It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night. No doubt the talented teams which staff these firms are hugely responsible for their success – and those assets don’t increase or diminish in value with market volatility. But the team is only part of the story. Client assets (AUM) do correlate to a great extent with the market, but client relationships do not. In fact, bad markets can put clients into “play,” offering opportunities to pick up new relationships and new AUM from competing firms. The opposite is also true—strong client relationships are a source of assets to manage, in good times and bad, and serve to underpin the intrinsic value of an investment management firm.Finally, the intellectual property of a firm: the investment management process, the client service experience, and the marketing program which drives new client acquisition all work to ensure that a firm has a steady (if not always stable) stream of revenue and profitability in bull markets and bear markets.Avoiding the Curveball of Market PricingMost partners in RIAs instinctively view the value of their firms from the perspective of intrinsic value. We generally agree with this, but caution that market pricing still offers information and parameters which can’t be ignored, especially in a world of alternative returns. Our assignments often revolve around the concept of “fair market value” – and the second word in that standard cannot be ignored.Even in a fair market value framework, though, it can be useful to remember that buyers and sellers of investment management firms usually don’t perceive the value of these firms to be nearly as volatile as market pricing of publicly traded RIAs. A useful perspective is that of the antique car market. With few exceptions, even cars which eventually become very collectible experience steep depreciation during the first couple of decades after their manufacture. Most never recover, but those with some discernible mystique eventually become worth what they initially sold for, some of those sell for their initial price adjusted for inflation, and a precious few become worth much more. The value of this last group of sought after automobiles, however, is not the steel and glass and rubber, but the intangibles of beauty and engineering prowess. Speed and scarcity don’t hurt either.A focus on building intangible assets cements the foundation of intrinsic value for investment management firms, in good markets and bad. Do that and you’ll have a warehouse full of Gullwings.
Five Reasons Your Financial Projections Are Wrong
From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.Why do our operating and capital budgeting forecasts always seem to turn out to be too optimistic?Excessive optimism is a common problem in corporate forecasting exercises. The good news – or maybe it’s the bad news, depending on your perspective – is that overly optimistic projections are not necessarily the result of intentional errors on the part of your family business managers. Rather, behavioral economists tell us that humans are prone to overconfidence as a result of what they refer to as cognitive biases. One of the best non-fiction books of the past decade explores how these cognitive biases function and their ubiquity in everyday life, including business forecasting. All family business directors would benefit from reading Daniel Kahneman’s Thinking, Fast and Slow. In this post, we present a thumbnail sketch of the most common cognitive biases contributing to overly optimistic forecasts.1. Illusion of ControlWe tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control.Simply put, we humans fail to appreciate just how little control we have over the events that go on around us. This tendency may well have some beneficial side effects in our everyday living, but it quickly becomes a liability when family business managers begin to forecast future results for a new project. In looking back at prior events for guidance, we tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control. As a result, we assume that – based on what we have learned from the past – we will do better this time. However, our control over future outcomes – even if we have truly learned some valuable lessons, and will therefore execute better – is much smaller than we assume. The result is a tendency to formulate overly optimistic forecasts, since we operate under the illusion that we exert far more control over the outcome than we actually do.2. Availability BiasThe availability bias describes the fact that we tend to assign too much weight to observations that are easy to recall from our memory. For example, someone contemplating a visit to the beach is likely to overestimate the likelihood of a shark attack relative to other perils because – although exceedingly rare – when sharks attack, it is news.For family business managers, the availability bias manifests itself when scenarios that have either happened before or are easily imagined get assigned too much weight in a probability distribution. We construct mental probability distributions not on the basis of statistical likelihood, but relative to the ease with which we can quickly generate examples of particular outcomes. Successful family businesses have a history of good outcomes which managers unconsciously draw upon when assessing the likelihood of future outcomes. This can contribute to overly optimistic forecasts.3. Desirability BiasThe desirability bias names the tendency to accept things as true that we want to be true. Since family business managers naturally want their proposed project to have a good outcome, the desirability bias suggests that they will actually screen out evidence or data that does not support the desired outcome (project success), while emphasizing and highlighting evidence and data that does support the desired outcome. It is not hard to see how the desirability bias contributes to unrealistic projections.4. Anchoring EffectBehavioral economists use the term anchoring to describe the tendency for our estimates to get “stuck” on the first number we see or impression we receive, even when there is no logical basis for doing so. Kahneman provides the following example of the anchoring effect: when asked to estimate Ghandi’s age at death, individuals who are initially asked if he was older or younger than 114 will estimate a much older age than individuals preliminarily asked if he was older or younger than 35. The preliminary question has no bearing on the estimate of Ghandi’s age, but respondents invariably get anchored to that initial number.Since the initial expectation for any capital project is that it will be successful (otherwise it wouldn’t be seriously considered), it is natural for family business managers to become anchored to the initial expectations, even in the face of evidence to the contrary.5. Extrapolation BiasWe fall prey to the extrapolation bias when we assign too much weight to recent events. A classic example is that after seeing a coin-flip land on heads five times in a row, people will begin to extrapolate that trend into their expectations for future outcomes of the coin-flip even though the results of previous coin flips have no effect on the outcome of the next flip.For family business managers, the extrapolation bias comes into play when the 15% revenue growth experienced last year is assumed to persist even in the face of no, or contradictory, evidence.Organizations, like family businesses, are better equipped to counteract the baleful effects of cognitive biases than individuals are.Apologies if this list seems a bit depressing. If these biases are really a part of human nature, must family business directors be resigned to receiving overly optimistic project forecasts? The good news, as summarized by Kahneman in Thinking Fast, Thinking Slow, is that organizations like family businesses are better equipped to counteract the baleful effects of cognitive biases than individuals are. The two most important steps that family businesses can take are to (1) promote awareness among managers of what the cognitive biases are and how they influence forecasting, and (2) create and institute procedures that help limit the damage from cognitive biases. Our family business advisory professionals can help with both tasks; give us a call to discuss your needs today.
David Smith Joins Mercer Capital and Opens Houston Office
Mercer Capital is pleased to announce that David Smith, ASA, CFA has joined the firm and leads the firm’s Houston office.Smith, formerly the leader of the Houston valuation practice of HSSK, has over 20 years of business valuation experience. He values businesses, business interests, and intangible assets for financial reporting, corporate tax, corporate M&A, employee stock ownership plans, and gift and estate tax purposes.David joins the firm's Oil and Gas industry team. Throughout his career, he has worked extensively with clients in the oil and gas industry. He has performed numerous valuations in the oil and gas exploration, oil and gas field services, oil and gas equipment, and gathering system and pipeline industries.David holds the Accredited Senior Appraiser designation from the American Society of Appraisers and the Chartered Financial Analyst designation from The CFA Institute.“We are very pleased to have David join us. He brings a depth of experience and expertise to the firm,” commented Matt Crow, Mercer Capital’s president. “David has a stellar reputation in the Houston market and will build a strong team for the firm in Houston. We are committed to the Texas market and David’s addition allows us to continue to serve that market with the highest quality valuation and consulting services.”Bryce Erickson, Mercer Capital's Oil and Gas industry team and Dallas office leader, remarked, "Given David's experience, his addition greatly strengthens our ability to serve our oil and gas clients. We couldn't be happier to have him on board."Smith said, “I was initially interested in Mercer Capital because of their strong reputation. Once I met the people, I knew it was the right decision. Mercer Capital is one of the most respected business valuation and financial advisory firms in the nation. Their work and people are highly regarded. I’m looking forward to building the Houston office and am happy to be part of this great team.”For more information about David, view his CV.
Preventing, or At Least De-Escalating, Family Feuds
“[He is] the epitome of the child with rich parents who wakes up on third base and thinks he hit a triple.”A recent article in the New York Times about the bickering Neumann family caught our eye with that description of an entitled family member. The taunt is cutting enough without context, but the depth of the family’s issues comes into clearer focus when we learn that the quote is from a woman describing her own father. Though not a family business fight, the Neumann family strife does revolve, predictably enough, around money: specifically, the disputed sale of enormously valuable artwork owned by the family.
Perhaps most disconcerting is not the specifics of the Neumann family travails, but the broader overall trends in intra-family legal disputes noted in the piece. According to one partner at the Los Angeles law firm, Weinstock Manion quoted in the article, “We can’t hire enough attorneys.” That comment alone is a sad commentary on the inability of a successful family business to guarantee family harmony.
So how should family business directors think about their role in making sure their family does not turn into the Neumann’s? In our experience, it is important for directors to think about this question in terms of both preventing family strife from starting and de-escalating volatile situations that already exist.The Ounce of PreventionAmong the responsibilities of family business directors is providing guidance and oversight to the risk management function of the firm. Family businesses face manifold risks associated with the operating environment, industry and economic conditions, capital availability and the like. But directors cannot afford to overlook the risk of shareholder dissension to the business. Certainly, there are no guaranteed strategies for preventing shareholder discontent, but in our experience, most cases of serious shareholder angst are rooted in communication failures and breaches of basic economic fairness.Prioritize CommunicationFamily business directors seeking to minimize the risk of shareholder in-fighting need to prioritize effective shareholder communication. Shareholders crave and deserve regular, objective information regarding the performance and outlook for the family business. One of our colleagues relates the advice of his mentor in the asset management business: “Clients don’t leave because they lost money, they leave because you didn’t communicate with them while they were losing money.”Effective shareholder communication requires more than sending detailed financial statements to shareholders at random intervals. Family business directors who prioritize communication establish a schedule of timely communication throughout the year that focuses on turning financial statement data into a clear narrative regarding the company’s strategy, recent financial performance, and outlook for the future.Commit to Basic FairnessRetaining earnings only to acquire low-yielding assets that do not fit any discernable corporate strategy will likely raise hackles.Second is a commitment to basic fairness. This means making corporate finance and operating decisions that benefit all shareholders, not just one generation or select employee shareholders. Basic economic fairness manifests itself in multiple ways – here are a few examples:The family business has a coherent strategy that guides investment and distribution decisions. If the shareholders understand and approve of the strategy, reinvestment of earnings to fund attractive capital projects in lieu of distributions will generally not frustrate shareholders. On the other hand, retaining earnings only to acquire low-yielding assets that do not fit any discernable corporate strategy will likely raise hackles.The family business has a clearly defined capital structure target. If shareholders know what the target capital structure is, the rationale for it, and have been asked for input regarding risk tolerance, the likelihood of debt-triggered shareholder anxiety is reduced. If instead, the family business borrows money (or refuses to borrow prudent amounts of money) at random without any long-term goal or objective, shareholder distrust is likely to rise.Family shareholders who also work in the business are paid fairly. Managing a family business is hard. Non-employee shareholders are occasionally guilty of thinking that managing the business should be a form of volunteer work, while family business insiders sometimes think that non-employee family members aren’t entitled to any economic fruits of their labors. Both of these perspectives are misguided, and left unchecked, can mushroom into serious strife. Since the potential for mistrust can run so high when it comes to compensation, this is a great reason to have a few truly independent directors on the board to help provide insight regarding what a real market-equivalent wage is for positions held by family members. In the end, appropriate transparency is crucial.The Pound of CurePrevention is never totally effective. Sometimes the acrimony has reached a point that family business directors need to find a way to de-escalate the situation for the good of the business. Below, we suggest a few paths forward.Objectively Evaluate Shareholder ComplaintsThe first step is for family business directors to objectively assess the economic merit of the various complaints of the disgruntled family members. If the complaints have merit, then appropriate changes should be made. Framing the dispute in terms of business decisions that have rational economic answers can help de-personalize the situation and make a workable resolution much more likely.Identify Shareholder ClientelesFraming disputes in terms of business decisions that have rational answers can help de-personalize the situation and make a resolution much more likely.As family business directors, how well do you really know your family shareholders? Outspoken Uncle Jerry may be the one calling for changes, but timid Aunt Tess may feel exactly the same way. Directors can benefit from having a mechanism to gauge shareholder attributes and preferences. If done well, this process can reveal groups of shareholders that have similar attributes and preferences. If a given clientele is large enough, it may be appropriate to consider structural changes that specifically address the clientele’s needs. This may involve a distinct class of shares or spinning off a particular operating division.Willingness (and Will) to SeparateFinally, the disagreement may be so fundamental that the best path forward for all parties is to redeem the shares of the disaffected shareholders. For shareholders being redeemed, this requires a willingness to forego potential future distributions and capital appreciation from the family business. For the remaining shareholders, this means taking on additional financial risk to pay for the redemption. For both parties, a redemption transaction requires agreement as to the price paid and terms of payment. Converting arguments to economic transactions forces both parties to carefully assess how strongly they really feel about the sources of disagreement and may help them disentangle the personal and business components of the dispute.ConclusionThe biggest threat to the sustainability of your family business may not come from competition or evolving technologies. It may come from the family itself. As a family business director, you should be attuned to this risk and take the steps necessary to help prevent, or at least de-escalate such situations. For an outside perspective on the economic merits of a family dispute that threatens your business, call one of our family business advisory professionals today.
Limited Partners, What Are Your Rights?
Legal Rights and Valuation Considerations For Your Limited Partner Interest
A partnership is a business owned by two or more individuals. In its most basic form, a partnership typically falls into one of three categories: a general partnership, a joint venture, or a limited partnership. While the specifics of these three types can vary depending on the goals of the business, they all share similar features.For the purposes of this post, we will be examining benefits and rights we have come across in performing valuations over various types of partnership structures and their relation to value. And while Mercer Capital has worked with complex legal structures in the scope of our work, we do caveat that we are examining these issues through the lens of informed business professionals. If you have specific matters regarding your investment that require legal advice, you should consult an attorney.How Does a Limited Partnership Work?A limited partnership is a type of partnership that has at least one general partner and one or more limited partners. Under this structure, the partners unite to conduct business and only the general partner is liable beyond the extent of the amount of money invested. Each limited partnership has a general partner who is responsible for the day-to-day management of the business. While a general partner is typically an individual, it is not uncommon for separate entities, such as a management company, to fill this position. This type of general partner structure is seen commonly in private equity and hedge funds. The general partner has complete control of operations, and they assume the debts and liabilities of the partnership. Since the general partner is in charge of the successful operation of the business, they are typically compensated in the form of management fees, performance fees, or both depending on the structure and purpose of the entity.Because limited partners do not participate in the day-to-day operations, their financial liability is limited to the amount of invested money into the partnership.In addition to a general partner, the limited partnership also has to have at least one limited partner. Sometimes referred to as “silent partners,” limited partners do not have to do anything except invest in the business and receive a share of the profits. Because limited partners do not participate in the day-to-day operations, their financial liability is limited to the amount of invested money into the partnership, similar to owners (members) in a limited liability company (LLC). In order to maintain this “limited” status, though, limited partners may not contribute more than 500 hours of work towards the limited partnership or else they may be considered a general partner.The tradeoff to this financial limit of liability is that limited partners have no say in management or business decisions. They are also only compensated in the form of dividends or capital appreciation pro rata or as otherwise agreed upon in the partnership agreement. More to the point, they do not have the ability to request dividends or sell/partition the underlying assets directly. We will show further below how this lack of ability directly impacts value of a limited partner’s interest.However, this does not mean that limited partners do not have other rights and entitlements to ensure that their investment is appropriately utilized. First, we will look at activities in which limited partners may participate and still retain limited liability.Safe HarborsAs mentioned, limited partners are not only limited by the amount of their investment but also in their involvement in business operations. However, there are some activities in which a limited partner can engage which will not impact their level of liability, these are known as, “safe harbors.” These activities may include the following:Serving as an agent, contractor or employee of the companyServing as a board member, officer, director or shareholder of the company, provided they do not own a majority shareProviding consultation to the general partner(s) of the companyRequesting or attending a meeting of partnersActing as a surety for the partnership to guarantee or assume its specific obligationsVoting on changes that may affect the nature of the limited partner relationship
Many limited partners do not realize they have these safe harbor activities allowing them to exercise a level of power while protecting their liability and maintaining limited status. Best practice, of course, would be to consult your partnership agreement or attorney to ensure that no conflicts arise.Rights as a Limited PartnerAlthough not a requirement, the vast majority of partnerships are born through a partnership agreement (sometimes referred to as a limited partnership agreement or “LPA”). This contract is between two or more partners and is used to establish the rules and responsibilities of the parties conducting business, such as capital contributions, withdrawals, profit and loss distribution, and financial reporting.Contained within partnership agreements are specific rights and duties outlined for both limited partners and those acting as the general partner. The rights of limited partners in a limited partnership, LLP, or even an LLC theoretically share similar to those of a shareholder in a corporation.In the absence of specific provisions in a partnership agreement, there are generally rights available to a limited partner in conjunction with the safe harbor activities mentioned above. A summary of rights we have encountered include the following:Voting within safe harbor provisionsInspection of books and recordsAbility to bring derivative actionAssignment of interest without dissolution of partnershipRight to withdraw from partnershipApplication for dissolution of partnership if business purpose cannot be fulfilled
Specific rights available to you may vary depending on the facts, circumstances, and structure of your partnership. To fully understand what is available to you, be sure to review your partnership agreement or consult an attorney.Valuation ConsiderationsKnowing your rights as a limited partner is important so that you can stay informed and ensure that your investment is deployed and utilized correctly. Another important item to understand is the valuation considerations of your limited partnership interest.We can differentiate the roles and responsibilities fairly easily as general partners do the work to ensure successful operation and limited partners provide the capital, let the general partners work, and earn a passive return. From a valuation standpoint, it may be harder to conceptualize how much a limited partner interest is worth compared to a general partner, a different limited partner, or even the entire partnership as a whole. We refer to our “Levels of Value” chart to provide a visualization of where a limited partnership interest may fit in terms of a valuation hierarchy.
A limited partner that owns a minority interest in a private partnership falls at the bottom of this chart. But how do we get down there from the net asset value?
There are likely multiple tiers of discounts applicable to a limited partner interest. The first is the portion attributable to the general partners. This is made in accordance with their capital contribution, though it is frequently small as the general partner receives payment through management fees.
Secondly, because limited partners lack the ability to make the decisions afforded to general partners, they will likely be subject to a minority interest discount. There have been observed ranges of 7-10% for the minority discount, but this amount can be much higher or even lower. It all depends on specific characteristics of the partnership. This brings us to the marketable minority level of value in the above chart. However, limited partner interests aren’t typically marketable, meaning limited partners do not have the ability to freely dispose of their interests like they could sell shares in a publicly traded company for instance.
Knowing your rights as a limited partner is important so that you can stay informed and ensure that your investment is deployed and utilized correctly.This brings us to our final discount, the marketability discount. There is a wide range of potential marketability discounts and again, these depend on the characteristics of the partnership in question. At Mercer we have seen marketability discounts range between 20-45%, but similar to the minority interest discount, these discounts can go much lower or even much higher depending on multiple factors regarding the partnership. Frequently, these discounts are considered in tandem with any minority interest discount applied, and the total effective discount must be considered.An example of this tiered discounting is provided below of a limited partnership with a total Net Asset Value of $100,000 and a general partner interest of 1%. In order to illustrate the calculation of value at the non-marketable minority interest level, we have used a minority interest discount rate of 5% and a discount for lack of marketability of 20%.
The result of the calculation yields a conclusion of value at $75,240 with an effective discount rate of 24%. This shows how a limited partner whose net asset value share of $95,000 can be discounted to reflect the lack of control over their position and the lack of marketability for a sale or assignment of interest.
ConclusionKnowing rights entitled to a limited partner in connection with understanding the relative value of their investment enables limited partners to make informed decisions.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets, companies, and partnership interests in the energy industry (primarily oil and gas, biofuels, and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your limited partnership interest. Contact a Mercer Capital professional today to discuss your limited partnership valuation questions in confidence.
How to Value an InsurTech Company
FinTech companies are the emerging and hyped sector of the financial services industry. Looking at FinTech’s recent activity, people can see that many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn” – an industry term describing a tech company valued at a billion dollars or more. While this business trajectory may seem simple and attractive, FinTech companies usually have a highly complex structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.Valuing a FinTech company can be very complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all FinTech companies have large differences, including what niche (payments, solutions, technologies, etc.) they operate in or what stage of development the company is in, understanding the value of a FinTech company is critically important. More specifically, within the FinTech industry, an exciting niche termed InsurTech is emerging and threatening to change the traditional state of the insurance industry.InsurTech NicheInsurTech is a fast growing niche that operates in a massive global insurance industry with premium revenues of about $5 trillion annually. InsurTech is the term applied to many companies that are using technology to disrupt the traditional insurance industry landscape. InsurTech has high growth prospects and the potential for InsurTech to innovate and disrupt remains large. Funding for InsurTech companies in recent years has spiked, especially for early-stage companies. Incumbents in the insurance industry have been slow to adopt disruptive, high-growth InsurTech, partly because insurance is so massive and has been around for such a long time. Additionally, many traditional insurance companies can benefit from InsurTech solutions that serve to enhance customer satisfaction and improve the efficiency of operations by leveraging technology and enhancing the delivery of certain insurance offerings and solutions through digital channels.Technology and innovation have disrupted many other long-established industries, such as the impact of medical technology in the healthcare industry. Insurance players, who maintain legacy systems believe that established customer connections will reduce the threat of InsurTech. However, this may not be the best strategy because insurance is often purchased begrudgingly. The historically strained relationship between customers and carriers is a rather vulnerable point along the insurance value chain. InsurTech companies can offer innovative technology that creates more touchpoints for customers and reduces many customer pain points.Market ConsiderationsUnderstanding how well a given InsurTech company is doing within this FinTech niche is one of the most important factors in determining its value. Market dynamics such as market size, potential market available, and growth prospects are important to understand. A valuation will consider absolute market value, existing competitors, and existing incumbents. The regulatory environment is another important consideration when valuing an InsurTech company. Financial services, such as banks and insurance companies, are heavily regulated, so understanding the rules and regulations is necessary for developing an accurate valuation.Like other FinTech niches, certain solutions within InsurTech are relatively new and have the potential to disrupt the entire insurance industry. Since many industry incumbents have been slow to adopt this new technology, the range of this innovation has yet to be fully felt and rules/regulations have yet to change. While regulatory stability may seem favorable now, concrete rules and regulations are complex and can be hard to predict as regulators react to rising InsurTech involvement. Understanding these complexities is important to valuing InsurTech companies, as these regulations could help or hinder an InsurTech’s growth potential.Company ConsiderationsWhen valuing a startup, quantitative information (financial and operating history) is limited; therefore, qualitative information can be extremely important in determining a company’s value. The quality and experience of the management team can be important. Knowledge of the insurance industry including understanding customer preferences, technology integration, the competitive and regulatory environments can enhance an InsurTech’s company value.An InsurTech company’s ownership of intellectual property and other intangible assets, like strategic partnerships, all else equal, should be considered and could increase a company’s value, assuming they are in place and well documented. When in place and demonstrated, intangibles are an important qualitative consideration.The stage of development of a FinTech company can also impact its value. Companies typically set milestones and track their own progress, and meeting these milestones might affect their valuation. Milestones usually include initial round financing, proof of concept, regulatory approval, obtaining a significant partner, and more.Milestones are important to set and track as the more milestones a startup meets, the less uncertainty exists and the more value is created. For example, an InsurTech company with established technology, increased customer touchpoints, and the potential to increase revenues will be more valuable to a potential acquirer than a newer startup. In addition, meeting later stage milestones often provide greater value than meeting early stage milestones. When the valuation considers future funding rounds and the potential dilution from additional capital raises, a staged financing model is often prepared and the valuation will vary at different stages as shown below.Valuation ApproachesAs InsurTech companies enhance business operations and reduce costs, valuations for these companies will become more important. There are three common approaches to determining business value: asset approach, income approach, and market approach. Each valuation approach is typically considered and then weighted accordingly to provide an indicated value or a range of value for the company, and ultimately, the specific interest or share class of the company.The Asset ApproachThe asset approach determines the value of a business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. This approach is generally inappropriate for technology startups as they are generally not capital intensive businesses until the company has completed funding rounds. However, it can be instructive to consider the potential costs and time that the company has undertaken in order to develop proprietary technology and other intangibles.The Market ApproachThe market approach determines the value of a company by utilizing valuation metrics from transactions in comparable companies or historical transactions in the company. Consideration of valuation metrics can provide meaningful indications for startups that have completed multiple funding rounds, but can be complicated by different preferences and rights with different share classes.Regardless of complications, share prices can provide helpful valuation anchors to test the valuation range. Market data of publicly traded companies and acquisitions can be helpful in determining key valuation inputs for InsurTech companies. For early-stage companies, market metrics can provide valuable insight into potential valuations and financial performance once the InsurTech company matures. For already mature enterprises, recent financial performance can be compiled to serve as a valuable benchmarking tool.Investors can discern how the market might value an InsurTech company based on pricing information from comparable InsurTech companies or recent acquisitions of comparable InsurTech companies.The Income ApproachThe income approach can also provide a meaningful indication of value for a FinTech company. This relies on considerations for the business’ expected cash flows, risk, and growth prospects.The most common income approach method is the discount cash flow (DCF) method, which determines value based upon the present value of the expected cash flows for the enterprise. The DCF method projects the expected profitability of a company over a discrete period and prices the profitability using an expected rate of return, or a discount rate. The combination of present values of forecasted cash flows provides the indication of value for a specific set of assumptions.For startup InsurTech companies, cash flow forecasts are often characterized by a period of operating losses, capital needs, and expected payoffs as profitability improves or some exit event, like an acquisition, occurs. Additionally, investors and analysts often consider multiple scenarios for early-stage companies both in terms of cash flows and exit outcomes (IPO, sale to a strategic or financial buyer, etc.), which can lead to the use of a probability weighted expected return model (PWERM) for valuation.Putting it TogetherGiven their complexity, multiple valuation approaches and methods are often considered to provide lenses through which to assess value of InsurTech and FinTech companies and generate tests of reasonableness against which different indications of value can be evaluated.It is important to note that these different methods are not expected to align perfectly. Value indicators from the market approach can be rather volatile and investors often think longer-term. More enduring indicators from value can often come from income approaches, such as DCF models.Valuation of an InsurTech company can be vital to measure realistic growth, to plan progression, and to secure employee and investor interest. Given the complexities in valuing private FinTech and InsurTech companies and the ability for the market/regulatory environment to shift quickly, it is important to have a valuation expert who can adequately assess the value of the company and understand the prevalent market trends.
Q4 2018 Call Reports
Volatility Drives Investors to Low-Fee Passive Strategies
Reflective of the headwinds that the industry is currently facing, asset managers generally underperformed broad market indices during the fourth quarter of 2018. As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees.
As we do every quarter, we take a look at some of the earnings commentary of pacesetters in investment management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Q4 volatility drove investor outflows.Volatility was the dominant theme as 2018 came to a close. U.S. equity markets set record highs during the quarter only to see those gains erased by late December. The selloff experienced toward year-end sent the equity markets into correction territory with virtually every asset class ending the year with negative returns. — Philip James Sanders, CEO, CIO, & Director, Waddell & ReedTurning next to flows. There are a couple of high-level themes that shaped our quarter. In general, elevated market volatility in the fourth quarter increased industry-wide client risk aversion, which led to slowing sales activity and delayed funding. In addition, we had elevated levels of retail redemptions in equities and liquid alternatives due to fourth quarter seasonality, which in the case of liquid alternatives was exacerbated by significant outflows from products with challenging recent performance relative to benchmark. — Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.Gross flows for the quarter were strong at $4 billion, while net flows were negative $1 billion as many investors retreated from higher-risk asset classes and rotated into cash. — David Craig Brown, CEO & Chairman, Victory Capital Holdings, Inc.At the end of 2018, the market drawdown, volatility, and industry-wide outflows dominated attention. Our AUM declined by more than 17%, and our stock price declined by more than 30%. — Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset Management, Inc.Theme 2: Previously, industry pacemakers suggested that the return of volatility to the markets offered opportunities for active managers. However, recent volatility has pushed investors to more passive strategies. While volatility can, at times, provide a favorable backdrop for active managers, and we firmly believe that research and insight can identify differentiated ideas for investors, the flow toward passive strategies remains steady in 2018. — Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.Our ETF business, VictoryShares, had positive net flows of $121 million in the fourth quarter, bringing full year of 2018 net flows to $1.1 billion. We continue to be pleased with the strong momentum and market share gains we're seeing in VictoryShares and note that we have experienced positive net flows every quarter since our acquisition of the business in 2015.
— Terence F. Sullivan, CFO and Head of Strategy, Victory Capital Holdings, Inc.Clients who faced large tax bills while their equity mutual funds delivered negative active returns experienced this firsthand and shifted to ETFs in the fourth quarter. […] I truly believe it's becoming more recognized, the superior nature of the ETF structure versus a mutual fund. We have heard many instances where many mutual funds who had negative NAV at the end of the year, but they also had capital gains, taxes that they were identifying to their clients. And the clients, I think, in many cases, just got quite aggravated by paying taxes with the negative NAV. Obviously, with an ETF, you control your tax basis. And I think this is becoming a bigger and bigger issue. Tax navigating for the long term, your tax position, for taxable individuals and institutions, is very important. — Laurence Douglas Fink, Chairman & CEO, BlackRock, Inc.Theme 3: Recent fee compression is largely attributable to a shifting asset class mix on lower equity balances and passive inflows. Much of this attrition is likely to be temporary in nature. I would say that as you think about the fee movement, it is driven by asset mix shift. That if you think about it, was a bit magnified in the fourth quarter given the volatility. I think it's important to focus on mixed shift versus erosion because that is truly what we're seeing here. It's about the asset classes that we're having momentum in. And I would also say that it is not a permanent movement. We have asset classes, and therefore fees that range quite broadly as we've discussed in the past. And we have seen and would expect to see momentum in some of those asset classes that higher–have higher fees, and therefore, could move it in the other direction.
— Terence F. Sullivan, CFO & Head of Strategy, Victory Capital Holdings, Inc.Our effective fee rate, what you see trending down, it's really—it is a mix shift topic for us. And you would imagine, in risk-off environments, people putting money in money funds, et cetera, that you see that happen. Oppenheimer [Funds] during the period had the exact opposite. There is an aggressive—or I should say aggressive, quite successful in emerging markets and in international equities, and those are higher capabilities. And again, that is sort of the natural flow of things within an organization. So client demand will drive those mix shifts. There's very little we can do about it. — Martin L. Flanagan, President, CEO, Director, Invesco Ltd.For the fourth quarter, aggregate fees decreased 27% to $1.2 billion from a year ago, and the ratio of aggregate fees to average assets under management declined year-over-year from 82 basis points to 63 basis points, entirely driven by lower performance fees. Notably, the ratio advisory fees to average assets under management remain flat year-over-year. — Jay C. Horgen, CFO & Treasurer, Affiliated Managers Group, Inc.
In summary, we continue to see many of the same trends we have highlighted in previous quarters.The industry is still evolving to increased fee pressure.Scale remains at the forefront of conversation as demonstrated by recent M&A activity.Rising yield curve and equity market volatility continue to pull assets into fixed income products.
Q4 was rough, to say the least, for most asset managers as both AUM and effective fee rates declined. However, most saw some normalization of flows in January. We will continue to follow changes in asset mix, which will drive fee rates in 2019.
Basics of Financial Statement Analysis
Part 1: The Balance Sheet
This post is the first of four installments from our Basics of Financial Statement Analysis whitepaper. In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company. The balance sheet summarizes a company’s financial condition as of a particular date.Similar to a photograph, the balance sheet does not record any movement, but preserves a record of the company’s assets, liabilities, and equity at a particular point in time.The fundamental accounting equation, as illustrated in Exhibit 1, is intuitive: Assets = Liabilities + Equity.The balance sheet “balances” because what the company owns (the left side of the balance sheet) is ultimately traceable either to a liability (an amount that is owed to a non-owner) or equity (the net or residual amount attributable to the company’s owners).In broad strokes, the balance sheet relationships are analogous to the economics of home ownership – the equity in one’s home is equal to the excess of the value of the house at a particular time over the corresponding mortgage balance.Equity value can grow through either (1) appreciation in the value of the house, or (2) repayment of the mortgage.In either case, equity is the residual amount.Principal Asset & Liability GroupingsAn experienced reader of financial statements can learn a lot about a company’s operations, strategy, and management philosophy by reviewing the balance sheet.The relative proportion of the major asset and liability groupings will differ on the basis of whether the company is a manufacturer, retailer, distributor, or service provider.Similarly, the relative proportion of liabilities and equity provides insight into the risk tolerances and financing preferences of the company’s managers and directors.Exhibit 2 summarizes the principal asset and liabilities groupings for operating companies.While many of the concepts are similar, analyzing the financial statements of financial companies (banks, insurance companies, etc.) is outside the scope of this article.Cash & EquivalentsCash is a surprisingly slippery asset in the context of balance sheet analysis.On the one hand, cash is king, and it is essential that the company have sufficient cash to meet obligations as they come due.No company has ever gone bankrupt because it had too much cash.On the other hand, cash balances beyond what is needed to operate the business safely don’t really accomplish much.Especially with today’s low interest rates, cash is a sterile asset that does not contribute to the company’s earnings.The appropriate cash balance for a business will depend on factors like seasonality and upcoming debt payments or capital expenditures.Working Capital (Current Assets less Current Liabilities)The designation “current” is applied to assets if they are likely to be converted to cash within the coming year and liabilities if they are likely to be paid within the coming year.The net of current assets over current liabilities is referred to as working capital.Working capital is often an underappreciated use of capital for businesses.Investments in accounts receivable and inventory are no less cash expenditures than purchases of equipment or the acquisition of a competing business.The cash conversion cycle is central to working capital analysis.As shown in Exhibit 3, the cash conversion cycle is a measure of operating efficiency for the business.Measuring the time from cash outflows for inventory purchases to cash inflows from collection of receivables, the cash conversion cycle provides perspective on the amount of working capital required to operate the business.A shorter cash conversion cycle frees up capital to be reinvested in more productive assets in the business or distributed to shareholders.For some companies with limited inventory needs or predominately cash sales, the cash conversion cycle can be very short, or even negative (meaning cash is received from customers before it is paid to suppliers).As discussed further in a subsequent section, trends in working capital balances can signal whether the company is accumulating stale inventory or is at risk of future charges for bad debt.Net Fixed AssetsThe balance of net fixed assets represents the accumulated capital expenditures of the business over time less accumulated depreciation charges.In contrast to inventory purchases and operating expenses, which offer only short-term benefits to the company (inventory has to be replenished and workers need to be paid again next week), capital expenditures are expected to provide benefits to the company over a multi-year horizon.As a result, such expenditures are “capitalized” on the balance sheet and expensed bit by bit over the service life of the asset in order to match the cost of the asset to the periods during which the company benefits from owning the asset.Depreciation is the annual charge that reflects the apportionment of the cost of a long-lived asset to the periods that benefit from the asset’s use.Over the life of the asset, the cumulative depreciation charges will equal the cost of the asset.In other words, the capital expenditure is charged to earnings as an expense over time.At a given point during the asset’s life, therefore, the balance sheet will show how much was paid for long-lived assets (the “gross” balance) and the accumulated depreciation charges that have already been recognized for the use of the asset, with the difference between those two figures being the balance of net fixed assets.Exhibit 4 illustrates the balance sheet presentation for long-lived assets over time.Analysis of net fixed assets is subject to two limitations associated with historical cost accounting.First, current accounting rules do not allow the values to be adjusted to current market value.This can be especially problematic for real property which might be expected to appreciate.For example, land that was acquired for $500 decades ago may have a current market value that is considerably higher.However, the balance sheet will continue to report the land at its original cost (land is not depreciated for accounting).Second, depreciation is an accounting technique for allocating the cost of long-lived assets to different accounting periods – it is not intended to be a forecast of the future value of an asset.In Exhibit 4, the net balance of the subject asset at the end of Year 2 is $500.That is not an estimate of the asset’s market value at that date, which might be $500 only by coincidence.As a result of these limitations, analysis of the fixed asset accounts should generally focus on relative proportions to other balance sheet components (i.e., does the company own or lease its primary facilities) and changes at the margin (are annual capital expenditures greater or less than annual depreciation charges) rather than absolute values.Goodwill & IntangiblesNot all of the company’s valuable assets are presented on the balance sheet.The historical cost accounting model only captures assets that the company has acquired in exchange for cash.Some assets, such as tradenames, technology, customer relationships, and workforce accrue slowly over time rather than as the result of a discrete transaction.For example, the accumulated advertising expenses of the company, which build the value of the tradename over time, are expensed as incurred, and never reach the company’s balance sheet.For many companies, these intangible assets can actually be more valuable than the tangible assets that are found on the balance sheet.The major exception occurs when one company buys another.In this case, Company A (the buyer) will record the hitherto unrecorded intangible assets of Company B (the company acquired) on Company A’s balance sheet.Since a transaction has occurred, the intangible assets of the acquired company will now be presented on the buyer’s balance sheet, as explained below, while the buyer’s internally-generated intangible assets will continue to be ignored.The excess of the amount paid for the business over the net tangible assets of the acquired business is added to the buyer’s balance sheet as either a specific intangible asset or goodwill.Certain identifiable intangible assets such as customer relationships and tradenames are amortized (analogous to our depreciation discussion in the preceding section), while goodwill (the amount left over after all other tangible and intangible assets have been recognized) is not subject to amortization, but is periodically tested for impairment.As with fixed assets, current accounting rules do not permit assets to be written-up to market value, so the analytical value of the goodwill and intangibles is limited.The principal questions to consider when evaluating goodwill and intangibles balances include:Has the company historically grown organically or through acquisition?If the balance of goodwill and intangibles is modest, the company has relied on internal organic growth, whereas if the balance is large and growing, the company is fueling growth through acquisition.Has the company been a successful acquirer?While some identifiable intangible assets are subject to periodic amortization, a sudden decrease in the balance of goodwill corresponds to an impairment charge, implying that the acquisition giving rise to the goodwill has underperformed relative to expectations.Interest-Bearing DebtThe operations and assets of the company are financed through either debt or equity.Evaluating the subject company’s capital structure is an important element of balance sheet analysis.Using debt increases the potential return – and risk – to the company’s shareholders.In order to assess whether the subject company is conservative or aggressive in its use of debt, it is helpful to compare the debt balance to other measures of financial performance and condition.Relative to shareholders’ equity.One obvious point of comparison is to equity, the other potential funding source.Comparing debt to the reported shareholders’ equity on the balance sheet is a simple and quick measure of the company’s reliance on debt compared to equity.When doing so, however, remember that the balance sheet reports historical cost figures, not current market values.While the current market value of debt is unlikely to stray too far from the balance sheet figure, the current market value of equity will often bear no relationship to the balance sheet.Relative to market capitalization. When calculating the weighted average cost of capital, the appropriate weightings on debt and equity should reflect market value, not balance sheet amounts.For public companies, market value of equity is known, but for private companies, it must be estimated.In neither case can the number be read off the balance sheet.Relative to earnings. A common measure of debt capacity is to relate the balance of debt to EBITDA (we will define and discuss EBITDA in a subsequent section of this series).Lenders commonly reference this measure in assessing a borrower’s ability to service a given debt load.Assessing the company’s debt burden is a key element of reading a set of financial statements.Ultimately, there is no single “correct” amount of debt for a company.The right amount of debt is a function of multiple factors, not least of which is the risk tolerance of the company’s shareholders.Shareholders’ EquityFor most operating businesses, reported shareholders’ equity bears little or no relationship to market value.As a result, analysis should focus on the period-to-period change in the equity balance rather than the absolute dollar amounts.In fact, most financial statements include an explicit reconciliation to help the reader evaluate changes in equity during the period.As summarized in Exhibit 5, the major components of the reconciliation of shareholders’ equity include the following items:ConclusionThe balance sheet provides a point-in-time summary of what the company owns and what the company owes.Experienced financial statement readers can learn a lot from the balance sheet, but the primary limitations are that not every asset is represented on the balance sheet (i.e., homegrown intangibles) and the historical cost of some long-lived assets (i.e., land) may be very different from current market value.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper
Credit Quality at a Crossroads
Last week, the Mercer Capital Bank Group headed south for a scenic trip through the fields of the Mississippi Delta, including the town of Clarksdale located about 90 miles from Memphis. Clarksdale’s musical heritage runs deep with such performers as Sam Cooke, John Lee Hooker, Son House, and Ike Turner born there, while Tennessee Williams spent much of his childhood there. Explaining the Delta’s prolific artistic output, Eudora Welty, a Mississippi writer, noted the landscape stretching to the horizon and the juxtaposition of societal elements – all these forces churning like the Mississippi river nearby.Despite its gritty roots, Clarksdale now is experiencing its own hipster renaissance. It may not be Brooklyn, but the Bank Group noticed signs for last weekend’s Clarksdale Film Festival. Visitors can stay at a refurbished cotton gin, enjoying their Sweet Magnolia Gelato made from locally sourced ingredients. Presumably, craft cocktails are available as well, this being the Delta.Beyond these recent additions to the tourist landscape, though, one attraction put Clarksdale on the map – the Crossroads. At the intersection of Highways 49 and 61, the bluesman Robert Johnson (who lived from 1911 to 1938), as the story goes, met the Devil at midnight who tuned his guitar and played a few songs. In exchange for his soul, Johnson realized his dream of blues mastery.The point of this article is not that Lucifer lurked behind the revaluation of asset prices in the fourth quarter of 2018. Instead, the market gyrations laid bare the dichotomy between bank expectations regarding asset quality and the market’s view of mounting credit risk that was overlaid by a need to meet margin calls among some investors. Indeed, credit quality faces its own crossroads.Highway 49Along Hwy. 49 lies the town of Tutwiler, about 15 miles from Clarksdale. There, in 1903, the bandleader W.C. Handy heard a man playing slide guitar with a knife, singing “Goin’ where the Southern cross’ the Dog.” Handy adapted the song, which references the juncture of two railroads, thereby making it one of the first blues recordings.From Call Report data, which includes 3,644 banks with total assets between $100 million and $5 billion, signs of credit quality deterioration remain virtually undetectable.Loan growth continued apace in 2018, maintaining the community banking industry’s recent 10% annual growth rate (Figure 1, which shows the trailing twelve month change in loans). Notably, commercial real estate loan growth decelerated in 2018. Although this presumably pleases the regulatory agencies, competition from non-banks (e.g., insurance companies) and budding risks surrounding certain sectors (e.g., retail) likely explain the slowdown.In absolute terms, nonperforming loans (nonaccrual loans plus loans more than 90 days past-due) declined in each year between 2014 and 2017 (Figure 2). As of September 30, 2018, however, NPLs increased by 4% over December 31, 2017, led by farmland NPLs (up 37%, or $258 million), agricultural production NPLs (up 32%, or $90 million), and commercial and industrial NPLs (up 8%, or $149 million). Given loan growth, though, the ratio of NPLs to loans continued to decline, falling slightly from 0.81% to 0.79% between December 31, 2017 and September 30, 2018.Annualized charge-offs for the year-to-date period ended September 30, 2018 also compare favorably to the comparable prior year period, foreshadowing a possible post-recession low in the net charge-off ratio for fiscal 2018 (Figure 3).
As they are wont to do, regulatory agencies noted some concerns regarding asset quality. However, consistent with our research into the community banking industry’s asset quality trends, the OCC also observed that “credit quality remains strong when measured by traditional performance metrics.”1 Despite its view of building credit risk, the OCC rated 95% of banks’ underwriting practices as satisfactory or strong in 2018, virtually unchanged from the 2017 level.2 Economic growth, corporate profits, and employment trends also support a sanguine view of credit quality.
While also observing weaker underwriting – for example, covenant concessions – rating agencies predict better credit performance among leveraged loans and commercial mortgage backed securities in 2019. For 2019, Fitch Ratings projects a 1.5% leveraged loan default rate, down from 1.75% in 2018. Further, commercial mortgage-backed security delinquencies, which declined by 103 basis points to 2.19% between year-end 2017 and 2018, are expected to range between 1.75% and 2.00% in 2019. The Amazonification of the retail sector, which led to retail bankruptcies and defaults on loans secured by regional malls, contributed to higher delinquency and default rates in 2018 but may subside in 2019.
The view from Hwy. 49, before reaching the Crossroads, looks favorable from the banking industry’s standpoint.
Highway 61In the words of the writer David Cohn, the Mississippi Delta begins in the lobby of the Peabody Hotel (in Memphis) and ends on Catfish Row in Vicksburg, Mississippi.3 While his observation alludes to the economic as well as the geographic extremes of the Delta region, Highway 61 is the Delta’s spine connecting Cohn’s poles.One of the more concerning statistics is the level of corporate debt. Though household debt trended down following the Great Recession (see Figure 4), nonfinancial business debt has reached near record levels as a percentage of GDP.4 According to Morgan Stanley, BBB-rated corporate debt surged by 227% since 2009 to $2.5 trillion. This leaves approximately one-half of the investment grade corporate bond universe on the cusp of a high-yield rating. Moody’s migration data suggests that BBB-rated bonds have an 18% chance of being downgraded to non-investment grade within five years, which may overwhelm the high-yield bond market.5
Regulatory agencies also observed looser underwriting. For new leveraged loans, the Federal Reserve noted that the share of highly leveraged large corporate loans – defined as more than 6x EBITDA – exceeds previous peak levels in 2007 and 2014, while issuers also are calculating EBITDA more liberally by making aggressive adjustments to reported EBITDA.6 From the OCC’s perspective, competitive pressures from banks and non-banks, along with plentiful investor liquidity, have led to weaker underwriting particularly among C&I and leveraged loans. According to the OCC, community banks are not immune. An example of weaker underwriting cited by the OCC is “general commercial loans, predominately in community banks” for which it compiles a list of shortcomings: “price concessions, inadequate credit analysis or loan-level stress testing, relaxed loan controls, noncompliance with internal credit policies, and weak risk assessments.”7
Despite unemployment rates below 4% and some evidence of rising wages, consumer loan delinquency rates have risen in 2018 (Figure 5). Some lenders, such as Discover, already have begun reducing exposure to heated sectors like unsecured personal loans.
Fears of a downturn crystallized in the fourth quarter of 2018 with the Federal Reserve’s December rate increase, trade friction with China, and signs of economic slowdowns in countries such as Germany. Option-adjusted spreads on corporate debt, after remaining quiescent through 2017 and most of 2018, widened suddenly, approaching levels last observed in 2016 when oil prices collapsed (Figure 6). According to Guggenheim, the fourth quarter spread widening implies a 3.2% high yield corporate debt default rate, up from 1.8% for 2018.8
The perspective gleaned from Hwy. 61 is not necessarily alarming, but it does suggest that, directionally, risk is rising.
The CrossroadsCredit lies at a crossroads, consistent with a late cycle economic environment. Reported credit metrics are not improving significantly, nor are they worsening; conditions suggest continued low charge-offs and loan loss provisions in the nearterm. However, the market sniffs rising risks in various corners of the economy, most notably in corporate debt. Howlin’ Wolf sang, “Well I’m gonna get up in the morning // Hit the Highway 49.” Where are banks headed? Macroeconomic conditions ultimately will be determinative, but banks should avoid complacency in this environment marked by conflicting signals and aggressive competition. The poorest loans, in retrospect, often are originated in times such as these.End Notes1 OCC Semiannual Risk Perspective, Fall 2018, p. 1.2 OCC Semiannual Risk Perspective, Fall 2018, p. 22.3 Cohn, David, Where I Was Born and Raised, 1948.4 Federal Reserve, Financial Stability Report, November 2018, p. 18.5 Guggenheim Investments, Fixed Income Outlook, Fourth Quarter 2018, pp. 1 and 8.6 Federal Reserve, Financial Stability Report, November 2018, p. 20.7 OCC Semiannual Risk Perspective, Fall 2018, pp. 11 and 24.8 Guggenheim Investments, High Yield and Bank Loan Outlook, January 2019.
Do The Upstream Sector's Mosaic Of Indicators Create A Clear Picture?
Considering the precipitous drop in oil prices at the end of last year, 2018 finished with somewhat unexpected results in the upstream sector. Take the OGJ 150, one of the industry’s upstream indexes. It was on a roller coaster. It began the year at 1,858 and generally climbed for the first three quarters. It peaked on October 9th with a closing of approximately 2,021. It then took a fall and finished the year at 1,522 about 18% off from the start of the year. However, it has since climbed back up in January and closed last week at 1,646.Questions and opinions abound. Causes, concerns, opportunities and optimism are being bandied about. There are several indicators out there that are sending mixed messages. Pricing, supply, DUC counts, LNG growth, bankruptcy activity, capex budgets and merger and acquisition trends are out there to name a few that interplay with each other. They create a visual of what is happening and what could happen going forward. We’ll look at a few of these to try to get more clarity.Prices (Bearish)As U.S. crude oil prices plunged by 40% in the fourth quarter of 2018, from $75 in the beginning of the quarter to $45 per barrel at the end of December, valuations dropped alongside prices. What were the causes? Reasons started with concerns about potential increasing of U.S. shale output, inconsistency in Russia and OPEC’s execution of their production deal and fears of a global economic slowdown. Even OPEC’s deal with Russia to cut 1.2 million barrels per day during the December 6-7 meeting couldn’t stop oil prices from falling. The sharp decline once again demonstrates that higher prices fostered by supply-side management have a difficult time lasting.On the other hand, natural gas prices benefited from seasonal fluctuations. Prices jumped to over $4.80 per mcf in mid-November due to several factors including an early and colder winter hitting North America. In its December edition of the Short-Term Energy Outlook, the EIA reported the price of Henry Hub averaged $4.15/MMBtu in November, up 27% from October. Higher inventory helped to smooth price volatility in the energy market, but U.S. natural gas inventories began the season at a 15-year low. This will most likely be a temporary issue, as reserves are plentiful and the LNG market will begin to offtake more supply in 2019.[caption id="attachment_24731" align="alignnone" width="640"]Source: Bloomberg[/caption]
It is relatively rare to see the inverse relationship between crude oil and natural gas prices. A more than 50% increase in natural gas prices was coupled with nearly 30% downturn in crude oil prices during a seven-week period from early October to mid-November. Long oil short natural gas, once a popular trade by speculators, was punished during this unusual period of time. Natural gas prices ended the year at $2.94 per Mcf, a 2.3% decrease for the fourth quarter and essentially flat for the year.
Supply and Demand (Bullish)In 2019, it is expected that the U.S. will continue to lead the growth in oil supply worldwide. Improving pipeline capacity, particularly in West Texas, and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S. Good news is that a lot of this supply will be at a lower cost to producers because part of the costs has already been sunk. Drilled but uncompleted wells (“DUCs”) which jumped to new records in 2018 will likely be drawn down as a lower cost production alternative. This will contribute to supply growth.According to the December Short-Term Energy Outlook, the EIA expects global liquid fuels consumption to increase by 1.5 million barrels per day in 2019. Growth is largely coming from China, the U.S. and India. U.S.-China trade tensions remain high entering 2019 and have shaken up most if not all industries, and oil and gas is not an exception. China is the second largest in terms of oil consumption and surpassed the U.S. as the world’s largest crude oil importer in 2017. Slower growth in China is looming for the demand side of crude oil. In 2019, the continuation of worldwide central banks tightening pressures global economic growth and the prices of assets and commodities. Higher rig counts and higher capital expenditures by major oil & gas companies worldwide during the recovery also cause concerns of oversupply. According to Baker Hughes, as of December 28, 2018, the rig count in the U.S. was 1,083, 16.6% higher from December 29, 2017.LNG (Bullish)U.S. LNG daily production hit record high of 5.28 Bcf during the week of Christmas, according to S&P Global Platts. Large-scale additions to production capacity in 2018 included Shell’s Prelude and Inpex’ Ichthys, both offshore Australia, and Novatek expanded its Yamal LNG facility, while demand is slowing down in Asia, the biggest LNG market in the world. Europe is likely to play the key role in absorbing all the additional production as geopolitical factors, pipeline capacity issues and the controversial Nord Stream 2. Also, Gazprom’s contract for gas transit via Ukraine is expiring at the end of this year and surprise during negotiation is always possible among Russia, Ukraine and Europe.Going forward, LNG capacity will grow significantly in the U.S. The ability to send U.S. gas overseas will be a welcome reprieve for an oversupplied domestic gas market. This could create positive price pressure in gas markets. However, this could also have more localized effects as opposed to widespread.Bankruptcies (Mixed to Bearish)After ebbing for the past several years, bankruptcies in the energy sector increased slightly in number and dollars. According to the latest bankruptcy tracking report from Haynes and Boone LLP, bankruptcies upped a notch in 2018.[caption id="attachment_24732" align="alignnone" width="606"]Source: Haynes and Boone LLP[/caption]
Thoughts on these statistics are mixed. With the drop in prices in the second half of 2018, concern could mount that more bankruptcies may be ahead. The good news is that many companies have already restructured their balance sheets over the past few years and oriented their business models to operate at $50 oil and $3 gas. Therefore, they can have some stability in this pricing environment.
However, at the same time, a number of public companies made announcements of significant reductions in their 2019 exploration and production budgets. This could lead to an increase in filings for remaining producers who may have tighter cash positions in the event of capex and budgetary strains.
Capital Spending for 2019 (Mixed)North American E&P spending as a whole is expected to lag behind international markets but is estimated to grow 9% in 2019, according to a global E&P report released from Barclays. Barclays noted, however, “spending is exposed to more downside risk given the recent oil price collapse,” which isn’t fully captured in budgets that have been approved thus far. It’s also important to note that not all companies have announced 2019 plans yet.Several companies (such as Apache, Diamondback, Parsley, Centennial, Halcon and Chesapeake) are expecting to make budgetary reductions.[caption id="attachment_24733" align="alignnone" width="640"]Source: Shale Experts[/caption]
However, several others (such as Anadarko, Pioneer and Devon) appear to be looking to maintain or even increase rig counts in the Permian Basin in 2019.
[caption id="attachment_24734" align="alignnone" width="640"]Source: Shale Experts[/caption]
Hess Corp announced a 2019 E&P capital and exploratory budget of $2.9 billion slated for 2019, up from $2.1 billion in 2018. Approximately 75% will be allocated to high return growth assets in the Bakken and Guyanna.
ConocoPhillips has set a capex budget for 2019 of $6.1 billion, which is comparable to its 2018 capex, excluding any acquisition costs. Approximately $3.1 billion will be allocated to rigs across the Eagle Ford, Bakken and Delaware plays.
M&A (TBD)Activity in this realm has been relatively slow lately. This is probably due to the drop in oil prices. However, this pricing could also portend more M&A activity. Upstream valuations are trading at relative lows compared to the wider stock market. This could combine for more transactions in 2019. Companies plan for longer term pricing and long term expectations, using the futures curve as an indicator, are still around $54 going out about five years.There is a lot of capital in the marketplace that is waiting to be placed. If these conditions continue, it could give rise to more deals and more dollars in 2019.ConclusionThe indicators are out there, and one thing’s for sure—they don’t all align. Economist Karr Ingham, while recognizing the challenges of some of these bearish signals, remains optimistic. “The growth in Texas crude oil production even in the face of lower prices, rig counts, drilling permits and employment compared to 2014 peak levels remains the story of the year.”Valuations have suffered in 2018, but if the structural undergirding of the recovery over the past few years is strong, then the U.S. upstream sector should still be able to not only survive but thrive in 2019. Whatever happens, this muddied picture will become more clear as the year gets going.Originally appeared on Forbes.com.
Lifestyle / Pay & Need Analysis
This presentation was delivered by Karolina Calhoun, CPA/ABV/CFF at the AICPA 2018 Forensic & Valuation Services Conference.Learning objectives include:Identify and Classify Assets & Liabilities to include on marital and separate balance sheets:
Examine documentation and accuracy of the supportAssemble relevant information:
Current accounts (bank, brokerage) vs long-term compensation accounts (401k, pensions, etc.)Evaluate monthly budget for each spouse:
Compare/contrast spouse's budgetsEvaluate the payor's ability to support and the payee's need for support:
Lifestyle analysis comes into play here as the historical expenses may be used as a basis for monthly budget, however, depending on the finances, may or may not be supported post-divorceLifestyle analysis also provides the ability to measure the division of net worth at date of divorce and future net worth accumulation over time
RIP to the Father of Index Investing
John Bogle’s Legacy Endures with the Prominence of Passive Investing
Perhaps John Bogle’s greatest legacy is not founding Vanguard (nearly $5 trillion in total AUM), but his common sense (and yet often contrarian) approach to long-term investing. “In investing you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. And they won’t be foolish enough to think that they can consistently outsmart the market,” Bogle told the New York Times in 2012.“Don’t look for the needle in the haystack. Just buy the haystack.” – John Bogle on the merits of passive investing over active managementUnfortunately, most investors haven’t stayed the course. For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year while the average equity fund investor earned a return of only 5.19%. High costs and market timing are largely to blame, which is why passive investing has dominated active management over this period.Ironically, the king of active management is a huge fan of Bogle’s. You may recall Warren Buffett’s bet with Protégé Partners that an index fund would outperform their selection of hedge funds over a ten-year period. Buffett’s investment vehicle was Vanguard’s S&P 500 Admiral Fund (VFIAX), which outperformed Protégé’s fund of funds for nine of the ten years. Buffett’s advice on investing is right out of Bogle’s playbook, “Stick with big, ‘easy’ decisions and eschew activity.” Easier said than done, unfortunately.Most active managers probably feel differently. According to the Associated Press, investors paid 40% less in fees for each dollar invested in mutual funds during 2017 than they did at the start of the millennium. That’s great for investors, but not so good for mutual fund providers and active managers.“Stick with big, ‘easy’ decisions and eschew activity.” – Warren BuffettStill, there might be a silver lining to all this for some active managers. It’s hard to envision a world without stock pickers and market timers. After all, what would happen to asset prices if nobody paid attention to them? For the active managers that have survived the so-called flowmageddon to passive products, there’s ample opportunity to pick up market share and less competition for undervalued assets. Best-in-class asset managers could very well come out ahead over the long run.The problem is best-in-class asset managers are scarce. Over 90% of active managers underperformed the S&P 500 over the last market cycle. Such underperformance has led to all sorts of problems for the industry, including asset outflows and fee pressure that pushed most of these businesses into bear market territory last quarter.Active managers can’t blame Bogle for their recent woes. He merely shed light on an obvious deficiency in their value proposition (alpha in excess of fees), and investors have responded accordingly. What’s especially problematic is the recent trend seems to be accelerating. An estimated $369 billion flowed out of long-term U.S. active mutual funds in 2018, versus net inflows of $72 billion in 2017. By comparison, outflows were a little more than $200 billion in 2008.So if you’re a contrarian like Bogle, is now the time to get back into active management? It could be. Most active managers haven’t beaten the market since 2008, so they’re long overdue, especially if you consider their outperformance during bear markets:In addition, high dividend ETFs often underperform their active counterparts since many of them are programmed to buy the highest yielding securities, regardless of fundamentals. Interestingly enough, actively managed Vanguard Dividend Growth has outperformed the Vanguard Dividend Appreciation ETF since 2007 even after fee considerations.Still, we think Bogle would advise most investors to keep it simple and stick with passive investing. He has undoubtedly saved millions of investors around the world from the higher fees and (often) subpar performance of active management. So, next time you imbibe, pour one out for John Bogle and, perhaps, the active management industry as well.
Shareholder Redemptions in Family Businesses
Are They Good or Bad?
Over the weekend, the New York Timespublished an opinion column by Chuck Schumer and Bernie Sanders in which the senators decried the increasing prevalence of stock buybacks among the country’s largest publicly traded companies. On Messrs. Schumer and Sanders’ reading, share repurchases epitomize a corporate philosophy that prizes shareholder value at all costs and gives short shrift to the long-term sustainability of such companies, negatively affecting workers and other stakeholders. Whatever the public policy merits of the positions outlined in the column, it does acknowledge and highlight two essential characteristics of share buybacks. First, from the perspective of the business, redeeming shares is economically equivalent to paying dividends. Second, using capital to repurchase shares can limit the amount of capital available for investment to grow the business.Reading the column made us think about shareholder redemptions for family businesses: Do shareholder redemptions hurt or help family businesses? Of course, that question does not have a simple answer. Not all shareholder redemptions are created equal, so in this post, we’ll outline three possible redemption scenarios and identify what attributes suggest whether a given shareholder redemption will help or hurt a family business and its relevant stakeholders.Scenario #1 – Excess Liquidity and Limited Reinvestment OpportunitiesThe family business in our first scenario has historically retained all earnings. As the company has matured, attractive investment opportunities have become increasingly scarce, and management has successfully avoided the temptation of investing in capital projects promising inadequate returns. As a result, the family business has accumulated excess liquidity.
The company elects to redeem one branch of the family shareholder tree that is geographically and socially removed from the rest of the family and has expressed a desire to achieve liquidity. The shareholder group collectively owns 25% of the outstanding shares and can be redeemed for $100. Following the redemption, the market value balance sheet now looks like this:
Following the transaction, the remaining shareholders endure less of a drag on returns from low-yielding cash assets, and the company retains ample financial flexibility to meet strategic investment opportunities that may arise. In this case, the shareholder redemption was clearly a positive outcome for all the shareholders, and did not trigger any negative consequences for employees or other interested stakeholders.
Scenario #2 – Excess Borrowing Capacity and Moderate Reinvestment OpportunitiesIn our second scenario, the family business operates in a growing industry presenting moderate reinvestment opportunities. The founding and second generations have been averse to debt, seeking to repay outstanding balances as quickly as possible. At present, there is no debt outstanding. The market value balance sheet is summarized below.
As the third generation has assumed primary leadership of the family business, they have prioritized diversification and reducing the concentration of family wealth in the business. In order to fund investments outside the business, the directors elect to redeem 25% of the outstanding shares, funding the redemption through a bank loan. The post-redemption market value balance sheet is summarized below.
In this case, the shareholder redemption accomplished two things: (1) helped secure the family’s financial foundation by establishing a basket of wealth that is not tethered to the fortunes of the family business, and (2) potentially reduced the family business’s overall cost of capital through the prudent use of available financial leverage.
From the perspective of other employees and other interested stakeholders, the outcome is perhaps a bit more mixed.
While the post-redemption financial leverage is by no means imprudent, the risk of financial distress in the event of softening economic conditions is heightened. As a result, employment levels and wages may be under greater scrutiny if a recession were to occur.At the same time, use of a more optimal capital structure may reduce the hurdle rate used to evaluate capital investments, making growth opportunities relatively more attractive.Further, since the family has reduced its financial dependence on the business, the shareholders may actually be more willing to take risk inside the business and pursue growth more aggressively, with positive consequences for employment and wages.Finally, depending on what form the family’s diversifying investments outside the business take, there may be positive externalities for the community at large through investment in start-up enterprises, real estate development, or other activities.Scenario #3 – Optimal Capital Structure and Abundant Reinvestment OpportunitiesIn our final scenario, the family shareholders of a growing family business have been feuding for years. With tensions reaching a breaking point, the directors have concluded that redeeming the dissenting group’s 25% ownership interest is the only way to preserve family ownership of the business. Industry fundamentals are attractive, and the family business has identified a strategy that promises abundant opportunities for financial rewarding capital investment. The company has relied heavily on debt financing in recent years to execute on its growth strategy.
The Company’s existing lenders have little appetite for extending further funds to finance the $100 redemption. The family has no desire to accept equity investment from outside sources, so the redemption is financed with a high-yield loan from a so-called mezzanine lender. The loan is costly both with respect to the interest rate and the inclusion of equity warrants, which the family business has the right to redeem at exercise. The market value balance sheet following the purchase is summarized below.
For the remaining shareholders, the redemption has defused a volatile family situation, but at the cost of assuming a much riskier ownership position. The greater post-transaction financial leverage has magnified both the potential upside and downside for the remaining shareholders. Of perhaps even greater significance, the obligation to use operating cash flows to service the redemption financing will “crowd out” capital investment, and may impair the company’s ability to execute on its strategy. This diversion of cash flow away from attractive investment opportunities is a very real opportunity cost to the remaining shareholders, which we can think of as the cost of family dysfunction.
For employees and other stakeholders, the repercussions of this shareholder redemption are uniformly negative. The elevated financial risk increases the exposure of the company to even temporary downturns, as lender covenants may force management to adopt more of a short-term perspective than it otherwise would. The limited financial flexibility is likely to cause growth to slow, shrinking opportunities for promotions and wage growth. Finally, the post-redemption capital structure may increase the likelihood of the business being sold. Depending on the characteristics of the buyer, a sale of the business may have negative consequences for both employees and the local community. In other words, the costs of family dysfunction are not confined to the family.
ConclusionSizable shareholder redemptions can serve a number of purposes in a family business. Though clearly not an exhaustive list, in this post we have laid out three representative scenarios for major shareholder redemptions and the likely consequences for both family shareholders and other stakeholders.Your family business is unique. If you are contemplating a shareholder redemption, our experienced family business advisory professionals can help you and your fellow directors assess the likely outcomes for all the relevant parties and chart the best path forward.
Mercer Capital’s Value Matters® 2019-02
Estate of Powell v. Commissioner
Five Questions to Ask Your P&L
A Great Start to 2019 is a Thorough Lookback at 2018
Earlier this month, the RIA group at Mercer Capital took some time to outline our points of focus for the year ahead. Group consensus is that the investment management industry is facing an unprecedented number of cross-currents, making the vision for 2019 anything but 20/20. Last year was kind of a “meh” year for investment management, with a couple of interesting IPOs and an impressive level of M&A activity, but also generally unhelpful financial markets and pronounced multiple contraction across the space. Add to that a surplus of economic uncertainty and a deficit of political stability, and we see ample ground to speculate as to the future of the RIA community. But indulging in guessing games gives you little reason to follow this blog, so we’ve decided to spend more time this year giving perspective as to what money managers can control.A Not-So-Random Walk Through Your Income StatementNow that January is almost over, we know that many of you have wrapped up quarterly investor communications and can now take a moment to think about your firm’s operations, direction, and other practice management issues. A useful place to begin your plan for 2019 is doing some fundamental research on your own business, starting with the P&L. It’s easy to take internal financials for granted, but if you take a step back and consider your results from operations as if you were an outsider doing due diligence, you’ll give yourself the opportunity to gain an insight or two that is directly relevant to the outlook for your RIA. Here are five questions to organize a review of your financial statements. Simple enough, but these five questions lead to about five hundred more.1) What Do Your Revenue Trends Tell You About the Overall Health of Your Business?One of the more unique characteristics of investment management firms is that, for the most part, run rate revenue can be calculated on any particular day, given closing AUM and a realized fee schedule. But revenue is a flow rather than a stock, and the trends in what generate revenue for an RIA say plenty about the overall health of the firm. This diagnostic works best at a granular level.Breaking down trends in revenue into trends in AUM and realized fees is revealing. In fact, one of the first things we do when researching a new client is to develop a quantitative history of their revenue to evaluate the success of their marketing plan, investment management skills, client retention, and value to the marketplace.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise, regardless of what sort of investment management firm you operate.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise.Regarding trends in assets under management, we’ve noticed over the years that wealth management firms tend to focus on net inflows, and asset management firms pay more attention to investment performance. We recommend you look at both. New clients gained net of terminations has implications for the effectiveness of your marketing and client service models, as do new contributions from existing clients net of withdrawals. Keep in mind that this latter measure may also be indicative of the demographics of your client base, especially if you have more retail clients (as opposed to institutional). Wealth management firms pay less attention to investment performance, but we sense those days are changing. We learned last year that the CFA Institute is studying ways to extend GIPS (Global Investment Performance Standards) to wealth management firms, and while this may still be years away, you should start thinking about being ahead of the trend. The most successful firms won’t hesitate to study their firm’s performance from as many perspectives as possible, looking for ways to improve.As for fees, it has been widely reported that the industry is coming to terms with what investment management services are worth to different types of clients. Early warnings of an army of robo-advisors turned out to be hype, but there is clearly fee pressure (or at least fee consciousness) in every sector of the industry. What matters to you is your fee schedule. What are you earning today versus last year, and can you trace that by the product or service you offer over time? Are changes in your realized fees earned a product of changes in client composition or product offerings, or are you having to price existing products to existing clients more competitively to gain or retain business?2) What Are Your Labor Costs Relative to Market?Whether you’re part of an asset manager, wealth manager, trust company, or any other sort of investment consultant, your biggest cost is labor. Twenty years ago, RIAs could afford mostly to ignore labor costs because the growth of the industry, heady fees, and favorable markets offered operating leverage that would reliably outrun any margin pressure from overpaying people. Those days are gone, however, and what we hear regularly is clients looking for ways to become more disciplined about compensation. Unfortunately, that isn’t easy to do.Although there are several significant compensation studies performed regularly in the investment management industry, the data isn’t very useful to actually set compensation levels for staff or owners. Data is usually given in ranges, which can be very broad, and it’s difficult to compare positions across firms since even titles like “portfolio manager” can mean different things in different offices. In addition, perceptions of what is necessary to recruit and retain staff can vary. We’ve had some clients in secondary markets report that labor costs were lower there than in gateway cities. Others report that it takes more money to recruit talent to secondary markets because qualified talent wants to live in New York and San Francisco. This issue becomes more acute the more specific a skillset is needed on an asset management team.We think it’s more useful to think about labor costs holistically. How does your compensation program relate to your overall business model? Is the plan scalable? Does the plan create an appropriate tradeoff between returns to labor and returns to capital (distributions), or are you disguising senior talent compensation as a benefit to ownership? There is no one answer. Wealth management firms necessarily look more at individual production as it relates to compensation, although in ensemble practices it may be more appropriate to consider sharing in firmwide profitability. Asset managers lean more toward paying for strategy performance, although doing so can be difficult in persistently unfavorable markets.Labor costs are the biggest tradeoff to margin, and at some level speak to the scale and efficiency of the RIA. That said, one has to expect margins to vary based on the type of investment management business. An institutional manager with a concentrated strategy benefits from extraordinary operating leverage as compared to most wealth managers. But margins, and the trend in margins, can tell a story about your business model, and how you are staffing it.3) Is Your Technology Spending Appropriate for Your Business Model?Robo-advisors may not have made a dent in the industry yet, and indeed may never, but technology is becoming more essential to the RIA community anyway, and that trend isn’t going to abate. The challenge, at this point, is to identify what tech spending is worthwhile, and what is just spending for its own sake. Technology is a big bucket and means different opportunities to different people.We see a great deal of spending on IT across the investment management firm spectrum, but it seems like the jury is still out in many cases as to whether or not firms are seeing a real payoff from it. Is your technology spending focused on marketing (like Salesforce) or compliance? Are you trying to fuel growth, reduce costs, or improve client service?Do your tech spending habits suggest that you have a real technology strategy, or are mostly reactive? And have you made a conscious decision to have your firm be on the leading edge of tech for asset management (sometimes the bleeding edge), or are you content with being on the trailing edge. Tech is such a challenge for the industry that many firms have dedicated a position in the organization to follow this area of practice management. At the very least, others are making it part of the job qualification for a chief operating officer.4) Are Your Marketing Dollars Actually Growing Your Business?When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted. Mixed markets and mature investment allocations have changed all of that, and firm leadership who got into the business because they liked picking stocks have been slowly waking up to the reality that they’re in sales.When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted.One value to disaggregating changes in revenue, as discussed above, is seeing the effectiveness (or lack thereof) of your firm’s marketing plan. Taking a hard look at how much you spend on marketing and where it's being spent is another worthwhile use of your time. Performance matters to clients, but alpha alone won’t attract new clients or retain as many of your existing assets as you might like.We heard an excellent presentation on differentiating your marketing message last fall, led by Megan Carpenter at Fi Comm Partners. The upshot of the presentation is that financial services are, from a client’s perspective, generic. Developing a unique way to differentiate and communicate your service offering keeps you from becoming a commodity and having to auction yourself to your clients.We’re not a marketing consulting firm, but we notice firms having a difficult time connecting their spending on growth initiatives, like marketing, with the actual growth of the firm. You may not be able to develop a measurable, one-to-one relationship between your spending on distribution and the growth of your business, but if you can’t articulate – even to yourself – the relationship between your monetary commitment to growth and your client asset acquisition rate, then it might be time to find a way to do that.5) Is Your Profit Margin Threatened by Ownership Issues?The profitability of an RIA speaks to more than just the results from operations. Often, where profits go is more telling than where they came from.Is your firm fully distributing? That is, are you able to pay out all, or mostly all, of your profits as distributions? If so, then you must be funding most of your growth initiatives, in terms of human capital development and marketing, within your normal expense structure. Will this remain the case, or will you be required to use profits to fund partner buyouts or firm acquisitions? Is your ownership on board with those reallocations of distributable cash flow? Just like compensation tends to be sticky in downturns, most RIA partners don’t like the feeling of reductions in distributions – even if they understand it intellectually.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders? Depending on how you structure ownership, you can utilize distributions for any one or all of these, but it’s likely your RIA did this without even realizing it. Part of the wisdom that comes from interrogating your financial statements is making what was accidental intentional, and in the process developing some greater degree of control over your firm’s destiny.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders?How sustainable is your profit margin? If markets took a sustained 20% hit, would that wipe out your profitability? Is your buy-sell agreement up to date or could an ownership dispute derail your business? What is the trend in the margin (growing, shrinking, stable) and why?For a professional service firm, distributions can be an effective way to reinvest in the business – given that the business is one of human capital rather than machinery and equipment. The question to consider is whether or not you’re using distributions as a way to grow, sustain, or monetize your business model.If Your Financial Statements Told a Story, How Would it End?The investment management industry has been transitioning from one where a rising tide lifted all boats to one of winners and losers. Issues that could once be overlooked by clients, like performance and pricing, no longer are. As a consequence of client behavior, issues that could once be overlooked by RIA leadership, like staffing and ownership transition need serious attention. We seem to be entering a period where there will be a premium on intentionality and accountability, and the financial results of your operations for last year are an informative source of objective commentary on how you’re doing.If a picture is worth a thousand words, then a detailed P&L is worth several thousand. Just make sure that your financial statements tell the same story about your business that you tell yourself. If you’re not allocating resources to support the business you think you’re running, make a New Year’s resolution to seek greater alignment.
Risk and Return
Working Interests and Royalty Interests
Because of the historical popularity of this post, we revisit it this week. Originally published in 2017, this post helps you, the reader, understand the various risk factors which pertain to mineral interests.
U.S. Mineral Exchange defines a mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Last week we reviewed the three types of mineral interests – royalty interests, working interests, and overriding royalty interests. This week we analyze the risks associated with working interests versus royalty interests. An overview of royalty interests and working interests is included below:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid.
Central to corporate finance is the principle that returns follow risk. As the risk of an investment increases, so do potential returns and potential losses; lower risk means less expectation for reward. The Oil and Gas Financial Journal illustrates oil and gas investment risk in the following graphic:When valuing mineral interests, it is important to consider the nuances of each type of mineral interest. Given that risk and asset values are indirectly related, it is important to keep in mind the various risk factors which pertain to the mineral interest. We’ll begin by examining the various risks surrounding both types of interests.RiskBoth working interests and royalty interests are exposed to fluctuations in oil and gas prices. When crude oil prices fell in mid-2014, so did the value of working interests, whose worth is based on the present value of the cash flows generated from production, and the value of royalty interests, whose value is based on future payments of revenue. Further, both working interests and royalty interests face the risk of depletion as oil and gas wells are depleting assets. Even if the price of oil and gas is stable from one year to the next, a well may have 30% less production in its second year. This can dramatically decrease the yield of particular royalty and working interests.Holders of working interests can mitigate the risk of depletion by drilling new wells or improving production of existing wells. While this gives a working interest holder more flexibility, it also requires a substantial investment in CAPEX. Working interest holders accept all fiscal burdens associated with the drilling process.Royalty interest holders, on the other hand, bear no cost of production but are at the mercy of their operators. Only the working interest owner can decide to halt production when prices drop and to increase production when the drilling environment is favorable. The Oil and Gas Financial Journal compares buying a royalty interest to “buying an income strip in producing wells, and the risks are primarily price volatility and depletion.”Each type of interest has unique attributes, but the fact that working interest owners are responsible for operating expenses makes working interests inherently riskier than royalty interests which are characterized by monthly “mailbox money” precipitated by zero costs. We see this when examining the volatility of select E&P companies who spun off their royalty interests into royalty trusts structured as MLPs.The royalty trusts above generally demonstrate less volatility, which is often used as a proxy for financial risk, than their parent E&P companies. The principles of risk and return, however, tell us that because there are fewer risks associated with royalty interests they will yield lower returns than their riskier counterparts. Royalty interests range in percentage ownership of revenues from 0.025%-25%, meaning that, at the highest royalty interest, at least 75% of revenue is still funneled to the working interest owners. Due to differences in risk, royalty interests are unlikely to generate the magnitude of returns that working interests can experience. At the same time, they are less likely to experience the same degree of loss.ReturnThe standardized measure of investment performance for a given unit of time is return. Investment returns have two components. The first, yield, measures the current income (distributions) generated by an investment. Capital appreciation, the second component, measures the increase in value during the period. As shown below, total return is the sum of yield and capital appreciation.Royalty trusts commonly make substantial distributions because they generate revenue as long as their operators are drilling and they have minimal operating expenses. Thus it is important to examine total return when comparing interests in E&P companies, who own working interests, and royalty trusts who own royalty interests. In the chart below we examine the total returns of the companies introduced above and their associated royalty trusts.As expected, the E&P companies which hold working interests show higher returns and steeper losses than their associated royalty trusts.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
How Much Money Does Your Family Business Really Make?
This post is part of our “Talking to the Numbers” series for family business leaders. In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements. Asking better questions will lead to better financial and business decisions.
In our last post in this series, we focused on operating income, which is a critical measure for evaluating the performance of management since it is unaffected by financing and tax decisions made by the board of directors. Net income, on the other hand, reveals how those board-level decisions influence your family business’s earnings and ability to pay dividends. Everyone likes to talk about EBITDA and EBIT – and those are important metrics – but only net income measures the increase in the family’s wealth from owning the business.
Exhibit 1 summarizes the different “tests” that a family business faces as we move down the income statement.For the family business to be truly profitable, operating income must be sufficient to cover financing costs. And taxes are a fact of life, so Uncle Sam must take his share before the real profitability of your family business can be discerned.Financing CostsAnalysts often refer to operating income as EBIT, or earnings before interest and taxes. Interest expense is the cost of financing the portion of the family business funded by debt. All financing sources – both debt and equity – have costs, but only the cost of debt is measurable by accountants. (We’ll address the cost of equity in a future post.) So interest expense is what shows up on the income statement.The amount of interest expense on the income statement depends on the amount of debt on the balance sheet and the rate charged by lenders. The relationship between balance sheet leverage and interest burden for our data set is summarized in Exhibit 2.Reviewing the data in the exhibit above, we can discern the strong positive correlation between balance sheet funding and the interest coverage ratio. The principal exception to this relationship is in the energy sector, where depressed operating earnings have increased the proportion of EBIT that is required to pay interest costs.How risky is your family business from an operating perspective?From a balance sheet perspective, companies tend to use more financial leverage in industries that rely on large investments in physical assets (telecommunications and utilities), and less in industries that rely more on human capital and intellectual property (such as information technology).From an income statement perspective, recurring revenue and predictability of earnings are also indicators of debt capacity. To illustrate this, we sorted the companies in our data set into two groups on the basis of observed year-to-year volatility of EBIT. The companies demonstrating less volatility had median debt to invested capital ratios of 43%, while the median for companies in the higher volatility group was 35%.For family business directors, the key questions around financing costs include:What is the appetite for risk among our family shareholders? Are our family shareholders willing to accept greater financial risk in exchange for the opportunity for higher returns?How risky is our family business from an operating perspective? Do we have good visibility into future earnings from year-to-year, or do operating earnings vary markedly from period to period?Income TaxesUnlike financing costs, income taxes are proportional to pre-tax earnings. As a result, income taxes do not affect the risk profile of a family business, but they do influence the returns – and dividend paying capacity – of a family business. We make a couple observations when studying our public company data set, both of which are evident in Exhibit 3.First, the effective tax rate for public companies (income tax expense as a percentage of pre-tax income) has historically been less than the prevailing statutory rate. Second, the effective tax rate is inversely related to company size: the effective tax rate for large cap companies in our data set was just under 28%, while the effective tax rate for small cap companies was a bit over 33%. We suspect this is attributable to a couple factors: (1) the largest companies likely have the greatest access to the most sophisticated and effective tax strategies, and (2) the large cap companies likely earn a greater portion of their income in lower-tax international jurisdictions than do small cap companies.How does your family business’s effective tax rate compare to the statutory tax rate?For family businesses, there is the added wrinkle of deciding whether to adopt a tax pass-through structure. Many family businesses elect to be organized as S corporations (or other pass-through forms), while public operating companies are generally organized as C corporations. While the S election eliminates one layer of taxation, it is not necessarily the optimal structure for all family businesses, particularly following the implementation of the Tax Cuts and Jobs Act of 2017.The most important thing for family business directors to understand about the S election is that the legal and economic consequences of the election are reversed. Legally, the S election removes the obligation to pay income tax on corporate earnings from the corporation. However, economically, the S election relieves shareholders of the obligation to pay dividend tax on distributions from the corporation.Let’s unpack that a bit.Though an S corporation does not have to write a check to the IRS, its shareholders are required to do so for the full amount of taxes on the earnings “passed-through” to the shareholders. These taxes are due whether there is a corresponding distribution from the company or not. Therefore, an S corporation has to make a distribution to its shareholders sufficient to make them whole on the pass-through tax liability they are now legally obligated to pay. So from an economic perspective, the company still has to pay taxes on its income; those taxes are just routed through the shareholders as distributions. But having paid those taxes, the shareholders have no further obligation for taxes on additional distributions received from the family business.As a result, the economic benefit of the S election to family business shareholders will be most pronounced for businesses that have the capacity to distribute a substantial portion of net (after tax distribution) earnings. Shareholders of family businesses that do not plan to make significant after-tax distributions may, in fact, be worse off under an S election, since the personal tax rate (29.6% assuming eligibility for the qualifying business income deduction) is higher than the C corporation tax rate (21%).Family business leaders should seek answers to the following questions when thinking about income taxes:How does our family business’s effective tax rate compare to the statutory tax rate? Are there available strategies that could reduce – or at least defer – the tax drag on net income and dividend capacity? A penny of taxes saved really is a penny earned.Should our family business be organized as an S corporation? What is the likely future relationship between dividend payments and earnings reinvestment? What used to be a slam-dunk analysis in favor of the S election is no longer nearly so straightforward. The reduction in C corporation tax rates may have tipped the scales back in favor of C corporation status for some family businesses.ConclusionSo how much money does your family business really make? EBITDA is an important measure for a lot of reasons, but there are significant claims on the cash flow measured by EBITDA before it trickles down to the family shareholders. As a family business director, the decisions you make with regard to financing and tax structure can have a material effect on how much money the business really makes. Contact one of our experienced family business advisory professionals today to discuss how best to approach these important decisions.
Mineral Interest Owners: How to Know What You Own
As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry. This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own.
We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1]
Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.” As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres. That is: 640 acres per section times ¼ times ½.
The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow:
“To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.”
This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at:
80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals. This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved. As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country. Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value. For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO
2018 Was a Banner Year for Asset Manager M&A
Asset manager M&A was robust throughout 2018 against a backdrop of volatile market conditions. Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during 2018 increased 49% versus 2017 and total disclosed deal value was up nearly 140% to $18.0 billion. In terms of both deal volume and deal count, asset manager M&A reached the highest levels since 2009.
M&A was particularly strong in the fourth quarter when Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call back in 2017:
"Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets. FOCS also announced multiple sub-acquisitions by its affiliates during the second half of 2018.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a long-running bull market in asset prices that finally capitulated in late 2018. Over the past several years, steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen. Now that the market has pulled back, AUM, revenue, and earnings are likely to be lower for many asset managers.The recent market pullback will impact sector deal making in several ways. Notably, earnings multiples for publicly traded asset managers have fallen considerably during 2018, which suggests that market sentiment for the sector has waned as the broader market has declined. While the lower multiple environment is clearly less favorable for sellers, market volatility may force some smaller, less profitable firms into selling in order to remain viable. For buyers, the lower multiple environment may make the sector look relatively underpriced though some may be spooked by the recent volatility.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.
How to Constructively Engage with a Dissatisfied Family Shareholder
Publicly-traded Ashland Global Holdings (ticker: ASH) recently announced a series of steps intended to pacify activist investor Cruiser Capital, which owns approximately 2.5% of the company’s shares. Cruiser has proposed four new directors at Ashland, citing a number of factors contributing to their dissatisfaction with the status quo in a November 2018 letter to the board:Ashland’s refusal to engage with industry experts recommended by CruiserCruiser’s belief that Ashland is “severely undervalued”Cruiser’s belief that Ashland “has demonstrated persistent operational underperformance”Cruiser’s belief that the board needs new voices to better represent all shareholders
In an effort to head off a protracted and potentially embarrassing proxy fight, Ashland announced earlier this month that it would add two new directors, adjust board committee composition and leadership, and have one long-term director step down. Whether Ashland’s proposed moves will placate Cruiser remains to be seen.The source(s) of contention among shareholders can simmer for years, ultimately yielding a toxic stew of resentment, strife, or even litigation.Privately-held family businesses are not exposed to the threat that an activist investor such as Cruiser Capital will accumulate a significant ownership position. But does that mean that “shareholder activism” is something that family business directors don’t need to take seriously? We don’t think so.In our experience, while family businesses are not vulnerable to activist investors, they may have disgruntled family shareholders to deal with. Given the tangled personal dynamics in family business, directors would probably prefer to deal with a third-party activist investor like Cruiser Capital than an unhappy sibling or cousin. Since family business ownership interests are illiquid, the source(s) of contention among shareholders can simmer for years, ultimately yielding a toxic stew of resentment, strife, or even litigation.We noted the specific items Cruiser was taking umbrage to above – what would a list of disgruntled family shareholder complaints look like? The most common points of contention include the following:The family business is not paying a sufficient dividendThe family business is being run by the wrong family membersThe family business is not making the right investmentsThe family business board needs some fresh facesThe family business holds too much cash or other non-operating assetsThe family business is engaging in related party transactions on an unfair basisThe family business is not as profitable as it should beThe family business management team is over-compensated
The list could certainly go on. Sometimes such complaints have merit, and sometimes they don’t. Yet even a perceived problem is a real problem to the discontented family shareholder.
The authors of a 2018 article on the Harvard Law School Forumon Corporate Governance and Financial Regulation identify three components of an effective response by public companies to activist investors. The recommendations translate well to family business boards dealing with one or more disgruntled family shareholders.1. Objectively Consider the Activist’s IdeasOf course, all families are different, but just because Uncle Harry makes a recommendation does not necessarily mean it’s wrong. It is difficult, but necessary, for family business directors to lay aside whatever personal dynamics may be at work and objectively evaluate the economic merits of the proposed action. This could involve going beyond intuition and “gut feel” for a question and gathering relevant data that can inform the decision. Family shareholder activism will naturally be perceived by management and the board as personal (and in some cases the complaints may be truly personal and nothing more). However, family business directors have a duty to make appropriate decisions for the long-term sustainability of the business even if their feelings have been hurt. Sometimes, a major change is the right thing to do, even if it is uncomfortable. The presence of independent non-family board members or trusted advisors can help family directors filter out potentially distracting personal dynamics and evaluate proposals on their merits.2. Look for Ways to Build ConsensusThe authors of the article suggest finding points of agreement with activist shareholders. In the context of family businesses, the first step is to demonstrate a commitment to objectively evaluating the shareholder recommendation by actually talking to the shareholder about his or her concerns and proposed action. Stonewalling or ignoring the shareholder will only make the situation more combustible. Engaging with the shareholder may reveal that a relatively simple “fix” may exist that neither the frustrated shareholder nor the board had previously considered.The second step would be to solicit input regarding the contested issue from a broader selection of family shareholders. This can be done through informal conversations or through a more structured confidential survey process. Soliciting other opinions may confirm that the disgruntled shareholder is merely giving vent to what are ultimately personal frustrations, or it may reveal to the board that there is, in fact, a broad consensus among family shareholders that the issue is a real problem that needs to be addressed. In either event, the process will demonstrate to the activist shareholder that their concerns are being taken seriously.3. Tell the Company’s StoryThe best defense, as they say, is a good offense. Similarly, the best way to deal with disgruntled family shareholders is to foster positive engagement with all shareholders before any of them become disgruntled. Senior management and the company’s directors should always be telling the company’s story to the family group. There are three basic levels of family business storytelling:History and LegacyEvery family business has a “founding myth” that informs the company’s culture and ethos. At appropriate family forums, senior managers and directors should tell and re-tell the company’s story so that it becomes firmly embedded in the family’s DNA. Some even advocate using dedicated spaces to serve as continuous reminders of the company’s history and legacy.Industry Dynamics and StrategyFamily shareholders should have the opportunity, through periodic education opportunities, to understand the broad contours of how the relevant industry works and the family business’s place in that industry. Non-employee family shareholders should understand the primary production inputs required, the value-added processes of the company, the attributes of customers, key regulatory issues, and the nature of competitive rivalry in the industry. This background knowledge will provide the basis for shareholders to understand the company’s basic strategy and the implications of that strategy for dividend policy, capital budgeting, and financing decisions.Ongoing Performance ReportingThe sad truth is that public companies treat their anonymous shareholders better than many family businesses treat their family shareholders. Public companies provide regular, detailed communication to their shareholders regarding how the business is performing and what the future looks like for the business. Yet many family businesses do not have a schedule of regular communication with shareholders to keep them informed on the performance or outlook for the business. Merely sending out financial statements is not enough, however. Management and directors need to convert the raw financial data into information that tells the company’s story.Most cases of family shareholder strife can be traced to a failure to communicate.We’ve never heard about a disgruntled family shareholder that complained about knowing too much about the family business or receiving too much relevant communication from the company. Rather, most cases of family shareholder strife can be traced to a failure to communicate. The most appropriate intervals, format, and content for shareholder communication will not be the same for every business, but an effective communications program will include all three of the elements discussed above.ConclusionAre all of your family shareholders positively engaged with the business? The cost of failing to engage with shareholders in a constructive way can be very high. Whether it is providing an independent perspective on shareholder disagreements, helping develop consensus on contentious issues, or crafting an effective shareholder communications program, our family business advisory professionals are eager to assist you and your fellow directors in promoting positive shareholder engagement. Call us today to discuss your situation in confidence.
Oilfield Services in 2018
A Year in Review
Companies in the energy sector and the broader market experienced an interesting year showing steady and strong growth in Q1-Q3 and met volatility in Q4, which effectively erased gains on the year and even resulted in negative returns.The oilfield services (OFS) sector, in particular, was impacted heavily during last quarter’s downturn driven primarily by fears of oversupply in the market and E&P companies cutting back and looking for discounts. Oil prices steadily rose from about $47 per barrel in August 2017 to over $73 per barrel in October 2018 as OPEC and a Russia-led pact of non-OPEC members coordinated efforts to bring supply production into balance.However, reports of increased global supplies, including from countries such as Saudi Arabia, Russia, and the U.S. resulted in prices falling again. WTI experienced a 44% decline from a 2018 high of $75 per barrel to lows of around $43 in late December. The OSX, the index tracking OFS sector stock performance, was sideways for the most of 2018 and fell in tandem with the fourth quarter oil crash, resulting in an all-time low for the index of $80.
The large and rapid hits were reminiscent of the declines experienced in 2014, and operators have been playing it close to the chest in terms of spending. Volatile oil prices and E&P spending will be among the major factors contributing to overall OFS performance going into the new year.
M&A ReviewTransaction activity for the oilfield services sector for 2018 was near identical to 2017 in terms of number of deals, and total deal value saw a slight uptick. Low volatility and stable growth that defined 2017 markets and steadily increasing oil prices for most of 2018 have allowed for moderate transaction activity compared to the two years prior to 2017. This environment has also facilitated OFS companies to be more methodical in acquisitions compared to the past.As we discussed in a prior post, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings especially in technology and other efficiencies.
The following table shows select transactions that occurred in 2018 with relevant enterprise value multiples, as companies sought strategic growth opportunities. Despite the fourth quarter turmoil, transactions from October to December constituted over 30% of total year deals.
The observed mix of transactions for the year covered a broad spectrum of subsectors within the OFS sector. Contract drilling and well servicing/completion companies appeared to have slightly more transaction activity compared to other subsectors, but there was not an apparent trend identified within subsector deal activity.Fewer Bankruptcies for 2018Bankruptcies in the energy sector have ebbed since 2015 and 2016, but the recent slump in commodity prices do not point toward continued improvement for 2019, according to the latest bankruptcy tracking report from Haynes and Boone LLP.During 2018, the OFS bankruptcy filings decreased both in number to 12 filings and in aggregate debt of $3.85 billion compared to 2017 which consisted of approximately 40 filings and aggregate debt of $35 billion.However, with oil prices dropping over a third of its value in the final quarter of the year, a number of public companies made announcements of significant reductions in their 2019 exploration and production budgets, directly impacting prospects for many OFS companies. In turn, this could lead to an increase in filings in the first quarter of 2019 in the event of capex and budgetary strains.But while a number of companies are expecting to make budgetary reductions, several are looking to maintain or even increase spending in 2019.Spending and Outlook for 2019Analysts with Moody’s Investors Service believe that the health of the OFS sector is still quite weak with many burdened by high debt and added pressure brought by the drop in crude prices in late 2018. But the sector could see a 10% to 15% increase in overall earnings in 2019 as E&Ps increase spending. The key factor alluded here is that spending for many of these companies is anticipated to follow later in the year after riding out Q4 2018 shocks.Spending for many of these companies is anticipated to follow later in the year after riding out Q4 2018 shocks.Sajjad Alam, vice president-senior analyst for Moody’s, said in his report, “Most of that growth will likely come only later in 2019 after the heightened oil-price volatility of late 2018. Infrastructure constraints in the Permian Basin will also limit OFS operators’ ability to raise prices early in 2019.”Limited spending is a concern for OFS companies as many E&Ps weigh the choices surrounding budget appropriations. But many companies and private equity firms still appear to be committed to proposed capex budgets of increased spending on much needed infrastructure.Hess Corp announced a 2019 E&P capital and exploratory budget of $2.9 billion slated for 2019, up from $2.1 billion in 2018. Approximately 75% will be allocated to high return growth assets in the Bakken and Guyanna.ConocoPhillips has set a capex budget for 2019 of $6.1 billion, which is comparable to its 2018 capex, excluding any acquisition costs. Approximately $3.1 billion will be allocated to rigs across the Eagle Ford, Bakken, and Delaware plays.North American E&P spending as a whole is expected to lag behind international markets but is estimated to grow 9% in 2019, according to a global E&P report released from Barclays. Barclays noted, however, “spending is exposed to more downside risk given the recent oil price collapse,” which isn’t fully captured in budgets that have been approved thus far.Value ConsiderationsFrom a valuation perspective, we examined a selection of guideline company groups for relative value changes over time. One way to observe this relative value change is to look at enterprise value, adjusted for cash, relative to total book value of net invested capital (debt and equity) held by the company or “BVIC.” Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm.Take for example, Land Contract Drilling and Services subsectors:
EV/BVIC multiples have fallen since the middle of the year and even below observed 2017 levels. Investors were not expecting to receive adequate return on capital deployed at these companies. After analyzing our guideline companies for oilfield services and equipment overall, observed average and median multiples for 2018 were below 1.0x for 2018.
The only outliers within this sector are pressure pumping and fracking concentrated businesses, which are more directly tied into the value expansion in the oil patch. The demand for pumpers’ technology and services has driven through the fourth quarter woes, showing that the market recognizes the contributions from these companies.
ConclusionAs the energy sector brings in the new year, continued strategic M&A and fewer bankruptcies indicated positive signals for the health of the sector, but the fourth quarter collapse in oil prices have had companies and analysts alike cautious on the outlook for 2019 as evidenced in value considerations above.Ultimately OFS is weak right now due to multiple factors; however, there are reasons for optimism in the sector and growth opportunities during these uncertain times.Several companies underperformed to close out 2018, and many have made adjustments to conserve cash through debt restructurings, leverage reduction, and stringent capital discipline. Although oil prices have rebounded somewhat in the first weeks of January, volatility is still a primary concern when it comes to forward planning.U.S. spending is expected to increase in the next year, but many budgets among larger North American E&Ps have been reduced or have yet to be unveiled, which could mean further reduction of spending compared to preliminary estimates.Ultimately OFS is weak due to multiple factors stemming volatility, general market uncertainty, and the price crash; however, steady and methodical M&A during the year coupled with very few bankruptcy filings and prospects for late E&P spending increases offer optimism in the sector and growth opportunities during uncertain times.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.
Trust Banks' Performance and the Role of Technology
Trust banks have generally lagged the broader indices since the financial crisis of 2008 and 2009. Against a bearish backdrop for the industry, all three trust bank stocks declined in the last few months of the year with falling client asset balances and rising labor costs.Rough year for trust bank stocks, especially State Street
Northern Trust and BNY Mellon performed more in line with the market and traditional banks while State Street’s underperformance is largely attributable to investor skepticism surrounding its purchase of Charles River Systems last summer.
Customers Demand Improved Technology OfferingsAs noted during a Conversation with Jay Hooley and Ron O’Hanley at State Street, the industry is going through a “time of unprecedented change.” Investment firms are devoting more time and resources to keep up with the most recent technological offerings and improve the overall client experience. These dynamics are especially true for trust banks where increased regulation has encouraged advancement in data management.IT investment is outlined as a clear priority for success. BNY Mellon invested $2.4 billion in IT last year and plans to spend another $2.7 billion going forward to develop their operating platform. Northern Trust utilizes technology in order to provide momentum to its growth strategies and cut costs “to take advantage of new technologies such as robotics to slim down its permanent workforce.”Another example of trust banks’ directing resources to technological development is State Street’s recent acquisition of Charles River Systems for $2.6 billion. Charles River is a financial data firm that runs a software platform used by more than 300 asset management firms. According to Ron O’Hanley, President and CEO of State Street, “This acquisition represents not only a significant investment in our future but also the recognition that the ability to assist clients in managing their data needs and extract insights from their data is increasingly the most important differentiator for our industry.”Investors disagreed as STT’s share price declined sharply after the announcement (pessimism surrounding the acquisition) as the 38% increase in total assets under custody from the acquisition will not be met with proportional increases in revenue. At the moment, investors are questioning if State Street’s focus on data management in addition to asset management will, in fact, create shareholder value in the long run.Is Pricing Indicative of Performance in a Down Market?Trust bank trailing and forward multiples have fallen in line with the broader market.
A quick glance at year-end pricing shows the group valued at 9-13x (forward and trailing, respectively) earnings, down from 14-16x at year-end 2017 as the outlook on future cash flows has stalled with the recent market correction.
Despite trust banks’ underperformance during 2018, investment management fees increased year-over-year (as of the third quarter, the most recent information available). Servicing fees varied by company. State Street saw a decline in serving fees due to what it explains as “client transitions and challenging industry conditions.” BNY Mellon’s fees were relatively flat and Northern Trust saw an increase in servicing fees partially due to the UBS fund administrator acquisition which closed in late 2017. But, as a whole, trust banks saw improved net interest margins due to higher U.S. market interest rates and increases in trading services with the recent uptick in volatility.
Are Investors Too Bearish on State Street? State Street’s stock price has been hammered even more than the industry as a whole. State Street’s ETF business has historically helped it outperform peers. However, legacy contracts have disabled them from cutting fees in order to remain competitive. State Street has begun restructuring its ETF business, but it will take time to regain its market position. Despite these challenges, State Street’s share of the U.S. ETF industry was at an all-time low by July of this year. Despite the recent struggles with its ETF business and the market’s perception of the Charles River acquisition, State Street ($34 trillion in AUCA) is still on track to surpass BNY Mellon ($34.5T AUCA) as the largest custody bank by in terms of assets under custody/administration.Trust Companies are Bullish on TechnologyTrust Companies are relying on technology to ease some of the pressure from their customers on cost. More barriers to entry have developed in the industry as regulators have made it harder to obtain approval to operate as a custody bank. This stricter regulation has forced these companies to adopt technological platforms which, if done properly, can provide a valuable service to its customers.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes. In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry. We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Is Your Family Business Ready for the Next Recession?
Let’s start with the good news: the last U.S. recession ended almost ten years ago. So for nearly a decade, family businesses have been operating in a climate of sustained (though rarely flashy) economic growth, which has helped contribute to strong balance sheets, revenue and profit growth, and investments in innovation.Now the bad news: the next U.S. recession is closer than it has ever been. We are not professional economists, and we make no predictions regarding when the next recession will commence. However, we do not believe that the business cycle has been repealed, and that another recession will eventually occur. It may or may not be in 2019 (for the record, we hope it’s not), but one is eventually coming.As a director, now is the best time to think about how your family business is positioned for the next recession, whenever it comes. In this post, we review some ways family business directors can prepare their companies to survive (and perhaps even thrive during) the next recession.Operating EfficiencySustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business.One of our family business clients told us a long time ago that it’s easier to make good decisions when you don’t need the money. We have always thought there was a lot of wisdom in that. Sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business. When business is going well, it can become easy to put off hard decisions regarding expense management. But today, when you don’t “need” the money, is the time when you are likely to make the best decisions in support of the long-term sustainability of the family business. If you wait until you are feeling the pressure in the heat of a downturn, it will be harder to make appropriate expense management decisions.Are there areas of your business that are not operating efficiently? Right now, before the next recession strikes, is the best time to evaluate vendor relationships, human resources, and operating procedures with a view to making sure your family business is in fighting trim.Are there underperforming business lines or territories that need attention? When consolidated profits are strong, weak business units can avoid scrutiny. Are there business lines that you should consider divesting while it’s still a seller’s market?Balance Sheet StrengthManaging the balance sheet is a continual trade-off between efficiency and flexibility. We often write about the perils of “lazy” capital in family businesses, yet some measure of financial flexibility can help sustain family businesses during economic slowdowns. Balance sheets can be fortified in advance of a recession by shedding underperforming or non-operating assets and using all or some of the proceeds to reduce outstanding indebtedness. Bankers prefer to lend money to those who don’t need it, so now could be an optimal time to expand borrowing limits on lines of credit, re-negotiate loan covenants, etc.Has your family business accumulated non-operating assets during the economic expansion that are limiting the company’s financial flexibility?What are the sources of capital available to your family business? Does the company have unused capacity on revolving credit agreements? What covenant provisions could potentially impair the company’s ability to access undrawn financing or otherwise limit financial flexibility during a recession?Competitive DynamicsAn economic disruption may present opportunities for patient family businesses.One oft-touted benefit of family businesses is the ability to maintain a long-term focus and avoid the short-termism that can afflict non-family public companies. Taking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity. You don’t have to outrun the bear as long as you can outrun the other hunters. Now is the time for management teams and boards to do a careful assessment of competitive and industry dynamics with a view to identifying what opportunities might arise for the family business to solidify its long-run competitive position during a recession.If your industry were hit with a recession, which players would be most negatively affected? What strategies would be appropriate for your family business if competitors were to experience financial distress?Would a prolonged recession prompt one or more of your competitors to consider selling assets? If so, do you have an acquisition “wish list” for the next buyer’s market?Operating LeverageOperating leverage refers to the prevalence of fixed (as opposed to variable) operating costs in your family business’s capital structure. When revenues are expected to increase, operating leverage is everyone’s friend since the earnings impact of a growing topline is magnified by expanding profit margins. Unfortunately, the magnification effect also works in reverse, as stagnating or shrinking revenues at family businesses with significant fixed operating costs will trigger more dramatic declines in profitability as margins contract.What does your family business’s operating cost structure look like? Are the company’s operating costs primarily fixed, or do they vary somewhat proportionally with revenues?Has your family business benefited from operating leverage during the economic expansion? Are there available opportunities to shift to a greater emphasis on variable costs?Revenue CyclicalityThe cyclicality of revenue refers to the sensitivity of a family business’s revenue stream to overall economic growth. Companies that sell non-discretionary goods or services exhibit less revenue sensitivity since customers need such products and services regardless of the economic environment. Demand for food, personal care products, healthcare, and similarly situated industries can soften during a recession as consumers trim budgets, but the sensitivity is muted relative to that for discretionary goods and services (automobiles, home renovations, leisure goods, etc.) that consumers can more readily forego or defer when belts need to be tightened.How sensitive is your family business’s revenue to the economy? If your company operates in an inherently cyclical industry, are there any strategies available to reduce the company’s revenue exposure to an economic slowdown?ConclusionWe sincerely hope that the next recession doesn’t start for a long time. Whenever it does start, though, you need to be prepared. As a family business director, you will probably never be able to make your business “recession proof” but now is the time to evaluate what steps are prudent to prepare for the next downturn. Our family business advisory professionals have lived and worked through several recessions (and have the scars to prove it). Give us a call to discuss positioning your family business for the next one today.
Q4 2018 Review and Outlook for 2019
Oil Prices: 40% Off From Its Four-Year HighIn the fourth quarter of 2018, U.S. crude oil prices plunged by 40%, from $75 in the beginning of the quarter to $45 per barrel. The sanctions on Iran, OPEC’s third-largest producer, seemed to be the last push to higher prices in late September. The recovery since 2016 has been primarily driven by the supply side of the equation: OPEC’s production cut lowered inventory, and geopolitical tensions (such as Iran and Venezuela). The years-long recovery ended in just three months. The reasons include concerns about swelling U.S. shale output, rising crude oil inventories, inconsistency in Russia and OPEC’s execution of their production deal, and fears of a global economic slowdown. OPEC’s deal with Russia to cut 1.2 million barrels per day during the December 6-7 meeting couldn’t stop oil prices from falling. The sharp decline once again proved higher prices driven by supply almost always have a difficult time lasting.Natural Gas Prices: A Roller Coaster Ride in the Fourth QuarterNatural gas prices soared to $4.70 per mcf in mid-November due to several factors including an early and colder winter hitting North America. It's relatively rare to see the inverse relationship between crude oil and natural gas prices, which happened in the fourth quarter of 2018. A more than 50% increase in natural gas prices was coupled with nearly 30% downturn in crude oil prices during a seven-week period from early October to mid-November. Long oil short natural gas, once a popular trade by speculators, was punished during this unusual period of time. Natural gas prices ended the year at $3.25 per mcf, a 9.8% increase for the fourth quarter and 10.1% rise for the year. The roller coaster ride exhibits the notion that there are few long-term supply issues in natural gas in North America.Outlook for 2019It was truly a dramatic quarter for the industry. The fourth quarter of 2018 marked the end of the two and a half-year oil price recovery that began in 2016, while natural gas prices reached their highest point since 2014. Volatility disrupted capital intensive industries in general. Large investments consisting of millions, or even billions, may take years to complete while circumstances may totally change within a short period, such as the fourth quarter of 2018 we just experienced. However, many producers make capex decisions based on long-term expectations. The latest World Bank commodities price forecast released on October 29, 2018 shows Brent crude will average $74.0 in 2019 and approximately $69.2 from 2020 to 2023.According to the December Short-Term Energy Outlook, the EIA expects global liquid fuels consumption to increase by 1.5 million barrels per day in 2019, with growth largely coming from China, the U.S., and India. Trade tensions between the U.S. and China remain high entering 2019 and have shaken up most, if not all, industries, and oil and gas is no exception. China ranks second in oil consumption and surpassed the U.S. as the world’s largest crude oil importer in 2017. Slower growth in China is looming for the demand side of crude oil. In 2019, the continuation of worldwide central banks tightening pressures global economic growth and the prices of assets and commodities. Higher rig counts and higher capital expenditures by major oil & gas companies worldwide during the recovery also cause concerns of oversupply. According to Baker Hughes, as of December 28, 2018, rig counts in the U.S. were 1,083, 16.7% higher than December 29, 2017.Improving pipeline capacity and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S.In 2019, it is expected that the U.S. will continue to lead the growth in oil supply worldwide. Improving pipeline capacity and the combination of horizontal drilling and hydraulic fracturing continue to drive higher and more efficient production in the U.S. According to the EIA, U.S. crude oil production recently set a record of 11.5 million barrels per day in September 2018. For a single week in November 2018, the U.S. was a net exporter of crude oil and petroleum products. EIA expects U.S. crude oil production will average 10.9 million barrels per day in 2018, up from 9.4 million barrels per day in 2017, and will average 12.1 million barrels per day in 2019.U.S. LNG daily production hit a record high of 5.28 Bcf in Christmas week, according to S&P Global Platts. Large-scale additions to production capacity in 2018 included Shell’s Prelude and Inpex’ Ichthys, both offshore Australia, and Novatek expanded its Yamal LNG facility, while demand is slowing down in Asia, the biggest LNG market in the world. Europe is likely to play the key role in absorbing all the additional production given geopolitical factors, pipeline capacity issues, and the controversial Nord Stream 2. Also, Gazprom’s contract for gas transit via Ukraine is expiring at the end of this year and surprise during negotiation is always possible among Russia, Ukraine, and Europe.The EIA expects Brent spot prices will average $61 per barrel in 2019 and that West Texas Intermediate (WTI) crude oil prices will average about $7 dollar per barrel lower than Brent prices next year, while Henry Hub natural gas spot prices to average $3.11 per MMBtu in 2019. With ongoing oversupply concerns, stabilizing geopolitical tensions, and lower forecasts for global oil demand, it appears in 2019 oil prices have a long way to recover to its previous high in 2018.
2019 Outlook: Gasping for Air Replaces 2018’s Rainbow Chasing
What a difference a year makes. A year ago corporate tax reform had been enacted that lowered the top marginal tax rate to 21% from 35%. Banks were viewed as one of the primary beneficiaries through a reduction in tax rates and a pick-up in economic growth. Now investors are questioning whether bank stocks and other credit investments are canaries in the U.S. economic coalmine.As 2018 draws to a close, bank fundamentals are very good; however, bank stock prices have tanked. SNL Financial’s small-, mid-, and large-cap bank indices have fallen by more than 20% since August 31, which meets the threshold definition of a bear market (i.e., down 20% vs. 10% for a correction).
Markets, of course, lead fundamentals, and corporate credit markets lead equity markets. Among industry groups, bank stocks are “early cyclicals”, meaning they turn down before the broader economy does and tend to turn up before other sectors when recessions bottom.
Large cap banks peaked in February while the balance of the industry peaked in the third quarter after having a fabulous run that dates to the national elections on November 8, 2016. The downturn in bank stock prices corresponds with weakening home sales, widening credit spreads in the leverage loan and high yield bond markets, a ~40% reduction in oil prices, and a nearly inverted Treasury yield curve.
To state the obvious: markets—but not fundamentals so far—are signaling 2019 (and maybe 2020) will be a more challenging year than was assumed a few months ago in which the economy slows and credit costs rise. The key question for 2019 then is: how much and is a slowdown fully priced into stocks?
Our next issue of Bank Watch will entail a deep dive into credit, but for this issue, we observe that a global unwind of leverage is underway as the Fed extracts liquidity from the system. Bond buying (QE) and ultra-low rates helped drive asset prices higher. The reverse is proving true, too.
Bank FundamentalsBank fundamentals are in good-to-great shape. During the third quarter all FDI-Cinsured institutions reported aggregate net income of $62 billion, up 29.3% from 3Q17. Excluding the impact of lower taxes, 3Q18 pro forma net income would have been about $55 billion, up 13.9% from 3Q17. The data is more nuanced once the industry is segregated by asset size, however.As shown in Figure 3, ROA and ROE have nearly rebounded to the last pre-crisis year of 2006. Importantly, capital has increased significantly and, thereby, provides an additional buffer whenever the next downturn develops.
As it relates to 2019, bank fundamentals are not expected to change much other than credit costs are expected to increase from a very low level in which current loss rates in all loan categories are below long-term averages. Wall Street consensus EPS estimates project mid-single digit EPS growth for the largest banks, primarily as a result of share repurchases and a slightly higher full year NIM, while regional and community bank consensus estimates reflect upper single digit EPS growth from the same factors and somewhat better loan growth.
However, credit and equity markets imply the consensus is too high given the sharp widening in credit spreads and drop in bank stock prices the past several months. Although markets lead fundamentals, market signals about magnitude are less clear. Given continuing growth in the U.S. economy that on balance will be helped by lower oil prices, it seems reasonable that an increase in credit costs the market is forecasting will be modest, and as a result, bank profitability will not be meaningfully crimped in 2019.
The Fed: 2019 Rate Hikes Seem UnlikelyWhenever the Fed embarks on an extended rate hiking campaign, the saying goes the Fed hikes until something breaks. The market is signaling that the December rate hike—the ninth in the current cycle—that pushed the Fed Funds target from 2.25% to 2.50% when the yield on the 10-year UST bond was ~2.8% may be one of those moments. What’s unusual about the current tightening cycle is it represents an attempt by the Fed (but not the BOJ, ECB or SNB) to extract itself from radical monetary policies in which the Fed is raising short-term rates and shrinking its balance sheet at the same time.
Given the flat yield curve, it is hard to see how the Fed will hike the Fed Funds another couple of times as planned for 2019, unless the Fed wants to invert the yield curve or unless intermediate- and long-term rates reverse and trend higher. Presumably the $50 billion a month pace in the reduction of its US Treasury and Agency MBS portfolio will continue. Alternatively, perhaps the Fed will bow to the market and not raise rates in 2019 and slow or even halt the reduction in its balance sheet to stabilize markets.
As it relates to bank fundamentals, the impact on net interest margins will depend upon individual bank balance sheet compositions. Broadly, however, a scenario of no rate hikes implies less pressure to raise deposit rates, and rising wholesale borrowing rates should stabilize. The result, therefore, should be a little bit better NIMs than a slight reduction if the Fed continues to hike given that deposit rate betas for many institutions are well over 50% now. More important for banks if the Fed pauses vs continues to hike would be the impact on asset values (higher all else equal) and, therefore, credit costs.
Bank Valuations: Support but Never a Stand-Alone CatalystA synopsis of bank valuations is presented in Figure 4 in which current valuations for the market cap indices are compared to the approximate market top around August 31, November 8, 2016 when the national election occurred, and multi-year medians based upon daily observations. An important point is that valuation is not a catalyst to move a stock; rather, valuation provides a margin of safety (or lack thereof) and thereby can provide additional return over time as a catalyst such as upward (or downward) earnings revisions can cause a multiple to expand or contract.Bank stocks—particularly mid-cap and large-cap banks—enter 2019 relatively inexpensive to history. The stocks are cheap relative to 2019 consensus earnings with large cap banks trading around 8x and small cap banks at 10x; however, the market’s message is that the estimates are too high. It is hard to envision that estimates are dramatically too high as proved to be the case in 2008 unless the economy is poised to roll-over hard, which seems unlikely. Assuming no recession or a shallow recession, then, the modest valuations may result in bank stocks having a good year even if fundamentals weaken and analysts cut estimates because the limited downside in earnings had been adequately priced into the stocks by late December.Bank M&A: Slowing Activity for 2019 LikelyOutwardly, 2018 has been another good year for bank M&A even though activity slowed in the fourth quarter. There were few notable deals other than Fifth Third’s pending acquisition of Chicago-based MB Financial valued at $4.8 billion at announcement and Synovus Financial’s pending acquisition of Boca Raton-based FCB Financial Holding valued for $2.8 billion at announcement. Even before bank stocks rolled over the shares of both Fifth Third and Synovus severely underperformed peers as investors questioned the exchange ratios, cost saving assumptions, credit risk (especially at FCB), and whether the buyers could keep the franchises intact as key personnel defected elsewhere.The national average price/tangible book multiple expanded to 173% from 166% in 2017 and about 140% in 2014, 2015 and 2016 before the sector was revalued in the wake of the national election. The median P/E of 25x was within the five-year range of 21x to 28x.The total number of bank and thrift transactions through December 24 totaled 261, which equated to 4.4% of the commercial bank and thrift charters as of year-end 2017. During 2014–2018, the number of acquisitions exceeded 4% each year except for 2016 when activity at the beginning of the year was hampered by weak stock prices as a result of a slowing economy that was marked by a collapse in oil prices and sharply wider credit spreads.
Weak bank stock prices crimp the ability to negotiate deals because most sellers are focused on absolute price rather than relative value when taking the buyer’s shares as consideration; and, buyers usually are unwilling to increase the number of shares being offered given a limitation on minimum acceptable EPS accretion and maximum acceptable TBVPS dilution. A notable late year exception occurred when Cadence Bancorporation opted to increase the number of shares it will issue to State Bancorp by 9.6% because the double trigger in the merger agreement signed during May when Cadence’s share price was much higher came into play.
Although there is no change in the driver of consolidation such as succession issues, shareholder liquidity needs, and economies of scale, a slowdown in M&A activity in 2019 is likely because bank stocks will enter the year depressed. Deals that entail some amount of common share consideration will be tough to structure unless sellers will be willing to take less, which most will not do with operating fundamentals in good shape for now. All cash deals will be impacted less, but all cash deals are more prevalent among very small institutions in which pricing usually occurs at a discount to those that entail some proportion of common shares.
Summing It UpThe market is shouting fundamentals will weaken in 2019 after a long period of gradual improvement following the Great Financial Crisis, which most likely will be reflected in sluggish loan growth and modestly higher credit costs; however, bank stocks may surprise to the upside as they did to the downside in 2018 provided a) there is no recession or a shallow one; and, b) the Fed relents and does not hike further and potentially slows the run-off of its excess bonds (and liability reserves). For clients of Mercer Capital who obtain year-end valuations, rising stock prices since the presidential election may be reversed partially, given the compression in market price/earnings and price/tangible book value multiples that occurred in 2018.
RIA Stocks Suffer Worst Quarter Since the Financial Crisis
Most Traditional and Alternative Asset Managers in Bear Market Territory After Turbulent Year for Global Equities
Following a decade of (fairly) steady appreciation, RIA stocks finally capitulated with the market downturn and growing concerns over fee compression and asset flows. As a leading indicator, such a decline suggests the outlook for these businesses has likely soured over the last year or so.What Goes up Must Come Down…Prior to last year, RIA stocks benefited immensely from the bull run that began in March of 2009, besting the market by over 60% during this favorable period for asset returns.[caption id="attachment_24166" align="alignnone" width="814"]Source: S&P Global Market Intelligence[/caption]
In 2018, this trend reversed course, and the return of market volatility and negative returns precipitated a broad decline across all industry sectors.
[caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption]
Traditional active managers have felt these pressures most acutely as poorly differentiated products struggled to withstand downward fee velocity and at the same time have been a prime target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules as a result.
Reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the fourth quarter. As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses as displayed by their performance in the last quarter.
[caption id="attachment_24165" align="alignnone" width="820"]Source: S&P Global Market Intelligence[/caption]
Does Size Matter for RIAs?The corresponding RIA size graph seems to affirm this. The larger firms generally outperformed smaller RIAs, though all categories were down in the quarter. Still, this trend is, admittedly, a bit misleading since the smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 30% during the quarter, although this is the least diversified category of RIAs with only two components. As such, this category is subject to a high degree of volatility due to company-specific developments. Most of our clients are in this size category, and we believe it is highly unlikely that these businesses lost almost a third of their value (in aggregate) over the quarter as suggested by the graph below.[caption id="attachment_24166" align="alignnone" width="821"]Source: S&P Global Market Intelligence[/caption]
Generally speaking, larger RIAs typically attract higher valuations due to the benefits of scale and a more diverse AUM base. Still, capacity constraints can be an issue, particularly for niche and small cap investment products. So, unless you’re BlackRock, there’s probably a sweet spot for optimal asset size.
A (More) Bearish OutlookThe outlook for these businesses is market driven, though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic, but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.On balance, the outlook for 2019 doesn’t look great given what happened to RIA stocks last quarter. The market is clearly anticipating lower AUM, revenue, and earnings with the recent correction, which could be exacerbated by asset outflows if clients start withdrawing their investments. Friday’s steep advance could be a silver lining, though volatility remains high. More attractive valuations could also entice more M&A, which is still relatively subdued despite the recent uptick in dealmaking. We’ll keep an eye on all of it in what will likely be a very interesting year for RIA valuations.
Cooler Weather Could Heat Up Appalachia
As the calendar turns to 2019, we turn our attention to the Appalachia region, and not by coincidence. Cooler temperatures in the winter months tend to lead to increased natural gas prices and consumption, and the Appalachia region is the largest natural gas producer in the country. Fourth quarter energy prices moved in opposite directions—crude prices declined steadily over the period and natural gas prices increased from about $3.0 to $3.5 per Mcf, peaking at over $4.8 in mid-November.November Price SpikeIn its December edition of the Short-Term Energy Outlook, or STEO, the EIA reported the price of Henry Hub averaged $4.15/MMBtu in November, up 87 cents, or 27% from October. It attributed this increase to colder temperatures and lower inventory levels. The EIA estimated that inventory in the U.S. stood at 3.0 trillion cubic feet at the end of November, which was 19% lower than the five-year average.Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree.Declining nearly 26% since its peak six weeks prior, the run-up in natural gas prices appears to have only been temporary. As we discussed with crude oil in our Q2 newsletter, higher inventory helps to smooth price volatility in the energy market. During this part of the year, natural gas inventories are drawn down as people fire up their heating units, but this year the initial draw down of inventories hamstrung as U.S. natural gas inventories began the season at a 15-year low. Increased production, spurred by the season and higher prices, has increased supply to meet demand to a degree. Milder weather forecasts and energy substitutes (coal) have reigned in prices as well.As we alluded to recently, the price spike was also due in part to short covering by hedge funds in response to the rapid decline in crude prices. Worried investors diverted funds from oil to gas to compensate for accumulating losses in oil. Given the smaller nature of the gas market compared to oil, there was an uptick in activity and prices. Quickly rising prices led to an overbought market that subsequently corrected and has been trending downward with trading volume throughout the end of the year.Appalachian Ethane Storage HubAt the beginning of December, the U.S. Department of Energy published a report to Congress on the feasibility of establishing an ethane storage and distribution hub in the United States, specifically, the Appalachia region. The report noted that significant production growth is expected to occur in the Permian and Appalachia, though the latter trails the former in terms of current infrastructure (95% of ethane storage in the U.S. is located near the Gulf Coast). Storage hubs balance seasonal supply and demand variations, and are crucial to smooth volatility, as evidenced by the November activity. The report notes that a distribution hub near the Marcellus and Utica plays would help allay geographic concentration risk along the Gulf Coast that is susceptible to severe weather events (e.g. Hurricanes Harvey and Irma). While such a hub would provide a competitive advantage, the report crucially notes it would not be in conflict with further expansion of infrastructure in the Gulf Coast.U.S. Secretary of Energy Rick Perry, who signed the report, said, “There is an incredible opportunity to establish an ethane storage and distribution hub in the Appalachian region and build a robust petrochemical industry in Appalachia.” While the report focused on the economic benefits of a hub, detractors note the lack of consideration of environmental costs. It remains to be seen how this will impact production and pricing in the region, but it would undoubtedly be a boon for the region and the industry.Rig Counts and ProductionAccording to calculations based on data from Baker Hughes, rig counts in North America increased 2.9% in the last three months and 16.6% over the last twelve months. The Permian Basin led the way and currently has just fewer than 500 rigs, representing about 46% of total rigs in the U.S. By comparison, the Appalachia region has had below 80 rigs since July 2015 though it has remained relatively consistent, above 70 since last May.Though production has spiked, Appalachia significantly lags the other regions in terms of total production.Oil production in the Marcellus and Utica plays has increased by 45.1% in the past year, growth even higher than the Permian. Though production has spiked, particularly in the second half of the year (up 34.8% since June alone), it’s important to recognize the magnitude: Appalachia significantly lags the other regions in terms of total production.Natural gas is the major focus of the region, where production has increased 15.5% in the past year, trailing both the Permian (34.1%) and the Bakken (25.1%). Again, size plays a role in these growth figures as Appalachia has about 2.5x the production than the next largest play, the Permian. A deeper dive into the DUCs tells a slightly different story, however, with the inventory of drilled but uncompleted wells declining 17% in the region over the past 12 months. This could temper the rate of growth for production for the region in 2019 if drilling in the regions doesn’t increase.Valuation ImplicationsAppalachia has consistently lagged the other regions in terms of EV/production multiples, also known as price per flowing barrel. The Permian took center stage in 2017 but has retreated back to the rest of the pack. The lower multiple seen in Appalachia is largely due to declines in enterprise values, though increasing production has played a role as well.Despite the recent increase in price, the EIA expects increased production in 2019 will cause the average price of natural gas to drop 6 cents, compared to 2018, to $3.11. This could explain why key players in the region are seeing lower stock prices.Range Resources is the largest natural gas producer in the Marcellus, but it has not seen a positive impact from higher prices over the past few months. The company’s share price has dropped further than the overall market, but this cannot solely be attributed to swings in natural gas prices. While Range’s share price has dropped along with the recent slide, it did not get the same treatment when the market spiked in mid-November. Since its long-term debt obligations do not begin to mature until 2021, the drop in share price has had a significant impact on its enterprise value. Range is uniquely positioned with capacity on the Mariner East 1 pipeline that will allow it to tap into the rising global demand for NGLs, so there is potentially an upside to its current price.ConclusionNatural gas prices have followed a curious path in the past three months with index prices spiking at the Henry Hub, but gas being flared in record proportions and even given away at a loss in the Permian. While pricing will remain dynamic, there are certainly positives for natural gas producers heading into 2019 with the potential for an ethane storage hub in the Appalachia region and a ramp-up in production of NGLs to satisfy the global market.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
RIA Valuation Insights: Best of 2018
Happy New Year to all our readers and subscribers! Here are the five most popular posts from 2018.1. S Corp RIAs Disadvantaged by the Tax Bill: New but UnimprovedFor this post, Matt Crow likens Ford’s lackluster revamp of its Mustang model to the tax bill’s impact on RIA S corps. As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good for certain pass through entities by effectively reducing the tax advantage that S corps have over C corporations, especially for non-distributing firms. The TCJA also excluded investment management firms from the QBI deduction beyond a certain income limit. While the tax bill’s reduction on C corp rates was generally beneficial to market returns and AUM balances, it did not necessarily enhance the tax efficiency of S corp RIAs as many industry participants had hoped.2. Summer Reading for the RIA Community – Focus Financial’s IPOThis pre-IPO post emphasized many of the concerns we had on Focus’s valuation that investors seem to be grappling with now. Specifically, heavy (and controversial) adjustments to reported earnings, continuing net income losses, “organic growth” questions, and the recent market downturn are all weighing on FOCS, which has lost nearly half its value since September. We’ll keep an eye on this one for its broader implications on RIA aggregators in the wealth management space.3. The Role of Earn-outs in Asset Management M&AThis post is really just a link to our whitepaper on the topic since there’s frankly too much to write about in the blog format. Despite the relatively high level of sophistication among RIA buyers and sellers, contingent consideration remains a mystery to many industry participants. We offer this whitepaper to explore the basic economics of earn-outs and the role they play in negotiating RIA transactions.4. The Haves and Have-Nots of the RIA IndustryThis post explores why wealth managers have recently outperformed their asset manager peers and what this means for the broader industry moving forward. Fee compression and the rise of passive management have seemingly benefited wealth management firms to the detriment of asset managers in recent years. Volatility over the last few months has likely exacerbated this trend for many active managers, though some mean reversion may be long overdue.5. Asset Manager M&A Activity Accelerates in 2018Zach Milam discusses continuing gains in asset manager M&A despite the industry’s recent headwinds. RIA aggregators, a rising cost structure, and highly scalable business models are all culprits to yet another banner year for sector dealmaking. It will be interesting to see how the recent downturn will affect this trend in 2019, which we’ll also be blogging about in the coming months.
Mercer Capital’s Value Matters® 2019-01
Dividend Policy and the Meaning of Life
Value Drivers of a Store Valuation
Auto dealers, like most business owners, are constantly wondering about the value of their business. Dealers can actually influence the value of their store by understanding the value drivers of a store valuation and addressing them on a consistent basis. So what are some of the value drivers of a store valuation?
Six Different Ways to Look at a Dealership
So, how does a dealer evaluate their dealership? And how can advisers or formal business valuations assist dealers examining their dealership? There are at least six ways and they are important, regardless of the size.
‘Twas the Blog Before Christmas…
Mercer Capital RIA Holiday Quiz
‘Twas the blog before Christmas and throughout our staff Analysts were separating wheat from the chaffWe listened to Cramer (who sounds so serene) While gigabytes of spreadsheets danced on our screensWith equities swooning and bitcoin’s collapse Recovering hedgies are risking relapseAnd wealth managers nestled at home with a beer In hopes that a Santa-rally soon would appearAs midtown Manhattan glistened with snow You could almost forget fees had fallen so lowBut regardless of struggles, this is still a great biz So enjoy your Christmas with our RIA quiz!Merry Christmas! We will be back in January.If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrTtFc_2Bo1XwLsGscpjK7cNEu.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey
M&A in the Marcellus-Utica Shale
The Beast in the East
The domestic natural gas market has benefitted from large expansion in recent years, and this can be largely attributed to the growth experienced in Appalachia. According to a Deloitte study, Appalachia was the world’s 32nd-largest natural gas producing region in 2007, with levels comparable to Bolivia and Kazakhstan. As of 2017, it was the third largest, trailing only the full United States and Russia.Companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Henry Hub prices have been hovering around $3/MMBtu for over three years and recently have increased to just over $4/MMBtu in November due to a combination of expectations of colder than usual weather and short squeezes, increasing trading and price influencing in a market that is much smaller than oil. Despite the long-term low price environment, supply and demand have increased, driven primarily by the increased demand needs from the power sector. Economic viability of recoverability has not been impacted in light of the lower prices as Deloitte estimates that 50 years’ worth of natural gas can be recovered for less than $3/Mcfe.Despite the continued growth, transaction activity in the Marcellus-Utica in 2018 was slower than in 2017. Some companies have been moving in to capitalize on the increased demand for natural gas, as indicated by the energy outlook by the EIA, while others are restructuring their balance sheets in order to focus primarily on oil. While companies may not be rushing to the Marcellus-Utica in a similar manner as the Permian, companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Recent Transactions in the Marcellus-Utica Details of recent transactions in the Marcellus-Utica, including some comparative valuation metrics are shown below. Overall, deal count and average deal size have decreased from twelve months ago. There have been a handful of large deals though that show increased interest in the area.Ascent Resources Acquires 113,400 Acres in OhioAscent Resources, a company founded by Aubrey McClendon after he left Chesapeake Energy, announced that it is buying 113,400 Utica Shale acres in multiple deals along with 93 operating wells located in eastern Ohio for a total of $1.5 billion. The new acreage puts Ascent at over 300,000 Utica acres and catapults the company into one of the largest privately owned E&P drillers in the U.S. The selling companies are CNX Resources and Hess (each selling their share of a joint venture for $400 million each), Utica Minerals Development and a fourth, unnamed seller.The CNX and Hess JV sale marks a complete exit in the play, and both companies plan to utilize proceeds to fund share repurchase programs, pay down debt, and focus on growth opportunities in other established plays, such as the Bakken.Chesapeake Energy Sells Entire Utica Position to EncinoIn an even larger deal, Chesapeake Energy disposed of its entire interest in the Utica Shale to Encino Acquisition Partners for about $2 billion. EAP is backed by the Canadian Pension Plan Investment Board and Encino Energy. Chesapeake sold its stake in the Utica Shale to strengthen its balance sheet and further shifts its focus from gas production to oil, Chesapeake CEO Doug Lawler said in an interview. “We will absolutely be driving for a greater percentage of oil production in our portfolio,” Lawler said. “We hope to achieve that through organic growth, exploration and future acquisitions.”The sale to Encino Acquisition Partners includes 320,000 net acres in Ohio’s Utica Shale and 920 wells that currently produce about 107,000 barrels of oil equivalent per day. The purchase price also includes a $100 million contingent payment based on future natural gas prices. With a sale price of approximately, $2,222 per acre, this appears to be in line with the median transaction amount for 2018.Observed M&A Trends in the Marcellus-Utica Large Exits and Balance Sheet AdjustmentsSimilar to trends we observed last year in the Marcellus-Utica, large companies that have had established presences are moving out of the play entirely to focus on higher margin assets. Demand for natural gas is very high, but the inexpensive extraction costs paired with longer laterals for extraction have allowed supply to catch up, causing prices to remain low and relatively flat in the long term, with the exception of the high trading volume experienced last month.The price run-up in November, however, appears to be short-lived, and the commodity appeared to be overbought. High expectations and rising EIA forecasts for domestic production explain why the U.S. gas futures market has held backwardation even though near-term pricing has spiked. Futures prices for 2019 and 2020 have declined back to the $2.50 to $3.00 range, and with margins remaining low for the foreseeable future, it makes sense for companies to adjust their balance sheets and unload assets that are not meeting their margin goals.Continued Ease of M&AAlthough the low price and low margin environment has caused some to exit the Marcellus and Utica plays, the stable prices environments make mergers and acquisitions easier, with public companies in a better position to make deals than private equity investors.The stable prices environments make M&A easier, with public companies in a better position to make deals than private equity investors.According to Robert Hagerich, Senior Vice President at Macquarie Capital (USA) Inc., established public companies are looking to expand acreage and existing holdings, and can use their stock as currency to buy leases that are adjacent to their holdings with operating midstream infrastructure and production volumes that can be immediately booked with the purchasing company. On the other hand, private equity buyers are usually financing the exploratory drilling that expands the core fairways of the shale plays essentially buying an option on improved prices.
This trend began in the later part of 2017, and it has continued into 2018. "Stable pricing brings buyers to the table," says Hagerich. "Buyers are looking for leases that are exposed to the core areas of the shales, contiguous acreage, leases held by production, ownership of the gathering system and access to more than one transportation pipeline."
The low volatility nature of the natural gas market compared to oil or LNG facilitates M&A activity and allows for consolidation opportunities as observed from the merger of Blue Ridge Mountain Resources and Eclipse Resources Corp. in August and the heavy consolidation activity from EQT in 2017.
The Marcellus-Utica continues to be a powerhouse for natural gas production and doesn’t show signs of slowing down anytime soon. Strategic transactions in the area allow companies to focus on assets that drive their core business and others to consolidate in the area and supply the growing demand for natural gas in the U.S.
We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
What Business Is Your Family Business In?
This post is part of our “Talking to the Numbers” series for family business leaders. In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements. Asking better questions will lead to better financial and business decisions.
When engaging in shop talk about a client project, our colleagues inevitably start by asking, “What business is the client in?” In nearly all cases, the appropriate response to the question is a brief description of the client’s industry. But for a small minority of clients whose financial performance is truly extraordinary, the correct response is that they are in the “money making” business. For these clients, the particular “it” of what they do is secondary to the fact that they make a lot of money doing it. Has your family business joined the exclusive club whose members are in the “money making” business?Has your family business joined the exclusive club whose members are in the “money making” business?The income statement reveals the profitability of your family business. You can think of the income statement as a series of increasingly difficult tests. If the company can charge a price for its goods or services greater than the cost of production, it will have passed the first test, and gross profit will be positive. The second test is this: Can the family business sell enough units to cover its overhead expenses? This test is harder, as it requires the business not just to be profitable on a per-unit basis, but to generate enough volume to support the selling, general and administrative expenses necessary to operate the business. Looking at our data, we observe that just five companies failed the first test (i.e., reported negative gross profit), but 69 companies failed the second test.Exhibit 1 summarizes median operating margins by industry. The sum of the two stacked columns is the median gross margin for each industry (gross margin = operating margin + S, G&A). In general, some of the volatility in gross margin by industry gets smoothed out a bit at the operating margin level. For example, the relatively high gross margin for industries like healthcare and information technology is largely offset by high overhead costs. On the other hand, lower gross margin sectors such as industrials and materials, have lower overhead burdens.Three broad themes relevant to family businesses emerge from our consideration of the operating income data.Operating Leverage is Real, so Revenue Growth is ValuableFor family businesses that are focused on long-term sustainability, focusing on revenue growth is not optional. Standing still is generally a recipe for a slow (or perhaps even fast) painful death. The cost of doing business rises every year, and revenue growth is essential to maintaining profitability. To the extent a business has fixed costs – and all do to some degree – faster revenue growth can contribute to margin enhancement. Exhibit 2 summarizes the operating leverage enjoyed by the companies in our analysis. Consistent with our analysis in a prior post, we divided our universe of companies into three groups based on their observed historical revenue growth.As noted in Exhibit 2, the median operating margin for the high growth companies increased over the period, from 10.9% to 12.0%, while the median operating margin for the low growth companies decreased by approximately 240 basis points. As noted in the rightmost column, the effect of operating leverage (both positive and negative) is to magnify the impact of changes in revenue on earnings. For the high growth companies, operating leverage multiplies a 15.4% revenue growth rate to an 18.2% earnings growth rate. For the low growth companies, shrinking operating margins contributed to an 8.0% decline in earnings despite revenue falling a more moderate 2.5%.Operating leverage matters to family businesses. As directors think about operating leverage, the following questions are good to mull over.How much “slack” is there in the current overhead structure? Could our family business absorb a 5% increase in revenue without incurring additional overhead? 10%? 20%?How would our customers respond to a price increase? For some businesses, a modest price increase can be the quickest route to revenue growth with little to no impact on operating costs. How easy would it be for customers to switch to a competitor in the event of a price increase? Or, would competitors be likely to follow suit?Operating Margin is a Component of Risk ManagementOperating margin provides a buffer against the inevitable rough patches that any business faces. For family businesses, layoffs and other austerity measures prompted by economic downturns or other business headwinds are especially stressful. One perspective on margin as a component of risk management is the concept of a breakeven point. The breakeven level is the sales volume that will generate enough “contribution margin” to cover the business’s fixed costs.Estimating the breakeven level for your family business requires an assessment of which costs are fixed (over the relatively short-term), and which are truly variable with the amount of sales. Making a precise calculation is not the point, however; understanding how sensitive operating income is to changes in sales is more important than calculating precisely what level of sales corresponds to breakeven operating income.Since public companies aren’t required to disclose their fixed and variable costs, Exhibit 3 illustrates the concepts using two hypothetical family businesses.Company A and Company B currently generate the same 10% operating margin. But breakeven analysis reveals that Company A (with a greater proportion of variable to fixed costs) is better able to withstand a reduction in sales. Operating income for Company A does not fall to $0 unless sales tumble by a third, while revenue slipping by just 15% causes Company B to begin losing money. Panel B illustrates how a higher operating margin reduces the breakeven level for both companies. In other words, operating margin is not just about cash flow and profits, but is also an important element of risk management. Family business leaders attuned to risk should consider questions like these when analyzing operating margin:Does it make sense to consider changing the cost structure to emphasize fixed or variable costs more? If there is a risk that future revenues will decrease, a variable cost structure will reduce the breakeven level, whereas if the outlook is for robust revenue growth, a fixed cost structure will provide a boost to earnings growth.What is my family business’s exposure to a potential economic downturn? Does the business operate in a counter-cyclical business that has historically weathered recessions with ease, or do even mild recessions pose an existential threat to the business? We are not predicting when the next recession will occur, but that there will be one, we are quite certain. The best time to plan for that eventuality is before it comes, when the flexibility to adapt is greatest.Diligence in Expense Management is RewardedNo family business can save its way to prosperity: you really do have to spend money to make money. However, diligence with regard to operating expenses – in flush times as well as bad – pays dividends.To test this theory, we reviewed operating expenses for the companies in our data set. Year-over-year growth in operating expenses across the group varies dramatically. Since extreme changes are likely the result of acquisitions or dispositions, we focused on the subset of companies for whom year-over-year operating expense growth ranged from -2.5% on the low side to +7.5% on the high side. We then further divided this group into those whose expenses grew less than +2.5% (a rough proxy for inflation), and those whose expense grew at rates higher than inflation. Exhibit 4 summarizes relevant data for these two subgroups.The companies that were more diligent managing operating expenses were far more likely to see revenue grow faster than operating expenses. Those that failed to contain operating expenses were more likely to see margins slip because of expense growth outpacing revenue growth.Family businesses let spending discipline slide at their own peril.What opportunities exist at my family business for optimizing labor costs? Are there capital investments that can promote labor efficiency?How does the structure of our sales & marketing function fit with our product offerings and markets served? Are there opportunities to enhance the effectiveness and efficiency of our selling and marketing efforts?How is our administrative staffing? Do we have the right people in the right places with the right tools to succeed?
Operating income is the foundation of your family business’s ability to pay dividends, invest in the future, and obtain attractive financing. What business is your family business in?
Is Focus Financial an All-Terrain Investment Vehicle?
Management Claims Their Model is Recession Proof; Unfortunately, it isn’t Analyst Proof.
Last week was turbulent for equities around the globe, but Focus Financial (Nasdaq: FOCS) was hit particularly hard. Less than five months since IPO, Focus closed Friday at $27.45, decidedly below where the offering priced at $33, and not much more than half the share price achieved less than three months ago.
[caption id="attachment_23631" align="alignnone" width="756"]Source: Bloomberg[/caption]
I was thinking about Focus Financial last week when I found myself in traffic behind a Hummer H1. The H1 was the original Hummer, built by AM General based on their military vehicle, the Humvee. An H1 is immense, weighing in at about 8,000 pounds. H1s were capable of climbing boulders and steep grades and fording streams and rivers as deep as 30 inches. Because of these extreme characteristics, the public initially overlooked how difficult the vehicle was to park, maintain, and even keep fueled. Sales of the H1 peaked in the mid-90s. In 1998 GM bought the brand and started producing a more civilian variant, the H2, and then an even smaller (albeit still very large) H3. About a decade later, GM gave up as the public lost interest. Hummer executives must have been frustrated when the media lampooned their products for being ungainly and inefficient. After all, Hummer never pretended to be anything else.
I sensed a similar frustration in Rudy Adolf’s voice last week as he pleaded Focus Financial’s case at the Goldman Sachs U.S. Financial Service Conference. The recent share price performance of Focus clearly suggests the market is losing interest in the issue, and it doesn’t seem to have anything to do with Brexit or yield curve inversions. Instead, the analyst community seems to have soured on the Focus story, which is strange to us because the story hasn’t really changed since the company filed the first version of its S-1 back in May.
Focus's Business ModelFocus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.To revisit the narrative, Focus Financial’s principle business is acquiring preferred cash flow stakes in RIAs. The preferred cash flow stake is a percentage (often half) of a “partner” RIA firm’s earnings before partner compensation (EBPC). Focus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff. The selling firm’s continuing partners retain all of the downside profit risk and share pro rata with Focus in the profit upside. The partner firms retain a considerable degree of autonomy in that Focus doesn’t really effect operational control, doesn’t rebrand the partner firms using the Focus name, and doesn’t require partner firms to sell Focus branded investment products.As we have asserted previously, there is good and bad in the practice of transacting preferred stakes. In theory, the practice puts a floor underneath Focus’s revenue stream in the event of bad markets. Focus management suggests that only 75% of partner firm revenues are AUM driven, the portfolios generating those fees are only 56% invested in equities (44% fixed income), and there is a 70/30 split of partner firms that bill in advance versus those that bill in arrears. Focus management states that this means a 10% change in equity valuation only moves Focus’s results by 2.9% in the same quarter (10% times 75% times 56% times 70%) and 1.3% in the following quarter (10% times 75% times 56% times 30%). The granularity of this data may be more enticing than it is useful. We know the reality of market impact on Focus is much more complicated, as changes in the margins of partner firms, the impact of bad markets on non-fee revenue, and the cumulative impact on fee producing assets all weigh in on cash flows. Further, we wonder if a sustained bear market wouldn’t gut the management companies of Focus’s partner firms, as sustaining Focus’s cumulative preferred distributions would deprive the management companies of the partner firms from cash flows needed to maintain market compensation.Differing PerspectivesThe analyst community is fixated on Focus’s growth prospects, accuses the company of underperforming expectations in the third quarter, and is worried that the current market behavior will impede M&A opportunities. Focus management responds that M&A is lumpy, and that their experience in the credit crisis a decade ago suggests that bad markets can slow larger deals, but small transactions still occur. Further, management does not believe the company underperformed in the third quarter, just that the analysts expected too much of them.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”That comment – that the analyst community oversold Focus – caught my attention. Having gone public at $33 per share on heavily adjusted earnings, Focus doesn’t have a history of profitability to form a reliable foundation for value. If Focus had IPO’d at $18 and drifted up over the first few months to the mid-20s, it would be viewed today as a success. I’m not suggesting that $18 was a more appropriate valuation at IPO, but an excessive valuation at offering can be an albatross for a public company – and that may be how we eventually see this situation.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.” Adjusted means they can grow by acquisition, but they’ll be expending cash and equity to fund that growth. Organic growth is estimated at 10%, but it includes acquisitions by partner firms. Management justifies this because broker-dealers include advisor recruiting in their organic growth rates. That’s a risky justification, because the economics of broker-dealers has been eroding for decades, and many see the practice of paying to poach advisors as a sign of an industry in distress.Nine months ago, the investment banking community wanted to see Focus as the ultimate RIA – but it was never that. Focus is a complex feat of financial engineering which demonstrates, above all, how difficult it is to build a consolidation model in the investment management community. We think it’s inappropriate to fault management for doing what they said they would do in the S-1. Nonetheless, like anyone who’s ever driven a Hummer, they could be in for a rough ride.
Is Your Family’s Capital “Lazy?”
What We’ve Been Reading
At a recent meeting with longstanding family business clients, management mentioned that one of their independent directors had introduced the term “lazy capital” into the family’s vocabulary. We had never heard that term before, but it perfectly encapsulates something we see at too many family businesses: an undisciplined capital allocation process that tolerates sustained underperformance. We ran across a couple articles this week that, while written with public companies in mind, made us think about the perils of “lazy” family capital.Capital, Culture & CommunicationThe first article posted by Big 4 accounting firm EY was entitled “Is Your Capital Allocation Strategy Driving or Diminishing Shareholder Returns?” In the piece, EY offered eight leading practices for allocating capital, two of which made us think about our family business clients.Number three on EY’s list was this: “Establish a ‘cash culture’ that prizes cash flow and does not tolerate unnecessarily tying up capital.” Perhaps it is more natural for public companies to prioritize a “cash culture” than it is for family businesses. After all, family businesses have the advantage of not being on the quarterly reporting treadmill, or worrying about the day-to-day or week-to-week changes in share price. Yet, a “cash culture” need not result in unhealthy short-termism. For family businesses, a “cash culture” can help provide the foundation for long-run sustainability. The managers of a family business with a healthy “cash culture” understand that family capital does have alternative uses outside the family business, and are focused on being good stewards of the capital that the family has entrusted to them. As a result, “cash culture” family businesses are more flexible, more attuned to emerging risks and opportunities, and ultimately more accountable to the family.Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.The seventh item on the EY list was to “Align capital allocation, strategy, and communications.” Relative to public companies, some family businesses are late to the party when it comes to sophisticated capital budgeting tools. However, despite the merits of net present value, internal rate of return and other quantitative concepts (which are many), those capital budgeting tools accentuate, rather than diminish, the importance of a clearly-articulated corporate strategy to allocating capital properly. Quantitative tools can be used (whether intentionally or not) to support proposed capital projects that do not advance the family business’s strategy. The quantitative greenlight should be viewed as a necessary, but not sufficient, condition for approving capital projects. Knowing that corporate strategy is essentially the art of saying “no” at the right times, successful family businesses require a compelling and simple answer to the “why” question: Why is the proposed project a good fit for us?Public companies work hard to ensure that corporate strategy is effectively communicated to existing and potential shareholders. The results of failing to do so can be disastrous – if public company shareholders don’t understand or don’t believe or simply don’t know what the company’s strategy is, they can vote with their pocketbooks by selling shares. When public company investors head for the exits, the share price becomes depressed, leaving the company vulnerable to hostile takeover or vulture investors.Since family shareholders do not have ready liquidity, does that diminish the importance of communication for family businesses? No. If family business directors fail to communicate well, family shareholders eventually become disengaged, suspicious, and far too often, litigious. Family businesses simply have too much at stake not to take communication seriously. Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.Putting the Family Business on a (Capital) BudgetA recent “Head to Head” feature in the Financial Times (subscription required) pitted two economists against each other on the topic of share buybacks. One economist, citing the baleful influence of aggressive share repurchases, argued that they should be strictly curbed, while the other praised the effectiveness of buybacks in promoting a long-run perspective on the part of company managers. The specific arguments put forth (with varying degrees of cogency) don’t need to concern us here, since they apply to public companies.For family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases?But for family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases? Most family business directors are rightly wary of wild swings in annual per share dividend payments. However, one side effect of that concern is that when financial performance is strong, undistributed capital at the family business may be inclined to put on the stretchy pants and become “lazy.” A disciplined dividend policy can actually result in an undisciplined reinvestment policy. When retained capital is plentiful, it becomes more tempting to approve marginal capital projects, or those with only a tenuous connection to the family business’s strategy. Repurchasing shares can function as the release valve that allows family business directors simultaneously to maintain a steady annual dividend and keep the family business on a prudent financial diet when it comes to capital investment.The biggest challenges surrounding share repurchases for family businesses are getting the price right and communicating with shareholders. A price that is too low will take economic advantage of selling shareholders, while a price that is too high may cause a proverbial run on the bank. Shareholders need to be fully informed about why the repurchase is occurring, at what price, and what their options are with regard to tendering shares.Share repurchases won’t be a good fit for every family business. For some, a periodic special dividend may fulfill the same function. But they are a key tool available to family business directors in the ongoing fight against “lazy” capital.
Before Selling Your Oil and Gas Royalty Interest, Read This
Because of the historical popularity of this post, we revisit it this week. Originally published earlier this year, this post helps you, the reader, think through important issues when considering selling your oil and gas royalty interest.
There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.
There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Understanding how royalty interests are valued will ensure that you maximize the value.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.Before attempting to sell your mineral interest, understand these issues.Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.1Recognize Production and Price as Value DriversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well.Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.Proceed with CautionWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Beware of online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue. While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.A lack of knowledge regarding the worth of your royalty interest could be very costly.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our post, Three Types of Mineral Interests.
Accounting for Risk in Oil and Gas Reserve Valuations
Reserve Adjustment Factors and Risk-Adjusted Discount Rates
One of the most complex aspects of oil and gas valuation is accounting for the risk associated with proved developed nonproducing reserves (PDNP), proved undeveloped reserves (PUD), and the less certain probables and possibles (P2 and P3 Reserves).When valuing proved developed producing reserves, estimates of future production, pricing, and expenses are based on historical results. However, production projections and expense forecasts are more speculative when it comes to PDNP reserves as they are not based on recent production history, and are even more abstract when it comes to PUD reserves since the wells have not yet been successfully drilled.Accounting for RiskGenerally, there are three ways to account for the additional risk associated with PDNP, PUD reserves, probables, and possibles:Using a risk-adjusted discount rate (RADR),applying a reserve adjustment factor (RAF), orutilizing a modified option pricing model.
In this post, we outline the basics of risk-adjusted discount rates and reserve adjustment factors.
Some of the best guidance on measuring this risk is published by the Society of Petroleum Evaluation Engineers (SPEE). Every year at its annual meeting in June the SPEE presents the results to its annual survey to better understand the parameters used in property evaluation.
The SPEE Survey is a global study, however, the majority of participants evaluate U.S. properties. The June 2018 survey had a total of 266 responses with over 80% of participants spending over half of their time evaluating U.S. properties. It covers a wide range of topics such as futures prices, costs and escalation, accounting for risk, reserve disclosures, and probabilistic methods. The survey presents the average RAF and RADR, as well as the 10th percentile, 50th percentile, and 90th percentile results, based on the reserve type.What are RADRs and RAFs?A RADR is used to discount future cash flows to their present value while compensating for the additional risk associated with estimating future production from PDNP, PUD, P2, and P3 reserves. A RADR is higher than a discount rate used in a typical discounted cash flow analysis associated with companywide cash flows. Risk-adjusted discount rates generally fall within the range of 10% to 27%, according to the SPEE Annual Survey.Reserve adjustment factors are applied to the present value of all future cash flows after a standard discount rate has been applied. RAFs vary widely; PDNP reserves generally have RAFs of 100% (no discount), while we have observed appraisals that have applied an RAF of 0% (implying a 100% discount) to PUD, P2, and P3 reserves.There are many qualitative factors that should be considered when determining the appropriate RAF or RADR.The current pricing environment. Is it economical to drill or start producing in the region given the current pricing environment for oil, natural gas, and NGLs?Regional infrastructure issues. Is the necessary infrastructure in place to move products to market or is future production dependent upon increasing infrastructure out of the region?Outlook/health of operators. For non-operators, there is additional risk associated with this relationship with a third party. Is the operator considering exiting the region due to the local drilling economics? Does the operator have enough capacity to bring new projects online? Is the operator financially stable or at risk of going out of business?
These are just some of the many pertinent questions to ask when analyzing the risk associated with PDNP and PUD reserves.Applying a RAF or RADRGenerally the application of a RADR and RAF are interchangeable; however, it is important to avoid double counting risk when determining an appropriate discount rate to use in conjunction with a RAF.The examples below show typical valuations of PUD reserves. The first applies the 50th percentile result of the SPEE Survey for the reserve adjustment factor (60%) and the second uses the 50th percentile result for the risk-adjusted discount rate (20%).The results presented in the survey do not necessarily present reserve adjustment factors and risk-adjusted discount rates that compensate for the same level of risk, as shown by the lower valuation conclusion reached when using the RADR from the 50th percentile. For a test of reasonableness, it is important to consider the implied risk-adjusted discount rate based on the selected RAF. In the example above, a 60% RAF is approximately equivalent to a 15.25% risk-adjusted discount rate.Market Evidence for RAFs and RADRsThere is evidence in the public marketplace that undeveloped reserves are priced at a discount to their proven producing counterpart.
For example, a recent acreage transaction in Gaines County was priced at a significantly lower acreage multiple than a transaction in Cochran County Texas, although the acreage was relatively close (only one county away). The acreage in Gaines County is in the Midland Basin, but the acreage in Cochran County is in the Northern Shelf; thus, in theory, the acreage in Gaines County is considered to be of higher quality. The acreage in Gaines County, however, consisted entirely of undeveloped acreage whereas the acreage in Cochran consisted of mostly producing acreage.
The transaction of undeveloped acreage in Gaines County of the Midland Basin transacted at a 76% discount to acreage in Cochran County in the Northern Shelf, which equates to a reserve adjustment factor of 24%.
While there are unique aspects of every transaction which make them hard to compare, there is a logical case to be made for the appropriateness of reserve adjustment factors and risk-adjusted discount rates. In the valuation profession, the most commonly used standard of value is “fair market value” which is defined as:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.[1]A hypothetical investor would weigh the risks associated with the development of PUD reserves and would consider an investment in these assets to be inherently riskier than an investment in PDP reserves. As valuation professionals, we account for this risk by application of a RADR or RAF.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, biofuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.[1] American Society of Appraisers, ASA Business Valuation Standards (Revision published November 2009), “Definitions,” p. 27.
Evaluating Acquisition Offers To-Do List
The tyranny of the urgent imposes itself on family business leaders just as it does on everyone else. In this series of posts, we will offer various to-do lists for family business directors. Each list will relate to a particular family business topic. The items offered for consideration won’t necessarily help your family business survive the next week, but instead, reflect priorities for the long-term sustainability of your family business.In last week’s post, we explored how to respond to unsolicited acquisition offers. This week’s to-do list is about being prepared for such offers if and when they come.Gauge Family Members' Appetite for a Sale of the BusinessDo you know what your family members think about a potential sale of the business? Would they be aghast at the thought of selling the fruit of great-grandfather’s labors? Would they be reluctant to sever the economic ties that bind the extended family together? Or, would they welcome the opportunity to harvest the gains that have accrued through the family’s efforts? Would they like to diversify their holdings? Would the thought of being emancipated from the shackles of economic dependence on the family be liberating? Would your family relish the opportunity to just be a family without the mental overhead of being a family business?Getting the answers to these questions can be as simple as have a few informal conversations with key family members, or by including questions designed to uncover such preferences in an annual shareholder survey. Either way, it is best not to assume you know how the family feels. The best time to get an unbiased view of what the family thinks about selling is before the acquisition offer comes in.Identify the Attributes of an Acquirer to Whom the Family Would be Willing to Sell the BusinessIf the family is not opposed on principle to a potential sale, what sort of acquirers would the family find palatable? As we previously discussed, what sellers want economically is a motivated buyer, whether that is a private equity firm or a strategic acquirer. However, the family is entitled to have a preference as to who the next owner of the family business will be. Is the family comfortable with a group of MBAs in a faraway city determining the fate of the business that bears the family name? What about a competitor that may close certain locations or institute significant workforce reductions? What would be the impact on the family legacy if the business gradually (or abruptly) melted away into the legacy operations of a larger acquirer?These questions don’t have right or wrong answers, but the answers will reflect the family’s culture and values. Having clarity and consensus around these issues now will make responding to unsolicited offers that may be received later less stressful.Identify Steps That can be Taken to Improve the “Curb Appeal” of the Family Business How often have you heard a friend or colleague remark that, after having fixed their house up for sale, they wish they had made the improvements years earlier so they could have actually enjoyed them? The same regret can apply to family businesses. The same adjustments that you would make to improve buyer perceptions will likely also make your family’s ownership of the business more rewarding. So why wait? Even if you have no plans to actively market your family business for sale, now is the time to clean up the balance sheet (disposing excess or non-operating assets, securing favorable long-term financing, etc.) and fix the leaks in the income statement (expenses that don’t relate to the operations of the business, and other potential “adjustment” items that a buyer will cause a buyer to question the “quality” of your business’s earnings).Assess Reinvestment Opportunities for the Family in the Event of a SaleAfter a sale, the family will have a pile of money instead of an operating business. What comes next? Will you distribute proceeds to the shareholders, or will you set up a family holding company to reinvest the proceeds? What are the implications for the family of reinvesting versus distributing sale proceeds? What sort of reinvestment strategy is likely to meet the needs of the family? Marketable securities? Real estate? Another established operating business? Venture capital? How do the prospective returns on those asset classes compare to the returns you would expect from continued ownership of the family business?Interview Potential Financial Advisors that can Help the Family Evaluate Offers and Execute TransactionsDo you have an existing relationship with a trusted corporate finance team that can help you when an unsolicited offer arrives? If not, it is better to shop around for that advisor now, rather than in the heat of responding to an offer that you did not set the timetable for. A qualified advisory team will have deep valuation and transaction experience. A great first step in developing such a relationship is having the advisor perform a set of calculations to help establish a benchmark range for evaluating potential acquisition offers. A corporate finance advisor can also help evaluate potential acquisition opportunities that your family business may want to consider.The professionals in our Family Business Advisory Services practice have decades of experience helping family businesses evaluate and respond to unsolicited acquisition offers. Call us to help you get started on knocking out your to-do list today.
Edelman/Bach Rift Highlights Challenges to RIA Partnerships
Partner-Level Conflicts at Firms of All Sizes Continue to Fragment the Industry
The recent controversy surrounding Ric Edelman’s cease-and-desist letter to his former partner, David Bach, is another reminder of how difficult it can be to sustain wealth management partnershipsdespite their (sometimes) obvious advantages. This week’s post explores the sources of these disputes and what you can do to avoid them.No Family Feuds in this BusinessUnlike most closely held businesses, RIAs are rarely owned by related parties. One would think that this lack of corporate nepotism would alleviate some of the ownership tensions and succession planning issues that many family businesses struggle with, but that is hardly the case. These businesses can be very valuable once they hit a certain scale, so there tends to be a lot to fight over when ownership disputes arise.How Disputes AriseThe recent Edelman-Bach debacle is just a high profile example of what’s going on at RIAs across the country as an industry with aging ownership looks to transition to the next generation of leadership. Edelman’s case may be more involved since it pertains to an alleged theft of trade secrets and two of the most recognized names in the advisory business, but it still shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners. A lot of our work at Mercer Capital revolves around resolving the valuation component of these disputes, so we see this acrimony firsthand.This case shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners.Unfortunately for our clients, this trend is not showing any signs of rolling over. A near decade of favorable market returns and wirehouse defections mean these businesses are more valuable than ever, and their numbers continue to increase. These realities, combined with an aging ownership base, likely portend more shareholder disputes and business partnerships that may not work out in the end. For an industry built on relationships, it seems ironic that so many RIA principals don’t get along, but perhaps this is more reflective of enterprising, type A personalities that often clash over firm direction and succession planning. In our business, we call them business divorces, and they can be every bit as rancorous (or amicable) as their marital counterparts.Ways to Avoid a Failed PartnershipSometimes partnerships don’t work out, and fortunately, there are things you can do on the front end to mitigate the likelihood of a costly business divorce that can take years to fully resolve. Here are a few preemptive maneuvers to consider as you’re evaluating a potential arrangement with another RIA principal or firm.Do Your DiligenceThis may seem obvious, but we often see business divorces that would have easily been avoided with an adequate amount of research on the counterparty. This requires a much deeper dive than a cursory review of AUM history, client retention rates, fee structures, production levels, etc. This process should involve several rounds of interviews with your prospective partner(s) and his or her staff, meetings with counsel over the anticipated deal terms, and even some correspondence with the partner’s major clients to understand his or her value-added proposition and likelihood of retention after the deal. This may seem like a huge hassle and distraction from your current job, but no amount of investigation is as costly and time-consuming as a failed partnership.Hire Advisors to Establish Pricing and TermsEven those who are experienced in the world of RIA transactions benefit from some outside perspective on what an appropriate value is for the acquired firm and/or how to structure the partnership moving forward. For larger transactions, it is common for both sides to hire representation (both legal and transaction-oriented), but it is not unusual for the two parties to jointly retain a single advisor for smaller deals to save costs. In most transactions and partnership pairings, there can be a widely disparate view on pricing and/or terms, and often it’s up to the advisors to bridge the gap and move the deal forward if doing so is in the best interest of their client.Negotiate a Buy-Sell Agreement While Your Incentives are AlignedIt’s also a good idea to have counsel draw up appropriate agreements (buy-sell, partnership, etc.) that govern not just the initial deal terms, but also the mechanism for future buy-outs and the dispute resolution protocol if one of the parties decides to part ways. People don’t usually plan for what happens if things don’t work out, but doing so can save you a lot of hassle down the road.Ask Yourself, "Can I Work With this Individual(s) on a Daily Basis?"You’re usually not just pairing with a co-owner but a co-worker as well, which means you’ll likely be spending a lot of time together after the partnership. Personality disputes are the leading causes of business divorces just as culture clashes are the primary contributors to failed acquisitions in our experience. Somehow, this usually gets overlooked when a firm or individual is looking for a business partner even though it should be the first thing on their mind. Business and partner combinations can look great on paper but quickly turn sour if the two parties simply don’t mesh. We see it all the time, and the fall-out typically leaves both sides worse off than they were before the deal.The best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.The list goes on, but these are the main things to think about before signing up a new partner or acquiring another firm. We don’t know exactly how the Edelman-Bach dispute is going to play out, but it will likely be very costly and distracting for both of them. Perhaps this discourse could have been avoided with a bit more diligence and contemplation.We’re not saying that all RIA business combinations are doomed for failure. Such partnerships can be (and often are) mutually beneficial arrangements for all parties involved. We’re just reminding you that the best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.
6 Ways to Look at a Business
Along the road to building the value of a business it is necessary, and indeed, appropriate, to examine the business in a variety of ways. Each provides unique perspective and insight into how a business owner is proceeding along the path to grow the value of the business and if/when it may be ready to sell. Most business owners realize the obvious events that may require a formal valuation: potential sale/acquisition, shareholder dispute, death of a shareholder, gift/estate tax transfer of ownership, etc. A formal business valuation can also be very useful to a business owner when examining internal operations.So, how does a business owner evaluate their business? And how can advisers or formal business valuations assist owners examining their businesses? There are at least six ways and they are important, regardless of the size of the business. All six of these should be contemplated within a formal business valuation.At a Point in Time. The balance sheet and the current period (month or quarter) provide one reference point. If that is the only reference point, however, one never has any real perspective on what is happening to the business.Relative to Itself over Time. Businesses exhibit trends in performance that can only be discerned and understood if examined over a period of time, often years.Relative to Peer Groups. Many industries have associations or consulting groups that publish industry statistics. These statistics provide a basis for comparing performance relative to companies like the subject company.Relative to Budget or Plan. Every company of any size should have a budget for the current year. The act of creating a budget forces management to make commitments about expected performance in light of a company’s position at the beginning of a year and its outlook in the context of its local economy, industry and/or the national economy. Setting a budget creates a commitment to achieve, which is critical to achievement. Most financial performance packages compare actual to budget for the current year.Relative to your Unique Potential. Every company has prospects for “potential performance” if things go right and if management performs. If a company has grown at 5% per year in sales and earnings for the last five years, that sounds good on its face. But what if the industry niche has been growing at 10% during that period?Relative to Regulatory Expectations or Requirements. Increasingly, companies in many industries are subject to regulations that impact the way business can be done or its profitability.
Why is it important to evaluate a company in these ways? Together, these six ways of examining a company provide a unique way for business owners and key managers to continuously reassess and adjust their performance to achieve optimal results.
A formal business valuation can communicate the company’s current position in many of these areas. Successive, frequent business valuations allow business owners and key managers the opportunity to measure and track the performance and value of the company over time against stated goals and objectives.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2018
How to Determine Whether an Asset and Its Appreciation is Marital or Separate Property
Under Tennessee law, marital property is subject to property division and separate property is excluded from property division in a divorce. The underlying factor in this distinction is whether the increase in value between the date of marriage and the date of divorce resulted from efforts by a spouse, known as active appreciation, or from external (economic, market, industry) forces, known as passive appreciation. While these concepts seem simple, the classifications are only part of the story.Classification of Marital and Separate PropertyTennessee Code 36-4-121 defines marital property as “all real and personal property, both tangible and intangible, acquired by either or both spouses during the course of the marriage up to the date of the final divorce hearing.”The same code section defines separate property as “all real and personal property owned by a spouse before marriage, property acquired in exchange for property acquired prior to marriage, property acquired by a spouse at any time by gift, bequest, devise or descent, etc.”Can a Marital Asset Ever Become Separate or Can a Separate Asset Ever Become Martial?Let’s examine this question in the context of a business or business interest as an example. If a couple or spouse starts a business or acquires a business interest during the marriage, then it would be classified as marital. Any appreciation or increase in value of the business or business interest would also be classified and remain a marital asset.Conversely, if a spouse starts a business or business interest prior to the date of marriage or acquires it by gift, bequest, devise or descent, then initially that business or business interest would be classified as a separate asset. What happens to that business or business interest if the value changes during the marriage? The increased value or appreciation of a business or business interest could be classified as marital or separate. How is this possible?If both spouses contribute to the preservation and appreciation of a separate property business or business interest and the contribution is “real” and “significant,” then the appreciation (increase in value) of the business or business interest would be determined to be a marital asset and subject to division. This is known as active appreciation.If, on the other hand, both spouses do not contribute to the appreciation in value, there is no appreciation in value, or the appreciation is attributable to passive forces, such as inflation, then the separate property business or business interest would remain separate.The following steps assist the financial analyst during the process: Is the business, or business interests, marital or separate?
a. Compare the formation or inheritance date(s) to date of marriage.If the answer to (1) concludes pre-marital, separate property, value the business as of the date of marriage as a starting point. Then, value the business as of the date of divorce (or as close to as possible).If the value has increased from the date of marriage to the date of divorce, a determination of active (marital) versus passive (separate) shall commence.What Must Be DemonstratedTennessee code states that the substantial contribution of the non-business spouse “may include, but not be limited to, the direct or indirect contribution of the spouse as a homemaker, wage earner, parent or financial manager, together with such other factors as the court having jurisdiction thereof may determine.”A non-business owner spouse must be able to demonstrate two things in order for appreciation of a separate property business or business interest to become a marital asset: substantial contribution of both spouses contributing to the appreciation,and actual appreciation in the value of the business or business interest during the marriage. Most often, a valuation of the business or business interest at the date of marriage and also the date of filing would be required among other things to try and support this claim.This article has used a business or business interest to illustrate the concepts of martial vs. separate assets and also the appreciation in value. It should be noted that there could be potentially other considerations for these same issues with other assets, such as investment properties or passive assets (401Ks, etc.).ConclusionA financial expert, specifically one with expertise in business valuation, is vital in the determination of active appreciation (separate) versus passive appreciation (marital).The professionals of Mercer Capital can assist in the process. For more information or discuss an engagement in confidence, please contact us.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2018
Non-Operated Working Interests: Are You Investing in the Operator, the Oilfield, or Both?
Joint Ventures in Oil and Gas
Joint ventures (JVs) are fairly ubiquitous in the energy sector with as much as 71% of upstream investment through alliance or JV relationships. Companies will often enter into JVs to share the sheer capital intensive load of upstream and midstream activities.An oil and gas JV in its most basic form is fairly straightforward. A company will take on the operator role by working the field and constructing or managing the infrastructure in a given area, and another company will assume a non-operator role by providing capital so that each player is mutually benefited. Those entering into these relationships may contribute assets, capital, technologies, or even combinations of the aforementioned in order to access advantages such as scale, risk sharing, or entry into a specific market or play and both share in the future costs.Megaprojects of over $1 billion are largely structured as JVs and are especially useful to capitalize on synergies, infrastructure, and risk sharing. In an EY study of 365 megaprojects, JVs made up 85% of the projects in upstream activities and over 50% were in LNG and pipeline projects.
On the surface, this may seem like an effective way for companies to structure a hedge and mitigate systematic risk through diversification of assets, but in reality, the benefits of a JV are much harder to realize. Management considerations quickly become complicated and time horizons tend to be short-lived. Research has shown that as many as 70% of JVs in oil and gas tend to fail within 5 years.
From a valuation perspective, struggling or failing JVs can put a strain on overall company value as future income streams are subjected to a greater amount of uncertainty and, thus, are further discounted. In addition, most JVs lack a defined exit plan as a study from Boston Consulting showed that only 19% of respondents had a clear exit strategy. Even in a well-structured JV agreement, the absence of an exit strategy in an environment of high failure rates inevitably results in large tangible and intangible exit costs that can erode the value the JV initially was set up to create.
Does the success of the JV hinge on the quality of the oilfield or the technical ability of the operator?Put simply, executing a successful joint venture requires a number of items working in harmony such as solid due diligence, good location, cooperation between both firms, and a degree of luck on the bet they are making.It seems a bit contradictory that a large number of projects are structured as joint ventures if they have such a high failure rate. This begs the question, does the success of the JV hinge on the quality of the oilfield or the technical ability of the operator? The answer, we think, lies somewhere in the middle.Location, Location, LocationEven with the difficulties of maintaining a successful JV, many companies have been entering into joint ventures to take advantage of the oil boom that the U.S. has enjoyed for the past several years. Not surprisingly, a large portion of recently formed upstream JVs since 2016 has been in the Permian Basin, and several large midstream JVs have been formed in the Gulf of Mexico.
Recently, Williams Companies Inc. announced that it is forming a joint venture with privately-held Brazos midstream in the Permian Basin to gain exposure to crude and NGL and position itself for potential midstream opportunities.
Williams is offering their gas gathering assets for a 15% stake in Brazos as part of the JV terms, with Brazos retaining 85% in the venture as well as operatorship. Almost all of the assets including gas and crude pipelines, storage and a planned processing plant are coming from Brazos Midstream with Williams offering dedicated acreage, a small amount of gas gathering infrastructure and inexpensive sources of financing.
Companies have been scrambling to get a piece of the pie in the more recent surge in demand for natural gas.Even though the Permian has seen a large amount of activity and natural gas prices remain low, companies have been scrambling to get a piece of the pie in the more recent surge in demand for natural gas. Royale Energy has recently entered in a JV with California Resources Corp. to drill 30 wells throughout the Rio Vista Field, the largest dry gas field in California. This agreement expands on a previous JV and will give Royale up to three years to drill in any of the formations on the property.The historic property is abundant with gas, producing approximately 4 trillion cubic feet from more than 15 stacked gas reservoirs, and according to Royale, “The joint venture will lead to multiple years of drilling activity at Rio Vista at a time of upward trending natural gas prices due to declining natural gas inventories nationwide.”These transactions are but a few of the many JVs structured in areas to take advantage of the location and the resources it has to offer in a demanding market. And while it may seem like a no-brainer for the non-operator to search out operators in successful plays, many have had a history of missing the mark when it comes to structuring effective non-operated portfolios resulting in value being left on the table or outright failure.Adding Value to Non-Operating PortfoliosOil and gas companies are typically skilled at maximizing value with their operated assets. But more often than not, these companies tend to take a backseat approach to their non-operating portfolios, almost akin to treating them like equity investments. The detached and unsystematic treatment conflicts with the shared responsibility for the success or failure of their ventures.Boston Consulting Group identifies three main sources of value loss due to failure of material participation by non-operators: A nonstrategic approach, inconsistency, and lack of priority.They also outline a four-step framework for non-operators to add value to their non-operational portfolios:Clear strategic intent about what each non-operating venture (NOV) asset contributes to broader company goalsSharp risk and opportunity assessmentConsistent NOV organization and governanceRigorous execution strategies for each NOV asset
The critical factors within this framework that can really determine success within a JV are operator assessment and analyzing venture risk.
Non-operators with longstanding relationships and clearly defined roles and objectives (for example, ExxonMobil and Shell’s continued relationship in the North Sea) would most likely apply a less stringent approach to assessing key operator risk. But those looking to invest in active plays in the U.S. from a non-operator perspective should assess operators on the following criteria:Level of experience and familiarity of the play/assetUnderstanding and application of proven technologiesHistory of productivity and efficiencyClear understanding of role within the partnershipStrong safety, environment, and previous contract records andAlignment on ethics.
Venture risk must be analyzed by non-operators to properly determine uncertainties related to the underlying objective within the JV. Resource size, character, and technology application must be considered especially when undertaking more exploratory ventures. Commercial and economic uncertainties should also be analyzed since a major culprit for failing JVs are large cost overruns and other unexpected costs.Final ThoughtsA major benefit of a JV is to gain exposure to areas and effectively deploy resources and capital where it could be best used and thus create maximum value. As we have mentioned above, however, failure rates are very high in the short term mostly as a consequence of cost overruns due to inadequate planning. But the natural frictions associated with a JV make planning and communication all the more important. While non-operators need the proper location for success in a joint venture, they can get further through proper due diligence and planning concerning operators.We have assisted many clients with various valuation needs in operator and non-operator roles in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
How Generational Differences Should Define Advisors’ Interactions with Clients
A Review of <i>The Gen-Savvy Financial Advisor</i> by Cam Marston
Cam Marston and his firm, Generational Insights, provide research and consultation on generational issues. In his most recent book, The Gen Savvy Financial Advisor, Cam Marston provides a guide to tailoring your financial services to Matures, Baby Boomers, Generation Xers, and Millennials.
Financial advisors have personalized their services to meet the needs and expectations of Matures and Baby Boomers, but Gen-Xers are in their prime earning years, Millennials are developing saving habits they will have for a lifetime, and both groups think about their personal finances differently than their parents and grandparents.
Marston’s book highlights the challenges that financial advisors currently face trying to earn the business of a new generation of investors. Because wealth management is a business based on trust, clients need to be comfortable with their advisor, and as your client base becomes more diverse, establishing this connection may not be as easy as it once was. To meet the needs of each generation of investors, you must understand their distinct concerns.
Are We Really That Different?Stereotyping generations is a risky business, but Millennials like me are accustomed to these stereotypes. My generation has been accused of ruining home-ownership, marriage, newspapers, chain restaurants, and department stores, while we are known to have a weird obsession with smartphones, avocados, and our dogs.Consumers’ buying habits have changed, but why does this matter for your wealth management firm?While it’s easy to shrug off these stereotypes, the reality is, I wrote much of this post sitting next to my dog I treat like a child, in the house I rent with two roommates, listening to music on a free music-sharing site. Cam Marston explains that consumers’ buying habits have changed, and financial services are no exception. But why does this matter for your wealth management firm?At risk of oversimplifying Cam Marston’s insight into simple generational differences, below is a brief summary of the defining features of each generation and Marston’s suggestions to meet the needs and expectations of each.MaturesMarston describes Matures as loyal rule followers who are demanding of respect. In general, they have under planned for retirement and are facing health concerns, but are a “small yet mighty” group. Marston suggests showing these clients deference and ensuring they are comfortable by providing quiet spaces for conversation, preparing for memory loss, inviting their children to meetings, and confirming they understand your technology platforms.Baby BoomersControlling over half of the wealth in the U.S., Marston describes Baby Boomers as competitive, nostalgic, idealistic, and young at heart. You can address the needs of these clients by meeting with them in person, showing optimism despite the fact that many are postponing retirement to take care of elderly parents and adult children who still live at home, and recognizing their successes.Marston further distinguishes between two subcategories of Baby Boomers: Leading and Trailing. Leading Boomers have begun to reach retirement age, have adult children, have simplified their lifestyle, and are moving investments to more conservative outlooks. Trailing Boomers, on the other hand, still have children in school and are more focused on paying for their children’s college and building personal wealth.Gen-XersUnlike most, Marston remembered to include Gen-Xers in his analysis, rather than ignoring this in between cohort to focus on Boomers and Millennials. Gen-Xers are at the peak of their careers; they are tech-savvy, loyal customers, whose referrals should be valued. They grew up in the information age which means that they are naturally curious and ask many questions.This provides a unique opportunity for financial advisors. Marston discerns that financial advisors can earn the respect of Gen-Xers by providing them with insight that they were not aware of after extensive research. Gen-Xers are a captive audience to a firm’s online database of educational resources.MillennialsNow the largest generation, Millennials are well-educated, issue-oriented, individualistic, and impatient. Millennials were greatly affected by the Great Recession which has led them to become risk-averse. This leads to an inherent disconnect between Millennials’ comfort level with stock exposure and their lengthy timeline to retirement, which suggests they should be investing aggressively. To meet the needs and expectations of Millennials, Marston suggests transparency, brevity, up-to-date technology offerings, and recognition of their individuality.Female Millennials have become the most well-educated generation in U.S. history; however, the majority of financial advisors are men (only 16% of CFA charterholders in the U.S. are women). Financial advisors are more often dealing with female individuals and heads of households, and Marston warns, “Be careful to not make any comments about appearances that may seem […] “creepy.” While I do not believe that Men are from Mars, Women are from Venus, sensitivity to the current gender environment is key in establishing relationships with female high-earners.The Great Opportunity of Wealth TransitionsValuation firms often view the number of multi-generational relationships in a firm as a measure of risk reduction. This is an increasingly important metric as Baby Boomers are expected to transfer $41 trillion of their wealth to their heirs; however, as Cam Marston notes, 60% of children fire their parents’ financial advisors after they inherit their parents’ wealth. Cam Marston devotes a chapter of his book on how to manage these generational transfers.A well-developed relationship with Baby Boomers should lead to an opportunity to work with their children.This transfer provides a great opportunity for financial advisors, who seek to maintain their relationship with Boomers’ children. Marston explains that a well-developed relationship with Baby Boomers should lead to an opportunity to work with their children. However, “The Common belief is that Millennials will not do business with their parents’ advisors. If you treat the Boomers’ children the same way that you treat Boomers, that will be true.”While Marston provides great insight into managing relationships with both Boomers and Millennials, I was left wanting more information on how to effectively manage these relationship transitions.We Can All Learn Something from Marston’s BookWhile this book is directed towards financial advisors, there is something for everyone in the client services profession to learn.The increasing importance of online first impressionsOffering varying levels of technology to ensure different age groups are comfortable with your offeringsBalancing formal and informal relationships
As Cam Marston notes, it sometimes feels that you are just on a different wavelength than your prospective clients. While the soft skill tips in this book can help you connect with different generations, it is just as important to have a diverse staff of advisors who can connect with clients that have different backgrounds, diverse values, and unique needs.
While advisors are adapting to earn the trust of different generations, this adaptation is not new. Advisors have always tailored their services to meet the unique needs of each of their clients. Today the needs of your clients may vary more, which may lead your meetings to look even more different, but your mission as an advisor is still the same: to bring financial security and prosperity to your clients’ lives.
How Should We Respond to an Acquisition Offer?
Successful businesses don’t have to go looking for potential acquirers—potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but serious inquiries from legitimate buyers of capacity occasionally appear that require a response.What Kinds of Buyers are There?Buyers are generally classified into two categories.Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years. While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business. Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering. In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high. Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth.
Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers. Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.Evaluating Acquisition OffersMost family businesses have no intention of selling; however, when a legitimate, unsolicited offer arrives, what do you do?Evaluating acquisition offers is ultimately the duty of the board of directors, not the family at large. Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer. That does not mean that the directors will not care about Uncle Charlie’s perspective. As we’ve discussed, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer. For larger families, the prospect of receiving a potentially attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.Family business directors should evaluate offers along several dimensions.Buyer MotivationWhat has prompted the offer? If it is a strategic acquirer, what sort of operational changes would be expected post-transaction? Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name? Or, could the sale increase opportunities for employees and expose the brand to new markets? If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition? Will the company’s ability to withstand normal economic downturns be compromised? Will the buyer want members of the family active in senior management to continue to run the business? The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.Buyer CapacityDoes the buyer have the financial capacity to actually execute the transaction if it is agreed to? If external financing is required, will it be available to the buyer when needed? Basic due diligence goes both ways. Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.Price & Transaction StructureWhat seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction. A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds. A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less. Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash—what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control? There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.Price is not EverythingJust because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale. Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush? If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road. Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics. Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.Reinvestment OpportunitiesDoes the family have a plan for putting sale proceeds to work? Once again, what the business “means” to the family comes to the fore. Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit? Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family? If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family? Will such investments provide the same degree of family cohesion as the legacy business? A sale of the family business may have unintended, and potentially far-reaching consequences for the family.Responding to Acquisition OffersOnce the board has evaluated the unsolicited offer, there are essentially four responses to choose from:Reject the offer. If the directors conclude that the proposed price and/ or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction. If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close. However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal. There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors—direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business. The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire. The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers. Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.Engage in a full sale process/ auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale. In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers. After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business. With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction. A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.Bringing Together the Right TeamThere is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before. As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain. The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.Trusting the buyer to do your tax homework can be a very costly mistake.Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary. Trusting the buyer to do your tax homework can be a very costly mistake. An experienced tax attorney is essential to maximizing after-tax proceeds to the family.The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement. My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders. Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time. An experienced financial advisor takes that burden off of management.When it comes to assembling the right team, business owners sometimes blanch at the cost. However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction. The family will only sell the business once, and there are no do-overs. As we recently heard someone say, “Cheap expertise is an oxymoron.”
Haynesville's Gigantic Gas Resurgence Could Be A Winner In LNG Export Race
Ever since producers took some big financial beatings after prices plummeted a few years ago, the Haynesville Shale play has positioned itself for an economic resurgence. For those following natural gas production in the U.S., this should not come as a surprise. It has a lot going for it.Haynesville’s Wells – Bigger, Faster, StrongerConsider the following:It’s a behemoth of a gas field that produces enormous wells. It’s been known for some time that the Haynesville has potential, but that is being realized further as more experience is developed among operators. For example, long lateral wells (some now stretch nearly two miles each) can produce up to 24 bcf of natural gas. Compared to the nearby Eagle Ford Shale, whose wells produce 12-15 bcf of natural gas, the Haynesville wells are big. In today’s low gas price environment, this matters quite a bit.The formation is more naturally pressurized than many others. This means, among other things, that more gas is produced in the first year. This is important, considering how expensive it is to drill these wells, and in turn, it means higher rates of return for investors (since time can erode returns according to present value theory).Breakeven prices have fallen. According to Chesapeake, which has the largest acreage position in the Haynesville, breakeven prices are currently between $2.00–$2.25 mcf. Even with price differentials of about $0.60 to Henry Hub, this provides an opportunity for profitable wells. Two or three years ago, this was considered an improbability.
Investors have noticed. Amid the land rush for liquid plays such as the Permian Basin, some investors have quietly spent billions to reposition themselves in the Haynesville over the past few years at relatively low valuations. The most notable of which is Jerry Jones’ $620 million investment in Comstock Resources over the summer. Comstock has been one of the leading players in the basin for years and is confident that their experiences, amid a rough recent financial history, will propel them going forward. Lesser known private companies such as Aethon Energy and Indigo Natural Resources (which has contemplated going public) have also poured substantial investments into the play in the past few years.LNG Exports – A New Proverbial Finish LineThat said, one of the vexing problems that the natural gas sector often has is getting the product to relevant markets. The current situation in the Permian Basin is a prime example. Even though gas production is there, it doesn’t matter much if it can’t easily and inexpensively get to where it’s needed. And while the Haynesville has had its own struggles in this area, there may be solutions on the horizon to provide some relief. This is where the Gulf Coast LNG export resurgence comes into the picture.Currently, the ability to export LNG is relatively trivial. The continental U.S. has only two facilities operating with less than 4 bcf of capacity per day. That’s about to change. The Gulf Coast alone has nearly 8 bcf per day capacity under construction and another 6.8 bcf per day has been approved. Over 26 bcf per day has additionally been proposed. Facilities are being proposed up and down the coast from Brownsville, Texas to Pascagoula, Mississippi.
[caption id="attachment_23202" align="alignnone" width="640"]Source: Federal Regulatory Energy Commission[/caption]
Along with capacity, transportation is getting easier too. The widening of the Panama Canal has certainly helped. In addition, certain transit restrictions on LNG vessels were lifted just last month. Over the past two years, 372 LNG transits have passed through the canal; and incredibly, earlier this year three tankers crossed at the same time. This is incentivizing the investment and engineering race to get capacity built and shipped to foreign markets. Most recently, Germany initiated stepstoward installing an LNG import facility.Haynesville’s Head Start – A Shorter And Cheaper Race To RunIn the race to chase efficiencies, the Haynesville’s proximity to the Gulf Coast provides a big opportunity for investors.What are the options to service the strongly growing demand? There’s a plethora of potential gas sources in the U.S. to fit the bill. Currently, the largest supply is the Marcellus and Utica shales in Appalachia, and this would seem to be a natural fit except that there is a problem. Prices for gas in the region are far below Henry Hub prices. In addition, transportation costs tower above other plays due to the multi-state journey it needs to take to get to the Gulf Coast. By the time the gas arrives at its destination, it would almost certainly lose money for producers. Margins are simply too tight right now in the gas business and efficiency is becoming increasingly critical.In the race to chase efficiencies, the Haynesville’s proximity to the Gulf Coast provides a big opportunity for investors. At a recent conference, Tom Petrie, a leading energy investment banker, gave some estimates of transportation costs from proximate U.S. gas basins. Not surprisingly, the Haynesville was by far the cheapest at $0.25 per mcf.
[caption id="attachment_23203" align="alignnone" width="587"]Source: Oil and Gas Investor, Petrie Partners[/caption]
In a business where the window for profitability is small, pennies per mcf matter a lot. Naturally this dynamic calls for more localized gas. Considering the Gulf Coast concentration of LNG facilities, the Haynesville, Eagle Ford and other nearby plays may have a leg up with proximity and infrastructure ability to get gas to facilities.
The Haynesville looks like it could have an international role to play in energy markets going forward. That is a golden opportunity to create value. As for the Marcellus and Utica shales in Appalachia, they might miss out on this one. It makes one wonder, why haven’t LNG applications shown up in Pennsylvania yet?
Originally appeared on Forbes.com.
Q3 2018 Call Reports
Coping with Rising Volatility and Fee Pressure
While equity market volatility was relatively subdued during the third quarter, 2018 as a whole has seen much higher volatility than last year. This volatility may be an opportunity for active asset managers, although the industry continues to face fee pressures and increasing costs. Scale is increasingly important for asset managers as assets flow into lower fee products due to secular trends in the industry and de-risking during recent periods of heightened volatility.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Periods of heightened volatility may drive some client rebalancing, but there may also be opportunity for active managers. [W]hen I see this volatility, it's actually a good thing because what it shows is the value of prudent fiduciary advice, which is what our partners are really focusing on. So as I said in my remarks, in so many ways, I like the volatility. I think it's a good thing. And I don't see some major impact in terms of our flows or if there's one thing we learned in 2008, our client retention remained excellent. And what really helped was ultimately the very prudent approach that our partners took towards the constructing their portfolios. – Rudy Adolf, Focus Financial Founder, CEO & ChairmanAsset and wealth managers are rethinking their business models and looking for ways to operate more efficiently and rigorously managing risk in more volatile market environments. – Laurence Douglas Fink, Blackrock Chairman & CEOAnd I think the volatility is, as we said, is an opportunity for our investment teams as well as the business. And we've seen some rebalancing occur, but the relationships and the long-term clients are very strong, and we think the business is positioned very strong, so we don't see anything abnormal with regards to the rebalancing. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEOTheme 2: Scale is increasingly important in the industry as firms seek to gain distribution leverage and spread rising costs over a larger asset base.[W]e've talked about the opportunity to potentially leverage our collective scale and find ways to be more efficient. And we do see significant opportunities there. As I mentioned, we have early days with respect to procurement, and Pete and his team are working on the common financial platform. And those will yield some real efficiencies for us. And that will allow us to do three things - One will be to compete more effectively on price; secondly, to be able to invest more in our business as that's being required and needed; and then thirdly, to potentially return more for shareholders. – Joseph A. Sullivan, Legg Mason Chairman, President & CEO[I] think large acquisitions are very difficult. There's a lot of risk in them, I think, in just the brand and who you are as a firm. But I think, again, if the right situation came up where you think you can take out a lot of costs and create value, we're going to certainly look at that and be open to that. – Gregory Eugene Johnson, Franklin Resources Chairman & CEOIncreased size will enable us to continue to invest in areas that are critical to the long term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets. – David Craig Brown, Victory Capital CEO & ChairmanTheme 3: Asset flows continue to be impacted by secular trends towards low fee passive products and the recent heightened equity market volatility.[W]e do see a continued move to passive, but we think the rate of that growth probably slows a little bit. [W]e are believers in active management. We believe that good, active managers do deliver alpha. You got to prove it. You got to earn your fees in that respect. People are looking for differentiated, uncorrelated returns. – Joseph A. Sullivan, Legg Mason Chairman, President & CEOThe other area where you're seeing, especially from the wires, which is starting to become a bigger driver of their business, and one of the reasons why we believe over the next five years, ETFs will double in size, is how more and more wires as they move more towards away from brokerage and more to a consultative relationship or advice, they're using more models. And in the models are heavily populated by different BlackRock and iShares products. – Laurence Douglas Fink, Blackrock Chairman & CEOWhile we saw a modest pickup in industry flows during the third quarter, primarily attributable to ETFs, we also saw accelerated derisking by many clients in an environment marked by continuing trade tensions, a further slowdown in emerging markets, and the steepening yield curve. – Gary Stephen Shedlin, Blackrock MD & CFOWe have seen fee pressure, which we've talked about on past calls. When you get into the very large allocations, especially in the public funds or the sovereign wealth funds, and when you get to the sizeable mandates, there's been a real shift in the market price of fees right now. They've gone much lower than we're willing to go. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEO
Four Themes from Q3 Earnings Calls
We Read the Q3 Earnings Calls so You Don’t Have to
Improvements in technology have driven the shale revolution. Among these improvements are both cost cutting by oilfield service providers and longer laterals from E&P companies. While capacity constraints from a lack of infrastructure has led to pricing differentials (particularly in the Permian Basin), a lack of inventory in the global oil market is expected to support higher prices, while also increasing price volatility.As we plan to do every quarter, we take a look at some of the earnings commentary of large players in the oil and gas space to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Regardless of Region, Longer Laterals are Driving Efficiencies for E&P Companies[W]e continue to capture efficiencies through longer laterals. Last year, our program averaged 8,000 feet, but our portfolio high-grading efforts and asset swaps are enabling us to push beyond that, especially in New Mexico. Our average lateral length for the entire program will increase 20% next year to 9,700 feet. – Jack F. Harper, President and CFO, Concho Resources, Inc.We expect to continue to improve returns through the use of longer laterals and optimizing completion techniques. – Taylor L. Reid, Director, President, and COO, Oasis Petroleum, Inc.[T]here's quite a bit of room for 15,000 foot and even longer laterals in the Eagle Ford, particularly in the Western area. […] On the Permian, it's really driven by the existing well in the lease geometry. So there's areas where there's quite a few 15,000 foot wells. – Herbert Vogel, EVP – Operations, SM EnergyThe well mix in the Eagle Ford during the third quarter included a higher proportion of western acreage wells. While the pay is thinner in the west, there's less faulting, which allows for longer laterals. The longer laterals you can drill, the better the efficiencies to be gained during drilling and completions. – Ezra Y. Yacob, EVP of Exploration and Production, EOG Resources, Inc.When you break down the value of drilling long laterals, there are three areas to consider: development efficiency; well performance; and capital efficiency. [… Development efficiency] is our ability to maximize access to the reservoir with a single wellbore, allowing us to develop more acreage and resource from a much smaller footprint. […] It’s still early in the game when it comes to evaluating well performance for long laterals […] but none of our reviews have indicated any adverse impact of lateral length to well performance. […] Longer laterals can significantly reduce and even eliminate a number of costs in areas such as well pad and road construction, top-hole drilling, drilling and completion mobilizations, surface facilities and reduce cycle times. […] We are now at the point where the time to drill an additional 5,000 to 10,000 feet of lateral length may only be a couple of days requiring minimal incremental capital to being spent. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Longer laterals allow companies a host of advantages in terms of cost, while not necessarily negatively impacting performance. While longer laterals have been used in the industry for some time now, industry players have been more vocal about the possibilities created by drilling longer laterals. Lateral length has consistently increased over the years. For example, the average lateral length per well in West Virginia was 2,500 feet in 2007, compared to more than 7,000 feet in 2016. Although they are not the common place, many operators have reported laterals in the 12,000 to 13,000 feet range.Longer laterals lower costs for E&P companies which increases firms’ values with more revenue reaching the bottom line. Of course, there are limitations. Longer laterals generally require the consolidation of acreage ownership.Theme 2: Oilfield Services Costs are Expected to Remain SteadyNew technology is increasing drilling speeds, drilling more consistent targets and lowering cost, all at the same time. Combined with cost reductions from local sand, water recycling and infrastructure projects, we are well on our way to achieving our stretch goal of reducing average cost 5% by year-end 2018. […] As we near the end of 2018, industry activity is slowing. Consequently, the service sector is experiencing a period of softness in the market. To take advantage of market conditions, we elected to secure some of our existing service providers through the fourth quarter for next year's program. This will capture favorable prices and sustain the operational continuity of these high-performing service providers into 2019. – Lloyd W. Helms, Jr., COO, EOG Resources, Inc.My perspective long term on service costs is that what [oilfield service] companies really needed was utilization and now we're seeing that across the industry. A lot of them are pretty much fully utilized. And we still see a lot of expansion within our industry today. That's what's going on when you look broadly. So, these service companies are getting healthier all the time. And so, instead of just forcing prices up, continually getting more efficient and with more utilization, we think it could stay in about the same plane that it's in today. – Harold G. Hamm, CEO, Continental Resources, Inc.[W]ith respect to service costs, what we're seeing at least at this point is not a lot of move overall in the service costs. There are pockets of small things that we've seen bump up. We're optimistic on the pressure pumping side that it's going to be flat to down. And so we're not anticipating a big move in service costs for 2019, but we'll continue to monitor that. – Thomas B. Nusz, Director and CEO, Oasis Petroleum, Inc.In regions where drilling has ballooned, service providers are fully utilized. New players are entering these markets to deal with the expansion, which has helped keep prices steady. In regions where there is less activity, some players are looking to lock in longer-term contracts to take advantage of lower costs. Regional market dynamics are different, though the impact on oilfield service costs appears to be the same.Increased activity means more revenue for E&P companies and oilfield service providers. However, if oilfield service providers are able to command a higher price, E&P companies, valuations will suffer. However, the majority of industry players believe that oilfield servicers will not continue to raise prices next year.Theme 3: Infrastructure Issues PersistCosts have started to stabilize as the industry awaits new long haul pipe capacity before increasing activity […] the drilled but uncompleted backlog has reached new highs and will likely be a catalyst for activity once the new pipeline projects are completed. The Midland discount to Cushing's WTI has narrowed as capacity may come online sooner than previously expected. The futures curve indicates that Midland barrels will be priced at a premium WTI in 2020 and beyond. – Timothy A. Leach, Chairman & CEO, Concho Resources, Inc.Range has also seen significant, improved in-basin pricing compared to last year as the Appalachian gas market is benefiting from new pipeline capacity additions in both northeast and southwest Pennsylvania […] Over the next couple of years, we expect basis to remain strong in southwest Pennsylvania as additional pipelines are placed into service that will keep that portion of the basin free-flowing in the other markets. – Jeffrey L. Ventura, President and CEO, Range Resources Corp.Although we expect to see oil differentials to be wider for the fourth quarter, we retain our existing annual guidance, although likely in the upper half of the guidance range. The productivity of the Bakken is driving a significant expansion of basin takeaway. We expect to see the expansion of existing pipeline capacity as well as new pipelines entering the basin. Some of this capacity will come online in the next few months with a strong ramp-up through 2019 and entering 2020. On the gas side, we expect fourth quarter gas differentials to remain strong and reiterate our annual guidance. Looking forward to 2019, we expect a significant expansion of gas processing capacity in the Bakken, expanding as much as 50%. – John D. Hart, SVP, CFO, and Treasurer Continental Resources, Inc.If you look at the DAPL [Dakota Access Pipeline] and size that line until you know that you've got expansion capabilities there that it's going to be almost 40% more capacity that's going to come on with that eventually. That was from their initial projections to where that's going to go. So, that's a good bit of capacity right there that they'll be adding. And the next is new construction. Obviously […] there's a lot more oil to come out of the Bakken. And so, these new pipeline projects are going to pay off beautifully as time goes on. So, there's going to be a lot of brownfield, greenfield pipe to be added. – Harold G. Hamm, CEO, Continental Resources, Inc.As we’ve discussed, differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter due in large part to capacity constraints from a lack of infrastructure in place to bring the product to market. As we see from these quotes, infrastructure issues aren’t confined solely to the Permian as many operators are dealing with in basin pricing differentials. Infrastructure issues are curbing the gains that are typically associated with rising prices and production. Theme 4: Less Inventory in the Global Market Leads to Higher Prices and More VolatilityLooking at the macro environment, with the oil markets in a more balanced position, OECD commercial stocks have declined to below the 5 year rolling average. U.S. crude and product stocks, which account for around 40% of total OECD inventory, have reduced significantly over the last year to the middle of the range. With lower stock levels, the oil price remains volatile to any uncertainties, particularly around supply and geopolitics. Recent factors include the impact of U.S. sanctions on Iranian exports, supply disruption from Venezuela, together with production uncertainty from Libya and levels of spare capacity within OPEC. In summary, the oil price outlook has strengthened. We expect the oil market to remain volatile in the near term, characterized by lower stock levels and ongoing geopolitical factors. We expect current supply concerns to ease and continued robust demand growth to be matched by growth in the U.S. tight oil production and additional supply from non-OPEC countries. – Brian Gilvary, CFO, British PetroleumIt all comes back to supply and demand in the world, and we still see demand strong, about 1.5 million barrel to 1.8 million barrels of new oil. And on the supply side, hopefully, we can keep up with that. About 65% of that will come from the U.S. But if we go forward with the Iranian sanctions, as I anticipate, take another 800,000 barrels off the market, long term, things are going to get tight. And so, we expect it to be pretty close going forward through the end of the year. So, oil prices are going to be strong, and hopefully we'll have a cold winter to keep us there with natural gas. – Harold G. Hamm, CEO, Continental Resources, Inc.When there are supply constraints, price tends to go up. Despite increases in production in the United States, global oil production has experienced declines, causing global oil inventories to be drawn down amid strong demand. When there are lower levels of global inventory, there is less supply available to smooth volatility in the energy market.Higher crude prices should be a positive sign for the E&P industry. However, it must be viewed in the context of the global environment. With significant differentials experienced regionally, companies are not reaping the benefit of global price improvements. Further increased volatility makes it more difficult for companies to make accurate projections, which is particularly important given the size of the capital budgeting decisions required in the industry.
What is Your Firm’s “Brand” Worth?
Building the Value of an RIA Involves Making it More Than a Group of Professionals
The announcement from Merrill Lynch last week that they were cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product with an Ambiguous BrandA couple of weeks ago I was driving around Memphis enjoying the fall weather when I spotted a unicorn, or, more specifically, a Bricklin SV-1, decked out in fall colors. The Bricklin was an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.If the Bricklin were a metaphor for a cohort of RIA practices, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor versus Returns to CapitalWhen the C suite at Merrill Lynch decides to cut advisor payouts, they are shifting cash flow returns from labor to capital. Advisors probably feel like they are being devalued, and arithmetically they are. But what Merrill is also doing is testing their brand value. Can they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill's opting to remain in the broker protocol can be seen as confidence in their brand to attract, grow, and retain an advisor network. Whether that confidence is misplaced or not is something we’ll be able to answer definitively in time.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit suggests the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers are alleging that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit suggests that even association with a tarnished brand can impair a career. It’s an interesting lawsuit because in blaming the firm for advisor performance, it suggests that the advisor/client relationship is more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit is basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach with uniform and templated marketing programs, and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied, and Ric Edelman is pursuing legal action against his former partner, David Bach, for just that. Focus Financial has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less the name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity – we wonder how the Focus approach to branding will work over time.In the End, Brand Value is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than "what’s in a name?", the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.
AutoZone Provides Roadmap for Management Succession
The Founder’s Exit Doesn’t Need to Be the End of the Story for Shareholders
The Family Business Director blog comes to you each week from Memphis, Tennessee. Memphis is proud to be the home of AutoZone, Inc., one of the largest auto parts retailers in the U.S. AutoZone founder and long-time director Pitt Hyde recently announced that he would not stand for re-election to the board of directors.Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Although publicly traded since 1991, AutoZone traces its roots to a family business. Mr. Hyde’s grandfather founded Malone & Hyde, a grocery wholesaler, in 1907. The first AutoZone store – originally “Auto Shack” before a bit of subsequent re-branding – opened in 1979, and the growing concept was spun out of Malone & Hyde in 1986. Mr. Hyde turned over the reins as President and CEO of the company ten years later.Management transition is a sensitive topic for many family businesses. Founders of successful family enterprises are by definition exceptional individuals. The challenge for family business directors is ensuring that the unique attributes of key managers contribute to the sustainability of the family enterprise instead of crippling the business through unhealthy over-reliance or dependence on a single individual. Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Lesson #1 – Think More Broadly About Managerial SuccessFor a senior executive of a family business, success must be defined more broadly than the current financial results of the business. The notion of success should also encompass how the company is positioned to prosper after the executive’s tenure is over. This broader view of success will not take hold automatically, so directors need to evaluate how they are equipping, encouraging, and incentivizing senior management to think about sustainability.Are your senior executives focused on building a business that can flourish in their absence? Are you building a culture in which working yourself out of a job is a goal to be achieved rather than a fate to be feared?Lesson #2 – Commit to Developing a Successful Team & CultureCulture builds slowly in organizations, but once formed, culture is remarkably persistent even when there is turnover at the top. Of course, culture can be either good or bad. There have been plenty of stories in recent years about companies whose success has been undermined by a toxic culture. Family businesses are no exception. Ironically, a “family-first” culture at a family business can inhibit the retention of capable non-family executives that eventually become essential for the sustainability of the family business.AutoZone is known for a culture that is obsessively focused on the customer experience in their stores. Culture is the environment that empowers the team to execute the founder’s vision on a greater scale than the founder possibly could by himself or herself. At the time of Mr. Hyde’s retirement in 1997, the chain had grown from that original Auto Shack in Forrest City, Arkansas to approximately 1,500 locations. In the following two decades, the culture and team that Mr. Hyde had developed grew the concept to over 6,000 stores.How do you and your fellow directors describe the culture of your family business? Do the employees, customers, and suppliers who experience the family business’s culture every day describe it the same way?Lesson #3 – Develop a Passion for Things That Matter Outside the BusinessAlthough few would likely admit it, we suspect one reason that key executives avoid walking away from the family business is that they have not developed anything compelling to walk toward. Mr. Hyde’s philanthropic endeavors have made, and continue to make, Memphis a better place to live. Turning over management of a successful family business need not be followed by a “retirement curse.” Whether a new business venture or philanthropy, family business executives who intentionally cultivate interests outside the family business are more likely to execute a successful transition to the next group of managers.Are you and your fellow directors encouraging senior managers to develop outside interests that will make eventual transition easier?Does it Really Matter: What’s the Financial Benefit?Family business directors are stewards of the financial resources that the family has allocated to the business. So what are the financial benefits of focusing on management succession? There are two principal benefits that directors need to be aware of.First, an emphasis on management succession increases the likelihood of continued financial success for the family. AutoZone shares opened trading on April 2, 1991 at a (split-adjusted) price of $6.88 per share. At the time of Mr. Hyde’s transition out of the President and CEO roles almost six years later, the share price had grown to approximately $25, a compound annual return for investors on the order of 25%. The team and culture that Mr. Hyde left behind contributed to continued shareholder returns, with the share price today on the order of $800 (an annualized return over more than two decades of approximately 17%).Second, an emphasis on management succession actually increases the value of the family business in the present. The flipside of failing to plan for management succession is allowing the family business to remain unduly dependent upon a single individual. For multi-generation family businesses, such dependencies increase the risk profile of the company, which reduces the value of the business, and by extension, the family’s wealth. Even when there is no intention to sell, directors should be mindful of the value of the family business and aware of steps they can take to enhance or protect that value. Reducing key person dependency through active planning for management succession is an important step in doing so for many family businesses.Management succession needs and strategies will necessarily look different for every family business, but AutoZone provides a great case study for directors to consider. Management succession is not just a human resources issue, but can have major financial repercussions for the family. Our professionals welcome the opportunity to discuss in confidence how management succession is influencing the value and sustainability of your family business.For additional perspective on management succession, see Chapter 7 of our new book, The 12 Questions That Keep Family Business Directors Awake at Night.
What We’re Reading on the RIA Industry
Much of the sector’s recent press has focused on succession planning and M&A trends, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the asset and wealth management industries.Why Building a Multibillion Dollar Firm is Not for the Faint of Heartby Charles Paikert, Financial Planning
Growing an advisory practice into an enterprise with value beyond its founders is tough work. Transitioning to a sustainable enterprise means hiring the right group of people to gradually assume management roles, but many firms lack experience developing personnel internally. Consequently, RIAs are increasingly making lateral hires or expanding through M&A.Mark Tibergien and Dan Seivert Listen Up! Dave Welling Explains Why Rising Private Equity Involvement in the RIA Business is Flat-Out Greatby David Welling, RIABiz (guest author)
Many RIA industry commentators have decried PE firms investing in RIAs as little more than short-sighted financial engineers. In fact, many RIAs we’ve worked with wear employee ownership and lack of outside capital as a badge of honor. However, David Welling (CEO of Mercer Advisors, no relation) argues that PE capital may actually be a great thing for the industry and its clients. To be fair, Welling’s own firm has been PE-owned for 10 years, but nevertheless, he provides an interesting perspective on PE capital and its potential impact on growth and succession planning for RIAs.The Importance of Having Cultureby James J. Green, ThinkAdvisor
In our experience, firm culture is a key factor that contributes to an RIA’s success. Culture is not one-size-fits-all, and there’s certainly more than one way to build a culture that “works.” However, what successful firms tend to have in common is that they are deliberate about building a culture that values great people and differentiates the firm from the competition. This article profiles registered rep Steve Rudolph and his IBD firm HW Financial Advisors, and how being deliberate about great culture has helped the firm grow to $600 million AUM with six advisors.Merrill Lynch Cuts Broker Payby Lisa Beilfuss, WSJ
Merrill Lynch is cutting broker pay beginning in January. Merrill’s recently-announced compensation plan for 2019 includes a 3% penalty on brokerage and investment advisory production below $1.6 million annually. Many of Merrill’s 17,000 advisors see the move as an effort to promote cross-selling bank products, fees from which are not penalized under the new plan.Schwab Studies Zero-Fee Mutual Funds in Wake of Fidelity’s Zero-Fee Mutual Fund Launch, but Schwab CEO Walt Bettinger Still Wonders ‘What’s the Point?’by Brooke Southall, RIABiz
Asset managers are taking note after Fidelity won the race to the bottom by launching two zero fee index funds in August. Schwab CEO Walt Bettinger revealed that the firm is vetting the idea of launching similar zero fee products at the firm’s Fall Business Update.Wealth-Management Firms Battle Over Millennialsby Rob Curran, WSJ
Millennials’ financial assets are expected to grow to more than $11 trillion over the next 12 years. Clearly, this demographic is increasingly important for the wealth management industry, but it is unclear how well RIAs will attract millennials’ assets in the face of stiff competition from fintech products. On one hand, as millennials gain wealth and their financial lives become more complicated, they may gravitate to more traditional wealth management services. On the other, fintech products that started with a narrow focus are quickly expanding their product offerings and capabilities to meet growing demand.Top 6 Trends in Wealth Management: Chip Roameby Janet Levaux, ThinkAdvisor
Some of these trends are no surprise – growing use of cost-conscious products, greater managed account assets, increasing RIA assets and number of RIAs, etc… Perhaps more surprising is the persistent importance of baby boomers’ assets in the industry. Despite the supposed battle for millennials’ assets, baby boomers’ assets are projected to grow from $26 trillion today (50%+ of the total) to $40.7 trillion in 2027 (40%+ of the total).
In summary, succession planning remains a major issue for asset and wealth managers, and will likely remain so as the ownership base ages. For some “enterprise” firms, succession may be best handled internally. For others, PE or PE-backed aggregators may provide a sensible solution. For firms in the latter category, the same culture which makes those firms successful may be a barrier to raising outside capital. To further complicate matters, the industry backdrop remains one of declining fees, evolving products, and a shifting client base.
Dividend Reminders
Takeaways from General Electric
The recent announcement that General Electric is slashing its shareholder payouts by more than 90% has put dividends in the headlines in recent days. The news coverage provides an opportunity for family business directors to re-visit dividend policy at their own companies. While we wouldn’t want to suggest that the GE dividend news tells savvy family business directors anything they didn’t already know, a few reminders about dividend basics seem fitting.Reminder #1: In the Long Run, Earnings Must Support DividendsDespite the often breathless reporting of the GE dividend cut, it really should not have been too surprising in the context of earnings struggles at the conglomerate over the past several years. While the potential stability of dividends is often lauded, only profitable companies can sustain dividends. The relationship between earnings and dividends is called the dividend payout ratio. While a company may pay a dividend in excess of earnings in any given year, on a cumulative basis, the dividend payout ratio cannot exceed 100%. The following table summarizes the dividend payout ratio at General Electric over the past twenty-five years.
During the first ten years of our sample period (corresponding roughly to the peak of the Jack Welch era), General Electric paid out 47% of earnings to shareholders, retaining the rest for reinvestment. Over the next decade, the dividend payout ratio increased to 57%. This can be interpreted in one of two ways. Either the company was retaining less in response to a more difficult investing environment, or earnings simply did not keep pace with dividends. Where things become unsustainable is when dividends exceed earnings, as they did in the most recent five year period. Sustained dividends in excess of earnings means that new investors are providing returns to existing investors, and that’s called a Ponzi scheme.
What is your family business’s dividend payout ratio? Is it trending in a particular direction? If so, is that intentional, or simply a matter of drift that eventually will need to be corrected?Reminder #2: Dividends Mitigate Shareholder RiskCorporate finance texts tend to emphasize the role and function of dividends from the company’s perspective, and downplay or ignore the shareholders’ perspective. In family businesses, dividends are often viewed solely as a means of providing current income to finance shareholder consumption (and that’s not a bad thing – everybody likes a little mailbox money). However, too many family business directors tend to ignore the role of dividends in mitigating the risk of shareholder returns. On the far side of all the earnings turbulence described above, the GE share price is essentially unchanged over the past twenty-five years. Despite having traded as high as $60 per share in 2000, GE shares are currently changing hands at about $10 per share, compared to about $8 per share in 1993. For a buy-and-hold investor, capital appreciation has been negligible. However, over that same period, shareholders have collected nearly $17 per share in dividends, and no amount of future market gyrations can take that away.
Business value accrues slowly, but can evaporate quickly. Even at good companies, like GE. Even at stable family businesses. When I was in business school in the late 90’s, GE was the epitome of a well-run company, and it would have been unthinkable to my cohorts and me that the company might decrease in value over the next two decades. All businesses are susceptible to future decreases in value, whether of the slow-drip or sudden “black swan” variety. For family business shareholders, who often don’t have the luxury of diversified portfolio holdings, dividend payments can provide a needed cushion to returns in the event of a material decrease in share value.
Where have the returns to your family shareholders come from: dividends or capital appreciation? What do your family shareholders’ personal balance sheets look like? Can they withstand a sudden (and sustained) decrease in share value?Reminder #3: Dividends Are a Signaling DeviceNot only do dividends provide current income and mitigate shareholder risk, but they are also an efficient means of signaling the board’s outlook for the company to shareholders. The dividend cut at GE provides at least two important signals to investors. First, the dramatic reduction signals to shareholders that there is no easy way out from the current mess. GE is in capital preservation mode – the dividend is not being cut to fund suddenly abundant investment opportunities, but because the board expects earnings to remain depressed for some time. Foregoing dividend payments will help shore up GE’s balance sheet and enhance the company’s ability to undertake the restructuring necessary for long-term sustainability. Second, the GE board’s decision to preserve a $0.01 per share dividend signals to shareholders that the company remains on a shareholder-first footing. Once the mess is cleaned up, shareholders should expect the dividend to increase. If GE had cut the dividend entirely, shareholders may well wonder if the board would ever be inclined to bring it back.Business value accrues slowly, but can evaporate quickly.For family shareholders, the signaling effect of dividends may be even more pronounced. Public company shareholders receive detailed financial reports every quarter, and the stock market provides a daily assessment of forward expectations for the company. For many family shareholders, in contrast, the most tangible “report” they ever receive on the health of the family business is their dividend check. Even if financial statements are available, many family shareholders don’t really know how to read them, or have the inclination to try. But everyone knows how this year’s dividend check compared to last year’s.What is your current dividend signaling to your family shareholders? If you were to change the dividend, what signal would that send? How effective is your shareholder relations program? Do your family shareholders know the company’s core strategy and how dividend policy interacts with that strategy, at least in broad outline?Reminder #4 – Dividends Are Not a “Cost” to the CompanyThis one may be a touch pedantic, but we think it is important. Various news outlets – including the Wall Street Journal – have discussed how much money the divided cut will “save” the company, as if cutting the dividend were akin to finding a new, cheaper source for office supplies. Dividends are not an expense: they represent one of only two forms of returns to shareholders. Shareholders are not vendors: they own the company.Dividends are not an expense: they represent one of only two forms of returns to shareholders.We often observe a similar phenomenon in family businesses. Shareholders (especially those in younger generations) may be treated as if they don’t have a legitimate claim on the company, and a desire for dividends is seen as impertinent or selfish. It may or may not make sense for a given family business to pay a dividend, but in no case are dividends a “cost” to the family business.Is your family business’s dividend policy rooted in an economic assessment of the available investment opportunities, or is withholding dividends a not-so-subtle strategy for manipulating and controlling family shareholders?In our experience, dividend policy is the most vexing financial issue facing family business directors. If you need some help asking the right questions about your dividend policy, give one of our professionals a call to discuss your situation in confidence.
Royalty MLPs Are Devouring Mineral Assets To Fund Growing Investor Appetites
Last year Kimbell Royalty Partners went public in a $90 million IPO. In May of this year, Kimbell announced its acquisition of Haymaker Minerals for $404 million in cash and stock. To top it off, last month Kimbell priced a follow on public offering for $57 million. The Haymaker acquisition remains the largest corporate mineral acquisition so far this year and exemplifies the continuing growth in a relatively new niche of publicly traded MLPs: Royalty MLPs. With around $1 billion in corporate or mineral rights acquisitions so far this year by leading royalty MLPs and mineral aggregators Viper Energy Partners (VNOM), Kimbell (KRP) and Black Stone Minerals (BSM), the segment is consolidating fast in a historically opaque market. Going back decades, the royalty and mineral market has been dominated by smaller, private transactions oftentimes with information asymmetry in negotiations. The strategy for Kimbell and its peers: create liquidity and thus value in an attractive, yet relatively untapped marketplace.Royalty-focused MLPs and mineral aggregation has the potential to provide growth through acquisitions and distribution payments that public investors desire.Kimbell is the most recent entrant to the public market and is emblematic of the increasing capital stacks being deployed to buy up mineral rights all across the country. Private equity players such as Haymaker’s sponsors, KKR and Kayne Anderson Capital Advisors, LP have been growing participants in this space, especially after the drop in oil prices in 2014.On the investor side of the equation, individuals and institutions are looking for opportunities to be exposed to mineral plays and benefit from technological advances without taking operator risk. This is a primary attraction of these types of investments, and many of these investors’ best platform to do so is through public companies. More and more investors are looking to the mineral market to find investment growth. The emerging field of royalty-focused MLPs and mineral aggregation has the potential to provide this growth through acquisitions, as well as distribution payments that public investors desire. Kimbell’s acquisition of Haymaker is a good example of this.Royalty MLPs and aggregators (not to be confused with royalty trusts which do not actively aggregate minerals) have only recently entered the public investment sphere, although the oil and gas mineral market has been around since Colonel Drake begat the industry in 1859. Viper Energy Partners IPO’d in 2014, Black Stone Minerals followed in 2015 and Kimbell went public last year. Performance this year has generally been strong with Black Stone Minerals lagging. Viper Energy Partners has led the way this year in market value increase. Two factors appear to be pushing it ahead of its peers: (1) it is focused in the hot Permian Basin; and (2) about 39% of its acreage is operated by its sister company, Diamondback Energy (the “other” FANG stock).[caption id="attachment_22837" align="alignnone" width="683"]Source: Bloomberg[/caption]
Growth aside, yields are the primary investment objective for these vehicles. Although potentially more volatile, the yields this year have been healthy as well.
[caption id="attachment_22838" align="alignnone" width="640"]Source: Bloomberg[/caption]
Alongside the acquisition, Kimbell converted its tax status from an MLP to a C Corp, a growing trend in light of the recent tax law changes. Now that the corporate tax rate is lower than the individual tax rate, the tax pass-through structure of an MLP does not provide the benefit it once did. Kimbell believes that this conversion will give the company access to a much broader base of investors and access to a more “liquid and attractive currency.”
Tapping The Vast Mineral Royalty MarketKimbell estimates that the total oil and gas royalty mineral buying market is close to $500 billion, excluding overriding interests which are hybrid style mineral interests. These estimates suggest that public companies make up only about 2% of the total market or about $10 billion, with the two largest players, Black Stone Minerals and Viper Energy Partners, making up over $8 billion of that total market value. While the public minerals market is only made up of a handful of companies giving public investors a limited number of investment options, the private minerals market is highly fragmented. Organizations such as the National Association of Royalty Owners work to educate mineral owners, but they still only scratch the surface of the market.
Small mineral aggregators can operate with a higher attention to acreage details. These small aggregators are able to focus more on negotiating directly with the landowners and handpick the acreage of their choosing. As a result, they expect higher yields than the public companies. While these yields are higher, the acreage is typically less diversified. Combined with their small size, these investments are inherently riskier than a larger, more diverse pool of assets, such as those held by public royalty trusts.Liquidity Discounts And Valuation OpportunityKimbell’s acquisition of Haymaker also demonstrates disconnect between the public and private markets and the discounts at which private LPs are valued. It appears that private royalty LPs simply do not have the same access to capital as the public MLPs or C Corps. This lack of access is potentially why KRP and Haymaker had distinctly different yields and why KRP was able to successfully negotiate such a highly accretive deal. Valuation professionals call this a liquidity or marketability discount. Mercer Capital sees this phenomenon quite often when valuing client’s privately held assets as demonstrated in the chart below, which highlights these “levels” of value.
[caption id="attachment_22839" align="alignnone" width="640"]Source: Mercer Capital[/caption]
Private equity investors and sponsors recognize this too. Haymaker’s sponsors most likely saw the potential behind the accretive mix of the two companies, which is why they were willing to accept roughly 50% of the purchase price in Kimbell shares. Not only was Kimbell public, its transition to a C Corp opened itself up to a broad array of inexpensive capital, less expensive than what Haymaker likely would have been able to find on its own. This access to cheaper capital makes it easier for Kimbell to grow through acquisitions and continue to increase returns and shareholder value.The Royalty Sector Is Just Warming UpThis is one of the biggest deals so far this year, but it may not be the last. Regardless of whether the MLP moniker sticks or they mostly become C Corp vehicles, the market remains vast, and public royalty aggregators are still at the front end of the consolidation trend. Oil and gas conferences regularly feature these firms now and they have become a regular part of the industry’s conversation. However, as more light shines on this market, efficiencies will grow and value will eventually get harder to find. In the meantime, there is opportunity to feed investors’ appetites and value seekers with oil and gas royalty minerals.Originally appeared on Forbes.com.
Views from the Road: What Do Community Banks, FinTech, and Buffalo Have in Common?
In the last few weeks, I presented at two events geared towards helping community banks achieve better performance: the Moss Adams Community Banking Conference in Huntington Beach, California and the FI FinTech Unconference in Fredericksburg, Texas. The FI FinTech Unconference had a recurring visual theme of the buffalo, which struck me as an insightful image for a FinTech conference.Much of the discussions at both conferences focused on the ability of community banks to adapt, survive, and thrive rather than thin out like the once massive North American buffalo herd. Both events had several presentations and discussions around FinTech and the need for community banks to evolve to meet customer expectations for improved digital interactions. Beyond thinking that I will miss the great views and weather I had for both trips, I came away with a few questions bankers should consider.How Can Community Banks Compete with Larger Banks?Larger banks are taking market share from smaller banks and have been gathering assets and deposits at a faster pace than community banks (defined as banks with less than $10 billion of assets) the last few decades. For example, banks with assets greater than $10 billion controlled around 85% of assets in mid-2018 compared to 50% in 1994. This is a significant trend illustrating how much market share community banks have ceded. Further, larger banks are producing higher ROEs, largely driven by higher levels of non-interest income (~0.90% of assets vs ~0.55%) and better operating leverage as measured by the efficiency ratio (~59% vs ~66%). The larger banks may widen their lead, too, given vast sums that are being spent on digital enhancements and other technology ventures to improve the client experience.Can FinTech Serve as a Value Enhancer and Help Community Banks Close the Performance Gap with Larger Banks?Most community banks are producing an ROE below 10%—an inadequate return for shareholders despite low credit costs. As a result, the critical role that a community bank fills as a lender to small business and agriculture is at risk if the board and/or shareholders decide to sell due to inadequate returns. Confronting this challenge requires the right team executing the right strategy to produce competitive returns for shareholders. FinTech solutions, rather than geographic expansion through branching and acquisitions, may be an option if FinTech products and processes can address areas where a bank falls short (e.g., wealth management).Can Community Banks Hold Ground and Even Win the Fight for Retail Deposits?Many community bank cost structures are wed to physical branches while customers— especially younger ones—are increasingly interacting with institutions first digitally and secondarily via a physical location. This transition is occurring at a time when core deposits are increasing in value to the industry as interest rates rise. In response, several larger banks, such as Citizens Financial, have increased their emphasis on digital delivery to drive incremental deposit growth. Additionally, as funding costs increase, some FinTech companies are being forced to consider partnerships with banks. Thus far, the digital banking push and the formal partnering of FinTech companies and banks are incremental in nature rather than reflective of a wholesale change in business models. Nonetheless, it will be interesting to see whether community banks can adapt and effectively use technology and FinTech partnerships to compete and win retail deposit relationships in a meaningful way.How Can Community Banks Develop a FinTech Framework?Against this backdrop, I see four primary steps to developing a FinTech framework:Identify attractive FinTech niches such as deposits, payments, digital lending, wealth management, insurance, or efficiency (i.e., tech initiatives designed to reduce costs)Identify attractive FinTech companies in those nichesDevelop a business case for different strategies (estimate the Internal Rates of Returns and IRRs)Compare the different strategies and execute the optimal strategyWhat Are Some Immediate Steps that Banks Can Take Regarding FinTech?The things that banks can do right now to explore FinTech opportunities are:Get educated. There are an increasing number of events for community bankers incorporating FinTech into their agenda and we have a number of resources on the topic as wellBegin or continue to integrate FinTech into your strategic planDetermine what your customers want/need/expect in terms of digital offeringsSeek out FinTech partners that provide solutions and begin due diligence discussionsHow Mercer Capital Can HelpMercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategies. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech.We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution. We can:Help your bank identify which FinTech niches may be most appropriate for your bank given your existing market opportunitiesHelp your bank identify which FinTech companies may offer the greatest potential as partners for your bankHelp provide assistance with valuations should your bank elect to consider investments or acquisitions of FinTech companiesWe are happy to help. Contact us at 901.685.2120 to discuss your needs.
Originally published in Bank Watch, October 2018.
Intrinsic Value and Valuation Multiples
This presentation, originally delivered by Z. Christopher Mercer, FASA, CFA, ABAR at the Fairfax Bar Association's Annual Conference in October 2018, discusses the intrinsic value standard of value in Virginia divorce-related valuations of closely held business assets. Additionally, this presentation also covers developing valuation multiples with credibility.
What Do Your Customers Pay For?
This post is part of our “Talking to the Numbers” series for family business leaders. In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements. Asking better questions will lead to better financial and business decisions.
It may be a tiresome cliché, but your family business really does make money buying low and selling high. Gross margin measures the degree to which your family business is able to sell its goods or services for a price in excess of the costs to acquire the inputs needed to produce the product or service. As we move down the income statement, the line below revenue is cost of goods sold, which defines itself quite nicely. Gross profit is the amount of revenue left over after deducting cost of goods sold. Gross margin is the ratio of gross profit to revenue. It’s important to think about gross margin, because it tells you how much of a “mark-up” your customers are willing to pay for your good or service. The higher the “mark-up” the more revenue will be available to cover operating expenses and generate an operating profit.
Exhibit 1 summarized median gross margins for each industry sector during 2017:
Exhibit 1 and the supporting data confirm several intuitions regarding what customers are willing to pay (i.e., your family business’s ability to buy low and sell high).
It’s important to think about gross margin, because it tells you how much of a “mark-up” your customers are willing to pay for your good or service.Customers Are Willing to Pay for InnovationAmong the industry sectors, healthcare and information technology are the most fertile fields for innovation. So it should not surprise us that these two industry sectors boast two of the highest gross margins.Digging a bit deeper into the data confirms the importance of innovation to customers. Since revenue growth is a decent proxy for innovation, we sorted the companies in the IT sector by compound annual revenue growth (2013 through 2017). Exhibit 2 summarizes the size, growth, and gross margin attributes for the high and low innovation groups. The median gross margin for the fast-growing high innovation group (51.0%) exceeded that of the slow-growth low innovation group (44.5%).
Family businesses cannot afford to neglect innovation.
Is your family business investing in research & development to promote innovation that benefits customers?Is your family business listening to customers to discern where innovative solutions are most needed?Is your family business evaluating acquisition opportunities that would bring innovative product offerings to customers?Customers Are Willing to Pay for AccessThe telecommunications sector boasts the highest gross margins. In other words, customers are willing to pay prices far in excess of the marginal cost to the telecom companies of providing the service. This reflects in large measure the high fixed costs of providing telecom services and customers’ willingness to pay for access to those networks and the benefits they bring.While only a small proportion of family businesses operate in the telecom sector, the underlying principle is applicable to a broader range of companies.Is your family business where your customers need it to be? Are there opportunities for geographic expansion that would make it easier for key customers to do business with you?Does your family business think about capital investment strategically? Do you have a plan to deploy capital assets in a way that increases customers’ willingness to pay for the product or service you are offering? How can your family business use capital expenditures to build and maintain a strategic competitive advantage?It is important to think about adding incremental value to the company’s product or service.Customers Are Willing to Pay for Added ValueThe lowest gross margins noted on Exhibit 1 are in the materials sector. Companies in the materials sector sell production inputs to manufacturing firms in the industrials and consumer (discretionary and staples) sectors. The companies in these sectors add value to raw materials, converting them into industrial and consumer goods. The gross margins for the industrial and consumer companies are higher than those in the materials sector, reflecting their superior position in the value chain.Regardless of where your family business sits on the value chain, it is important to think about adding incremental value to the company’s product or service.Is there an adjacent product or service that your family business can provide to customers that will allow you to increase the value added by the business?Are there opportunities for vertical integration (whether through acquisition or direct capital investment) that would enhance the competitive position of your family business?Customers Are Willing to Pay for BrandsThe role of brands in customer behavior is critical in the consumer staples sector. These companies sell basic consumer goods (food, cleaning supplies, personal care products, etc.) and rely heavily on marketing and branding to drive sales. We sorted the consumer staples companies in our sample by gross margin, listing the twenty companies with the highest gross margins and the twenty companies with the lowest gross margins on Exhibit 3.There are undoubtedly a host of factors at work beyond just branding in the two lists noted above (for example, whether a company is a manufacturer or retailer). Yet, on balance, the high margin group consists of more well-known and readily identifiable brands than the low margin group. And the difference is not trivial: the median gross margin for the top 20 companies is 61% compared to 16% for the bottom 20 companies.For many family businesses, the family name doubles as the company brand. But even when that is not the case, the health of the brand is important.Is your family business investing appropriately in marketing and branding? Successful branding initiatives require sustained investment.Does your branding strategy align with the story of your family business and the business’s competitive strengths?Does your family business’s risk management process take into account potential threats to the company’s brand? A quality brand takes years to build but only days to destroy.
While our discussion in this post has focused on the price side of gross profit (what are customers willing to pay?), family businesses cannot neglect the cost side of gross profit (how much are we paying for inputs?). A diligent procurement function can contribute to gross margin as much as the customer-focused strategies discussed above. The most obvious buying efficiencies come from scale, which evident when we compare the median gross margin for the large cap (S&P500) companies of 42.1% to the 33.7% gross margin of the small cap (S&P 600) companies.
From a customer-facing perspective, innovation, access, value added, and brand are critical components of corporate strategy influencing gross margin. Family businesses should evaluate opportunities for enhancing gross margin along these dimensions while not ignoring opportunities for improved purchasing.
How to Interpret Breakeven Prices
Before mid-2014, few investors took notice of efficiency-oriented metrics, instead focusing on stories of new oil discoveries and the development of new wells and new technologies. Since the crash in oil prices, a new measure of success was brought to the forefront: breakeven prices.Since the crash in oil prices, a new measure of success was brought to the forefront: breakeven prices.Over the last couple of years, E&P companies have become more efficient, forced to create investor returns at $40 - $50/barrel oil. Well productivity has improved as companies drilled longer laterals and used less proppant. After the crash in oil prices, oilfield services companies lowered their prices to compete for limited work. As oil prices recovered, the price of oilfield services was slow to catch up. Additionally, companies have more capital discipline than they ever did at $100/barrel oil prices.Even as oil prices have started to recover, companies are showing lower breakeven costs than ever before. As shown in the chart below, breakeven prices in the Midland Basin fell by 50% from $87 in January 2014 to $44 in September 2018.
As more companies present this metric and more investors rely on it as an indication of performance, it becomes increasingly important to understand what it actually measures, and if breakeven prices can be compared consistently from company to company.
What is a Breakeven Price?The Wall Street Journal stated, “At its simplest, the metric represents the oil price that a company needs to generate enough cash so it can cover its capital spending and dividend payouts.” Most public E&P companies report breakeven costs in their investor presentations, oftentimes measuring themselves against peers. However, these companies rarely explain how they develop these metrics. Some companies, such as Chevron, don’t include covering dividends in this metric. Additionally, some companies look at project-specific breakeven prices which don’t always cover all spending and dividends.Many analysts and investors, including our oil and gas team, track Bloomberg New Energy Finance for region specific breakeven prices. Beginning in January 2014, Bloomberg began publishing monthly breakeven oil prices and breakeven natural gas prices for the following regions.
According to Bloomberg, breakeven prices by region are sourced from BTU Analytics and provide:
Average wellhead breakeven prices estimates for all wells turned to sales each month. Well economics calculations use a 10% discount rate. Well life is assumed to be 240 months. Gathering, processing, compression, fractionation, and operating expenses are estimated for individual basins and plays.While somewhat helpful, this definition leaves a lot unexplained. We talked to BTU Analytics so that we could better understand what it calculates.BTU Analytics’ data set includes 60,000 horizontal wells from 2013 to present across major basins in the continental U.S. Their data is collected at the well level and calibrated with production data from state agencies and reconciled with overarching trends discussed by major regional operators.BTU’s breakeven measure on Bloomberg is a half-cycle breakeven price, meaning that all operating costs from drilling to completion of the well are accounted for. Additionally, the costs to keep the well operating such as taxes, royalties, and gathering and compression costs are included. However, what is not included in Bloomberg’s breakeven calculation is just as important.What is Not Included in Bloomberg’s Breakeven Prices?Notably, the Bloomberg Breakeven Price does not include wellhead differentials. This means, that breakeven prices in the Permian are based off the WTI-Cushing benchmark, not off the regional hub which traded at as high of an $18 discount in August, according to pricing information from Bloomberg.As the Permian Basin struggles with bottlenecks, differentials have become exceedingly important to consider. Although there are plans underway to address the growing need for infrastructure in the Permian Basin, adjusting Bloomberg’s breakeven pricing to account for differentials observed at the wellhead is necessary to accurately understand a regions breakeven price.Additionally, according to Matt Hagerty at BTU Analytics,These breakevens exclude acreage acquisition costs which can vary significantly between operators and even across acreage for a specific operator.Other ConsiderationsAs mentioned previously, it is often difficult to compare breakeven prices across companies. Since BTU Analytics calculates each of these metrics, it would seem that they are more comparable across regions. But it is important to remember that these regional breakeven prices are averages and may not explain company or inter-regional dynamics.If we continue to rely on breakeven pricing, then it is pertinent that we better understand what is included in these calculations.In August of this year, breakeven prices in the Bakken fell below breakeven prices in the Permian. While we do not doubt the credibility of this metric, it leads us to consider the actual observations that make up this average. By mid-2016, the Bakken had only 22 operating rigs and even now has only 52 rigs as compared to 489 in the Permian. It would be interesting to get a deeper look at the standard deviation of breakeven prices in regions such as the Bakken, as these regions may exhibit a much wider range of breakeven prices.Even at $70 oil, investors and analysts alike are still talking about breakeven pricing, suggesting that this metric has survived the downturn. However, if we continue to rely on the metric, then it is pertinent that we better understand what is included in these calculations.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our oil & gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil & gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil & gas valuations and associated oil & gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Asset Manager M&A Trends
Deal Activity Continues to Accelerate Through the Third Quarter 2018
Asset manager M&A was robust through the first three quarters of 2018 against a backdrop of volatile market conditions. Several trends which have driven the uptick in sector M&A in recent years have continued into 2018, including increasing activity by RIA aggregators and rising cost pressures. Total deal count during the first three quarters of 2018 increased 45% versus the same period in 2017, and total disclosed deal value was up over 150%. In terms of both deal volume and deal count, M&A is on pace to reach the highest levels since 2009.
Thus far in the fourth quarter, M&A shows no signs of slowing down. Just last week, Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade. IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S. The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income. Invesco chief Martin Flanagan explained the rationale for scale during an earnings call last year:
"Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future. And I think a number of smaller-sized firms are finding that hard." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs over the last year. The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well. In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets. FOCS also announced several sub-acquisitions by its affiliates during the third quarter.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted. This has been due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc. – 2Q18 Earnings Call "[I] think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers…" Joseph Sullivan, CEO, Legg Mason, Inc. – July 2018 Earnings CallConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a bull market in asset prices that has continued through the third quarter of 2018. Steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. Because of increasing AUM and concomitant revenue growth, profitability has been trending upwards despite industry headwinds that seem to rationalize consolidation.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger, which could further facilitate M&A’s upward trend during the rest of 2018.
Is Growth Optional for Your Family Business?
This post is part of our “Talking to the Numbers” series for family business leaders. In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements. Asking better questions will lead to better financial and business decisions.
The income statement is a natural place to begin analyzing a company’s financial results, and revenue is the natural starting point for that analysis. We recently heard someone remark that everything good in business starts with revenue, and our experience working with family businesses of all stripes confirms that sentiment. While the absolute amount of revenue can be instructive (i.e., are we looking at a $10 million business or a $100 million business?), it is the trend in revenue that is most revealing. Is the business growing, treading water, or shrinking?Analyzing the Public Company DataTo gain a little more perspective on revenue growth for our benchmark universe of public companies, we pulled revenue figures for the five years ending with 2017. Comparing the 2017 revenue figures to 2013 revenues, we calculated the compound annual growth rate (or CAGR) for each company. For multi-year periods, the compound annual growth rate smooths out year-to-year variations and represents the overall annualized growth rate for the period.Exhibit 1 summarizes the compound annual growth rates for the benchmark universe. (For some background on this data set, see the first post in this series.)The top panel of Exhibit 1 indicates how revenue growth is distributed for each industry. For example, 16% of the consumer discretionary companies in our sample (the leftmost column), reported CAGRs between 2.5% and 5.0%, while 5% of such companies reported a CAGR in excess of 25%. In other words, each vertical column sums to 100%. The bottom panel indicates the median observed CAGR for each industry by index (which is a proxy for company size).Takeaways for Your Family BusinessPondering over this data for a while, we offer a couple of observations for family business directors.1. Industry Sets the Stage for Growth, but Does not Define It.The industry a business operates in is a powerful force in setting expectations for revenue growth. The differences in median CAGR across industries in Exhibit 1 are not trivial. At the extreme ends of the spectrum, energy company revenues over the period were hamstrung by a decline in oil prices (median CAGR of negative 8.2%), while healthcare companies were generally boosted by that sector’s growing share of the overall economy (10.9% annualized growth).However, the overall distribution of growth rates by industry is actually quite wide. Take for example consumer staples (the second column from the left). The median annualized revenue growth of 1.9% reflects a mature industry that – as a whole – is largely dependent on inflationary price increases for revenue growth. And yet nearly a quarter of the companies in that industry generated CAGRs in excess of 10%. What this suggests is that, even in mature, slow-growth industries, successful management teams can identify and execute on paths to revenue growth.Directors should be thinking about how industry dynamics are influencing revenue growth.In the context of a family business, directors should be thinking about how industry dynamics are influencing revenue growth. For example, a compound annual growth rate of 3.5% over the period examined would be consistent with maintaining market share for an industrial company, gaining market share for a consumer staples firm, and losing market share for a healthcare business. In other words, the same signal can carry different meanings for companies in different industries. As a family business director, you should ask yourself questions like the following:Does our family business have a strategy that acknowledges the reality of the industry but identifies opportunities to increase market share profitably?What sorts of strategies are most likely to increase market share for our business within the industry? Differentiating on quality and service? Or becoming a value leader?Where is the low-hanging fruit for revenue growth: price increases, geographic expansion, adding an adjacent product line, marketing to new customers, or something else?2. Revenue Growth Can Be Organic or AcquiredFor the industry as a whole, revenue growth is all organic (i.e., selling more widgets at potentially higher prices). However, for individual companies within an industry, revenue growth can be augmented by acquisitions. Organic growth requires a sustainable competitive advantage. Acquisition growth requires discipline to avoid overpayment.Real, long-term organic growth is hard. Absent one or more strategic “moats” around the company’s market niche, profits draw competition. What is unique about your family business that can contribute to sustained organic revenue growth?Supplementing organic growth with acquired growth brings its own set of challenges. Like nearly everything else in business, investing for growth is subject to the law of diminishing marginal returns: the more growth projects a company undertakes, the less effective the projects are likely to become. As a result, pursuing revenue growth without regard for the marginal efficiency of investment can actually prove detrimental to family shareholders. In other words, revenue growth must always be evaluated relative to the cost to achieve it.What is unique about your family business that can contribute to sustained organic revenue growth?One simple measure of investment efficiency is the ratio of revenue to invested capital (the sum of debt and equity financing). This ratio measures the revenue generated per dollar of capital used by management. If the ratio decreases over time, it suggests that the incremental investments made to achieve revenue growth are becoming less effective.The data summarized in Exhibit 2 suggests that – in aggregate – the public companies in our data set demonstrated imperfect discipline with regard to pursuing revenue growth. We sorted the companies in our sample by revenue growth, creating three subgroups of equal size. While the overall revenue turnover slipped a bit for all companies over the period analyzed, the high growth companies fared no worse than the low growth companies: in other words, the high growth companies were not chasing growth recklessly at the expense of shareholder returns.Corporate investment may take the form of either capital expenditures or merger & acquisition activity. Exhibit 2 also summarizes the relative mix of investment for the subgroups of companies. The data suggests that the high growth companies rely more heavily on M&A, while the low growth companies tend to focus more on capital expenditures. If we assume that capital expenditures are a (very imperfect) proxy for organic growth, this data confirms that the fastest growing firms are augmenting organic growth opportunities with strategic acquisitions.For family business directors thinking about revenue growth, this leads to some important questions.Does our family business have a culture that can accommodate growth through acquisition, or is organic growth the primary path forward?Are there logical acquisition targets that could boost revenue growth (at a reasonable price)?Does our company have the financial capacity to make an acquisition?Does our business have a qualified team of advisors to help execute on acquisition opportunities?
In sum, revenue growth analysis for a family business should focus on industry dynamics and the opportunities for organic vs. acquired growth.
Automobile Dealership Valuation 101
Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals.
BP & Diamondback Mergers Set Q3 Tone For Upstream Producers
The third quarter just wrapped for upstream producers. Stock performance has been volatile, infrastructure issues are lurking and the industry as a whole ended the quarter a notch above flat. However, approximately $21 billion in strategic acquisitions by BP and Diamondback Energy highlighted the continued optimism for the segment. BP’s merger looks particularly interesting as it focuses on the Eagle Ford while most investors have been looking to the Permian. BP’s earnings have yet to be reported, so stay tuned.BP’s Big DealBP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production.BP certainly wasn’t waiting for the industry’s current infrastructure issues to sort themselves out as they forged ahead with the biggest single upstream merger this year, a $10.5 billion acquisition of BHP Billiton. This is BP’s biggest acquisition in nearly 20 years. The primary assets acquired were spread across the Eagle Ford shale in South Texas, the Haynesville Shale in East Texas and to a lesser extent, the Permian Basin. Through this transaction, BP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production. BP was naturally enthusiastic about the deal, and after some review, this deal appears to have a lot of potential to create value for BP. Here’s why:This Is Not BP’s First Venture Into The Texas Shale PlaysBP dipped their toe into the Eagle Ford shale back in 2010, before they fully jumped into this deal. Joining with local dry gas powerhouse Lewis Energy, BP bought at $4,000 to 5,000 per acre for joint venture rights on the dry gas window of the Eagle Ford shale. Over the course of the past few years, BP has more than doubled per-well production in the Eagle Ford by utilizing improved production techniques. This experience, particularly in that region, could serve BP’s shareholders well going forward.There’s Commodity Price UpsideBP based their return models on $55 oil and $2.75 gas. As of the acquisition, oil prices were already in the mid-$60’s and closed around $75 this week. On the other hand, gas prices have been flat and returns have been driven by the cost side of the equation. Although only about 45% of the reserves purchased are liquids-based, it has the potential to boost returns and increase values.At First Glance, BP Does Not Appear To Have OverpaidWith over 80% of the assets weighted towards the lesser celebrated Eagle Ford and Haynesville plays, BP did not focus on the higher priced Permian Basin as much in this deal. Although the Permian’s stacked geology is superior, it is also more expensive. On a per net acre basis, BP paid just over $22,000 per acre.Diamondback Energy’s Big DealNot to be outdone, Diamondback Energy made two acquisitions within a week of each other that cost around $10.4 billion. Both transactions were in the Permian and were spread between the Delaware and Midland Basins. Both were similarly priced and are more oil and liquids heavy than BP’s acquisition, notable because margins for oil and liquids are generally much better than gas.The deals were notable because margins for oil and liquids are generally much better than gas.Diamondback’s larger deal was its purchase of Energen for $9.2 billion, providing 179,000 acres and about 90,400 barrels per day of current production. Diamondback also purchased AJAX Resources for $1.2 billion, gaining over 25,000 acres and about 12,130 barrels per day of production. Although smaller, this deal was more focused on acreage located in the Midland Basin.Betting On SuccessBased on implied production multiples of other companies, deal pricing for both Diamondback mergers was generally in line with current implied values and creates one of the largest pure-play Permian producers. All three transactions appear to either be generally in line with implied public company market valuations in their respective regions.Overall, upstream indexes were muddled in the third quarter, although earnings reports could shift the sentiment. BP and Diamondback are betting big that future quarterly (and annual) performance will be better.The Bigger PictureGenerally, oil prices started and ended the quarter in almost the same place – around $73-$74 per barrel, but it took a circuitous route, dropping down to $65 in mid-August before climbing back. West Texas, however, has been a different story. Differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter.
This gap has been created as a result of a supply traffic jam that has overwhelmed the Permian’s infrastructure. Production in Texas actually fell this summer due in large part to these issues, and this dynamic pervades beyond the Permian Basin. Appalachia and the Bakken have similar issues, although not discussed as often. Efforts are underway to alleviate these bottleneck issues in all of these areas, but it will continue to take time and capital. This extends not only from public markets, but private equity as well.
Have these issues impacted productivity or activity? So far, the answer is no. Capex budgets, a harbinger of drilling plans, have continued to grow and be revised upward for many producers. Drilling and production figures continue to climb everywhere but West Texas. However, that is temporary. Noting the Permian’s drilled but uncompleted (“DUC”) well figure, the Permian’s effective inventory is waiting to be unleashed on the market.
Could this be setting up strong earnings and production? One can only hope, and Diamondback and BP seem to think so. It appears the market may be transitioning from ascribing value on enthusiasm about potential shale production from undrilled reserves to realization of those reserves and more real dollars to show for it.
Originally appeared on Forbes.com.
Alternative Asset Managers
Segment Focus
Alternative investment managers took off in the wake of the financial crisis when investors flocked to risk mitigating strategies and uncorrelated asset classes; however, during 2015 and 2016 these businesses floundered against a backdrop of strong equity market performance. Alt managers bounced back in 2017, and over the last twelve months, have continued to perform well. Despite improving performance over the last two years, the industry continues to face a number of headwinds, including fee pressure, expanding index opportunities, and relative underperformance.Segment StrugglesHedge fund managers, in particular, have struggled since the financial crisis. Although industry assets reached a record $3.2 trillion in 2018, net inflows have stagnated and the record AUM level is primarily due to market increases rather than investor interest in the asset class. At the same time, the industry is struggling with fee schedules that continue to decline and a plummeting number of new funds being established.1Despite improving performance over the last two years, the industry continues to face a number of headwindsMany of the hedge fund industry’s woes can be traced back to significant underperformance over the last decade. Since 2009, the S&P 500 index has dwarfed the performance of hedge funds (as measured by the HFRI Fund Weighted Composite Index), and this underperformance has driven outflows and fee declines. Part of industry’s underperformance may be attributable to the protracted bull market. While it may seem counterintuitive that strong market performance would be a bad thing for an asset manager, a long/short fund that seeks to generate positive returns regardless of which way the market moves is naturally going to underperform during prolonged periods of steady market increases. Recent volatility in the equity markets may alleviate this underperformance, but the numbers haven’t been reported yet.Other categories of alt managers have suffered many of the same difficulties as hedge funds in justifying their value propositions over the last decade. Alternative asset classes saw major inflows after the financial crisis due to their lack of correlation with traditional asset classes. Fast forward to today, the S&P 500 index has grown at a nearly 16% CAGR since bottoming out in 2009. Investors holding asset classes uncorrelated to U.S. equities over the last decade probably wish they hadn’t been with hindsight.While performance has been volatile, alt managers closed out the year ended September 30 up 7.8%Industry PerformanceThe industry has endured and performed reasonably well over the last year, at least in the eyes of market participants. While performance has been volatile, alt managers closed out the year ended September 30 up 7.8% — making them one of the better performing sectors of publicly traded asset managers over the past year. For all the problems the industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle. While active management may not be as lucrative as it once was, it is still sought by many institutional investors to complement their passive holdings.Taking a closer look at the performance of the alt manager index’s constituent companies over the last year reveals that most of the positive performance was attributable to publicly traded private equity managers, with KKR, Blackstone (BX), and Apollo (APO) all beating the S&P 500 while Carlyle Group (CG) was up modestly. Oaktree Capital Management (OAK), which specializes in distressed debt, was down 5.8% while hedge fund manager Och-Ziff Capital Management (OZM) declined more than 50% over the last year on issues with succession and investment performance.Given the performance over the last year, the market appears to be reasonably optimistic about the prospects for most publicly traded alt managers, at least relative to other categories of asset managers. Some of the fundamentals are improving as well. Asset flows out of active products seem to have stabilized, and AUM growth has generally been outpacing fee compression in recent quarters. We think performance fees will likely continue to fall (in one form or another), but like active management, never be totally eliminated. So on balance, a modestly improving outlook for the industry appears justified.1 The Incredible Shrinking Hedge Fund. Bloomberg.
Analyzing Public Company Data for Family Business Insights
Talking to the Numbers Introduction
“You have to keep talking to the numbers until the numbers start talking back to you.”So goes the most memorable piece of advice regarding financial analysis I have ever received. Chris Mercer passed it along to me, and Chris attributes the saying to a mentor of his while working at First Tennessee bank in the 1970s. The admonition to keep talking to the numbers is a key component of our firm’s institutional DNA. It seems to me that the maxim is underwritten by two fundamental premises:First, persistence is rewarded in financial analysis. One has to keep talking to the numbers before they yield up their secrets. A surface reading of the financial statements will not necessarily reveal the Company’s underlying financial narrative. Financial statements are best read with a highlighter, pen, and calculator in hand. These are the tools necessary to move beyond simply discovering what the financial statements say to discerning what they mean.Second, there is an underlying coherence to the financial statements. With persistent prodding, the numbers will start talking back. The numbers presented in the financial statements are not just random data, but rather cohere with one another in a logical way that sheds light on the real-world activities of the business. In other words, financial analysis is about telling the company’s story, not just calculating ratios and making charts.
Reading financial statements well is all about asking the right questions. In this series of posts, our goal is to help family business directors ask the right questions of their financial statements. Asking better questions leads to better financial and business decisions.The Data Set We Are UsingIn contrast to private companies, which tend to keep their financial information to themselves, public companies are required by law to publish their financial statements on a regular basis. While the purpose of this requirement is to keep investors fairly and fully informed, one beneficial side effect is that these filings create a vast repository of financial statement data. We downloaded the data set for the analysis presented in this series from the Capital IQ database. We pulled data for companies in the S&P 1500 index, which includes large-cap (500), mid-cap (400), and small-cap (600) companies. Financial statement data for financial institutions, insurance companies, and REITs (FIRE for short) looks and feels a lot different than data for operating companies like manufacturers, retailers, and services companies. Since we wanted to focus on the latter, we screened out the former.Exhibit 1 summarizes the composition of the data set with respect to both industry and size.Having dispensed with the FIRE companies, our initial universe shrank by about 20%, from 1,500 to just under 1,200 companies.Understanding the Data: Illustrative ExampleExhibit 2 provides a preview of the types of metrics that we will analyze and comment upon in the posts to follow.To briefly illustrate what we hope to provide for readers through this series, let’s compare the median measures for healthcare companies and industrials (the fourth and fifth columns from the left). What can we discern from this data that will help family business directors ask better questions when reading financial statements?Reading financial statements well is all about asking the right questions.Measuring by EBITDA MarginAs measured by EBITDA margin, the healthcare companies are more profitable, wringing nearly twenty cents of cash flow out of each dollar of revenue, compared to just over fourteen cents for the industrials. Among other things, profit margins reflect the competitive dynamics of an industry. The higher margins for the healthcare companies are consonant with the prior observation regarding the centrality of innovation to modern healthcare companies. Since the industry has a lot of greenfield space to work in, successful companies have greater opportunity to carve out a profitable niche protected from direct competition. As the industry matures and growth slows, one might expect competition to increase and margins to come under pressure.How does the profitability of my family business compare to peers?Does my family business have a “strategic moat” that can help sustain superior profitability?Measuring by Forward EBITDA MultiplesThe forward EBITDA multiples indicate that investors would rather own a given dollar of EBITDA generated by a healthcare company than an industrial company. Unlike a performance measure like EBITDA margin, valuation multiples incorporate market expectations for a company’s future. As a result, multiples are positively related to expectations for growth and negatively related to the market’s assessment of risk. On balance, the market assigns a higher multiple to healthcare companies than industrials.What are the principal risks facing my family business? What options are available for mitigating those risks?How would a potential buyer assess the growth prospects of my family business? Which segments or business lines are poised for the greatest growth?Better questions lead to better insights, which lead to better decisions.Profitability vs. EfficiencyWhile the healthcare companies are more profitable per dollar of revenue, the industrials are more efficient at generating revenue per dollar of capital invested in the business. This may reflect a number of factors, among which is likely the nature of the respective asset bases. Industrial companies have a significant portion of their invested capital tied up in tangible, brick-and-mortar assets like property, plant & equipment, while healthcare companies are more likely to use intangible assets (intellectual property and assembled workforces) to generate revenue. In terms of return on invested capital, the industrials’ lower margin / higher turnover model actually wins out, generating pre-tax debt-free earnings equal to 14.1% of invested capital compared to 11.8% for the healthcare companies.How does my family business allocate capital to different segments or divisions?Do the managers of my family business have a clear mandate regarding shareholder objectives? Or, are performance expectations for managers ambiguous?Topics for AnalysisIn future posts, we will focus on individual elements of financial statement analysis, including:Revenue and Earnings PerformanceBalance Sheet CompositionReturn on Invested CapitalCash Flow :: Sources & UsesFinancial LeverageMarket Returns, Multiples & Risk
Throughout, we will focus on learning to ask better questions of your family business’s financial statements. Better questions lead to better insights, which lead to better decisions.
U.S. Energy and Private Equity
Show Me the Money
Private equity companies in the energy sector are positioned for an interesting opportunity. These companies have seen a surge of fundraising in recent years, leaving managers with large cash reserves or “dry powder” to be appropriately deployed. Despite the large amount of cash available, these firms are having trouble finding places to invest resulting in a decline in PE activity in 2016-2018 with deal counts dropping for the second year in a row by 8%. However, investments could see a marked increase in energy in the last quarter of 2018 and into 2019 as there is a climate of high demand for return on investment and low supply of cash needed for capital expenditures in upstream oil companies.Oil and gas prices in 2018 have been steadily increasing in the midst of strong demand and constrained supply, and the U.S. energy sector is at the center of this focus. Forecasts from the International Energy Agency (IEA) show that the U.S. is expected to supply almost 60% of the demand growth over the next 5 years as conventional discoveries outside of the U.S. have hit historic lows since the early 1950s.Supply-Side ProblemsU.S. companies seem adequately poised to capture business in the swelling energy market, but the mechanics needed to supply this demand growth are turning out to be somewhat problematic. Upstream management teams that survived the oil crash in 2014 have had to cut costs aggressively in order to stay afloat, with capex spending plummeting nearly 45% between 2014-2016. These cost cuts, while necessary a few years ago, have largely continued into 2018 and conflict with the strong increase in spending that is needed to improve daily output to reach current demand. Morgan Stanley believes this output has to increase by 5.7 million barrels per day by 2020 in order to keep up. This level of increased production has only happened once since 1984.Another issue facing supply is the lack of new oil discoveries. According to a study performed by Rystad Energy, discovered resources have fallen to an all-time low of around 7 billion barrels of oil equivalent in 2017. At current consumption rates, that is a replacement rate of around 11%, down from 50% in 2012. Not only are there fewer discoveries being made, but the sites found contain much less oil than prior discoveries.International AlleviationRussia and members of OPEC met in June and agreed to boost their collective output of oil production, amid U.S. sanctions on Iran, in order to help with the global shortfall and meet increased demand. Although there was no clear guidance on the increased output, the group has been tentatively aiming for an additional million barrels per day to overall production. World total oil supply has risen by approximately 680,000 barrels per day in July, but this was largely contributed by the Organization for Economic Cooperation and Development, a group of non-OPEC members that includes the U.S.In fact, from recent figures, Russia’s increased output amounted to only 20,000 barrels a day, and Saudi crude output actually decreased by 200,000 barrels a day. The decline in the oil production in Iran and Saudi Arabia and lackluster production boosts from Russia are proving that any alleviation in oil prices will come later as prices continue to rise. While the IEA agrees that the Saudis can supply over 12 million barrels a day, there is little incentive to do so as fiscal breakeven figures for Saudi oil production provided by the IMF show nearly $88 per barrel. Why turn on the spigots if there is no profit to be made?Shortfalls in CapexThe U.S. has been ramping up production to make up for the underwhelming boost in international output. For the U.S. to continue to operate at the required level to reach demand, large investments in capex are necessary. From a Deloitte study in 2016, the industry needs a minimum investment of about $3 trillion from 2016-2020 to ensure its long-term sustainability even in the case of non-linear demand. When paired against the operating cash inflows and the required cash outflows of listed entities, there is a gap of roughly $750 billion to $2 trillion to cover payouts, debt repayments, and upstream capex.
Even if companies have enough operating cash flow to fund capex on the lower levels, capex may not have the first call on available cash. Other balance sheet focuses and maintenance of reduced payouts may command higher priority for that cash.
So where does the money come from to close the capex gap and supply the growing demand? This is where private capital and U.S. shale come into play.Private Equity FactorsAs the price of oil steadily increases, private equity backers for these upstream companies should see a similar uptick in new fundraising. Historically, rising prices equates to higher investment returns. The scenarios outlined above create an opportunity for energy investors that is not likely to be seen again for many years. Not only is the demand outlook in the investors’ favor, but the return per dollar invested is attractive as well due to innovations in efficiency from U.S. companies, as mentioned in a prior blog post, in areas like the Bakken. Well completion times have fallen by roughly half since 2013, which allowed for U.S. upstream companies to profit on $30 per barrel.The disconnect between rising prices and the relative performance of publicly traded energy companies creates an opportunity for private ventures to collect properties and assets and start drilling. Global private equity raised a record of $453 billion from investors in 2017 leaving it with more than $1 trillion to put into companies and new business ventures. Subsequently, this has resulted in the record amounts of dry powder in $1 billion+ funds. Coming into 2018, U.S. oil and gas PE funds alone were holding around $52 billion in dry powder, which can be seen in the PitchBook figure below. EnCap Investments was the largest player holding approximately $6.75 billion to be deployed in its Energy Capital Fund XI. Other industry giants such as Riverstone Holdings and Blackstone are holding around $3 billion and $2.7 billion, respectively.
With such a large influx of new capital waiting to be deployed, the energy sector offers attractive opportunities to capitalize on the high level of demand coupled with rising prices and need for capital.
ChallengesThe challenges typically facing energy-focused private equity companies are that they tend to be risk-averse. New discoveries and new drilling are capital intensive in both cash and time. PE firms tend to gravitate toward established shale plays and, as a consequence, pay a hefty premium for a “sure bet.” As a result, one could argue the better use of capital would be making a long only bet on NYMEX and avoid the liabilities of owning an operating company.Additionally, the time horizons of these PE sponsors are often mismatched with the energy sector cycles. Cycles and manipulations by OPEC can occur over many years or even decades, while the typical time horizon for a PE sponsor is generally around 7 years.ConclusionPrivate equity firms are positioned to capture a rare investment opportunity in the U.S. energy sector.History has shown that there is a connection between higher oil prices and higher investment returns. In this relatively high price environment, private equity backers can supply the key ingredient of large capital injections to close the much-needed capex gap in U.S. upstream oil companies and enjoy the subsequent investment returns.We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
RIA Stocks Post Mixed Performance During 3Q18
During the recent market cycle, asset managers have benefited from global increases in financial wealth driven by a bull market in most asset prices. These favorable trends in asset prices have masked some of the headwinds the industry faces, including growing consumer skepticism of higher-fee products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as poorly differentiated active products struggled to withstand downward fee velocity and at the same time, have been a prime target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Investors have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are (so far) better positioned to maintain pricing schedules as a result.Third Quarter PerformanceReflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the third quarter. While major indices posted solid gains during the second quarter, the returns for asset managers were at best muted even though these businesses generally benefit from rising equity markets. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case. The reversal of that trend over the last two quarters may be indicative of investors’ increasing concerns about the headwinds the industry faces and the general uncertainty that arises late in the economic/market cycle.
Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 5.9%. Trust banks were also down 5.9% during the quarter, driven by poor performance at State Street and BNY Mellon – the index’s two largest components – after both companies reported weak Q2 performance and STT announced that it would acquire financial data firm Charles River Systems at a poorly-received valuation of $2.6 billion (9x revenue). Alternative asset managers were up 12.2% and were the only sector to outperform the S&P 500. Alternative managers have generally performed well in recent quarters as the product segment is less impacted by fee pressure than traditional active products. Wealth managers were up 6.0% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power.
While wealth managers performed well during the quarter, they were outpaced by wealth management firm aggregator Focus Financial Partners (“FOCS”), which closed out the quarter up 44% since its noteworthy IPO in late July. FOCS, of course, is not an RIA, but since FOCS is an aggregation of RIA cash flows, some comparison between FOCS and RIAs is inevitable. FOCS is not necessarily a proxy for the performance of RIAs since the success of the FOCS business model depends on more than just the performance of its partner firms. This is particularly true now as FOCS is growing rapidly and investors are arguably more attuned to FOCS’s ability to string together acquisitions at attractive deal terms than on the performance of the partner firms post-acquisition. Over time, FOCS’s performance should bear some resemblance to that of the underlying partner firms, but right now the performance of FOCS might not be telling us much other than affirming the market’s conviction that it will continue to grow rapidly through acquisitions.
Looking at the RIA size graph reveals that the mid-size public RIAs ($100-$500B AUM) were the clear winners over the quarter, up nearly 9%. RIAs with $10-$100B in AUM were down nearly 4.0%, while the largest category ($500B+ AUM) was down just over 6%. The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down over 18% during the quarter, although this is the least diversified category of RIAs with only two components. Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost over 18% of their value since July as suggested by this graph.
Market OutlookThe outlook for these businesses is market driven, though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does during the fourth quarter.
Determining the Right Hurdle Rate
How Good is Good Enough?
From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers. If family business directors are going to make good capital allocation decisions, they need to know what the right hurdle rate is. If the hurdle rate is set too low, the family may experience weak future returns. Setting the hurdle rate too high, however, introduces the risk that the family business will pass on attractive investment opportunities. In this post, we consider how the hurdle rate relates to the weighted average cost of capital.Should we set the hurdle rate for capital budgeting equal to the weighted average cost of capital (WACC), or should we set it higher than the WACC?Legendary wag and journalist H.L. Mencken once said that professors must have theories as dogs must have fleas. While a theory-infested business professor likely has a quick answer to the hurdle rate question, the practical answer is not so tidy for a real-life family business director.From a finance textbook perspective, the WACC is the theoretically correct rate to use when evaluating potential capital projects. Family business managers are stewards of capital entrusted to them by the family (and, potentially, lenders). The managers’ task is to allocate that capital to a portfolio of assets that earn returns in excess of the cost of capital. If a proposed capital project promises a return in excess of the cost of capital, taking on the project will increase shareholder wealth, and everyone goes home happy.Yet, many family businesses flout the textbook prescription and use hurdle rates for project evaluation considerably higher than the WACC. This practice is so widespread that it cannot simply be the result of CFOs-to-be falling asleep during capital budgeting class. Why, then, are incremental hurdle rate premiums so common?Why Premium Hurdle Rates Are UsedThere are two primary reasons companies elect to use premium hurdle rates in their capital budgeting analyses. For some companies, doing so is a hedge against potentially inflated cash flow forecasts submitted by overconfident managers. Other companies rely on premium hurdle rates as a capital rationing tool.Hedge Against Potentially Inflated Cash Flow ForecastsAccurately projecting future cash flows is difficult. In addition to the real uncertainties regarding future market and economic conditions, financial projections are subject to a host of cognitive biases that contribute to overconfidence and overly optimistic projections. These cognitive biases are the subject of a good deal of academic research, much of which is summarized entertainingly in Thinking, Fast and Slow by Daniel Kahneman. In sum, these biases are real and ubiquitous, and do not reflect any lack of good faith; they are simply part of the mental baggage of being human. Whether explicitly framed this way or not, setting a hurdle rate at a premium to the WACC acknowledges the likelihood that projections will be too optimistic.Ideally, however, family businesses should work to refine their capital budgeting process so that additional “projection risk” premiums are not necessary. If hurdle rates are set at a premium to the WACC, it is likely that managers’ cognitive biases will simply “recalibrate” to the new, higher, hurdle rate. In other words, a premium hurdle rate may work in the short term, but is ultimately an example of treating the symptoms rather than the disease.Rooting out cognitive biases is not easy, but if done can provide long-term benefits to the company. A first step is to simply raise awareness that such biases are real. When decision makers acknowledge the biases exist and how they work, they can work to consciously overcome them. Another step is adopting a formal program of tracking actual post-investment results for projections. Regularly reviewing prior investment decisions helps managers identify the characteristics of prior decisions (whether they turned out well or poorly). Knowing that the current decision on the table will be subject to review in future periods helps managers think more critically about the risks of a project. Finally, emphasizing return on invested capital (ROIC) as a measure of management performance can help limit overconfidence. ROIC helps corporate managers adopt a shareholder perspective since ongoing performance is judged not just on the basis of future operating results, but also the capital required to support the business. Making managers accountable for the capital committed to a project can contribute to more realistic projections of future results.Serve As a Capital Rationing ToolUnlike the imaginary companies that populate textbooks, real family businesses do not have access to unlimited amounts of capital. Even when there is a large pool of available capital, there may be other resource constraints that impose prudential limits on how many projects the company can undertake during a given period. In the face of capital (or other) constraints, using a premium hurdle rate can help narrow the list of potential capital projects to a manageable number. In other words, there are fewer projects with 12% returns than 8% returns. Using a premium hurdle rate can be a perfectly suitable way to ration scarce capital resources. However, we offer a couple of cautions for this practice. First, if there really are an abundance of capital projects that promise returns in excess of the WACC (which is what capital rationing implies), family business directors may need to investigate ways to alleviate the capital constraints. In the context of the funnel depicted above, finding additional capital (or management, or other resources) would benefit shareholders by limiting the opportunity cost of foregoing attractive investment opportunities. Second, family businesses should be wary of simply substituting a high hurdle rate for developing a clear strategy. For example, assume a company’s cost of capital is 10%. In our experience, a project with an 11% internal rate of return that advances the company’s strategy is preferable to a project which is expected to generate a 16% return, but does not promote the company’s strategy. In other words, a premium hurdle rate cannot replace a coherent strategy. Ultimately, the size of your family business’s capital budget cannot be assessed in isolation, but intersects with other strategic decisions regarding dividend policy and capital structure.ConclusionSo in the end, premium hurdle rates can be effective in taking into account that family businesses do not have the luxury of operating in the neat and tidy world of finance textbooks. However, it is critical that companies electing to use a hurdle rate premium not ignore the effect of cognitive biases on forecasting or the importance of corporate strategy in project selection. Treating the symptoms can be the right course of action in the short run, but family businesses concerned with long-term health should also treat the underlying disease.
How to Value an Oil and Gas Mineral Royalty Interest
Well-informed buyers and sellers are critical to an efficient market for royalty interests because there is a specialized and relatively complex body of knowledge to consider in the transfer of these types of assets.Often called a net revenue interest (NRI), royalty interests do not bear the costs of production and only participate in the potential upside of a resource. The value of a royalty interest, however, is often difficult to observe because they are typically closely held. In addition, once discovered and drilled, the natural resources are physically depleted, resulting in a declining asset as opposed to a growing one.A lack of knowledge regarding the worth of a royalty interest can be very costly. A shrewd buyer may offer a bid far below the interest’s fair market value, opportunities for successful liquidity may be missed, or estate planning could be incorrectly implemented based on misunderstandings about value.Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.This blog post summarizes our whitepaper – providing an informative overview of the valuation of mineral royalty interests within the oil and gas industry. While there are a myriad of factors (mostly out of a royalty holder’s control) impacting the economics of a royalty interest, this blog post focuses on valuation methodology.What Does the Valuation Process Entail?Valuation approaches refer to the basis upon which value is measured.There are three commonly accepted approaches to determining value:Asset-based ApproachMarket ApproachIncome Approach
In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value of a given entity.
Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration. However, due to fundamental structural differences between businesses and assets, the available valuation methodologies tend to be utilized differently when valuing royalty interests. 1The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets. While the asset-based approach can be useful when valuing companies operating within the oil and gas industry, this approach is not typically employed to determine the value of a royalty interest.Oftentimes a mineral royalty owner purchased land which included the mineral rights and an allocation of surface vs mineral rights was not performed. Additionally, considerable time may have passed between the time the surface and mineral rights were purchased and the valuation date. Adding to the ambiguity of the cost basis of the asset, mineral royalty interests are often family assets that are handed down for generations. For this reason, the asset-approach is rarely used to determine the market value of mineral royalty interests unless the mineral rights were recently purchased.The Market ApproachThe market approach utilizes transaction pricing from guideline transaction data or valuation multiples from a group of publically held companies to determine the value of a privately held enterprise or asset. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. This data can be derived from direct transactions of mineral royalty interests or from publically traded royalty trusts and partnerships.Direct comparable transactions of mineral royalty interests are often the best indication of fair market value. However, the data with which to benchmark a subject mineral royalty interest against is often unavailable. If it is available, a careful comparative analysis must be made. Royalty trusts and partnerships hold various mineral royalty interests in wells operated by large exploration and production companies. Royalty trusts and partnerships tend to have very low, if any, operating expenses and can be an investment to provide exposure to oil and gas prices.Acquisition data from these trusts can be utilized to calculate valuation multiples on the subject royalty’s performance measure(s). This will often provide a meaningful indication of value as it takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.Traditional oil and gas earnings multiples, such as EV/ EBITDAX, should not be used to calculate indication of values because royalty trusts do not have high operating costs and operational earnings margins are not a necessarily meaningful indication of performance for a royalty owner. Rather, a royalty trust's performance can be better understood by its distribution yield and potential for future revenue streams from new, undrilled wells.In many ways, this approach goes straight to the heart of value: a mineral royalty is worth what someone is willing to pay for it. However, the market approach is not a perfect method by any means for businesses or for mineral royalties.Royalty trust transaction data may not provide for a direct consideration of specific mineral royalty characteristics; it is imperative that the value conclusion be adjusted for differences in value level and in well economics, potential future drilling locations, among other factors. In any valuation, the more comparable the transactions are, the more meaningful the indication of value will be.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of a cash flow or ongoing earnings figure and the application of a multiple to those earnings based on market returns. For mineral royalty interests, however, we oftentimes perform a discounted cash flow analysis. This approach allows for the consideration of characteristics specific to the subject mineral royalty, such as its well economics making it the most commonly used approach for mineral royalty interest valuations.To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price values. The stream of revenue is then discounted back to present value using a discount rate that accounts for risk in the industry.Because revenue cash flows are the main driver of mineral royalty values, the income approach is the most reasonable and supportable valuation approach when determining the value of a mineral royalty interest.ConclusionA proper valuation of a mineral royalty interest will factor, to varying degrees, the indications of value developed utilizing the market-based and income-based approaches outlined above. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of the mineral royalty and its unique characteristics that provide relevance and credibility to these calculations. This is why industry "rules-of-thumb" are dangerous to rely on in any meaningful transaction.Such "rules-of-thumb" fail to consider the specific characteristics of an interest and, as such, often fail to deliver insightful indications of value. A mineral royalty owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the interest.Mercer Capital's Oil & Gas team has extensive experience valuing mineral royalty interests. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the interest. We hope this information, which admittedly only scratches the surface, helps you better shop for royalty valuation services and understand valuation mechanics.We encourage you to extend your wealth planning dialogue to include valuation of any mineral interests because, sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at (901) 685-2120 or (214) 468-8400.End Note1 Treasury Regulations 1.611-2(d) asserts that the income approach will not be used if the value of a mineral property can be determined using the cost-approach (under the asset approach) or the market approach. However, those circumstances are rare and not consistent with industry norms. The income approach is most often employed to estimate the fair market value of mineral properties such as this.
It’s Not Just Elon: Founder’s Syndrome Depresses the Value of RIAs as Well
About eight months ago, one of Elon Musk’s many business ventures, SpaceX, tested its Falcon Heavy rocket by launching Musk’s own Tesla Roadster into space. It’s now the fastest car in the universe, on a heliocentric orbit around the sun, complete with a mannequin in the driver’s seat named Starman. Given the career challenges he’s faced this year, Musk is probably ready to take the wheel himself.Entrepreneurship is an Investment ThemeInvesting in founder-led companies is a strategy favored by many investment managers, including some of our clients. The logic of the narrative is compelling: founders have interest, drive, and motivation. In our hometown of Memphis, the archetype for this is FedEx. Federal Express was a term paper in business school written by the founder, Fred Smith (who reportedly didn’t get a very good grade on the assignment). Founder-led businesses benefit from unique levels of dedication; Smith once covered Federal Express’s fuel bill with gambling winnings in Las Vegas. He devoted his inheritance and his life to the company and has retained a significant stake in the equity. Smith is now 74 years old and remains involved in the business. While the topic of succession comes up, key executive dependency is a comparatively minor topic when the company employs over 300 thousand people.Not all founders are like Fred Smith, though. While Tesla’s share price has proved remarkably resilient this year, it has had to be in light of the increasingly erratic behavior of founder, chairman, and CEO Elon Musk. From smoking pot in interviews to tweeting inaccurate insider information, Musk has made a mess of his leadership role in 2018 and highlighted the potential downside in founder-led companies.Every Company has FoundersTesla’s story is relevant to the investment management industry not just because many asset managers are invested in Tesla or otherwise invest in founder-led businesses. The Tesla story matters because most investment management firms are also founder-led businesses. The independent broker-dealer industry was born in the 1940s when wealthy investment professionals had to leave their commercial banking jobs because of Glass-Steagall. The majority of that generation of BDs are forgotten now because of consolidation or failed succession plans or both. The advent of ERISA in the 1970s brought about a new wave of money managers who built the RIA industry. The RIA industry is still expanding, despite a recent wave of consolidation.Most RIAs, independent trust companies, and hybrid RIA-BDs today are founder-led. The ones we work with are typically successful, having benefited greatly from the talents of their founders, whether in the discipline of attracting clients, choosing investments, or both. The trouble is that, while companies are usually designed to operate into perpetuity, founders ultimately suffer from mortality. Given the age of the RIA industry, many firms are facing succession issues, and many won’t survive it.When Vision Becomes a Blind SpotIf you’ve never read up on the theme of “founder’s syndrome,” then you’ve missed out on a key narrative that explains the valuation of many investment management firms. Founder’s syndrome is an organizational behavior in which a company is built around the personality of a prominent individual in a company, usually in a senior position, and often the founder himself or herself.Strong personalities can build strong organizations, but sometimes people start companies because they can’t work for anybody else. Can you imagine having Elon Musk as an employee? To the extent that the needs of a founder are made more important than the needs of the business, the business will suffer. If an RIA is a small enterprise that is more of a practice than an organization, this is no problem. In larger investment management firms, however, boards who once promoted the interests of a key professional may find themselves in the position of having to protect the business from that same person. While Bill Gross’s departure from PIMCO is a prime example, it is far from the only example. More often, we see situations where a creeping change in behavior leaves a senior professional with an outsized influence over the strategy of the firm, even when that strategy no longer serves the goals of the firm.If an investment management firm grows because of, rather than in spite of, its founder, then the next challenge arises, succession. Replacing a founder is nearly impossible because a leader in succession is necessarily going to have a different approach to running an organization. Second generation leadership is more likely to be more disciplined, cautious, and risk-averse. The organization itself will probably have to adjust to the second generation of leadership such that the needs of the company match the offerings of the executive.Diagnosing Founder’s SyndromeIf you’re wondering whether or not your RIA is suffering from founder’s syndrome, answer these three questions:Does your RIA, BD, or independent trust company principally exist to serve the psychological needs of your founder (i.e. an all-expenses paid ego trip)?
The willingness of a founder to identify with their business is a key motivator that leads founders to work harder and longer to ensure the success of the enterprise. With success, the business returns the favor, and it’s at that point that the founder has to consciously decide whether their firm is really a business or simply an extension of themselves. This often shows up in compensation plans, when the founder(s) fail to draw a market-based line between their pay as employees and their returns as owners. Since small RIAs are owner-operator businesses, this can be easier said than done. But if the economics of the business are sufficiently segregated, then the founder is more likely to be working for the business, rather than the other way around.Is your founder unable to delegate?
If your RIA’s success or failure rides on the skills, knowledge, and actions of your founder, then growth beyond a certain point will be difficult (if not impossible). Many founders are perfectionists and can’t accept work done differently than they would do it themselves. I once had a founder lead me through the office because he wanted me to meet the many talented people in his firm, only to instruct each one of them very thoroughly in exactly what he wanted them to tell me. Needless to say, if a founder cannot delegate, then the scale of their company will be necessarily limited to their own capacity to work.Is your founder willing to accept new leadership?
Graceful exits are difficult, particularly when your name is on the door. While founders certainly have a role in “letting-go,” transition plans are an organizational responsibility, so boards and other senior executives share in the role of providing for the sustainability of the organization. The one theme I’ve consistently noticed is that transition takes much, much longer than people think it will.
I learned long ago that people are a package deal – you take the good with the bad and you don’t get to pick and choose what parts of a person you accept. Like all founder-led companies, RIAs can benefit from the entrepreneurial zeal of the men and women who started them. Unfortunately, that same appetite for risk-taking can lead to reckless behavior, and the identification of a founder with a namesake enterprise can complicate succession planning. In any event, the risk associated with a founder-led RIA can lead to extreme results: taking advantage of a moon-shot opportunity, or a business that’s lost in space.
What Keeps Family Business Directors Awake at Night?
Mercer Capital provides sophisticated corporate finance services to family businesses throughout the nation. We know that stewarding a multi-generation family business is a privilege that comes with certain responsibilities, and each family business faces a unique set of challenges at any given time. For some, shareholder engagement is not currently an issue, but establishing a workable management accountability program is. For others, dividend policy is easy, while next gen development weighs heavily. Through our family business advisory services practice, we work with successful families facing issues like these every day.Our new book The 12 Questions That Keep Family Business Directors Awake at Night addresses the most common questions and challenges facing family business directors. Since we have striven for brevity—not to mention the fact that we don’t pretend to have all the answers—the chapters help you think through these questions. At the end of each chapter, we offer a list of potential action items to help family business leaders and directors prioritize which issues are most pressing to the long-term health and sustainability of the business. In the book we address:How Do We Promote Positive Shareholder Engagement? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.How Do We Communicate More Effectively with Shareholders? Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders is a common objective for family businesses.Does Our Dividend Policy Fit? Hands down, the most frequent topic of conversation with clients is establishing a dividend policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.To Invest or Not to Invest? The flip-side of dividend policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the target, family business leaders are concerned about identifying and executing investments to support the growth of the family business.Should We Diversify? We find that a striking number of the family businesses diversify rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?Does Father Always Know Best? Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we speak with are eager to develop and implement effective management accountability structures.How Do We Find Our Next Leader? Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business.Is There a Ticking Time Bomb Lurking in Our Family Business? Buy-sell agreements don't matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life's inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.What Is the Family’s Most Valuable Asset? Rising generations are naturally more diffuse than their forebears with regard to geography, interests, skill sets, and desires. Family leaders are interested in identifying appropriate pathways for the next generation to engage, learn, and grow in their contribution to, and impact upon, the family business.What Should We Do About Estate Taxes? Directors are keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.How Should We Respond to an Acquisition Offer? Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. It is important to know how best to evaluate and respond to such offers.Who’s In and Who’s Out? There are many reasons family members may want to sell shares: desire for diversification, major life changes, funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank?
For more on these topics, order a copy of our recently published book, The 12 Questions That Keep Family Business Directors Awake at Night.
Valuation of a Business for Divorce: Overview of Valuation Approaches, Normalizing Adjustments, and Potential Need for Forensics Services
Valuation of a business can be a complex process requiring certified business valuation and forensic accounting professionals.
Bakken Business
Companies that have maintained a presence in the Bakken since the downturn in oil prices are beginning to reap the rewards of their patience. Rising oil prices have begat increases in production, and efficiencies gained in recent years have led to higher margins and increased production. As noted in last week’s post about transaction activity in the region, while the Permian Basin has received much of the attention recently, the Bakken certainly appears to be back in business.Efficient and Engaged OperatorsContinental Resources, Hess Corporation, and Whiting Petroleum Corporation are among the biggest players in the region. Whiting has rebounded with its stock price up 141% in the past twelve months, and their related royalty trust Whiting USA Trust II has also shown improved performance. Speaking of the decline in oil prices, Continental’s CEO Harold Hamm said recently, “We would never have gained the efficiencies that we have today without going through that.” This can be further illustrated by looking at breakeven prices in the Bakken, which have dropped from about $77 in September 2014 to below $39 per barrel in the third quarter of 2018, lower than those seen in Texas.Greg Hill, President and COO of Hess, recently emphasized the importance of the Bakken in their portfolio, saying about 43% of Hess’ capex budget would be devoted to the region over the next three years, targeting $1 billion annually. He added that production constraints seen now in the Permian are very similar to those seen in the Bakken a few years ago.Infrastructure IssuesThe United States has long trailed other countries in terms of energy production. With the leaps and bounds made in production, the question for industry executives and investors alike is now what? Increased production has led to the need for better infrastructure, a problem currently besetting the Permian basin in particular. Extreme pricing differentials have occurred and plenty of natural gas coming off as a byproduct of oil production is being flared as a result.About 388 million cubic feet per day of natural gas was flared in June in North Dakota. Kinder Morgan, one of the largest energy infrastructure companies has proposed a $30 million natural gas pipeline that would alleviate 130 million cubic feet per day, with the project slated to begin construction mid-2019 and be finished by year-end, pending regulatory approval. Pipelines have been cast by industry executives as a safer alternative to rail transportation, though critics view this as a straw man argument. With the introduction of the Dakota Access pipeline (DAPL) in mid-2017, about half of the region's production (470,000 barrels per day of crude oil) will travel by this pipeline. Despite the DAPL and other pipelines like the one proposed by Kinder Morgan, rail travel will still figure heavily into the equation as refiners on the East and West coast have low pipeline connectivity and much of the oil from other regions ends up with one of the numerous refiners in the Gulf of Mexico.The Minneapolis Fed recently outlined five other projects aimed at increasing gas processing capacity, including a $100 million expansion of a natural gas processing plant near Killdeer, ND. While companies seek high levels of production to take advantage of higher oil prices, these infrastructure constraints have a negative impact. Hamm emphasized this point saying, “Instead of just producing oil, we’re going to make sure we produce shareholder return.”Rig Counts and ProductionAccording to Baker Hughes, rig counts in North America declined 1.0% in the last three months, but increased 11.4% over the last twelve months. The Permian Basin has led the way with an increase of 26.2% in the past year, leading them to have 46.5% of total rigs. Rig counts peaked in the Bakken in May 2018, reaching heights unseen since 2015, but the Bakken continues to trail the Eagle Ford, Permian, and Appalachia regions. While rig counts aren’t ballooning in Bakken, this may be because operators like Continental are focusing on completing wells that have already been drilled (“DUCs”), a cheaper alternative to drilling new ones.Although oil production in the Bakken has increased 9.9% in the past year, it lagged the other four regions covered with the Permian setting the pace with a 26.6% increase. Natural gas production in the Bakken increased 17.2% in that same time, again trailing the Permian’s growth of 25.5%. Given the Bakken only produces a little over a third as much crude oil and a fifth of the natural gas, it will be interesting to see if the Permian can maintain its torrid pace or if capacity constraints will allow others to close the gap.Valuation ImplicationsBefore the crash in oil prices, the Bakken was booming with the highest EV/production multiples, also known as price per flowing barrel. The Permian took center stage in 2017, but the Bakken is closing that gap as the Permian has come back to the pack a bit in 2018.ConclusionA rising tide raises all boats, and a rising oil price raises production in all regions. With the efficiencies gained, operators and investors in the Bakken and elsewhere will seek higher revenue and higher returns. Soaring production has led to unintended consequences such as flaring and inadequate infrastructure constraining capacity. Increasing this capacity will allow E&P Companies to increase returns and continue to ramp up production.We have assisted many clients with various valuation needs in the upstream oil and gas space in both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.
WHITEPAPER | The Role of Earn-outs in RIA Transactions
Earn-outs are as common to investment management firm transactions as they are misunderstood. Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants.Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction.This whitepaper is not offered as transaction advice or a legal primer on contingent consideration.The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry.Instead, we offer this whitepaper to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.
The Role of Earn-outs in Asset Management M&A
Earn-outs are as common to investment management firm transactions as they are misunderstood.Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry M&A participants. Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction.This whitepaper is not offered as transaction advice or a legal primer on contingent consideration. The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry. Instead, we offer this to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Download your copy of the whitepaper below.WHITEPAPERThe Role of Earn-outs in Asset Management M&ADownload Whitepaper
Launching the Family Business Director Blog
Corporate Finance & Planning Insights for Multi-Generational Family Businesses
This is the inaugural post for our Family Business Director blog. By way of introduction, we thought we would anticipate a few questions that you might have.Who Are You Writing this Blog for?We are writing this blog for directors of family businesses. Family business directors face a unique set of challenges: the strategic and long-term decisions that fall to any corporate director are overlaid with often complex family dynamics.Directors need to acknowledge the diversity of shareholder needs and preferences.For public company directors, shareholders are a nameless, faceless group of individuals and institutions “out there,” each of whom can come and go at their leisure. By contrast, family business directors bear a fiduciary responsibility to a finite group of siblings, aunts, uncles, cousins, and other kin, with whom they are likely to have some form of ongoing relationship outside of the family business. These very specific shareholders are likely to have very specific preferences and perspectives on the family business. Even non-family, or independent, directors will find that family dynamics intrude upon their decision-making. We suspect the pressures and challenges associated with sitting at the intersection of business and family are under-appreciated.What Will You Be Writing About?Owning a successful business can serve as the “glue” that holds a family together across generations and different branches of the family tree. Unfortunately, it can also be a source of contention, strife, and hostility. Within just a couple generations, it is not uncommon for economic interests and preferences among family members to diverge. If family harmony is a good worth pursuing – and we think it is – directors need to acknowledge this diversity of shareholder needs and preferences.Dividend policy touches on the core of what the family business “means” to the family.Dividend PolicyIn our experience, the most consequential decisions that family business directors make relate to dividend policy. But dividend policy for family businesses is never just about dividends. Dividend policy touches on the core of what the family business “means” to the family. Does your family business exist to grow, keeping up with the growth of your family as generations multiply through time? Or, does your family business exist to provide financial independence to current family members through substantial dividends?Capital AllocationDividend policy decisions are not made in a vacuum. If the quarterly dividend check is the picture that gets shareholder attention, corporate reinvestment is the negative image of that picture. Cash that is paid to family shareholders as dividends cannot be reinvested to grow the business, while cash reinvested in the business for future growth cannot be distributed to family shareholders. So, every decision about dividend policy is necessarily, and always, also a decision about corporate reinvestment. We refer to this as capital allocation.Capital StructureCapital structure is the release value when there are tensions between dividend policy and capital allocation. Family business directors are responsible for deciding how to finance the portfolio of assets that is the family business.Dividend policy, capital allocation, and capital structure are so inter-related that disagreement about any of them is really disagreement about all of them. Every post we write will aim to help family business directors think about these fundamental corporate finance decisions in a fresh light, and apply these insights to their unique circumstances to enhance the sustainability of their family business and preserve family harmony.
For more on these topics, check out our recently published book, The 12 Questions That Keep Family Business Directors Awake at Night.
Who Are You?We are Mercer Capital, a boutique financial advisory firm with offices in Memphis, Dallas, and Nashville. We have been working with multi-generation family businesses since 1982. After 36+ years and 11,000+ client engagements, there aren’t too many family business situations our senior professionals haven’t seen. In addition to consulting with family businesses regarding dividend policy, capital allocation, and capital structure, we provide independent valuation opinions, transaction advisory services, and litigation support services.How Do You Help Family Business Directors?We help family business directors make better dividend policy decisions based on the unique circumstances and needs of your family and business. We do this through the following services:Customized board consulting. We help you and your fellow directors understand the implications of the decisions you are called upon to make. We work with you to frame the decision to promote better outcomes, and help you formulate the relevant questions that need to be addressed and answered during board deliberations concerning your dividend policy, capital allocation, and capital structure decisions.Management consulting. We work with family business management teams to assess hurdle rates, develop sustainable capital budgeting processes, and evaluate potential acquisitions & divestitures.Independent valuation opinions. We provide independent, unbiased, and reliable valuation opinions for gift & estate tax planning, buy-sell agreements, and shareholder liquidity programs.Transaction advisory services. We help family business directors respond to acquisition offers, evaluate strategic alternatives, provide fairness and solvency opinions, and manage the marketing and sale of family businesses.Confidential shareholder surveys. By designing, administering, and summarizing the results of a confidential shareholder survey, we solicit relevant and timely shareholder feedback so you and your fellow directors can make fully-informed decisions in light of the preferences and risk tolerances of your family shareholders.Benchmarking / business intelligence. We turn available financial data from publicly-traded peers and other sources into relevant information that helps you and your fellow directors make better corporate finance decisions.Shareholder engagement. If your family business is to function as a source of unity rather than division, your family shareholders need to be positively engaged with the business. We help you do this by developing and providing customized financial education for your family shareholders. We present at family council meetings, shareholder meetings, and other gatherings on a wide variety of topics ranging from how to read your company’s financial statements to primers on the weighted average cost of capital, return on invested capital, and other topics.Shareholder communication support. Poor communication is the most common cause of family shareholder angst. We help family business directors identify the appropriate frequency, format, and content of financial reporting to shareholders. Making financial results accessible, understandable, and relevant to family shareholders is essential to achieving and preserving family harmony.
Thanks for trying us out. We’ve got lots of content that we are excited to share with you over the coming months and we look forward to getting to know you better. If you like what you see, please refer us to your fellow directors. It’s easy to sign up for weekly delivery straight to your inbox.
M&A in the Bakken
Under the Radar
Over the past year, followers of the oil and gas industry have taken note of the multitude of transactions occurring in the Permian Basin with large deal values and hefty multiples. But the price differential between WTI and other benchmarks has grown over the last few months, and some attention has moved from the Permian to other domestic shale plays. The activity in other regions such as the Bakken was at one point slow (when compared to the Permian) causing the recent increase in production and the swapping of acreage to fly under the radar while many were focused on Texas.Transaction activity in the Bakken in 2017 marked the departure of a number of companies that were active in the play, such as Halcon Resources. At the end of 2017 and into 2018, the exodus from the Bakken to the Permian continued. Recently, the Bakken is being viewed as another viable option to the Permian Basin, which has seen a growing price differential due to insufficient infrastructure. This, and rising oil prices, has resulted in an increase in production in the region, leading to more transaction activity and inflows of capital.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics are shown below.Overall, the average deal size has decreased from twelve months ago when companies sold off large bundles of assets to clean up their balance sheets and survive in the low oil price environment. While deals today may be smaller in size, they are more strategic in nature.Whiting Acquires 65,000 Acres from OasisOne of the largest deals in the region over the last twelve months was Whiting Petroleum Corp. purchase of 65,000 acres from Oasis Petroleum Inc. in June for $283 million. A Seeking Alpha contributor noted that this transaction is a “case of one company believing that it can achieve better results in an area that the other company considered lower quality acreage.” This is observed in Oasis’ acceptance of a lower than average transaction price per acre, and Whiting’s willingness to pay an above average price flowing barrel.US Energy Acquires 1,600 Acres from APEGOne of the smaller deals was US Energy Corp.’s acquisition of 1,600 acres from APEG Energy LP (a related party) for $18 million. US Energy and APEG Energy II, LP announced a strategic partnership in October of 2017 in a deleveraging transaction. APEG Energy II is one of Angelus Capital’s (a private equity firm headquartered in Austin, Texas) funds focused on acquiring domestic oil and gas assets. Since then, US Energy has focused on cleaning up its balance sheet to focus on producing oil assets. Recently, US Energy has been working to add assets that will immediately increase production in the Williston Basin and South Texas.US Energy expects their most recent transaction “will create additional opportunities for development and acreage swaps that would permit the company to continue consolidating its leasehold position in the area.” US Energy paid $44,500 per flowing barrel, which is in line with average production multiples paid in the region but is somewhat lower than those observed last year. Deal values last year may have been based on the expectation that production would increase in the future, inflating current multiples. Now that production has picked back up in the Bakken, deal multiples appear to have normalized somewhat.Observed M&A Trends in the BakkenThe following are two good examples of transactions we are seeing in the region this year:Strategic Deals Between Regional OperatorsOne of the disadvantages of the Bakken, as compared to the Permian, is that it is an older play and many of its sweetest spots have already been drilled. However, age is often equated with wisdom, and the significant experience of operators who have been in this region since the early 2000s gives them a competitive edge. As Senior Beck, a senior director at Statas Advisors explained, “The Bakken’s maturity and production characteristics could lead to a growth in consolidation over the next few years.”Acquisitions of Property by Non-OperatorsAdditionally, the prominence of activity of non-operators in the Bakken has increased. Private equity funds like Angelus Capital, single-family offices, and other providers of capital that see an opportunity in the Bakken are buying acreage and partnering with the best operators in order to realize superior returns on investment.Combining these trends, Northern Oil and Gas Inc. is a non-operator who aims to be the Bakken’s “natural consolidator.” In July it completed its largest acquisition yet of 10,600 net acres for $100 million cash plus approximately $190 million of Northern Oil stock. Northern Oil is relying upon the superior abilities of longtime regional operators and the trend towards consolidation. However, it is also an example of a non-operator who has become more prominent in the last year.The Bakken may have gone unnoticed for a couple years after the downturn in oil prices in 2014, but it may be rising back to prominence as increases in efficiency and cost reductions impress investors.We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.
Staffing for Value
With last week’s release of the 2018 InvestmentNews Compensation & Staffing Study, trends in pay and performance expectations are making the rounds in the RIA community. Even though we are a valuation firm, we are often asked to weigh in on compensation matters, as officer pay and firm value are typically intertwined. A few months ago, a client who reads our blog regularly sent me a photograph of his first car, a 1957 Chevy Handyman. The Handyman was a two-door version of Chevrolet’s station wagon series with less chrome and a powertrain oriented more to utility than the better known Chevy Nomad series. Because most Handymans were not well cared for (they were fleet vehicles that served manual laborers), examples like the one our client owned could be bought cheap. And because it was cheap, a teenager growing up on the West Coast, such as our client, had no qualms about using it to haul surfboards and damp surfers back and forth to the beach. Unfortunately, what can be bought cheap is often sold cheaper, and such was the fate of this particular Handyman. Today, a Handyman in prime condition is rare, and that which is rare, and sought after, appreciates.Stories like this drive the collector car market, and you can watch the appreciation curve on certain models mature as the demand created by nostalgia for first cars or dream cars meets the supply of accumulated wealth that comes later in life. Muscle cars from the 1960s have shot up in value over the past ten years because collectors who were teenagers in the 1960s have reached the peak of their careers, put their kids through college, amortized their mortgage, and can finally afford to buy back part of their youth at an auto auction. Professionals who follow the collector car market consider the price trends to be fairly predictable based on demographics.In the RIA community, regardless of firm size or type, there is a predictable relationship between staffing decisions (positions, expectations, compensation, etc.) and firm performance. It’s a well-worn phrase that the assets of professional service firms get on the elevator and go home each night, but that doesn’t tell the story of the value of the firm, which is not merely the assemblage of assets, but rather the organization, orientation, and utilization of those assets for a common purpose: serving client needs.Staffing Your ModelWe think compensation surveys offer interesting data, but that data needs to be filtered carefully to provide useful information. No two RIA business models are exactly alike, and staffing needs and compensation requirements of one model do not necessarily translate into another model. So while the averages of reported data are interesting, they have to be put into context to be meaningful.Some RIA models, for example, are highly vertical, focused on supporting the talents of one or two individuals at the top of the firm. In such a situation, compensation might be expected to be very top-heavy, as most employees of the firm serve to leverage firm leadership. This is common for niche asset management firms. Firms with a more horizontal orientation (lots of rainmakers contributing to the revenue stream) are inherently more sustainable, with less dependence on any one individual and an easier system to bring junior talent along into senior positions. Wealth management firms tend to exhibit this horizontal organization – at least most of the time. Aggregate compensation expense and margin can vary in both vertical and horizontal structures. It’s more important to know the “why” of your compensation structure than the “what.”Staffing for MarginMargins can be tricky to interpret. Too low and the viability of the firm is threatened by market downturns. Too high and the firm is vulnerable to market forces bidding away talent or bidding down fees. Since the key variable in firm profitability is compensation, it’s a good idea to keep an eye on your margins relative to market and your aggregate compensation expense relative to market. Most firms aren’t “average,” so there’s no expectation that you would be either. But the average is a benchmark to measure against, and if you can articulate why your margins and compensation costs are different than market averages, you’ll have a better handle on managing those numbers through different economic environments.Staffing for GrowthIn one sense, investment management firms are simply collections of people – and those firms can’t grow any faster than the people who compose the firms. Brent Brodeski published a useful article in Financial Planning a few months ago talking about the tradeoff between current profitability and growth. The message, which is worth reiterating, is that growth isn’t free. A common myth in the RIA industry is that, at a given scale, an upward trending market provides a tailwind that carries firms along whether they intentionally focus on growth or not. The problem is that RIA staff do not live forever, and without investing in subsequent generations of leadership and subsequent generations of clients, every firm will quietly begin to wind-down regardless of the market.Staffing for SustainabilityRIAs are business models that can, if managed thoughtfully, survive most any change in the business climate or market dynamic. Our oldest client firm dates to the 1940s, and during their 75-year history, they’ve experienced several changes in control ownership, client focus, and portfolio expertise. Adaptability is integral to sustainability. That said, having a staff that is motivated to adapt – not just be capable of it – helps provide for the firm’s needs as they change. A firm with 5% client turnover is a brand new firm every twenty years. Are you prepared to start over during the course of the next two decades? This is another place where benchmarking is useful as a reference rather than a rule. With many studies reporting that the average age of financial advisors now tops 50, does the average age of client-facing staff in your office suggest you are building the future firm or simply cashing in on what you built previously? This applies to your staff as a whole and to senior staff needs in particular. What would it cost to recruit a younger version of you today? Have you hired that person?Staffing for ValueWe often say that investment management is not a capital-intensive business, but the capital investment in a typical RIA is in human capital. Technology offers the promise of some relief, assuming regulatory requirements don’t consume those efficiencies over time. Most RIAs could operate at a higher margin than they report, but doing so would require understaffing – either in the number of employees or quality of employees – such that the clients of tomorrow aren’t being recruited, nor is the talent to service those clients being developed. Absent reinvestment in human capital, an RIA becomes a depreciating asset which, unlike collector cars, isn’t likely to evoke nostalgic interest years later.The one that got away
Beach Reading: Notice of Proposed Rulemaking – Qualified Business Income Deduction
Struggling to find a page-turning read for that late summer beach escape?May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA).Like a tightly wound murder mystery, the regulations weave a complex web.Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses.As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.1The Abridged Version of the NPR in One SentenceBank shareholders are eligible for the 20% Qualified Business Income deduction.2 Intrigued?If so, the story continues.PrologueBefore examining the NPR, several tax-related trends are evident in 2018 regulatory filings.Effective tax rates are fallingMore banks are converting from S corporations to C corporationsSecurities portfolio allocations are evolvingDespite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018.Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs.Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.Table 2 indicates conversion activity from C corporation to S corporation status.Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period.Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations.Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes.However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse.As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.Third, tax reform may influence banks’ investment portfolio positioning.While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies.Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018.This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.RefresherInternal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations.If only tax code provisions could be described in one sentence, though.The deduction may be taken against income generated by a Qualified Trade or Business (QTB).A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction.Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not.The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.Other IssuesWhile banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.Qualified Trade or Business DefinitionAn entity must be a Qualified Trade or Business to receive the 20% QBI deduction.From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.”While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition.Unfortunately for taxpayers, the NPR adopts the Section 162 definition.While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague.One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction.For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements.From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.The TCJA’s Definition of an SSTBEntities providing professional services generally are deemed SSTBs.The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets).Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB?Under the TCJA, it was unclear.The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset.This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB.This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.The “Crack and Pack” StrategyCommentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs.For example, consider a law firm that owns a building in which it operates.The law firm is an SSTB and its partners ineligible for the 20% deduction.The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB.Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).Alas, the IRS cracked down on the “crack and pack” strategy.The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction.However, the NPR may not entirely foreclose on all planning strategies.While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership.Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group.Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings.To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.ConclusionLike a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible.Perhaps a sequel to the NPR is in order.Originally published in Bank Watch, August 2018.1As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances. 2 To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018 NPR confirms this eligibility.
M&A Activity in the Oilfield Service Sector
From Surviving to Thriving
The oilfield service sector has recovered significantly since the crash in oil prices in mid-2014. As capex budgets have expanded, especially in the Permian Basin, demand for oilfield services such as drilling and pumping has increased. But what does this mean for transaction activity in the sector?The oilfield service industry was in consolidation mode over the last few years as smaller servicers struggled to survive in the low oil price environment which translated to lower day rates. Thus the relatively fewer transactions from 2015 through much of 2017 were mainly distressed sales.Now that oil prices have recovered, drilling activity has picked up, and day rates have increased, the reason for deals has changed. Rather than merging to survive, companies are acquiring in order to thrive. When discussing transactions in oilfield services sector over the past few years, maybe it should be called mergers THEN acquisitions.From Mid-2014 to Mid-2017 Oilfield Servicers Were SurvivingWhen oil prices fell, demand for oilfield services declined significantly. Despite the steep drop in prices, production did not fall through the floor because the cost of stopping and starting production can outweigh the loss incurred from lower oil prices. Still, the oilfield services sector felt the pain as many of its high value-added services occur at new sites rather than currently producing ones. With low oil prices, people became more judicious with how they deployed capital and new projects were largely tabled. Companies in financial duress were forced out of the market through consolidations and bankruptcy, as other sources of capital such as debt or additional equity offerings dried up due to the uncertainty surrounding future oil prices.M&A activity for the oilfield services sector was largely muted during the downturn in terms of both deal volume and value. Deal value would have been larger had Halliburton Company successfully completed its megamerger with its competitor Baker Hughes Inc. for an announced $34.6 billion. Instead of searching for synergies to boost revenue, companies were seeking to combine to eliminate duplicative expenses. In the case of Halliburton and Baker Hughes, the merger was expected to cut nearly $2 billion in annual costs according to the investor material seen below. Ultimately, this became the downfall of the deal as regulators denied it on grounds of decreased competition and reduced innovation on account of too much overlap in services.
One year after the U.S. Justice Department blocked the deal due to anti-trust laws, General Electric bought a controlling interest (62.5%) in Baker Hughes. The combined entity resulting from GE’s investment caused GE’s combined revenue to surpass Halliburton, becoming the second largest company by revenue in the industry, trailing only Schlumberger.
In early 2017, streamlining operations and eliminating expenses via consolidations was viewed as “the last big step to margin improvement,” according to the Coker Palmer Institutional. By the end of the year, there were 215 transactions in 2017, up 13% from 2016. As the tide began to turn, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings, particularly in digital technology.
Oilfield Servicers Are Now ThrivingAs oil prices have recovered, up to $60 a barrel at the end of 2017 and peaking at $72 in May 2018, transaction activity has increased, but the reason for this increase in activity has changed. Companies that survived the downturn in oil prices stood to gain as rising oil prices aided margins and increased capex budgets for E&P companies. As break even prices became less of a concern for the industry, growth and innovation became the focus. Oilfield services companies depend on innovation to distinguish themselves in a highly fragmented industry, and when prices caused capital to flow out of the industry, companies were unable to fund the research and development necessary to innovate. Now, that trend is reversing with funding flowing into the sector to support growth and innovation. This is particularly important due to the capital-intensive nature of oilfield services, requiring significant investment to buy more equipment to meet growing demand.The following table shows some strategic transactions that have occurred thus far in 2018, as companies seek growth opportunities. However, we are starting to see more investment from other sources.Private Equity Firms Are Suppling Growth CapitalAfter years of industry executives searching for diamonds in the rough, institutional investors have joined the fray. Over the last twelve months, there has been an influx of funds from private equity firms and hedge funds as growth, innovation, and fragmentation are all desirable traits for these investors.In March, Morgan Stanley Energy Partners (MSEP), the energy-focused private equity arm of Morgan Stanley Investment Management, completed an investment in Specialized Desanders, Inc. a Canadian-based oilfield equipment company that specializes in efficiently removing sands and other solids during the well flowback and production process. MSEP’s investment seeks to accelerate growth in the U.S. market and expand their product offerings.In August, MSEP continued investing with its announcement of a partnership with Catalyst Energy Services. Proceeds from the investment will be used to buy state-of-the-art equipment which will allow the company to grow to meet increased demands for modern completion designs from E&P companies.Black Bay Energy Capital recently closed its inaugural fund with commitments of $224 million, exceeding their $200 million target. This includes six investments in oilfield service companies exhibiting rapid growth that “improve the efficiency and cost-profile of oil & gas producers.”These investments made by MSEP and Black Bay show the three trends currently being exhibited in transactions in the oilfield services sector: niche product or specialty, innovative offering or technology, and growth. Whether it be strategic investors or private equity sponsors, acquisitions we are seeing now are largely spurring revenue growth instead of eliminating expenses.ConclusionTransaction volume in the oilfield services sector ebbed and flowed with oil prices over the last few years. On the way down, companies cut costs to survive, and mergers played an important role in increasing efficiencies in order to survive. On the way back up, companies sought capital to propel growth and fund innovation. As the market shifts from backwardation to contango and back again, Mercer Capital is here to help throughout all stages and economic environments.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.
Will Direct Indexing Become the Next ETF?
Since their launch in 1993, exchange traded funds (ETFs) have steadily attracted assets from mutual funds and active managers that have struggled to compete on the basis of performance and overall tax efficiency. Now many industry observers believe that the same may very well happen to ETFs with the recent rise of direct index investing (DII). For this week’s post, we look into the pros and cons of DII and the implications for the investment management industry.
Exchange traded funds took market share from mutual funds because most active managers do not deliver on their value proposition. That is, most active managers underperform their relevant benchmark after fees. ETFs, by their very design, cannot underperform the index they track (ignoring tracking error, which is usually negligible) and are usually quite inexpensive. ETFs gained traction with this obvious advantage and have dominated asset flows over the last decade.
After years of domination, ETFs appear to have a worthy contender in the form of DII. Both are intended to be a form of passive investing designed to track a certain index. The key distinction between the two is that a direct indexing investor actually owns the index’s underlying shares in a separately managed account, as opposed to units in a fund that track the index. Since owning all the stocks in, say, the S&P 500 or Wilshire 5000 (and in proportion to their market weighting) is not feasible for most investors, DII portfolios are usually comprised of a representative sample of securities that should mimic the index’s performance over time.
Advantages and DrawbacksThis design creates certain advantages and disadvantages to direct indexing versus ETF investing. By only investing in a subset of a given index, DII can achieve alpha, unlike passive ETFs. Of course, direct indexing can also underperform a benchmark, and depending on the sample size, can expose investors to idiosyncratic risk factors that ETFs minimize or eliminate through diversification. DII is therefore not a purely passive investment vehicle, and advisors should make their clients aware of this fact.Just as ETFs are considered more tax efficient than mutual funds, DII has certain tax advantages over ETF investing. Since direct indexers are investing in the underlying shares as opposed to a fund that holds the underlying shares, they can harvest losses when some of these securities decline in value. DII also allows investors to avoid selling the top gainers, while ETF sales effectively involve selling every share of the underlying index pro rata. Over time, such efficiencies can lead to considerable tax alpha relative to ETF and mutual fund strategies.Direct indexers can also tailor their portfolios to their unique circumstances better than an “off the shelf” ETF. DII can selectively avoid certain sectors of the economy or pursue businesses with higher governance standards. Such customization can be highly beneficial to investors with significant portfolio concentrations or ESG mandates.Liquidity is also a concern with ETF investing. The rising popularity of ETF products has caused distortions in the market when their daily volume exceeds that of their underlying securities. This disparity can be exacerbated during sell-offs. On August 24, 2015, a sharp decline in the overseas markets led to trading halts in eight S&P 500 stocks, which precipitated a “liquidity traffic jam” for 42% of all U.S. equity ETFs. In one example, shares of the Vanguard Consumer Staples ETF (VDC) fell over 30% while the underlying holdings only dropped 9%.Still, DII is often more costly and time-consuming than ETF investing. Picking representative securities and building customized portfolios can require considerable resources that are not needed for ETF investing. Trading costs are also higher, albeit at a diminishing rate with advances in rebalancing automation and fractional share investing. Monitoring costs can also be greater, especially for portfolios seeking to minimize tracking error.Weigh Your OptionsOn balance, DII is not for everyone. It probably does not make sense for smaller accounts with no diversification issues to pursue such a potentially costly investment strategy. ETFs and robo-advisors are probably better suited for many retail investors, including the mass affluent.For high net worth clients with significant concentrations and/or ESG needs, on the other hand, direct indexing is likely the superior option. ETF products and robo-advisory firms are simply not equipped to provide the specialized level of services that DII can accommodate for these investors. This void creates opportunities for wealth management firms and their advisors. RIAs providing comprehensive wealth management services can tout direct indexing as a tax-efficient investment strategy that can be tailored to a client’s particular situation.This may sound familiar. Wealth management firms have been providing these kinds of services well before the invention of ETFs. The difference is that now, with advances in technology and lower transaction costs, these kinds of services can be profitably offered to most high net worth families and not just the ultra-wealthy. Given the growing number of high net worth investors and rising demand for personalized investment solutions, direct indexing should be a boon for the wealth management industry as these trends continue to play out.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Middle Market Transaction Update First Quarter 2018
Transaction volume continued at a reduced pace during 2017 – with most market commentators contributing this diminished activity to business owners “waiting” for the impact of the business-friendly tax and regulatory reforms that had been promised by the Trump Administration.
Fidelity Wins the Race to the Bottom
Is Free the New Cheap?
Question: How many CFA charter holders does it take to change a light bulb? Answer: When you ask “how many,” are you asking for the mean, median, mode, a rolling average, variance or semi-variance to a certain population sample...?Paralysis by analysis often seems like a viable career track in finance, especially when it comes to product development. Even here, though, history offers a pattern of what to expect. Product development usually follows one of two paths in investment management: greater innovation or lower pricing. The former of these is a margin builder, while the latter can be a margin killer. After watching the price of trading drop for decades, it wasn’t so surprising when J.P. Morgan announced that it would offer free online trading for certain investors last month, but when $2.5 trillion manager Fidelity Investments announced they were going to be offering two “free” index funds, the industry rocked on its heels. Is this the next leg down for pricing of investment management, a publicity stunt by Fidelity, or something else altogether?Relating this, as I am wont to do, to historical events in the automotive history, I’m reminded of the down-market product disaster that Aston Martin attempted a few years back, the Cygnet. In 2011, faced with looming and more stringent EU emissions standards, Aston Martin decided the only way to comply was to market a high-volume, high-mileage micro-car that would average out with the automaker’s low-volume, low-mileage GTs. Developing an all-new car is prohibitively expensive, though, so a committee at Aston decided to license an existing eco-platform, the Toyota IQ, dress it up with leather and fancy badges, and sell it as a premium economy car. This offspring was priced at about a third of the MSRP of Aston’s other cars, but it was still three times as much as a Toyota IQ. So, was it an insanely cheap Aston Martin, or a ridiculously expensive Toyota? When Aston Martin launched the Cygnet (a name which accommodated an “ugly-duckling” appearance by suggesting it was the adolescent version of the company’s beautiful models like the DB9), their CEO stood on a mountain of product research on brand extension and projected annual sales of 4,000 units in the UK alone. Instead, Brits bought fewer than 300 baby swans over two years before Aston Martin gave up.The big asset gatherers like Fidelity, Charles Schwab, Vanguard, and Blackstone have been creating high volume, low price investment products at an increasingly prodigious rate for years. With many index products already available at ten basis points or less, the trip to zero was a short one for Fidelity and likely one they expect to recoup in other products and services once the client relationship is secured and the assets are in-house.Fidelity’s move was meant to look revolutionary, but it’s really revolutionary, and I don’t think it says much about where the investment management industry is going. Look no further than the progress of the robo-advisory business. I was an early subscriber to Financial Engines’s portfolio evaluation tools, but frankly lost interest in quarterly model analysis and dropped out after a couple of years. In the first ever “Robo Ranking” by Backend Benchmarking, the top-ranked robo-advisor is Vanguard’s Personal Advisor, mainly on the strength of its human advisor services that come with the algorithm in a competitively priced package. The lowest ranking robos scored poorly, in part, because of the lack of access to advisors.The ongoing theme of the repricing of investment management is that if value can be articulated and justified, reasonable fees can be charged. There is also ample evidence that human relationships are still highly valued in the RIA space. So while investment management products are subject to a high degree of price scrutiny and competition, investment management services are largely unaffected. It’s more likely that the fees available for investment management are being reallocated, rather than being diminished in aggregate. Time will tell.In short, I don’t know if the no-cost Fidelity products are going to go the way of the Cygnet, but I don’t think this is a Black Swan event either.
Oilfield Service Valuations
Missing The Party Or Just Fashionably Late?
Latecomers are inevitable at parties. They skulk in at the end, missing out on most of the fun, food and games that everyone else has been enjoying. Yet, savvy socialites aim to arrive fashionably late, after the labor of getting the party going but still in time to enjoy the night.When it comes to valuations, are oilfield servicers late to the proverbial oil patch valuation gala or just in time to enjoy the recovery?Energy Sector Performance ImprovingSince oil prices fell off a cliff in the summer of 2014, most other energy sectors have been climbing back in various phases of recovery:E&P company valuations are recovering as companies have benefited from increases in production, escalating acreage values, lower breakeven prices and a recuperating oil price. This is especially true in the Permian Basin. In fact, activity and production in West Texas is growing so fast that existing pipelines and infrastructure struggle to keep up.Meanwhile, US refiners, feasting on the spread between Brent and WTI, continue to see valuation gains as well. Refineries are busting at the seams, with current utilizations over 98%, and acquisitions abound. Refinery performance appears sustainable for the short to intermediate term, but in the long run, capacity may be a limiting factor.Even midstream and pipeline valuations, after taking a beating through the end of 2015, are recovering nicely. The current West Texas hydrocarbon traffic jam presents a growth opportunity for this sector.Past Oilfield Service Performance Oilfield service providers, drillers, pumpers and equipment providers enabled E&P companies to make impressive efficiency leaps. So, where do they stand today? One lens through which to view things is the OSX index–a popular metric to track sector performance.
Since mid-2014, the OSX index does not exactly portray an inspiring comeback by oilfield service companies. In fact, looking at the index alone might lead one to think oilfield servicers have not even received an invitation to this reputed party, much less arrived.
Earnings sunk in 2015 and bottomed out in 2016 as a result of producers cutting drilling and completion costs. Balance sheets went through significant write downs, impairments and asset sales. Not surprisingly, bankruptcies for the sector peaked in 2016 with 72 oilfield service companies filing for bankruptcy, up from 39 the year prior.
It was a mess, to say the least. Oh, but how things have changed in the past two years.
Current Oilfield Service Performance Higher oil prices, coupled with lower breakeven costs for producers, are making drillers, completers and a host of other servicers busier than a gopher on a golf course. Capex budgets for E&P companies, known as lead indicators for drillers and contractors, have taken off. While dormant for decades, proven drilling locations (PUDs) now multiply in light of new fracking technologies and their resultant economics. Drilling and completion budgets are not only growing for operators, but an increasing percentage of those budgets are being spent in West Texas.Utilization Rates and Day RatesSpecifically, as it pertains to oilfield service companies, two key metrics, utilization rates and day rates, have begun to align in a way not seen since 2014.By the end of 2017, utilization rates for certain rigs averaged around 80%, or almost fully utilized considering necessary downtime and transition from one drilling location to another. However, things are currently so hot that utilization rates have now risen to over 90%.Day rates, the measure of how much a servicer can charge an operator for every day the rig is operating, have been slower to increase. Increases in day rates started to move upward in the last six months or so. Estimates suggest that day rates will notch up 10-15% by the end of 2018. This is good news for oilfield servicers.Valuation TurnaroundNow that utilization rates and day rates are both trending upward, valuations should logically respond and by certain aspects, they are.Take, for example, a selection of guideline company groups: onshore drillers and pressure pumpers (fracking companies). One way to observe the degree of relative value changes is to look at enterprise value (sans cash) relative to total book value of net invested capital (debt and equity) held by the company or “BVIC”. Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm, which for drillers and pumpers is a notable threshold.
While 2016 was an anomaly (due to the significant balance sheet changes mentioned above), the rest of the time frame shows a clear trend. In 2015, with a multiple below 1.0x, investors didn’t expect to get an adequate return on the capital deployed at these companies. However, as 2017 came to a close and now moving into mid-2018, that trend has reversed. All except Parker Drilling have met or exceeded their 2014 multiples, and the average is around 1.2x. This suggests that the market is recognizing intangible value again for assets such as developed technology, customer relationships, trade names and goodwill.
For pressure pumping and fracking concentrated businesses, which are more directly tied into the value expansion in the oil patch, the trend is clear. Intangible asset valuations have grown even faster, more heavily weighted towards pumpers’ developed technology that is driving demand for these companies’ services. However, the recent infrastructure logjam in West Texas has pushed multiples lower. Nonetheless, the market has been recognizing the value contributions of these companies.
ConclusionTo be clear, nearly all of these companies had to shrink their balance sheets to get these multiples in line. This explains why some of the data is not as meaningful in 2016. However, it appears that’s what was necessary in light of the shift in the market.Overall rig counts have shifted downward since 2014 and are currently nowhere near prior levels, thereby forcing these companies to shed assets in recent years. That’s the price of market efficiency. However, with those challenges no longer weighing them down, some oilfield services companies may be finally arriving at the valuation party.Remember the initial question posed in this post: When it comes to valuations, are oilfield servicers late to the proverbial oil patch valuation gala or just in time to enjoy the recovery? Maybe the question to ask is: How much time is left before the celebration ends?Originally appeared on Forbes.com.
Why Scale Doesn’t Always Resolve Succession Issues
Recent challenges at Och-Ziff and Hightower highlight the struggles RIAs face in transitioning the business to the next generation of management. Size doesn’t alleviate this problem and may actually exacerbate it for some asset managers. In this week’s post, we explore what went wrong in these instances and what you can do to avoid a similar fate.Public MiscuesAs one of the few publicly traded hedge funds, it appeared that Och-Ziff figured out its ownership succession issue. Legacy shareholders could liquidate their holdings in the IPO or any time thereafter at the market price. Unfortunately, though, it did not resolve the firm’s management succession question. In December of last year, founder Dan Och informed the firm’s clients that his protégé and current co-CIO Jimmy Levin, age 34, would not be assuming the reins as CEO when Och decided to step down. Many believed Levin was the heir apparent after being promoted and receiving a huge incentive package earlier that year (worth nearly $280 million). Levin’s rapid rise reportedly irked other members of management, a few of which left the firm in recent years. OZM’s shares are off nearly 30% since this announcement despite eventually finding Mr. Och’s replacement a few months ago.Then, just last week, RIA acquisition firm HighTower Advisors announced that co-founder Elliot Weissbluth would be stepping down as CEO and HighTower would be seeking a new president and head of field services. Such turnover at the top means HT will likely have to look outside the firm for new leadership, which can be a long and expensive process when you don’t have a successor lined up.Certainly, OZM and HighTower are not the only RIAs with succession issues, and this is certainly not an exhaustive list.Last year, billionaire Ray Dalio, who started Bridgewater Associates in 1975, announced the second shakeup within a year at the top ranks of his $160 billion firm.Israel Englander, CEO of Millennium Management, was caught off guard in January when his potential successor abruptly resigned with plans to start a competing firm.George Soros and Seth Klarman have also struggled to prepare the next generation of leadership at their firms.
All of these businesses are industry leaders with tens (or hundreds) of billions under management. The fact that they struggle with management succession shows just how hard it is to actually pull off in practice. Firm size and longevity do not guarantee a smooth transition to the next generation of leadership. In fact, the success of these firms may have fueled complacency and impeded their succession planning – why look for new management when everything’s going so well? The problem is no one lives forever, and (most) people get tired of working.How to Transition WellSo what can you do now to avert succession issues down the road? It may sound like a cliché, but it’s never too early to think about the next generation of leadership. Most RIA principals are baby boomers that are approaching retirement age, and we suspect (mostly from firsthand experience) a fairly high percentage of them don’t have a formal (or even informal) succession plan. If you intend to evolve your practice into a sustainable enterprise and have something to sell when you retire, you need to be thinking about your likely successors and how to retain them.A logical starting point for accomplishing this goal is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value. This process ensures that selling shareholders are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they stick around after the initial buy-in. Basically, you want your interests aligned with the next generation of management, and gradually transitioning ownership to them at a reasonable price is one way of accomplishing this goal.It’s also important to relinquish your day-to-day responsibilities with ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she is assuming more of your responsibilities and not just your share count. Your work hours should go down over this transition period. When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Bryce Erickson is a Contributor to Forbes.com
Based upon the content in this blog, representatives from Forbes.com reached out to Bryce Erickson, ASA, MRICS with an invitation to become a contributor to Forbes.com in their Energy section.Read Bryce’s first contribution: "Oilfield Service Valuations: Missing the Party or Just Fashionably Late?"Bryce leads Mercer Capital’s Oil & Gas Industry team. He has more than 20 years of oil & gas industry and valuation experience both in the U.S. and internationally.On Forbes.com, Bryce will focus on industry developments, economic trends, and the impact on valuation for companies operating in the Permian, Eagle Ford, Bakken, and Marcellus & Utica regions, in addition to topics related to mineral rights and royalty owners.Bryce provides oil & gas companies, midstream operators, and oilfield servicers, as well as mineral & royalty owners with corporate valuation, asset valuation, litigation support, transaction & due diligence advisory, and other related services.
2Q18 Call Reports
After reaching record highs in late January, volatility in the equity markets picked up and has remained elevated through the second quarter. While volatile equity markets and normalizing monetary policy offer opportunity for asset managers, the industry continues to face fee pressure and increasing costs. At the same time, many asset managers are considering M&A as a means to gain distribution and operational leverage, reflecting the persistence of consolidation rationales in the industry.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Normalizing monetary policy and continued equity market volatility through the second quarter suggest opportunities for active managers. We continue to believe that the uptick in volatility and the gradual trend toward normalization of monetary policy on the part of global central banks will provide a more favorable backdrop for active management over time. – Philip Sanders, CEO & CIO, Waddell & Reed Financial, Inc. [A]t a time of change and transition in the debt markets, we're especially proud of our positioning in fixed income in what is the largest asset class in the world … And I'm quite sure that [our fixed income managers] would tell you that they welcome higher rates and are confident in their ability to find wonderful investment opportunities in such an environment. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.After a strong start to 2018, markets reversed mid-first quarter as escalating trade tensions, inflationary concerns and a flattening yield curve caused investors to pull back. Market uncertainty continued throughout the second quarter, reflecting ongoing global trade tensions, a slowdown in emerging markets, increased volatility and widening credit spreads. In the face of an uncertain and evolving investment landscape, clients have paused, deferring their investment decisions until they have greater clarity on the future. – Gary Shedlin, Senior MD & CFO, BlackRock, Inc.I think in a rising rate environment, a different kind of market, the value growth cycle, the 30-year spread of where we are of value versus growth, the strength of the dollar, all of these things can mitigate some of the pressures that we're seeing on the current flows. So I think that, that's – we don't think that's forever. – Gregory Johnson, Chairman & CEO, Franklin Resources, Inc.Theme 2: Fee pressure, distribution leverage, an aging owner base, and increasing regulatory compliance costs continue to be key drivers of sector M&A.Our [M&A] approach is very attractive to our target universe, which is prospective Affiliates that are looking for a permanent institutional partner and I would underline the word permanent there. [A]t the highest level, we're helping solve a demographically driven kind of management ownership and succession problem for these firms, and we have a solution that preserves and protects their unique entrepreneurial cultures across successive generations of management. That's why that kind of permanent underline is so important … Now in terms of the current environment – absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market. – Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.I think with the increase, the regulatory increase and the increase in expectations around due diligence, suitability and all of these things, it played – the distribution platforms just can't do it. Nobody can do it. And so I think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers, and then what I said earlier in my remarks, managers that can also work with them to create vehicles and unique structures to serve what they're trying to do for their clients in their region and then also potentially have the distribution support, the sales support, marketing support, all that kind of stuff to support the product and their salespeople, their bankers in the field. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc. [W]hen you look at capital, M&A is still the priority for the use of that capital on the balance sheet. And I think the challenges that you mentioned, and we all know, whether it's fee pressure, passive or just the move to advisory from brokerage, will continue to put pressure on organic growth rates. So we are, as we said on past calls, very active in looking. – Gregory Eugene Johnson, Chairman & CEO, Franklin Resources, Inc. [W]e also believe that you do need scale to be competitive in this marketplace. If you asked me about the level of scale you needed 5 years ago, I would not have thought that was such a hugely important factor for success going forward. It is, because of the demands on money managers going forward, to do more than just manage money for clients and not just invest in investment capabilities, but also in operational capabilities, largely around technology. So scale becomes really an important factor as you look to success going forward, so you can make these investments all been talking about. – Martin L. Flanagan, President, CEO, & Director, Invesco, Ltd.Theme 3: The industry is continuing to evolve in response to ongoing fee pressure. The way I think about it is in the core strategies, core fixed income, core equity, we're no different than anybody else. There's pressure within the industry on fee rates. That's clear … We're going to get some wins in core strategies, and they're going to be at lower fee rates than they were 10 years ago or they were 5 years ago or they were 3 years ago. But we're also winning business and we have the opportunity to win business in [alternative] strategies that we didn't have 10 years ago or 5 years ago or 3 years ago that are in higher fee rate. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.I generally think, consistent with the overall industry, as scale becomes more important and fees come under pressure … I think you'll see an increase in the amount of support provided by the model of a multi-boutique as opposed to each individual boutique doing everything themselves because again, it's generally always been a distraction and it's always been a little bit expensive. But I think now, with some of the competitiveness and the fee pressures, it's just makes more and more sense for that model … to provide support to grow the business, support to distribute the business and to do all those back office and operational things. – George R. Aylward, President, CEO & Director, Virtus Investment Partners, Inc.I don't know that anybody has really true pricing power in this business. Obviously, the better performance, you have a little bit of flexibility. But at the end of the day … there are always going to be strong competitive products that have good performance. And if you don't have competitive pricing structure, it's going to be really tough to grow those assets. – Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.
Public Royalty Trusts (Part II)
Can Revenue Interests Still Benefit from Capital Appreciation?
In a recent post, we explored the ins and outs of MV Oil Trust. We analyzed the underlying net profit interests it holds, the underlying properties of the trust, and the rights of unitholders including their rights during termination of the trust. This week, we will look into how these play into the composition of the MV Oil Trust’s stock price, and the balance struck between investor’s current return in the form of dividends and potential for returns from capital appreciation.Tradeoff Between Current and Future ReturnsThere is a natural friction between distributions of earnings versus reinvestment for growth. Young and growing companies tend to reinvest their earnings to fund future growth opportunities. Investors in such companies, therefore, have to be willing to forego upfront returns in hope of realizing greater returns down the road. Investors in mature companies, however, generally expect to receive dividends as a return on their investment because these companies typically have fewer opportunities for growth.Composition of Stock PriceWhile public royalty trusts are equity securities by name, they have unique characteristics that differentiate them from many equity securities. Investors typically take on exposure to equity securities for two basic reasons: receipt of cash dividends and anticipation of capital appreciation. Cash dividends are residual earnings of the Company paid to the investor at the discretion of management, and these are current returns. Capital appreciation occurs through the sale of shares at a price higher than what the investor paid, and this is a future return.Investors in public royalty trusts are typically seeking dividends. Because the investment is ultimately in a depleting asset (oil or gas reserves), capital (and therefore stock price) is expected to depreciate to zero in the long run. Many public royalty trusts, including MV Oil Trust, are restricted from acquiring more assets or interests, and most earnings are required to be paid out. These restrictions are similar to another type of trust: Real Estate Investment Trusts (REITs). Because most earnings must be distributed, dividends paid to investors would not appear to be constrained by the discretion of management, and therefore some investors consider investments in trusts to be less risky. This is not necessarily the case for royalty trusts, however, because the source of income is less stable and the ultimate level of cash distributions is dependent on the level of production set by the operator (who is not always associated with the management of the trust). Thus, investments in royalty trusts may be viewed to be riskier than investments in REITs due to this unique control structure.Let’s Get TheoreticalAccording to the dividend discount model, the intrinsic value of a stock is the expected value of future dividends, discounted back to the present at an appropriate discount rate. Forecasts of dividends are typically estimated for anywhere between 3-15 years, or until a time where future dividends will grow/decline at a stable rate. At this point, a terminal value is added, which accounts for all remaining value after earnings have stabilized, which is discounted back to the present.
In the case of public royalty trusts, units of the trusts tend to hold declining intrinsic value. That is, their intrinsic value will drop to zero upon expiration of the trust agreement. This would imply no terminal value, save for the potential liquidation of assets. In the case of MV Oil, the trust will distribute the net proceeds from the sale of assets upon dissolution of the trust, so there will be a terminal value that accounts for future production remaining from the underlying properties.
When a dividend is paid, the market value of the trust should decrease by the amount of the dividend. As an example, imagine a public royalty trust paying quarterly distributions of about 50¢ per share for the next two years prior to termination with a terminal value of zero. If the stock price is a little under $4.00, after accounting for the present value of these distributions, the stock price should decline by 50¢ upon receipt of the first dividend, because the stock at that point will only be worth the remaining seven distributions.
Capital Expenditures ConstraintsMV Oil Trust is restricted from acquiring other properties or interests, but it will still spend money on drilling new wells on their established sites, as well as covering maintenance of currently producing wells. These maintenance expenditures may affect the quantity of proved reserves that can be economically produced. Because MV Partners has agreed to limit the amount of capital expenditures in a given year, they may choose to delay certain capital projects into the next year when the budget allows. If operators do not implement required maintenance projects when warranted, the future rate of production decline of proved reserves may be higher than the rate currently expected. So, the capital expenditure limit, implemented as a protection for unitholders, could actually have a deleterious effect.Is There Any Room for Capital Appreciation?The question then becomes, can revenue interests in an oil and gas royalty experience capital appreciation? With the requirement to pay out substantially all of its earnings as distributions and restriction on acquiring new properties or interests, it would appear that capital appreciation is unlikely. However, as we have seen in the public market, commodity price expectations can vary and change significantly in a relatively short time period. In the case of MV Oil Trust, the rebound in commodity prices and subsequent return to distributions caused the significant increase in unit price over the past two years. Even though investors are purchasing the right to obtain future distributions, buying low and selling high on the units is possible, as with any investment. For public royalty trusts, investors would need to be able to anticipate shifts in either production or price.Drill Baby Drill?Capital appreciation for royalties is not limited to the potential upside from increasing crude and natural gas prices. MV Oil Trust has drilled new wells in each of the past three years, providing investors with an upside not seen in all royalty trusts. Additional wells increase capacity which will increase royalty revenue and therefore increase future dividends, thus raising the value of the trust. Proved undeveloped reserves (PUDs) present an upside to unitholders, and drilling wells is the next step in developing these reserves, so they can eventually be produced and sold.Many royalty trusts either have not recently drilled any new wells or they do not have any proved reserves that are left undeveloped. This includes Permian Basin Royalty Trust, Mesa Royalty Trust, Sabine Royalty Trust, VOC Energy Trust, San Juan Basin Royalty Trust, and Pacific Oil Trust.Some trusts originally had upside from wells that they were contractually obligated to drill in an “Area of Mutual Interest (AMI)” when the trust was started. This includes the three SandRidge trusts, which we discussed in a recent post. Chesapeake Granite Wash Trust and ECA Marcellus Trust I also agreed to drill wells in an AMI, neither have drilled any further wells after fulfilling this requirement. Thus investors in these trusts will likely only realize capital appreciation if crude prices unexpectedly increase and stabilize at this higher price.Hugoton Royalty Trust and Cross Timbers Royalty Trust have had little to no drilling in recent years, but both benefit from having XTO Energy as an operator, who has indicated plans to drill new wells that will benefit each of these trusts.Enduro Royalty Trust, MV Oil Trust, BP Prudhoe Bay Royalty Trust, and Whiting USA Trust II have all had drilling in recent years. MV Oil Trust’s undeveloped reserves represent 14% of proved reserves, representing potential upside from future drilling. Prudhoe Bay has drilled over 100 wells in the past three years, and it has experienced the third highest 2-year return. Whiting USA Trust II has significant undeveloped acreage in the Permian, which likely plays a role in its superior 2-year return for investors.The remaining four mineral partnerships are either C Corporations or MLPs. As discussed recently, they are designed to gather assets and grow through acquisitions. Because they are not structured as trusts, they are not required to distribute a substantial amount of their earnings.ConclusionEven when royalty trusts are prohibited from acquiring more assets, investors can realize capital appreciation if oil price expectations change, the operator of the underlying assets drill more wells and/ or increase their operating efficiency, or if management expedites distributions.While the value of the underlying asset of royalty trusts (royalty interests) are expected to decline over time, there is still an opportunity for capital appreciation with commodity price changes or additional drilling. Ultimately, declining revenue distributions for private owners of royalty interests typically do not benefit from capital appreciation, but selling at the opportune time can effectively function as capital appreciation.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
The Haves and Have-Nots of the RIA Industry
Despite the old maxim of a rising tide lifting all boats, the current markets are clearly more buoyant for wealth management firms than asset management firms. Many asset managers are trading at or near all-time lows from a valuation perspective, while financial advisory shops continue to accumulate client assets. For this week’s post, we’ll take a closer look at this trend, and what it means for the broader industry.The Story for Asset ManagersDon’t interpret this as our being bearish on asset management. Almost every asset management firm, public or private, is more valuable today than it was in 2009. The explanation for that is simple: rising markets lead to higher AUM, management fees, and earnings, so many of these businesses are worth 2-3x (or more) what they were a decade ago because profitability has (easily) tripled in the last nine years. As appraisers, we’re more concerned with the multiple (i.e. valuation) applied to these earnings since that’s what we take from the market and relate to our client company’s performance to derive value. Here’s how the market is currently pricing some of these businesses:Notwithstanding the run-up in their market caps since the last financial crisis, earnings multiples for asset management firms have mostly contracted, particularly recently. There are a number of rational explanations for this – fee compression, flight to passive strategies, ETFs, fund outflows, maturing industry, etc. This seems quite overdone for a business with a strong recurring revenue model and high margin potential through continued gains in AUM (like we’ve seen).So what gives? You’ll recall from your corporate finance classes in college that this multiple is a function of risk and growth. While there are certainly risks facing this business today, we don’t necessarily think the business’s cost of capital has increased much (if at all) over the last year as the sector’s risk dynamics haven’t changed much over the last year. Lower valuations must, therefore, be indicative of sliding growth prospects. Clearly, the market is telling us that the industry’s current headwinds (regarding fees and outflows) are likely to persist and may even be questioning the longevity of the bull market.Different Story for Wealth ManagersWealth managers chart another path. There’s not a whole lot of public market perspective on these businesses due to the lack of publicly traded wealth management firms, but there is some. Silvercrest Asset Management (ticker: SAMG), which provides family office and financial advisory services, is up more than 30% over the last year and currently trades at just over 21x trailing twelve months earnings.Then there are all the recent headlines surrounding Focus Financial Group, a serial acquirer of wealth management firms. Admittedly, we’ve contributed to some of this. As a result, you probably didn’t even know about the Victory Capital (multi-boutique asset manager) IPO that happened earlier this year. The market currently values Focus at nearly 5x revenue and Victory at well under 2x revenue even though VCTR is profitable and FOCS is not. Arbitrage opportunity?To be fair, these businesses have always been priced differently. Wealth managers often elicit a higher multiple because of their lower risk profile. Their clients (mostly individuals) are typically less concentrated and more likely to stick around when performance suffers. Asset managers on the other hand, typically enjoy higher margins since it’s less costly to service fewer relationships. This trade-off is nothing new and likely to persist.The Overarching NarrativeThe recent widening of the multiple gap and disparate performance over the last year suggests the two businesses are riding completely different trajectories. Again, the market seems to think that the fee compression and flight to passive movements are here to stay, and wealth management firms may be the indirect beneficiary of these trends. We don’t disagree with this but think there will always be a place for active management, especially for those firms with solid long-term performance and steady inflows. Still, this bull market seems to have forgotten about a sector that typically thrives in a bull market.Moving forward, we expect some mean reversion but aren’t ignoring what the market is telling us about the outlook for asset managers – it’s probably going to get worse before it gets better. Solid performance can buck this trend for any RIA, but consistently delivering alpha is a tall order. Since most firms underperform the market after fees, perhaps it’s not surprising that sector has struggled so much recently. Still, this has almost always been the case, so the industry’s current woes are more likely attributable to fee compression (or fear of fee compression) and surging demand for passive products. A bear market might actually help (relative) performance as many asset managers outperform during times of financial stress, but that would also strain revenue and profit margins. Attractive valuations could spur deal-making and consolidation, which could alleviate some of these pressures. We’ve seen some of this, but suspect more is on the way. Either way, we’ll continue to monitor these pricing trends and let you know how this all shakes out.
Trends to Watch in 2018
There are approximately 76 million members of the Baby Boomers in the U.S. – roughly 25% of the total population. Over of 60% of all businesses are owned by Baby Boomers, totaling nearly 4 million companies. Baby Boomers began turning 65 in 2011, and will do so at a rate of 10,000 people per month for another 12 years or so.
A Review of M&A Activity in the Downstream Oil & Gas Space
Nesting Dolls of Refinery Acquisitions
On April 30, 2018, Marathon Petroleum announced its acquisition of the newly formed Andeavor making Marathon the largest refiner in the U.S. (by capacity) and one of the top five refiners in the world. The merger is moving into its final stages, and Marathon’s CEO is positive about the combination of the two well situated companies.In this post, we analyze the recent acquisition history of Western Refining, Tesoro, and Marathon, which has started to look somewhat like nesting dolls of acquisitions.
For an industry that has had sluggish M&A activity in the last couple years, this line of acquisitions seems to hint to a possible trend of consolidation. Domestic oil production has increased significantly over the last couple years. Even though export bans on crude oil were lifted a couple years ago, overall, there is more crude oil in the U.S. that needs to be refined. According to the EIA, U.S. refining capacity is “virtually unchanged from 2017 to 2018.” Domestic refineries are now running at average utilization figures of 90%, as compared to the IEA’s global average of 70%. Building a new refinery takes time and money and has significant regulatory hurdles; thus U.S. refiners appear to be combining in order to increase efficiencies and meet the higher demand for their services as a result of the recent increase in domestic crude oil production.
Recent Acquisition HistoryThe table below shows metrics from the line of acquisitions leading up to Marathon’s acquisition of Andeavor, along with other recent transactions in the downstream space for comparison.Western Refining’s Acquisition of Northern Tier for $1.6 BillionIn late 2015, Western Refining bought all remaining shares of Northern Tier Refining, not already owned by Western Refining and its subsidiaries, for $1.6 billon. (Western Refining previously bought a controlling interest in Northern Tier for $775 million in 2013.) The resulting company had three refineries in Gallup, NM; St Paul, MN; and El Paso, TX.Western Refining paid 5.3x EBITDA for the remaining minority position in Northern Tier. Some analysts such as Albert Alfonso, originally believed that the deal was undervalued. While the deal multiples were quite a bit lower than the multiples observed in the downstream space at the time, it is important to consider the premiums paid for acquisitions of control versus the price paid in this acquisition of a minority position by a company that previously paid for control. For comparison purposes, this transaction is more similar to Delek’s 2017 acquisition of the remaining shares of Alon at 5.9x EBITDA for a minority stake.Tesoro’s Acquisition of Western Refining for $6.4 BillionIn November 2016, Western Refining and Tesoro Corporation merged to form Andeavor. Tesoro bought Western Refining for 10.6x EBITDA and 80% of revenues, which at the time was in line with the earnings multiples observed in Delek’s acquisition of shares of Alon U.S. Energy for 11.0x EBITDA. (Through this transaction, Delek gained control of the entity of which they originally owned 48%.) The newly formed Andeavor was the fourth largest independent refiner in the U.S.Tesoro had refineries in California, Washington, Alaska, Utah, and North Dakota. The addition of Western Frontier expanded their presence by adding refining locations in Texas, New Mexico, and Minnesota.Western Refining shareholders received either 0.4350 Tesoro shares, or $37.30 in cash per share. As compared to the previous day’s closing price of Western Refining, the shareholders received a 22.3% premium, according to a Fortune article about the transaction. In order to prevent dilution from the offering of additional shares, Tesoro announced it would increase its buyback program by $1 billion. The deal was expected to create between $350 and $425 million in synergies to be realized in the first two years of their combination.In addition to expanded refining capacity, the combined companies had over 3,000 retail stations.Marathon’s Acquisition of Andeavor for $23.3 Billion (Enterprise Value of $35.6 Billion)Marathon Petroleum is expected to close on its acquisition, newly formed Andeavor for 12.7x EBITDA, which shows a slight premium to the few transactions observed in the refining space lately. Andeavor shareholders will have the option to choose 1.87 shares of MPC stock, or $152.27 in cash per share. This represents a 25% premium to the closing price the day before the transaction was announced. In order to prevent dilution from the issuance of additional MPC shares, Marathon’s Board approved $5 billion repurchase authorization.The two companies were largely located in different parts of the country as shown in the map below. Andeavor Chairman and CEO Greg Goff (who will become Executive Vice Chairman at MPC) explained,“Look at the map of the two companies and the way they are positioned geographically in the United States and you come to the conclusion that this is a great opportunity to be able to bring the companies together.”The map below shows the locations of both Marathon and Andeavor’s refineries.
Marathon had six refineries in the eastern half of the U.S. and Andeavor had 10 refineries in the western U.S. and Alaska. The combined company will have approximately 15% of total fuel making ability in the U.S.
Additionally, the combined companies have over 7,800 branded fuel stations.
Immediately Accretive DealAccretive deals add more value than they cost, either over time or immediately. The Marathon and Andeavor deal is expected to be immediately accretive to earnings per share; meaning the price paid by Marathon is lower than the immediate expected boost in earnings per share post-acquisition.The deal is expected to create significant synergies resulting in around $1 billion over the first three years. These synergies will come as a result of stronger purchasing power, system optimizations, procurement efficiencies, leveraging of assets, and retail network efficiencies. Additionally, according to Marathon’s Chairman and CEO, Gary Heminger, thinks that the potential synergies could be even greater than the estimated $1 billion. However, that remains to be seen. Many analysts are sometimes skeptical of synergies due to their somewhat abstract nature.Did Marathon Pay Too Much?Marathon’s acquisition of Andeavor comes at a time when U.S. refineries are positioned to benefit from the increase in domestic production of oil and gas. Many refineries that purchase WTI crude are currently benefitting from the discount of WTI to Brent, which has lowered their costs of sales as refined product prices are still increasing. Refineries margins have increased 8% worldwide and almost 25% in the U.S. Midwest year over year according to British Petroleum’s Refiner Marker Margins and crack spreads have increased as shown in the graph below.
Management of both companies seem positive regarding the deal and there seems to be little reason to believe that the deal would face any resistance from regulators as there was is little overlap in the locations of the refiners. However, investors of MPC could ask if MPC paid too much?
Stock buybacks are generally a signal to investors that the Company views its own stock as a good investment. Additionally, management will generally not buy back shares if they think the stock is currently overpriced. Marathon’s announcement of a buyback should somewhat ease investors’ concerns.
ConclusionIt is hard to pinpoint the root cause of the recent consolidation activity in the downstream oil and gas space. The pressure of RIN expenses on smaller refineries that do not have the capacity to blend their renewable fuels could be one cause of consolidation. The immediate need for more operating capacity as U.S. oil production has increased might be pressuring larger refiners to purchase rather than build additional capacity. Additionally, the recent tumult of the global trade environment adds an additional layer of uncertainty for U.S. refineries whose main export market is Mexico.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help. Contact a Mercer Capital professional to discuss your needs in confidence.
Does the Money Management Industry Need Consolidation?
As World War II drew to a close, a military aircraft manufacturer in Sweden saw the post-war consumer economy as an opportunity to expand into cars, and the Saab automobile was born. For about 45 years thereafter, Saab established itself as a scrappy automaker known for innovation. Saab was the first automaker to introduce seatbelts as standard equipment, ignition systems that wouldn’t crush a driver’s knees in a collision, headlamp wipers and washers, heated seats, direct ignition, asbestos-free brake pads, and CFC-free air-conditioning. Saabs were distinctive, substantial hatchbacks with strong but efficient motors and enjoyed a devoted following. Unfortunately, Saab’s fan base was too small, and as the company struggled to build the scale necessary for global distribution, financial troubles drove them into the gaping maw of General Motors.In the late 1980s both GM and Ford were attempting to consolidate global automotive capacity and bring as many brands under their corporate hierarchy as possible. With consolidation came homogenization, as global behemoths looked for ways to cut manufacturing costs. Under Ford’s ownership, Jaguar and Aston Martin starting sharing parts with each other and their Dearborn parent. Ford, arguably, saved both marques and orphaned them before they were ruined. Jaguar is thriving today, and Aston Martin is planning its first public offering. Saab wasn’t so fortunate, with GM blending Saab’s mystique with Subaru (sushi with meatballs?) and Saturn (a space oddity if there ever was one). Saab struggled for about twenty years in GM’s dysfunctional family, but eventually the brand was wrecked and Saab was no more.Divergent Industry TensionsLike the automotive industry in late 1940s and 50s, the investment management industry is characterized by scores of independent firms who have found success in idiosyncrasy, providing clients a limitless variety of paths and approaches to common investment dilemmas. Some would suggest that this is the source of the industry’s strength, but not everyone agrees, as evidenced by the Focus Financial IPO two weeks ago.A key element of the Focus market opportunity is “fixing” the fragmented nature of the RIA industry, providing an ownership structure, exit opportunity, and transition mechanism for the thousands of independent advisory practices with a stream of profitability threatened by aging founders. This opportunity exists in an industry that is far from declining – in fact it is growing in clients, assets, and advisors. Focus can provide ownership transition capital to bring some order to this creative process and share in the profits along the way.The RIA industry is growing, but it is doing so because it is largely in a stage of de-consolidation, rather than consolidation. Most of our clients set up their own shops – whether in wealth management or asset management – because they were exiting larger firms they felt restricted their thinking, their business development, and their incomes. Investment managers are characteristically independently minded and entrepreneurially motivated. In many ways, the increase in investment advisory practices is an effort to recapture the careers available to what were once called stockbrokers forty years ago. One client of ours who escaped his wire house environment earlier this year decried how his former firm had been taken over by lawyers and accountants who were conspiring to restrict opportunities for both him and his clients.So many wire houses are now losing advisors to the RIA industry, broker protocol is splintering, and the only BDs reporting growth in advisors are doing so at great recruiting costs, which may or may not be recoverable. The alternative would be to acquire practices outright, but great entrepreneurs make miserable employees. Focus aims to thread this needle by acquiring a preferred interest in the profitability of partner firms (defined as Earnings Before Partner Compensation, or EBPC) that assures Focus a basic rate of return on investment but leaves the leadership of partner firms the opportunity for upside. Further, while the Focus holding company will provide programs in products, marketing, and compliance to partner firms, opting-in to those programs is treated like coaching, rather than being compulsory.Will the Focus “preferred stake in EBPC” work? Will selling partners be motivated enough to continue to grow their practices profitably? Will subsequent generations of partner firm leadership have enough upside to stick around or will they seek out other opportunities? Is coaching through encouragement enough to manage the activity of boutique investment advisory practices? Can subsidiary firm margins been grown enough to offset the corporate overhead of the parent?The Prevailing RhythmWe are obviously skeptical, but we’re not cynical. We’ve been around long enough (and have been wrong enough), so we are intently watching and listening to the drumbeat of the consolidators. Focus has put more thinking and garnered more capital to try to build critical mass in the wealth management industry than anybody else. They are not the only group trying to do this, but they’ve gone farther than anybody else. We don’t buy the idea that Focus is the public company barometer of the RIA industry, but it is the barometer of RIA consolidation. The question for the investment management industry remains: is consolidation the answer?
Now That Focus Has Priced – Is It Pricey?
After Focus Financial filed their S-1 in May, I drew some analogies to Ferrari’s public offering two years ago (NYSE: RACE), as both companies faced considerable skepticism at advent of their IPO. Last week, the two stories intersected once again, as the man who steered Ferrari to its public offering, Sergio Marchionne, died unexpectedly at 66, and two days later Focus Financial went public (Nasdaq: FOCS).Marchionne leaves behind an indelible imprint on the automobile industry. He almost single-handedly rebuilt the automotive landscape from its most unlikely corner, Italy, by squeezing $2 billion out of GM to recapitalize Fiat in 2005. With Fiat rescued from oblivion, Marchionne rebuilt Alfa Romeo, Maserati, and Ferrari under the Fiat umbrella. He took advantage of the credit crisis to bring Chrysler under Fiat’s control, and then took advantage of the subsequent bull market in luxury goods to take Ferrari public. He was trained as a lawyer, practiced as an accountant, and fueled by expresso and cigarettes. Above all, though, Signore Marchionne seemed to really love cars – something lacking in too many automotive executives these days.I won’t go so far as to compare Focus Financial’s founder, Rudy Adolf, to Marchionne, but it’s worth noting that, like Marchionne, Adolf pulled off what many others have tried, and failed, to do. Now that Focus is public, we have a new channel with which to study and benchmark the industry. We have lots of questions, but for this post, we’ll just look at the implications of the Focus valuation that is consequent from the IPO.Focus Is Richly PricedAfter a predicted pricing range of $35-39 per share, FOCS went public at $33. Of the $490 million raised in the offering (after underwriting fees), Focus is going to use a bit less than $400 million to pay down debt, about $35 million to settle equity compensation and other obligations to existing owners, and the remaining $60 plus million they’ll hold in cash for opportunities as they come along. If the underwriters exercise their greenshoe, Focus picks up another $75 million or so.We heard plenty of chatter about the implications of Focus pricing below the originally suggested range, but we don’t make too much of it. The $35-39 range was very high (as we’ll get into later in this post), and in any event, the trading activity immediately raised Focus shares up to the range (no doubt guided by the invisible hands of market makers associated with the book runners). The IPO was a success.Focus Didn’t Sell CheapOne thing we don’t have a question about is the magnitude of Focus’s valuation at IPO – it was expensive by any measure. In the quarter ending March 31, 2018, Focus reported a net loss of nearly $37 million on $196 million in revenue. In the prospectus, management provides a series of adjustments to redeem the quarterly loss to a net profit of almost $30 million and EBITDA of over $44 million.
We don’t take issue with many of management’s normalizing adjustments, as there are several non-recurring expenses associated with taking a company like Focus public. We are curious, though, about adding back non-cash equity compensation and the change in fair value of contingent consideration made for acquisitions. From the perspective of a shareholder, equity compensation is still a drain on earnings, because it dilutes existing shareholders’ claim on profitability. Since Focus is an acquisition company, it seems that any increased earn-out or other contingent payment expense increases the cost to Focus – whether in the form of cash or stock – such that these aren’t truly extraordinary items that a shareholder would disregard when calculating Focus’s profitability.
Any argument with these adjustments takes an already lofty IPO valuation for Focus to nosebleed levels. At the IPO price of $33 per share, Focus has an equity market cap (absent special allotments for the underwriters) of about $2.3 billion, and a total market capitalization inclusive of net debt of $2.8 billion.
If we look at the most recent reported quarter, annualize it to develop a measure of ongoing performance and further look at a year forward assuming a 20% annualized growth rate (10% to the mid-year), we show strong multiples of revenue and earnings (compared to industry standards), and higher-than-usual multiples of EBITDA. However, that’s only if you accept all of management’s adjustments. If instead, you don’t give Focus the benefit of adding back non-cash (but nonetheless dilutive) equity compensation expense, the resulting multiples of profitability are other-worldly.
The big issue that most analysts seem to have with Focus is that they want to be given credit for inorganic growth on their multiple while adjusting earnings to eliminate the cost of that inorganic growth. The Focus prospectus and roadshow presentation made much of their 20% growth historical and prospective topline growth, and everyone knows that growth is because of acquisitions. The prospectus doesn’t actually offer any estimate of organic growth, or same-store sales growth, because they credit organic growth for subsidiary-level acquisitions by partner firms. It seems to us that the costs of that growth are, indeed, relevant to earnings. So either we judge Focus as an acquisition company or an operating company, rather than give them credit for the topline performance of an acquisition company and the bottom line performance of an operating company.
Peer Comparisons Are DifficultFocus isn’t really an RIA, it holds preferred interests in profit sharing units in RIAs. Nonetheless, most analysts will lump them into the RIA space. The question is where?Earlier this year a small RIA called Victory Capital went public (Nasdaq: VCTR). Victory is an amalgamation of wealth management firms and an ETF offering. It’s about half the size of Focus, and it hasn’t fared too well since the offering. Another possible comp is Silvercrest, which probably feels forgotten by the public markets in the wake of attention given to Focus. Since neither Victory nor Silvercrest are really RIA consolidators, Focus management probably wouldn’t appreciate the comparison to them. Neither Victory nor Silvercrest have shown the topline growth of Focus Financial, although Silvercrest’s growth isn’t that out of line with what Focus has produced organically – maybe even better.While it’s difficult to find peers to compare Focus to, their valuation prices them more richly than even AMG. Is it reasonable to compare Focus to Blackrock? We don’t think so.Pricing ImplicationsMost CEOs appreciate the market validating their strategy with high multiples, but high multiples are a double-edged sword. In the 1990s, I had a number of clients at Mercer Capital involved in roll-up corporations of one kind or other that went public. Some worked, and some didn’t. While Focus isn’t directly comparable to many consolidators, some of what has been observed in other industries holds true here as well.High valuation multiples must be justified, and are often tested stringently with newer public companies. Focus promises high topline growth, with the implication that the profit margins will sort themselves out with scale over time. This is a common story for public companies in consolidating industries. The trouble comes when acquisitions are unavailable at reasonable terms or even accretive pricing, profits are uninspiring, and management feels pressured to do deals that don’t make sense just to demonstrate growth.Based on their own disclosures, Focus will have to continue an aggressive acquisition strategy to achieve the 20% plus growth expectations that it has set for itself. If that growth is accomplished with new share issuances (as they have employed in the past), the market may not appreciate the dilution. Focus could, of course, pay cash, as they have a fair amount of it on hand following the IPO; but cash isn’t free either. What the market will eventually want to see – and several commentators have already mentioned this – is organic growth. If the firms that sold Focus some participation in their profitability grow their AUM from either existing or new clients, the fees should translate into profit growth that will accrue to Focus. The S-1 is curiously vague about Focus’s historical organic growth – defining it as inclusive of subsidiary-level acquisitions by partner firms. We question whether or not this is a true metric of organic growth, and in any event, the numbers Focus has posted with regard to this aren’t terribly impressive: 13.4% in 2017 and mid-single digit growth in the two years prior to that. We’ve written elsewhere that Focus will eventually have to prove itself as an operating model, and not just as an acquisition model. Their success or failure in this regard will be judged, at least in part, by demonstrated organic growth.As for inorganic growth, Focus has interests, either directly or indirectly, in 140 plus firms. This leaves lots of room to grow in an industry with 15 thousand or so firms and a solid growth trajectory. If Focus stays priced at elevated multiples, it may raise expectations of sellers – especially in the circumstances where Focus is paying with stock. If, on the other hand, Focus shares settle to more normal multiples of profitability, sellers may be wary of selling into a downward trending share price. In some ways, it may be easier to attract acquisition candidates as a public company, but in others, it may be more challenging.Margins are another matter. Most investment management firms benefit from operating leverage as they grow, and Focus has suggested the same opportunity exists for them as well. Our concern here is that Focus is not a small startup asset manager, they are a $126 billion manager with over 2,000 employees in their affiliated firms and fourteen years of history – yet their EBITDA margin (even on a highly-adjusted basis) hasn’t crested 25%. It’s possible that additional scale will improve this metric, but being a public company is labor intensive, as is tracking the activities of 140 plus partner firms, seeking out more, and seeking ways to improve the performance of existing firms. It may be difficult to assess the Focus margin against that of more typical RIAs, but as the Focus story unfolds, management will have to explain how to evaluate the effectiveness of the 70 or so employees at the holding company, what a reasonable cost of operations is, and how much profitability can be expected.Nevertheless, They Did ItSetting all of my armchair quarterbacking aside, though, the fact remains that Rudy Adolf and his team pulled off what many have thought about but failed to do. The investing public now has a way to be involved in the profitability of the RIA phenomenon, and the RIA industry has a new funding source for transaction activity. Lots of questions remain, but if Sergio Marchionne could use the public markets to remake a moribund industry from a nation that isn’t terribly investor friendly, executing on the Focus business model should be an easy lap.
Public Royalty Trusts (Part I)
Can Revenue Interests Benefit from Capital Appreciation?
In previous posts, we have discussed the relationship between public royalty trusts and their market pricing implications to royalty owners. Many publicly traded trusts have a fixed number of wells, so the value comes from declining distributions. Some of the trusts have wells that have not been drilled, which represent upside potential for investors. The future growth and outlook potential for each type of publicly traded trust is significantly different and a potential investor would want to know the details. The same is true for a privately held royalty interest.In this post, we will explore the subject characteristics of MV Oil Trust. This will serve as a primer for a subsequent post in which we will look further into the composition of its stock price in order to better understand investors’ ability to achieve returns through distributions and capital appreciation.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely. The table below shows the performance and other key metrics of the 21 main oil and gas-focused partnerships that are publicly traded, as of July 12, 2018.
Clearly, there were some winners and losers, with more winners than losers. Of the winners, Whiting USA Trust II (WHZT) (+243%), discussed in a recent blog post, has had the highest price return. The focus of this blog post will be MV Oil Trust (MVO) (+99%), whose market value has nearly doubled in the past two years.
For comparison, the chart below shows the two-year returns from MV Oil Trust, Crude Oil, Natural Gas, and the S&P 500. Over the last five years, there has been significant correlation between MVO’s share price and the price of crude oil (93.3%) and less correlation with the price natural gas (74.6%).
MV Oil TrustOn January 24, 2007, MV Partners and MV Oil Trust completed an IPO. MV Oil Trust holds net profits interests, which represents the right to receive 80% of the net proceeds from all of MV Partners’ interests in oil and natural gas properties located in the Mid-Continent region in the states of Kansas and Colorado. As of December 31, 2017, the underlying properties produced predominantly oil (99% of production) from approximately 900 wells.MV Partners is the designated operator for these properties, but they are currently being operated on a contract basis by two affiliated companies, Vess Oil Corporation and Murfin Drilling Company, Inc. MV Partners pays an overhead fee to operate the underlying properties, which is based on a monthly charge per active operated well ($3.1 million average in the past three years).It is important to note that a majority (76% in the past two years) of the oil produced from the underlying properties was sold to a related entity, “MV Purchasing.” The price received is based on a recent NYMEX price, reduced for differentials based on location and oil quality. In 2017, the average differential between the benchmark and the price realized by MV Oil Trust was just under $5 per barrel. MV Oil Trust is extremely dependent on MV Partners and its related entities. Where this private company experiences difficulties, the trust would undoubtedly suffer, both in terms of production level and the amount it could sell.What is a Net Profit Interest?Trust unitholders receive 80% of the NET proceeds. “Gross proceeds” are the aggregate amount received by MV Partners from sales of crude oil, natural gas, and NGLs produced from the underlying properties. This does not include consideration for sale of any underlying properties by MV Partners, nor does it include any of the oil or gas lost in the production or marketing process. “Net proceeds” represents gross proceeds, less:Payments to mineral owners or landowners, such as royalties and expenses for renewals or extensions of leases;Any taxes paid by the owner of an underlying property;Costs paid by an owner of the underlying properties under any joint operating agreement;All exploration and drilling expenses;Costs or charges associated with gathering, treating and processing oil, natural gas and natural gas liquids;Any overhead charges, including the overhead fee payable by MV Partners to Vess Oil and Murfin Drilling; andAmounts reserved for approved capital expenditure projects (up to $1 million per 12 months), including well drilling, recompletion and workover costs.
Unitholders are entitled to quarterly cash distributions of substantially all of the trusts quarterly cash receipts, less the trust’s expenses and any cash the trustee decides to hold as a reserve against future expenses. As noted above, the trust’s share price is highly correlated with the price of oil because the trust is ultimately as valuable as the distributions it makes.Termination of the TrustUnlike a traditional royalty interest that continues into perpetuity, a net profit interest in MV Oil Trust will terminate on the later of:June 30, 2026, orThe time when 14.4 MMBoe have been produced and sold (equivalent to 11.5 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties)
As of December 31, 2017, the trust had received payment for approximately 8.0 MMBoe of the 11.5 MMBoe interest, or about 70% of the termination threshold. The trust will dissolve prior to its termination if it sells the net profit interest or if annual gross proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years. Upon dissolution, the trustee would then sell all of the trust’s assets and distribute the net proceeds of the sale to the trust unitholders.Underlying PropertiesThe underlying properties are in Kansas and Colorado, or the Mid-Continent region, which is a mature producing region. Most of the production consists of desirable light crude oil. Most of the producing wells are relatively shallow, ranging from 600 to 4,500 feet, and many are completed to multiple producing zones. In general, the producing wells have stable production profiles with total projected economic lives over 50 years and an estimated average annual decline rate of 8.6% over the next 20 years. This extended shelf life is attractive for unitholders of the trust because even though the trust is expected to terminate, the unharvested production capacity can still be sold.As seen in the tables below, the majority of proved reserves are developed, oil reserves. Also, the majority of acreage is in either the El Dorado or Northwest Kansas area.
The majority of the net operated wells are oil wells; however, there are also some non-operated oil wells. In the past three years, each Trust has added to its well count by drilling additional development wells. Most of these occurred in 2016 when 7.6 net wells were drilled. These additional wells increase production capacity and thus potential for future distributions.
Other Rights of Trust Unit HoldersNet proceeds received by unitholders exclude the sale of underlying properties, but this does not prevent the sale of assets. Unitholders will be compensated if a sale occurs. Further, the trust is only able to release the net profits interest associated with a lease that accounts for up to 0.25% of total production for the past 12 months without consent of unitholders. This sale also cannot exceed a fair market value of $500,000. This protects unitholders from having significant assets sold in any given year, which would decrease the level of future production.As mentioned earlier, capital expenditures are currently limited to $1 million per 12 months. These expenditures are further limited after the “Capital Expenditure Limitation Date.” This is defined as the later of:June 30, 2023, orThe time when 13.2 MMBoe have been produced and sold (equivalent to 10.6 MMBoe in respect of the trust’s right to receive 80% of the net proceeds from the underlying properties)
On this date, capital expenditures are further limited to the average of the prior three years of capital expenditures, which will likely drop it considerably below its current limit of $1 million per year.ConclusionIn our next post, we will use MV Oil Trust as a basis for examining how investor returns are affected by a royalty trust’s distribution of proceeds, volatility in the price of crude oil, the timing of entrance and exit, and other unique features of the royalty trust such as limits on capital expenditures. We will do this by looking into what goes into the stock price of royalty trusts and the tradeoff between current and future returns.When investing in a public royalty trust or using it as a pricing benchmark for private royalty interests, there are many items to consider that are unique to each royalty trust. The source of income, region, operator, termination, and other key aspects make each trust unique.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Capital IQ
M&A Update: Good Gets Better
After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion.
Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016.
The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x.
Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag).
Cash Deals vs. Mix/Stock DealsDig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth.
The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x.
Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE.
In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue.
Small Deals, Larger Deals, and Perhaps Big DealsM&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks.
Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket.
Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding.
We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition.
The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices.
How We Can HelpThe adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.Originally published in Bank Watch, July 2018.
Changing Tides on Lack of Marketability in Tennessee Courts
For years, cases such as Bertuca1 and Barnes2 governed the landscape on the issue of marketability in the valuation of marital assets in Tennessee family law cases. Specifically, Bertuca involved a company called Capital Foods which held several McDonald’s franchise locations. In the decision, Bertuca did not allow for a discount to be taken for the lack of marketability for a nonpublicly traded company and offered the following reasoning:“...no indication…has any intention to sell…thus, the value of the business is not affected by the lack of marketability and discounting the value for nonmarketability in such a situation would be improper.”While Barnes involved a dental practice, the Court offered a similar explanation for excluding a discount for lack of marketability:“...inappropriate because no sale was ordered and there [was] no indication in the record that the Husband ha[d] any intention of selling his minority stock.”Both cases focused on the lack of an actual/imminent sale rather than the lack of marketability of these two underlying companies when compared to a publicly traded equivalent. The cases also left business valuation appraisers in a quandary, since this treatment of the lack of marketability didn’t seem to match the fair market value standard. The fair market value standard, discussed in Revenue Ruling 59-60, discusses the relevance of a willing buyer and a willing seller and also allows for potential discounts for lack of control and lack of marketability, where applicable.So what has changed now? In April 2017, House Bill 348 was passed by the Tennessee legislature. This Bill amends the Tennessee Code Annotated Title 36, Chapter 4 (TCA 36-4-121), relating to the equitable division of marital property. Specifically, this Bill allows for “considerations for a lack of marketability discount, a lack of control discount, and a control premium if any should be relevant and supported by the evidence for such assets” “without regard to whether the sale of the asset is reasonably foreseeable.”Effective July 2017, discounts for lack of marketability can now be considered in the valuation of assets in family law disputes. As with the valuation itself, it’s important to hire an accredited/credentialed business valuation appraiser to assist in the determination, documentation and support of any discounts for lack of control and marketability, along with any applicable premiums.End Note1 Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV, 2007 WL 3379668 (Tenn Ct. App. Nov. 14, 2007).2 Barnes v. Barnes, No. M2012-02085-COA-R3-CV (Direct Appeal from the Chancery Court for Bedford County No. 27833, April 10, 2014).
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
Wealth Management Industry: Opportunities Abound Despite Headwinds
Wealth management firms have fared well in recent years on the back of rising markets, but the underlying drivers suggest an industry in flux; global investible assets are at all time highs, intergenerational wealth transfer is accelerating, and FinTech products are poised to disrupt. Yet, many analysts are skeptical about the industry’s prospects. Rising global wealth means that there are more assets for wealth managers to manage, and intergenerational wealth transfer means that there are also more opportunities to gain (and lose) clients. FinTech products threaten competition, but also offer efficiencies for agile firms. Depending on your point of view, the industry is either poised to grow or on the verge of massive disruption.The Next GenerationOne thing is clear: the wealth management industry has benefited from the fact that global wealth (and demand for wealth management services) has reached all-time highs. According to Capgemini’s 2018 World Wealth Report, global wealth held by high net worth (HNW) individuals grew 10.6% to more than $70 trillion in 2017. More wealth means, well, more wealth to manage, and revenue at wealth management firms has generally increased with the market. However, for wealth managers, business is also a function of who holds that wealth – and that is changing. As baby boomers continue to retire over the next decade, trillions of dollars of wealth will be transferred to a younger generation. This massive wealth churn is an opportunity for wealth management firms to attract a new, younger client base, but wealth managers face several challenges in appealing to that new demographic.One such challenge is the industry’s aging advisor base. According to data from EY, the average advisor is now 50 years old, and only 5% of advisors are under 30. As assets move from one generation to the next, a weak pipeline of new advisors is a looming threat for the industry. The age gap between clients and their advisors is poised to create real difficulties in attracting and retaining an evolving client demographic, particularly given the increasing prominence of FinTech-based competition. A lack of succession planning at many wealth management firms will only exacerbate these problems.FinTech's ImpactWith a changing client demographic, also comes changing expectations. As a result, wealth management firms face pressure to adapt their service and product offerings, most notably through changing the way that they utilize technology. On its face, FinTech-based wealth management products appear to be a threat to traditional human advisors, less agile firms will likely find this to be true. For other firms, FinTech-based solutions offer an opportunity to increase advisor efficiency and meet regulatory requirements by utilizing hybrid advice models. By utilizing FinTech solutions, wealth management firms can free up advisors from routine tasks and allow advisors to offer a greater breadth of client services and improve client relationships.Despite its potential benefits, technology is also partly responsible for the continued fee-pressure wealth managers face. According to data from McKinsey & Company, pricing on fee-based accounts dropped by five basis points to 1.08% in 2017. Establishing a personal connection with clients is one way wealth management firms can differentiate themselves to help maintain pricing power. According to a 2018 study by Capgemini, only 56% of HNW individuals said they connected strongly with their advisor. Despite the strong market returns over the last two years, this low satisfaction suggests that performance is not the only concern of wealth management clients.ConclusionThe current fee-conscious environment favors advisors that offer a value proposition that software cannot replicate at lower cost. Ultimately, such a value proposition will likely need to be based on establishing real relationships with clients. Growing revenue on the back of strong markets may have masked the changes in the business for many wealth management firms, and the party may end if equity markets normalize going forward. One thing the industry has going for it is that the demand for wealth management services is clearly there, and increasingly so. The performance of wealth management firms will depend in large part on how well individual firms are able to adapt to an evolving landscape to capture growing demand.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Details and Analysis of Kimbell Royalty Partners’ Acquisition of Haymaker Minerals & Royalties, LLC
As we have discussed in previous posts, there are 21 main oil and gas-focused partnerships that are publicly traded, as of June 30, 2018. Publicly traded royalty partnerships have been slowly regaining the value lost when crude oil prices fell below $30 per barrel in early 2016. In the two years since June 2016, 16 of the 21 royalty partnerships have had positive returns with an average return of 48%. Over the past two years, the remaining five partnerships experienced a negative 31% average return. In those two years, natural gas prices have experienced an insignificant increase of just 5%, while oil prices have risen more than 50%. The underperformance of natural gas prices is due to the surge in production of shale gas since 2006 and the more recent rise of natural gas production as a result of increased oil production.Kimbell Royalty Partners, LP (KRP)The youngest of the 21 partnerships, Kimbell Royalty Partners, LP (“Kimbell,” “KRP,” or the “Company”), went public in February 2017. The Company’s IPO opened at $18.00 per share, initially offering 5 million shares. Since going public, KRP’s price struggled in its infancy and fell under $16 per share in mid-August 2017. This year has been much kinder to Kimbell due to the high crude price with its share price peaking at $23. Approximately 70% of Kimbell’s revenues are from oil and natural gas liquids.
Of the 21 mineral partnerships, Kimbell, Dorchester Minerals LP, Black Stone Minerals LP, and Viper Energy Partners LP are the only non-trust royalty partnerships and are either C Corporations or MLPs. These MLPs and C Corps are designed to gather assets and grow through acquisitions, focusing on both dividend payments and the growth of shareholder value. On the other hand, the other 17 are royalty trusts, which have a limited pool of assets and must return most of the cash flow earned from the royalties to the shareholders through dividends. Trusts’ capital structures limit opportunities for reinvestment, making it difficult to grow their asset base through acquisitions. Of the MLPs/C Corps, Kimbell has the highest dividend yield at 7.63%, with Dorchester, Black Stone, and Viper at 6.23%, 6.76%, and 6.02%, respectively. KRP is the smallest of the four partnerships with a market capitalization of $370 million, while Black Stone and Viper each have market capitalizations near $3.7 billion. 1Acquisition OverviewPrior to its acquisition of Haymaker Minerals & Royalties, LLC and Haymaker Resources, LP (collectively, “Haymaker”), Kimbell had nearly 5.7 million gross acres in nearly every major oil and gas basin across 20 states with a primary focus in the Permian Basin and the Mid-Continent. Kimbell solely invested in mineral and royalty interests with the largest portion of its production concentrated in the Permian Basin, where it had 1.75 million gross acres of mineral interests and ~200,000 acres of overriding royalty interests (ORRIs). Currently, KRP has 25 active drilling rigs on its acreage and mineral and ORRIs on 50,000 wells. Kimbell’s holdings in the Permian Basin alone account for 26% of its net royalty acres, 60% of its gross acreage, and 60% of active wells on its total acreage.In comparison, Haymaker had ~5.4 million gross acres and ~43,000 net royalty acres primarily focused in the Mid-Continent. Haymaker had royalty interests in 33,800 wells and had more than double the number of active drilling rigs than Kimbell with 51.
Kimbell acquired Haymaker for $404 million with $210 million of cash and 10 million newly issued common units going to Haymaker’s sponsors. The acquired company’s private equity sponsors are KKR & Co. LP (“KKR”) and Kanye Anderson Capital Advisors, LP (“Kayne Anderson”). Alongside the acquisition, Kimbell converted its tax status from an MLP to a C Corp. Kimbell believes that this conversion will give the company access to a much broader base of investors and access to a more “liquid and attractive currency.” Kayne Anderson’s and KKR’s willingness to take the newly issued shares, which will account for ~37% of Kimbell’s outstanding common units, shows the potential for investment growth that is achievable for Kimbell but not necessarily for Haymaker. Kimbell estimates that the acquisition will not only be accretive due to the quality of the assets, the acquisition will also be highly scalable and reduce the G&A costs on a per Boe basis.
After the acquisition, Kimbell will have more than 11 million gross acres spanning 28 states, with 38,000 of its 84,000 wells in the Permian Basin. As of April 27, 2018, Kimbell’s 73 rigs account for 7% of the total rigs in the United States. To calculate price per acre, Haymaker’s 42,759 net royalty acres must be converted to the industry standard 1/8 conversion since Kimbell uses a non-standard method of calculating net royalty acres. The conversion, which assumes eight royalty acres for every mineral acre, results with Kimbell acquiring 342,072 net royalty acres for $404 million. This results in an implied price of $1,181 per net royalty acre. At the time of the transaction, Kimbell’s market capitalization was approximately $327 million with an 8.7% yield. Post-transaction, KRP’s FCF yield rose to 12%, implying a 15% yield for Haymaker prior to the transaction.
Much of Haymaker’s acreage is congruent to Kimbell’s existing acreage and is an evenly split oil and natural gas mix. Haymaker’s acres enhance the Company’s position in the Permian and Mid-Continent and also increase its exposure in the Appalachian Basin and the Marcellus and Utica Shales. After the transaction, Kimbell’s production will be approximately 2/3 liquids and 1/3 gas. KRP believes that through the consolidation of costs, their pro-forma G&A expense can decrease by as much as 50% to $3.22 per Boe. This decrease is due to the increased scalability of Kimbell after the transaction. The transaction is also projected to increase the net production per unit by 56%. The Company estimates the increased production and the cutting of costs alone could lead to a 20% increase in distributable cash flow per unit.
AnalysisWhy would two companies with relatively comparable assets have such drastically different yields? Is it due to the fact that Kimbell is publicly traded while Haymaker is private? Perhaps the solution lies between the vast differences in public and private mineral market share sizes.Kimbell estimates that the total mineral buying market is close to $500 billion, excluding ORRIs. Public companies only make up 2.5% of the total market with a combined enterprise value of ~$12.3 billion. The two largest public, Black Stone Minerals and Viper Energy Partners, make up a combined $8.3 billion of that total value. While the public minerals market is only made up of a handful of companies giving public investors a limited number of investment options, the private minerals market is highly fragmented.Small mineral aggregators can operate with a higher attention to acreage details. These aggregators have the ability to negotiate directly with the landowners and handpick the acreage of their choosing. As a result, they expect higher yields than the public companies. While these yields are higher, the acreage is typically much more focused on certain areas. Combined with their small size, these investments are inherently riskier than a larger, more diverse pool of assets, such as those held by public royalty trusts.Kimbell’s acquisition of Haymaker demonstrates the disconnect between the public and private markets and the discounts at which private LPs are valued. It seems that private royalty LPs simply do not have the same access to capital as the public MLPs or C Corps. This lack of access is potentially why KRP and Haymaker have distinctly different yields, 8.7% and 15%, respectively, and why KRP was able to successfully negotiate such a highly accretive deal. Private equity investors/sponsors seem to recognize this–Haymaker’s sponsors for example. Haymaker’s sponsors, a well-respected private equity firm (KKR) and one of the leading energy investors (Kayne Anderson), most likely saw the potential behind the accretive mix of the two companies, which is why they were willing to accept roughly 50% of the purchase price in Kimbell shares. Not only was Kimbell public, its transition to a corporation opened itself up to a broad array of inexpensive capital, far less expensive than what Haymaker could find. This access to cheaper capital makes it easier for Kimbell to grow through acquisitions and continue to increase its returns and shareholder value. Kimbell has the potential for growth as a public corporation far beyond what a private company like Haymaker could achieve.Public investors are looking for opportunities to invest in mineral plays; however, many of these investors’ only opportunity to do so is through public companies. Following the rise of crude oil prices, the increased demand from public investors has driven up the prices of the royalty trusts and MLPs and, in turn, lowered the yields. More and more investors, including institutional investors, are looking towards the mineral market to find investment growth. The emerging field of mineral aggregators has the potential to provide this growth through accretive acquisitions, as well as steady dividend payments, that public investors crave.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQOur thanks to Daniel Murchison who drafted and did much of the research for this post in collaboration with our Energy Group.
Valuation of a Business for Divorce: Overview of Valuation Approaches, Normalizing Adjustments, and Potential Need for Forensics Services
Valuation of a business can be a complex process requiring certified business valuation and forensic accounting professionals. Valuations of a closely held business in the context of a divorce are typically multifaceted and may require forensic investigative scrutiny for irregularities in the financials that may insinuate dissipation of business/marital property. Business valuations are a vital element of the marital dissolution process as the value of a business, or interests in a business, impact the marital balance sheet and the subsequent allocation/distribution of marital assets.Valuation ApproachesTo begin, the financial expert will request certain information and interview management of the Company. Information requested typically includes:Financial statements (usually the last five years)Tax returns (usually the last five years)Budgets or forecasted financials statementsBuy-sell agreementInformation on recent transactionsPotential non-recurring and/or unusual expensesQualitative information such as business history and overview, product mix, supplier and customer data, and competitive environment
The financial expert must assess the reliability of the documentation and decide if the documents appear thorough and accurate to ultimately rely on them for his/her analysis. The three approaches to value a business are the Asset-Based Approach, the Income Approach, and the Market Approach.The Asset-Based ApproachThe asset-based approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to write up (or down) or otherwise adjust the various tangible and intangible assets of an enterprise.The Income ApproachThe income approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.The Market ApproachThe market approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations.The Levels (Premise) of ValueDoes it make a difference in value per share if you own 10% or 75% of a business? You bet it does. A 10% interest is a minority interest and does not enjoy the prerogatives of control. How does this affect value per share? The minority owners bear witness to a process over which they may have no control or discretion. In effect, they often play the role of silent partners; therefore, the fair market value per share of a minority owner is likely worth less per share than the shares of a 75% owner.Likewise, a minority owner of a private business likely does not have a ready market in which to sell their interest. Minority ownership in a publicly traded company enjoys near instantaneous liquidity such as trading stock on organized and regulated exchanges. The unique uncertainties related to the timing and favorability of converting a private, minority ownership interest to cash gives rise to a valuation discount (lack of marketability discount) which further distances the minority owner’s per share value from that of a controlling owner’s value per share.The following chart provides perspective of the various levels of value. In most cases a valuation is developed at one level of value and then a discount or premium is applied to convert to another level. These discounts are known as discounts for lack of control and lack of marketability. Knowing when to apply such adjustments and quantifying the size of these adjustments is no simple matter, requiring the need for a credentialed business valuation professional.Importance of Normalizing AdjustmentsNormalizing adjustments adjust the income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. Keep in mind the levels of value in business valuation, discussed above. In creating a public equivalent for a private company, another name given to the marketable minority level of value is “as if freely traded,” which emphasizes that earnings are being normalized to where they would be as if the company were public, hence supporting the need to carefully consider and apply, when necessary, normalizing adjustments. There are two categories of adjustments.Non-Recurring, Unusual ItemsThese adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, expenses of non-operating assets, and the like. Examples include, but are not limited to:One-time legal settlement. The income (or loss) from a non-recurring legal settlement would be eliminated and earnings would be reduced (or increased) by that amount.Gain from sale of asset. If an asset that is no longer contributing to the normal operations of a business is sold, that gain would be eliminated and earnings reduced.Life insurance proceeds. If life insurance proceeds were paid out, the proceeds would be eliminated as they do not recur, and thus, earnings are reduced.Restructuring costs. Sometimes companies must restructure operations or certain departments, the costs are one-time or rare, and once eliminated, earnings would increase by that amount.Discretionary ItemsThese adjustments relate to discretionary expenses paid to or on behalf of owners of private businesses. Examples include the normalization of owner/officer compensation to comparable market rates, as well as elimination of certain discretionary expenses, such as expenses for non-business purpose items (lavish automobiles, boats, planes, etc.) that would not exist in a publicly traded company.For more, refer to our article “Normalizing Adjustments to the Income Statements” and Chris Mercer’s blog. The Need for Forensic ServicesThe process of valuing a business is complicated and the financial expert, during the course of his/her analysis, must consider various levels of value, normalization adjustments, as well as methods of valuation to most appropriately conclude on the business.Valuations of a closely held business in the context of a contentious divorce can be especially multifaceted and may require additional forensic investigative scrutiny for any irregularities in the financials that may insinuate dissipation of business/marital property in anticipation of the divorce and valuation. Examples may include, but are not limited to: Owner Compensation. Owners may reduce earnings in anticipation of divorce to appear to have lower earnings capacity. Owners or executives with ownership interest may have made arrangements within the business to receive a post-divorce pay-out. A financial expert, through review of historical financial statements and tax returns, as well as an analysis of the lifestyle of the family, may gather support of the true earnings.Rent expense. Owners of a company may also own the land and/or building to which the business’ rent expense is paid, otherwise referred to as a related party. If the rent has increased in anticipation of the divorce, the related party may be taking on pre-paid rent or higher than market rent rates to reduce income. A financial expert may review historical expenses and assess the reasonableness of the rent expense.Discretionary expenses. Owners may use business funds to pay for personal, non-business related expenses such as vacations, lavish cars, boats, meals & entertainment, among others. A financial expert can review historical transactions to assess if such items are non-business related and if normalization adjustments are necessary for valuation purposes.
It is important to consider these types of situations if only one spouse is involved with the operations and management of the company, otherwise referred to as the “in-spouse.” That spouse may, or may not, have been altering the financial position of the business in anticipation of divorce and a potential independent business valuation. The services of a financial expert can be vital to you and your client in such matters, as the accuracy of the valuation may impact the equitable distribution of the marital assets.ConclusionIf suspicions do not necessitate forensic services, perhaps only a business valuation scope is necessary. Furthermore, if the business or an interest was recently bought or sold, if it was recently appraised, or if its value is in a financial statement or a loan application, that information may go a long way in establishing the value of the business (if both parties feel that this value is a fair representation). However, since a business valuation report and expert witness are admissible in court as evidence and since the value of a business or interest impacts the marital balance sheet and the subsequent asset distribution, it may be exceedingly beneficial to hire a professional for evidentiary support.Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
RIA Stocks Post Mixed Performance During 2Q18
Over the last several years, asset managers have benefited from global increases in financial wealth driven by a bull market in asset prices. However, favorable trends in asset prices have masked some of the headwinds the industry faces, including increasing consumer skepticism of high-fee active products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as undifferentiated active products have struggled to withstand downward fee pressure and at the same time, have been a major target of regulatory developments. To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale). Consumers have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are better positioned to withstand fee pressure as a result.Second Quarter PerformancePerhaps reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the second quarter. While major indices regained traction during the second quarter, the returns for asset managers were generally more muted even though these businesses generally benefit from rising markets. The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case. The reversal of that trend last quarter may be indicative of investors’ increasing focus on the headwinds the industry faces and the general uncertainty that arises late in the economic cycle.
Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 3.7%, while other categories of asset managers generally saw positive returns. Trust banks were up 2.4% during the quarter, buoyed by a steadily rising yield curve which portends higher NIM spreads and reinvestment income. Alternative asset managers were up 2.8% during the quarter as this product segment is less impacted by fee pressure than traditional active products. Wealth managers were up 3.8% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power.
The RIA size graph below shows a similar trend for most of its categories. The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 15% during the quarter, although this is the least diversified category of RIAs with only two components. Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost nearly 15% of their value since April as suggested by this graph.
Market OutlookThe outlook for these businesses is market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does on the back half of the year.
Takeaways from FinXTech 2018: The Rise of Bank and FinTech Partnerships
I recently attended FinXTech, an industry event where the hosts at Bank Director bring together FinTech founders and bank directors and executives for productive conversations about the road ahead as partners (and competitors).Those discussions occurred against a backdrop in which FinTech, as a concept to enhance the customer experience and to drive operating efficiencies, is widely accepted by bank management, shareholders, and regulators. How “FinTech” is implemented varies depending upon resources. As shown in the Table 1, there has been no surge of M&A in which banks buy FinTech companies. Only nine of 276 transactions announced since year-end 2016 entailed a bank or bank holding company acquirer. KeyCorp, which has been one of the nine active FinTech acquirers, announced in June 2018 that it would acquire digital lending technology for small businesses built by Chicago based FinTech company Bolstr. At best, activity can be described as episodic as it relates to bank acquisitions, which appears to be designed to supplement internal development.The very largest banks such as JPMorgan Chase & Co. are spending billions of dollars annually to upgrade technology—a level of spending that even super regional banks cannot match. In contrast, community and regional banks have been left scratching their heads about how to address FinTech-related issues when money is a constraining factor.During the FinXTech 2018, the focus shifted from the potential disruption of a bank’s franchise by FinTech to the potential to partner with FinTech companies, which stood out to me as a marked change from prior years.Both banks and FinTech companies realize that they need each other to some degree. For banks, FinTech offers the potential to leverage innovation and new technologies to meet customer expectations, enhance efficiency, and compete more effectively against the biggest banks. For FinTech companies, the benefits from bank partnerships can include the potential to leverage the bank’s customer relationships to scale more quickly, access to funding, and regulatory/compliance expertise. Several examples of successful partnerships between banks and FinTech companies were highlighted at the FinXTech event. (You can read more about some of them here.)The FinTech/Bank partnership theme also was evident in GreenSky’s recent IPO, a FinTech company based in Atlanta. GreenSky arranges loans primarily for home improvement projects. Bank partners pay GreenSky to generate and service the loans while the bank funds and holds the loans on their balance sheet. As more partnerships emerge, it will be interesting to see if FinTech impacts the valuation of banks that effectively leverage technology to achieve strategic objectives such as growing low-cost core deposits, opening new lending venues, and improving efficiency. One would think the answer will be “yes” if the impact can be measured and is meaningful.Another trend to look for will be whether smaller banks become more active as investors in FinTech companies. For the most part, investments by community and regional banks in FinTech companies remains sporadic at best even though FinTech companies raised nearly $16 billion of equity capital between year-end 2016 and June 2018 in both private and public offerings. An interesting transaction we observed was a $16 million Series A financing by Greenlight Financial Technology, Inc., a creator of smart debit cards, in which the investors included SunTrust Bank, Amazon Alexa Fund, and $619 million asset NBKC Bank, among others.FinXTech 2018 included several sessions related to due diligence for FinTech partnerships; however, with limited M&A and investing activity by banks there was little discussion about valuation issues, which can be challenging for FinTech companies and differs markedly from methods employed to value a bank.Not surprisingly, we have lots of thoughts on the subject.With the emerging partnership theme from FinXTech 2018 in mind, view our complimentary webinar “How to Value an Early-Stage FinTech Company.” Additionally, if you have questions, reach out to one of our professionals to discuss your needs in confidence.Originally published in Bank Watch, June 2018.
Growing Pains Curb Valuation Gains in the Permian
2Q18 Review
[caption id="" align="aligncenter" width="337"]Too much to swallow?[/caption]
The story of the Permian Basin in 2018 so far has been developing as one of the finest proverbial "fishing holes" in the world. However, as the year has progressed, it appears many industry players have found their reputed "catch" too big to process and are scrambling to deal with it before it begins to stink.
Translation: the year began with a flurry of developmental drilling activity followed by an emerging bottleneck. The unintended consequence of this has been that some operators have been growing oil production too fast for pipeline and infrastructure to keep up. A pricing differential has arisen due to the supply glut and there has been concurrent stagnation in valuations. Here’s how some of it has transpired through the timeline of the first half of 2018.
Q1: Flocking to the PermianThe Permian's 2018 journey began on the same trajectory that 2017 ended with growth, investment, and more growth. This has been for a good triumvirate of key reasons too:Estimates vary by county, producer, and information source, but according to Bloomberg Intelligence, recent break-even prices in the Permian were as low as $38 in both the Delaware and Midland Basins.3Some of the best shale stacked geology in the world, andLong-standing pre-existing infrastructure to get petroleum to market (the play has been active since the 1920's).
It's no wonder the Permian continued to attract operators and capital. Capex budgets were not only growing for operators as a general matter, but increasingly higher percentages of those budgets were geared towards being spent in West Texas. The chart below demonstrates this trend:
Transactions in other basins were driven by motivations to re-deploy cash in the Delaware Basin, Midland Basin, or both. We discussed this in a recent post. Operators and mineral holders in other basins watched as activity and capital flocked to the Permian Basin.
Q2: Hydrocarbon Traffic Jam However, plans, forecasts, and reality clashed around the end of the first quarter of 2018. Although the takeaway capacity and infrastructure were present, it wasn't enough to keep up with growth, and it has burst at the seams. This first began to be hinted at back in 2017, in regards to the growth and when new pipelines were coming online; it was discussed as a real problem issue in April with a few foreboding articles.This has led to capacity issues on a meaningful scale and there's too much of a good thing as a result. Goldman Sachs' research team put together an interesting infographic that was referenced by HFI Research that characterizes it well:Local Permian Oil & Gas Prices: Falling FastThis has led to a rapid change in local wellhead prices in the Permian. As early as January 2018, wellhead prices in the Permian were trading at a premium to markets at Cushing, OK. However, as seen below in this Bloomberg chart, the gap skyrocketed over the course of the next 45 days and is currently hovering around $12 per barrel. The primary driver of this differential is nested in alternative transportation costs as shown above. This glut of production has rendered local natural gas to an almost forgotten status. In the Permian, natural gas at the wellhead is almost worthless in some cases. There's nowhere for it to go, and many producers have little choice but to burn (or flare) its' gas at the wellhead.
It's not bad news for all in the oil patch. Some players are embracing the turn of events. Refiners are welcoming the low prices as they are able to arbitrage price differences at the gasoline pump and midstream producers are getting top dollar to transport more crude out of West Texas. However, for many E&P producers (and royalty & mineral holders) this presents not only a problem from a pricing standpoint but from a future drilling standpoint as well. Plans made as recently as a few months ago are undoubtedly being reconsidered by many producers. The ones who have secured takeaway capacity are letting the market know about it.
Q3 and Beyond: Valuation Stagnation and what about Backwardation?Valuations for Permian focused producers have stagnated this year. Since January 1st only a handful of companies stock prices are up, while the majority have actually declined.
This would appear counterintuitive in light of the overall optimism in the space. Doesn't that bottleneck restriction push prices higher? Isn't that a good thing?
The answer is true in many respects, and producers worldwide and in other basins are reaping the benefits of this. However, as far as Permian focused producers are concerned, they don’t get these benefits. They are getting around $60 per barrel, instead of $70+ right now.
Also, remember that valuations are a function not only of reserves (which are just as robust and optimistic as they have been recently), but of ultimately the production, cash flow, and timing that result from the development of those reserves. This development has impacted all three:
Production is anticipated to be curbed (at least until the bottleneck is dealt with – which might not be until late 2019 at this point);Cash flow is impacted by both production limitations AND pricing differentials; andTiming of when those cash flows will be received has been delayed.
Speakers at a recent ASA Energy Conference in Houston, mentioned that certain upstream management teams have expressed elements of frustration that investors have not rewarded valuations with the oncoming of robust Q1 earnings, particularly out of the Permian Basin. We're not so sure that's the case. Acreage grabbing has slowed and earnings are expected to follow with all of the favorable aspects of the Permian. Perhaps trepidations about this bottleneck and pricing differentials have fueled concerns and hampered values.
Additionally, if futures curves are any indication, there is an expectation that prices will return from the current $70+ environment back down into the low $50s per barrel in a few years.However, the good news from a longer run perspective is that most producers make capital expenditure decisions from a longer-term perspective (several years out) due to the time it takes to deploy that capital and when it begins to make a return. With break evens so low, this disruption – even if it lasts through 2019, does not change the longer term outlook in the Permian. It mostly delays it, which is a good reason why stock values are on hold right now.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, biofuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Thinking About Going Exclusive?
Five Considerations for RIA/BD Hybrids Looking to Drop Their BD Status
With the Advisor Rule looming and commissions dwindling, it may be time for some RIA/BD hybrids to take it to the next level: drop the broker-dealer license and register exclusively with the SEC as an investment advisor. This week’s post focuses on what’s driving the downward trend in BD-only registrants and when it makes sense to abandon the hybrid model.
We’ve not included many images of hybrid vehicles on this blog, and for good reason. They’re usually not the most aesthetically pleasing cars and therefore unlikely to generate good click bait for our readers. They can, however, be extremely (fuel) efficient and practical in certain contexts. The same could probably be said of hybrid RIA/BD firms, as the traditional broker-dealer model continues to lose ground to hybrids and fee-only RIAs.
According to the Financial Industry Regulation Authority (FINRA), the number of broker-dealers has dropped 24% over the last decade, from 4,891 in 2008 to just over 3,700 today. The Credit Crisis is partially responsible as the entire industry’s reputation and financial viability suffered a huge blow, forcing many BDs to consolidate or go out of business. The rise of online DIY trading platforms and low fee ETF products exacerbated this trend as commission income spiraled downward to stay competitive. The rising expenses and nuisances associated with FINRA registration also pressured firms down the RIA path, and the recent overhang of the Fiduciary (now Advisor) Rule hastened this transition for many industry participants.
Many hybrids are considering dropping their BDs. Should you follow their lead? That really depends on a number of factors.1. BD Income’s Overall Contribution to Your Total RevenueIf commissions and/or trading income represent less than 10% of your total revenue, then you should seriously consider dropping the BD license. Your compliance and FA/broker expenses alone may well exceed what you’re taking in from the FINRA registration. This seems simple and obvious, but many hybrids originally operated as a broker-dealer, and the transition to (RIA) exclusivity can be daunting and sometimes difficult to implement in practice. The good news is that transition costs are one-time; whereas, the forgone compliance expense associated with dual registration is an ongoing benefit.2. Top Line Exposure to Bear MarketsIt’s been over nine years since we had a sustained market downturn. We’re probably overdue. Many hybrids have been transitioning toward the RIA model for quite some time but are reluctant to drop the BD license because it offers some cushion against falling advisory fees when AUM plummets with the market. The asset-based revenue model has been great for FAs largely invested in equities since the Financial Crisis, but that won’t always be the case. Commissions and trading income aren’t completely market proof but do offer some hedge against revenue declines from down markets. If your firm manages mostly equities and primarily charges asset-based fees, you may not want to totally abandon your BD status just yet.3. Emphasis Clients Place on the Fiduciary Standard Over the Suitability StandardMany years ago most your clients probably didn’t know or care about the distinction. Now your best clients, and particularly your best prospective clients, likely are not only familiar with these terms but understand the implications. If your hybrid is not technically a fiduciary, you may want to change that before ditching your BD license.4. The Costs (and Headaches) Associated with Dual RegistrationI think most industry participants would agree that less is more when it comes to regulatory oversight, and several clients have told us that FINRA compliance is more burdensome than the SEC’s. Devoting capital and resources to compliance matters can be a huge distraction. Abandoning the BD license could be a quick fix if it’s not doing much for you in the first place.5. Your Firm’s IdentityDo your clients and other stakeholders see the company as an advisory firm or broker-dealer? Are you operating as a fiduciary for clients or selling proprietary products and/or executing trades on their behalf? Either route may have served you well in the past, but it may be time to choose a path. Acting as a fiduciary to some (but not all) clients could lead to conflicts of interest and confuse your role to prospective clients. Picking a side would clarify this message and potentially land more business from investors looking for an RIA or BD firm but not necessarily both. If, on the other hand, a hybrid culture has been instilled across the firm for quite some time, it may not be worth the hassle or cost to go the exclusive route.Undoubtedly, there are other things to keep in mind if you’re thinking about going exclusive. You can take some comfort in knowing that you’re not alone. Industry consultants Cerulli Associates estimates that hybrids have grown to roughly 15% of the industry, up from 7% in 2004 as BD-only firms have declined in number while fee-only RIAs have grown more modestly in recent years. Still, this trend is probably not sustainable with a looming Advisory Rule, so you need to be thinking about your options if you haven’t already done so.
Take What You Can and Get Out
When oil prices crashed in mid-2014, companies were forced to become more efficient in order to survive. It became clear that location meant more than ever and companies could no longer justify operating in regions such as the Bakken and the Eagle Ford, where break-even prices were higher than they were in the Permian. Thus in order to stay in business, companies flocked to the Permian. This week, we look at how the increased appeal of the Permian Basin has affected M&A activity in the oil and gas sector.The trend towards the Permian Basin was somewhat slow to begin as the uncertainty that accompanied the price collapse led to a standstill in activity. While some investors were quick to move to the Permian when acreage was still relatively inexpensive, most were slow to sell their acreage in other basins as the low oil price environment pushed down the price of acreage. Now that the Permian has become the clear leader in production, M&A activity in the region has picked up and multiples for Permian acreage have increased due to high demand. Although it was three to four years ago that the Permian emerged as the cost leader, companies are still moving to the Permian with haste.This trend is especially apparent as it relates to Pioneer Natural Resources’ recent acquisition activity. Pioneer announced earlier this year that it would shift its focus to become a pure-play Permian producer, with plans to spend its entire $2.9 billion capex budget in the Permian Basin.Since the announcement, Pioneer sold Eagle Ford assets for $102 million and southeastern Colorado assets for $79 million, as summarized below. It appears that Pioneer was willing to take a loss in order to re-deploy capital to the Permian Basin.
In March 2018, Pioneer sold its assets in the Eagle Ford for $10,000/acre and $92,727 per flowing barrel. The price Pioneer received was in line, or even above, industry averages which are more along the line of $4,200/acre and $98,000 per flowing barrel.
However, this month Pioneer announced the sale of its Raton assets for only $79 million, a multiple of $5,600 per flowing barrel. Meanwhile, multiples for acreage in southeastern Colorado are not expected to be at the same level as multiples seen in the Eagle Ford. BusinessWire reported that this sale “is expected to result in a pretax noncash loss of $65 million to $75 million.”
Pioneer seems to have shifted its strategy from a planned liquidation to a "take what you can and get out" approach.While Pioneer just exited its current position at multiples lower than what might be otherwise expected for the region, they are looking to buy acreage in a region where multiples have flown through the roof. Recent acreage transactions in the Permian Basin are closing at median multiples of $16,000 per acre and over $180,000 per flowing barrel as summarized below, according to Shale Experts.Pioneer’s recent transaction activity shows the urgency with which companies are now shifting their focus to the Permian. Pioneer’s acceptance of a large loss for its Raton assets is symptomatic of the recent dominance of the Permian to all other U.S. shale plays. And while Pioneer accepted a loss in order to sell its acreage at meager multiples of $5,600 per flowing barrel, it will now likely use that cash to pay for Permian acreage at multiples of over $100,000 per flowing barrel.Part of the reason for paying the premium multiple can be explained by the existence of more proved undeveloped (PUD) reserves in the Permian Basin as compared to other regions. Many transactions in the Permian are motivated by the existence of future drilling potential over current production. Thus multiples of current production in the Permian are inflated when compared to transactions in regions that have more current production but less potential for the development of PUD reserves. However, the difference is mainly due to the obvious benefits of operating in the Permian Basin as compared to other unconventional shale plays, including low break-even prices, efficiencies generated multiple stacked plays, and lower costs from shorter transportation distances to refineries. However, it is worth noting that increased drilling activity in the Permian Basin is beginning to strain the existing infrastructure in the Permian, creating transportation bottlenecks (or as Bryce Erickson likes to call it, a hydrocarbon traffic jam).Javier Blas with Bloomberg recently pointed out the logistical difficulties in getting Permian oil and gas to market and the growing price differentials as a result. This could be a cause of short to intermediate term revenue and valuation disruptions for some producers.With such wide range of observed transaction multiples, it is especially important to understand each transaction and the main drivers of value before using a transaction as a benchmark of value. We have assisted many clients with various valuation needs in the upstream oil and gas space in the Permian Basin, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Piping Hot Permian
Production in the Permian is as hot as the summers in West Texas. Despite being discovered in the 1920s, it was not until 2007 that the region’s true potential was realized when hydraulic fracturing techniques were used to access the play's tight sand layers. Given its low-cost economics and large well potential, in recent years, the Permian has been in the limelight with operators and investors alike prioritizing the region.According to Baker Hughes, there are virtually no active gas-directed rigs, but significant gas production is still occurring in the region because natural gas is coming as a by-product from the oil rigs. As we discussed in a previous post, this is having a negative effect on natural gas prices and producers outside of the Permian. Companies in the Permian have an advantage because they do not have to choose between oil and gas, and production is more efficient. As such, the Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus.Rig Counts and ProductionWith many producers clamoring for a piece of the action, the number of rigs in the Permian has consistently grown at a faster rate than total rig counts in the country. As a result, the Permian has increased its share of total rig counts, as seen in the graph below. In June 2015, the Permian accounted for 27% of all rigs, but that number steadily increased to 45% as of June 2018. The number of rigs in the Permian has grown 32% in the past year, compared to 16% nationally; these figures were 156% and 125% for the year before that.
According to the EIA, production of oil and natural gas in the Permian Basin has increased at a compound annual rate of 25.0% and 21.1%, respectively over the last five years. In the past year alone, oil production increased 35.6% and gas production increased 26.5%, with over 45% of the U.S.’ crude oil and 15% of the country’s natural gas currently coming from the Permian Basin.1 A concerted effort has been made to increase efficiency, which has led to a rise in production per well. Oil production per rig in the Permian increased more than 36% in the last year, which, when combined with the rise in rig count, further emphasizes the focus on the region.
Economic ImpactWith this rush to West Texas, Midland and Odessa are in the middle of the action. The boom has had a large impact on their economies as a whole. Population growth from 2016 to 2017 was estimated at 4.2% for Midland and 4.8% for Odessa, compared to 2.0% for Texas and 0.8% for the country. Unemployment was also extremely low at 2.1% and 2.8%, respectively, compared to 3.8% for the state and 3.7% for the country. The national unemployment rate is already at its lowest of this millennium, emphasizing how razor-thin the margin is in Midland. This has caused significant labor shortages in other sectors of the economy as they cannot compete with $28/hour wages offered after minimal training requirements for workers in the oil sector.Valuation ImplicationsWe can understand the valuation implications for companies in the Permian Basin by looking at 1) royalty trusts and mineral rights aggregators and 2) E&P companies.Royalty TrustsPositive market sentiment for the Permian region can be viewed in the performance of both operators in the region and publicly traded royalty trusts with exposure to the Permian. As seen in the following tables, royalty trusts in the Permian have seen far superior two year returns. Also of note is the average size measured by market cap. Viper Energy Partners, Black Stone Minerals, and Kimbell Royalty Partners are all aggregators of mineral interests and are not restricted from acquiring new interests like many other royalty trusts. This causes them to be larger, and it also allows them to gain exposure to new, advantageous regions, which may play a role in all of them having exposure to the Permian.
Royalty Trusts typically decline in both production and level of reserves. For the trusts with properties outside of the Permian, they have averaged decline rates of 14% for production and 21% for reserves over the past three years.2 However, trusts in the Permian are increasing at average rates of 13% for production and 7% for reserves. This indicates the increased activity in the region, though again, it should be noted that some of the trusts that are not restricted from acquiring new properties are likely to be categorized in the Permian group as they would have sought exposure to the region.
E&P CompaniesAs seen in the graph below, E&P companies valuation multiples on average remain highest in the Permian, but they have declined 21% in 2018. Multiples in the Bakken and Eagle Ford meanwhile have cut into the gap, increasing 34% and 25%, respectively since the beginning of the year. The Marcellus and Utica continue to see the lowest valuation multiples and have declined by 2% in 2018. Companies in the Permian are generally more profitable than companies in other regions as explained by their lower break-even prices. According to Bloomberg Intelligence, recent break-even prices in the Permian were $38 in both the Delaware and Midland Basins.3 This represents a 6% decline for the Delaware Basin since June 2017, compared to a 28% decline in break-even price for the Midland Basin. These break-even prices compare favorably to $40 in the Bakken and about $44 in the Eagle Ford.
Production in the Permian appears to be full steam ahead. And as they say, if you can’t stand the heat, stay out of the Permian.
We have assisted many clients with various valuation needs in the oil and gas space in the Permian region, other conventional and unconventional plays in North America, and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
End Notes1 EIA; Calculations based on monthly crude oil and gas production and EIA drilling report by region
2 Capital IQ; Calculations based on production and reserve figures reported in royalty trust 10-K’s
3 Bloomberg Intelligence; County Level Estimate
3 Things All Mineral Owners Should Know
Minerals Workshop at the DUG Permian Basin Conference
On May 21, Mercer Capital attended the Minerals Workshop at the DUG Permian Basin Conference in Fort Worth, Texas. The agenda included five presentations and eleven speakers, including royalty brokers, royalty aggregators, and royalty managers.
Speakers included:
Leslie Haines, Hart EnergyGeorge Soulis, Oil & Gas Asset ClearinghouseDarren Barbee, Oil and Gas InvestorC.H. Scott Rees III, NSAIJames R. Elder, Momentum Minerals LLCNick Varel, Wing Resources LLCWill Cullen, LongPoint Minerals LLCJames Wallis, NGP Energy Capital ManagementJames S. Crain, EnCap Investments LPJohn M. Greer, Latham & Watkins LLPHenry S. May III, Post Oak Energy CapitalMike Allen, Providence Energy Corporation
We learned about changes in the royalty market, mineral investor required returns, private equity strategies and due diligence musts for buyers. In light of the information, three themes emerged that mineral owners should know about the royalty market.Growing Universe of Mineral BuyersWith the interest rate environment near all-time lows, many investors are looking for alternative investments to provide higher yields. This has driven private equity money into oil and gas. While part of private equity is targeting returns in operating exploration and production companies, mid-stream assets and refineries, significant money has found its way into the mineral and royalty market. Over the past four years, the mineral business has changed due to a surge in popularity. Minerals provide higher yield investment opportunities in a low yield environment. As a result of the surge, buying minerals is getting more and more competitive. Many of the speakers mentioned the prices for mineral buyers are increasing, and the market is attracting larger and more efficient mineral buyers. One speaker mentioned that prices on the ground have increased 40% to 50% in the last several years. In effect, increased competition is making it tough for the “small guys” to compete. A low yield investment environment is driving more money into the industry, increasing the number of buyers, increasing competition, and driving up prices of mineral interests. The chart below demonstrates the upward trend of the three most discussed mineral "aggregators" at the Minerals Workshop.Target Double-Digit ReturnsInvestments are graded based on the returns of alternatives and their prospective risk. For example, debt issued by the United States Treasury Department is considered “risk-free” (we can discuss the merits of that assumption later). Therefore, the yields for U.S. Treasury bonds and bills provide a measure of risk-free required returns. As of June 11, 2018, the 20 year Treasury bond yields approximately 3.10%, which means nothing without a comparison. For comparison, buyers of mineral rights have target returns upwards of 50% in some cases. While bonds produce low 3% returns, large capitalization equities in the public market return 5% to 8%. An asset class that can produce 50% returns is a significant difference! While part of the delta is due to the incremental risk assumed by the buyer, a significant reason for the delta is due to the negotiating power many mineral buyers have flexed in the industry over the last few years.To put it simply, demand for mineral rights was low in the last quarter of 2014. This is understandable as oil prices collapsed from $100+ to $20’s. Interest was low, oil and gas operators were going bankrupt, and the outlook was uncertain. As a result, the activity level for selling mineral rights was low to non-existent. Therefore, when one of the private equity speakers mentions “in 2015 there were many mineral interests to purchase,” it should come as no surprise. They were buying when there was “blood in the street.” Since that period of time, many operators have recovered, the Permian Basin has become the hottest shale play in North America, and oil prices have reached $60+. Investment capital has taken notice of the higher return opportunity and has created more demand for mineral rights. The interest has been spurred on by the promise of high rates of return.Of the 11 presenters, more than half shared their targeted internal rates of return for their investments. The interesting part of this discussion was not the high double-digit returns, but the range of returns each was targeting. For mineral and royalty interests, target rates of returns were 10% to 50%. It was clear that broad range was based on several factors including: (1) use of leverage; (2) time horizon; and (3) information. One might wonder how mineral buyers are able to create this type of return in an increasingly competitive market. The reason for this: actual and perceived information asymmetry between buyers and sellers.Asset Knowledge & Due DiligenceWhen a mineral buyer approaches a mineral owner, there is a real chance the buyer knows more about the minerals than the owner.Increasingly sophisticated buyers perform the following due diligence on mineral and royalty interests: (1) Analysis of the lease historical production; (2) well spacing analysis; (3) infrastructure analysis; (4) reserve and geological analysis; (5) decline curve analysis; (6) “closeology” analysis which is using public data from operators to assess the activity within an area; and (7) lease detail analysis. All of which, is done before offers are made to the mineral owner. However, buyers don’t stop there. After an offer is made, more due diligence is performed which requires mineral ownership approval. These due diligence steps are focused on cash flow and pricing differential analysis which can be understood from check stubs that royalty owners received each month.Since many mineral rights and royalty rights are passed down from generation to generation, it is not uncommon for the 2nd, 3rd, or 4th generation owners to negotiate from a disadvantaged position, due to lack of information sometimes not transferred from one generation to the other. All of the above due diligence items are available to the mineral owner; however, it takes time and experience to know where to find the information and to understand the data. Information asymmetry is one of the biggest reasons the market for royalty sellers is inefficient. Large, very highly capitalized buyers have invested the time and energy to understand the opportunities in minerals and utilize this advantage in negotiations.We have assisted many clients with various valuation needs in the upstream oil and gas space in the Marcellus and Utica areas, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Tax Reform and Purchase Price Allocations for Oil & Gas Companies
On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code.The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes.The change in tax rate will have the biggest impact on purchase accounting. In the energy industry, this will manifest itself in several ways. This blog post explores some of the impacts to valuations performed under fair value accounting in ASC 805 and ASC 820.Cash Flows and ReturnsWhen we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings.The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value). This could mean incentives for energy-oriented companies to (i) create a more modernized drilling rig fleet sooner that are best suited for today’s multi-frac lateral wells and (ii) accelerated plans to create more infrastructure and pipelines in active basins such as the Permian, Bakken and Eagle Ford. In addition, it also could drive more refinery and LNG liquefaction plant development. In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price.On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged.In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt.Keeping other inputs constant, this modestly increases WACCs.Relief from RoyaltyUnder the relief from royalty method, after-tax royalties avoided increase as the tax rate falls.However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.Scenario AnalysisIn a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit.Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted.As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.Cost ApproachThe cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used.If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected.If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB. Multi-Period Excess Earnings Method The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows.On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB.As far as contributory assets are concerned:Relief from royalty asset charges will increase under a lower tax rateWith and without scenario analysis with level payments charges will potentially decrease due to the lower base valueCost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculationsReserves & Goodwill The net impact of a lower tax rate on goodwill will vary by transaction. Since reserves are typically viewed through a pre-tax lens, the value of reserves could be muted (all else held constant). However, we note that if tax incentives increase CapEx and drilling plans, then more reserves could move up the category chain (P2 to P1 for example) and thus increase the fair value of reserves. If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill. This would apply more to intangible based energy companies. Upstream companies typically do not book goodwill. If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.The changes to corporate taxes under the new bill are wide-ranging.In addition to the effect of lower rates discussed in this post, fair value specialists need to be alert to how other specific provisions of the bill may influence individual energy companies.Impact of Tax Rate Decrease on Valuation MethodCash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction priceTax Amortization Benefits DecreaseRelief from Royalty Method Increase (potential offset by decrease in TAB)Cost Approach (pre-tax) No ChangeCost Approach (post-tax) Increase (potential offset by decrease in TAB)With and Without Scenario Potentially lower (potential offset by decrease in TAB)MPEEM May Increase or Decrease (depends on magnitude of other changes)
Summer Reading for the RIA Community
Focus Financial’s IPO Filings
Money, being what it is, never sleeps. It also never goes on vacation. I was, however, about to spend ten days away from the office with my older daughter in Scotland and England when Focus Financial (finally) filed for a public offering. One of the most anticipated events in the wealth management industry, the pendency of the Focus IPO didn’t cancel my trip, but I knew that my vacation was going to be at least punctuated by reading the S-1 along with my peers’ commentaries. I’ve now read the 275-page document a few times, and while it’s not your typical beach novel, the Focus prospectus is required summer reading for anyone in the RIA community.The First Question to Ask of Any IPO is “Why?”Initial public offerings are sacramental in the church of capitalism. At one time, IPOs represented a coming-of-age when growing asset-needy businesses could finally have the financing they required to expand into leading, mature organizations. Today, public offerings may just represent the day when private equity backers decide they would rather someone else own a business instead of them. IPOs can, in many cases, be read as a sell-signal.In spite of this, public offerings still generate a surprising amount of enthusiasm. My daughter and I started our trip at the Aston Martin dealership in Edinburgh, and the characteristically friendly Scots there chatted excitedly about Aston Martin’s upcoming IPO whilst making sure my daughter learned the ins and outs of at least a million pounds worth of stainless-steel, aluminum, and carbon fiber. Aston Martin’s IPO not only represents permanent equity backing for a uniquely capital-intensive business, it is also the triumph of a marque bought out of obscurity by a wealthy English industrialist, Sir David Brown. Brown not only manufactured and sold tractors by the thousands, he also understood the halo effect of auto racing to underscore a nation’s industrial competitiveness, and he was tired of seeing English cars lose to the Italians. Sir David was also savvy enough to take a page out of Enzo Ferrari’s business model and financed his passion for auto racing by selling expensive road cars. It was a prescient decision for Brown, as his eponymous series of “DB” cars were adopted by a mythological British figure, James Bond, and the combination sustained the brand’s identity for fifty years. It is highly unlikely that the DB11 would exist today if Sean Connery hadn’t been assigned a DB5 as his company car in the 1960s.Today, Aston Martin is once again following in the hoof-steps of the prancing horse, as Ferrari’s 2016 public listing was a huge success (NYSE: RACE). Ferrari is much more than an automaker, of course; it is a brand. Despite devotees like yours truly, Aston Martin’s intellectual property is no match for Ferrari, which boasts an adjectival name, a primary color, and a mascot that are instantly recognizable and merchantable. For Aston Martin’s listing to be successful, it will have to make it as an automaker instead of a fashion label – no doubt a much tougher slough.What Exactly is Focus Financial?All of this brings me back to Focus Financial, whose business model is a little difficult to, well, focus. The IPO is being hailed as a validation of the RIA industry, but the RIA industry doesn’t really need validation (it is proven and profitable) and Focus isn’t really an RIA.The Focus brand, for example, doesn’t really extend to the investors with their partner firms. If you review many of their partner firm websites, for example, you don’t see much mention of Focus, and any mention certainly isn’t prominent. Focus’s brand is directed at the acquired firm, a back-of-the-house system. The storefront is still the individual tradename and people of the partner RIA. In much the same way, the Focus financial statements aren’t really the consolidated statements of their affiliate firms, but rather a specifically defined interest in the cash flows of the affiliate firms. In mathematical terms, you might say that the calculus of the Focus financial statement is the first derivative of an RIA income statement rather than the RIA income statement itself.Focus acquisition model (adapted from pages 120-121 of the prospectus) Focus Financial is an aggregation of RIA cash flow streams, contingent rights, and responsibilities. The Focus model is to acquire between 40% and 60% of an existing RIA’s earnings before partner compensation, or EBPC, which post-acquisition is referred to as “target” earnings (Focus also has a program for wirehouse broker groups who want to go independent). The remaining EBPC is retained by a management company formed by the affiliate firm as a wage pool for selling partners. Focus takes a preferred position in the affiliate firms’ EBPC; the selling partners are responsible for delivering at least the dollar portion of EBPC sold to Focus (termed the “base” earnings). Any excess above target earnings is split pro rata. This asymmetric payoff dampens the downside volatility for Focus, but obviously also raises it for selling partners. Focus has a handy chart in their S-1 that illustrates the potential repercussions of this on partner firms. As shown in the example above, assume Focus acquires 60% of a selling firm’s earnings before partner compensation and EBPC is $3 million. If revenue grows by 10%, EBPC grows to $3.5 million. In the upside scenario, selling partners and Focus share in this 40%/60%, and selling partners see their management fees increase from $1.2 million (40% of EBPC established at time of sale) to $1.4 million (the $200 thousand increase representing 40% of the overall $500 thousand increase in EBPC). One can see how enough growth in AUM enables selling partners to recover their pre-acquisition compensation level, in addition to receiving proceeds from selling rights to part of their EBPC to Focus. The downside scenario is fairly dramatic, however. In the example, a 10% drop in revenue causes the selling partner compensation pool to drop by almost half, from $1.2 million to $700 thousand, which is less than a quarter of pre-transaction partner compensation. Because we haven’t experienced a sustained bear market since Focus completed most of their acquisitions, the downside implications of this arrangement on selling partner groups (and, in turn, on Focus) aren’t yet fully known. The disproportionate risk borne by the partners of affiliate firms is, presumably, known to them – although knowledge and experience sometimes yield different outcomes. We wonder how selling partner groups would behave in a market environment in which their compensation was severely restricted, remembering that retained EBPC is effectively wages for the continuing efforts of affiliate firm leadership.How Does Focus Pay for This?As anyone who reads this blog is fully aware, RIA transactions are typically a mixture of upfront payments and contingent consideration. Focus is no different, and while the prospectus doesn’t describe a sample transaction, it is clear that Focus uses both cash and equity to provide fixed payments and earn-outs. The equity consideration is valued by Focus, apparently with the assistance of third-party appraisers (not us!). More than one commentator has suggested that a downside to Focus Financial going public is that they can no longer “assign” a value to their stock, as it will now be determined by market. I’m sure that my peers who provide valuation services to Focus don’t appreciate the slight.The valuation of Focus is, at this point, somewhat complicated, and we are very interested to see how the market treats them. In 2017, Focus reported a loss of nearly $50 million on total revenues of $663 million. Last year was a good year for most RIAs, and to explain their loss, Focus management suggests a lengthy list of adjustments to get to a pro-forma EBITDA margin of about 22%. Market pundits so far are suggesting an enterprise valuation of $2.0 to $2.5 billion for Focus, which works out to about 8x to 10x pro-forma EBITDA.The question becomes whether or not you agree with all of management’s adjustments to travel from reported to pro forma EBITDA. Some off these add-backs are not controversial (eliminating non-recurring items such as delayed offering cost expenses), but over a third of management’s adjusted EBITDA for 2017 comes from eliminating non-cash equity compensation expense and adding back the change in fair value of contingent consideration.The analyst community remains divided on how to treat equity compensation, but we quote Warren Buffett’s old saying –“If stock options aren’t compensation, then what are they? If compensation isn’t an expense, then what is it? If expenses don’t belong on the income statement, then where do they belong?”For a shareholder in an acquisition platform like Focus Financial, equity compensation and contingent consideration are dilutive to earnings per share, and one would expect them to be recurring in nature. Further, a 22% EBITDA margin is low for a large RIA – even on a reported basis. Then again, Focus isn’t really an RIA.So we don’t have a good sense of what Focus’s profit margins will be once it matures to a steady-state enterprise. The financial history shown in the S-1 doesn’t really demonstrate the kind of operating leverage we might expect, but, to be fair, I think it’s still too early to tell.What Does Focus Do After an Acquisition?While the 55 Focus partner firms employ over 2,000 people, the holding company itself has about 70 staff members, most of whom are charged with growing cash flows through acquisition or by improving affiliate firm profitability. To enhance organic growth, Focus has staff assigned to affiliate RIAs to provide them with ideas to improve operations and marketing, much as broker-dealers do for their network affiliate RIAs. Eventually, Focus will have to transition from an acquisition platform to an operating platform, and these services will become more critical to fueling the growth engine.It’s worth pointing out that there is a cost to the staff and their activities at the holding company that is borne under the Focus model but not by an otherwise independent RIA. Further, the Focus prospectus doesn’t suggest that this cost is mitigated by explicit post-acquisition synergies such as personnel redundancies, although this probably happens from time to time. In addition, the prospectus is explicit that holding company staff is there to assist partner firms with growth and operations, rather than to impose rubrics and expectations. The idea is to maintain the entrepreneurial spirit of the partner firms and to avoid “turning entrepreneurs into employees.” Can thousands of people be directed with only carrots and no sticks? Probably not, and I’ve no doubt that Focus management realizes that.One test of the Focus model is whether or not the staff at the holding company can pay for themselves. Can they improve partner firm cash flows to more than offset the cost of the aggregation? If so, this will be a big success.Does the Focus Model Work?Focus has been in operation for a dozen years now, but it’s still very much a development stage company. Focus has proven itself as an acquisition platform. RIA transactions are difficult, and Focus has managed to attract and retain 55 direct partner firms. Several of these firms have themselves engaged in acquisitions after they became part of the Focus network, bringing the total number of firms under one umbrella to 140. Indeed, one major asset Focus can boast is its knowledge of the RIA firm landscape and how to successfully acquire and integrate wealth management firms.That said, acquisitions either consume distributable cash flow (the prospectus is clear that the company does not plan to pay dividends, which is very different from typical RIAs) or result in equity issuance (which can be dilutive of existing shareholder returns). Focus can build shareholder value by arbitraging returns if it can acquire firms at a lower multiple than it trades for, but this requires the market giving it a premium multiple on a sustained basis. Since acquisition multiples in the RIA community don’t usually happen at substantial discounts to publicly traded asset managers, it may prove difficult to enhance shareholder returns through acquisition – at least on a sustained basis.No doubt Focus has plenty of room to run as an acquisition platform, but longer term shareholder returns will require Focus to develop an operating platform that widens partner firm margins and speeds revenue growth to a greater degree than those same firms would do on their own. One test is easy to measure, and the other is not. Together, they form a major part of the holding company’s “alpha.”Analysts can look at Focus’s profitability and determine whether the model enhances RIA cash flow or not; as I mentioned earlier, current margins suggest they still have room for improvement. Determining whether or not an affiliate firm is growing faster in association with Focus is more difficult – there are many variables that would have to be isolated to do that. Since management teams share in profit increases, they theoretically have incentive to help the organization grow. Post-acquisition, of course, Focus takes a pro rata piece of that increase in profitability, and while the selling generation of partners gets compensated for this in the form of earn-out payments, successive generations will not. It will be interesting to see how second-generation partner firm leadership behaves.The Focus S-1 reports organic revenue growth – essentially same store sales growth – of 13.4% for 2017 versus 2016. Organic growth for the prior two years was reported in the mid-single digits. Whether or not those organic growth rates best industry averages depends on whom you ask. We think this will be a closely studied metric for Focus as it matures.Further, because Focus is an amalgamation of RIAs which still report independently, it is possible to review ADVs and track their partner firm AUM over time. We’ve done this, and the study predictably shows a wide variety of growth patterns across these businesses which are still run as independent entities. Some appear to have grown more rapidly after being acquired by Focus, and others not so much. It would take a good bit of work to track these growth patterns relative to financial market behavior, industry trends, and to segment out partner firms that are growing at least in part because of their own acquisitions. For now, Focus’s report on organic growth may be the favored big-picture performance measure.What Questions Remain?The most significant remaining queries for Focus Financial revolve around the theme of sustainability. In the near term, can Focus continue to attract enough sellers to monetize their know-how and identity as an acquirer? In the longer term, can Focus transition into an operating brand and grow organically in such a way that it proves the value they add as an organizing force in the RIA space? Will they show growth rates and margins that prove the value-add of the holding company?Focus is organized as more of a quilt (independent businesses) than a blanket (think wirehouse). Given that, can Focus direct their partner firm employees’ and principals’ zeal while avoiding the behavioral risks that come with independence? Will Focus ultimately have to become more regimented in the investment products it offers, the marketing approaches its advisors employ, the training and compliance procedures they require, etc.? There is a natural tension in all investment management firms between development and risk management, and as firms grow, the latter usually overtakes the former.Will succeeding generation leadership at partner firms be sufficiently incented to continue the growth that first made them attractive as acquisition candidates to Focus? The selling partners of affiliate firms have a relationship with Focus that younger members do not share.Why Does All This Matter?Most of the questions I’m throwing out in this blog post apply to the broader RIA universe, and not just to Focus Financial. The Focus IPO is significant because it represents the single-most direct response to major industry issues, while at the same time leveraging industry trends. With managed assets increasingly leaving bank-controlled brokers, the retirement era of the baby-boomers leading more and more assets to independent firms, and a transition planning crisis among RIA ownership groups, someone had to develop a model to organize, if not consolidate, this highly fragmented industry. Fourteen years ago, Focus’s founder Rudy Adolf sat at his kitchen table and decided to do just that.The Focus prospectus makes it clear that engineering a profitable solution to the RIA industries primary conundrums is not, however, as easy as defining the situation itself. As a conglomeration of independent businesses, the Focus financial statements are themselves gerrymandered in a way that takes some getting used to, and we don’t think their results will track the RIA industry as closely as some have suggested.None of this detracts from what Focus has accomplished. They have developed a business model to address very difficult acquisition and integration issues and have steadily grown their brand as an acquirer in the parentage of several prominent PE sponsors. In going to market, Focus management is committing to prove viability in public filings, conference calls, and daily trading. It is a major undertaking for any company, but even more so for the one who goes first. If Focus Financial is, like Ferrari, successful as a public company, no doubt Hightower and United will, like Aston Martin, consider following their lead.We look forward to seeing more.“Dad, which button controls the ejector seat?”
Tax Reform and Purchase Price Allocations
On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code.The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes.The change in tax rate will have the biggest impact on purchase accounting.Cash Flows and ReturnsWhen we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings.The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value).In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price.On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged.In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt.Keeping other inputs constant, this modestly increases WACCs.Relief from RoyaltyUnder the relief from royalty method, after-tax royalties avoided increase as the tax rate falls.However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.Scenario AnalysisIn a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit.Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted.As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.Cost ApproachThe cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used.If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected.If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB. Multi-Period Excess Earnings Method The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows.On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB.As far as contributory assets are concerned:Relief from royalty asset charges will increase under a lower tax rateWith and without scenario analysis with level payments charges will potentially decrease due to the lower base valueCost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculationsGoodwill The net impact of a lower tax rate on goodwill will vary by transaction.If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill.If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.The changes to corporate taxes under the new bill are wide-ranging.In addition to the effect of lower rates discussed in this article, fair value specialists need to be alert to how other specific provisions of the bill may influence individual companies.Impact of Tax Rate Decrease on Valuation MethodCash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction priceTax Amortization Benefits DecreaseRelief from Royalty Method Increase (potential offset by decrease in TAB)Cost Approach (pre-tax) No ChangeCost Approach (post-tax) Increase (potential offset by decrease in TAB)With and Without Scenario Potentially lower (potential offset by decrease in TAB)MPEEM May Increase or Decrease (depends on magnitude of other changes)
The Permian Boom Causing a Natural Gas Bust
The oil industry is cruising. Producers are flocking to many oil rich plays, most notably the Permian Basin, Bakken, and Eagle Ford. Producers in these areas are all looking to exploit multi-zone payouts and gain significant efficiencies with new deep lateral and horizontal wells.While this strategy is working very well for oil producers, often lost in the oil excitement is the byproduct, additional dry and natural gas liquids. For producers targeting natural gas, this is not good news. The U.S. has significant natural gas. While export demand is approximately 10% to 12% of all domestically produced natural gas, high supply and demand factors have kept prices relatively flat.The Economics of the Current Price EnvironmentThe articles below address the economics of the current price environment:Thank Goodness for Natural Gas Exports (Forbes)Demand for Natural Gas is Surging, but Glut Remains (US News and World Report)Why U.S. Natural Gas Prices Will Remain Low (Forbes)
While the low prices are favorable for consumers of natural gas, E&P companies are struggling. Producers of natural gas, specifically those operating in areas where crude oil is minimal, such as the Marcellus and Utica, are getting stretched thin, some beyond their ability to recover. Rex Energy Corporation (Rex) is the latest natural gas producer to file for a Chapter 11 orderly reorganization beginning with the sale of assets.
Rex Energy CorporationRex Energy Corporation is an independent E&P company that produces condensate, natural gas liquid (NGL), and natural gas in the Marcellus, Utica, and Burkett Shale. On May 18th, Rex announced that, following its previously announced strategic review, it has decided to begin an orderly sale process for its remaining assets in order to maximize their long-term value and prospects. To facilitate the sale and address its debt obligations, the Company initiated voluntary proceedings under Chapter 11 of the U.S. Bankruptcy Code with support outlined in a Restructuring Support Agreement signed by 100% of its first lien lenders and approximately 72% of its second lien noteholders.A review of their financial performance over the previous five years indicates declining revenues from lower natural gas prices. Revenue increased from 2013 to 2014, then declined during 2015-2017. This behavior is consistent with commodity price fluctuations. Operating income followed a similar trend which put pressure on the company to use debt to fill the gap. Debt doubled from 2013 through March 2018 and interest expense increased during all years and peaked at $62 million during the LTM March 2018 period. All of this was done hoping natural gas prices would increase to the point Rex could reach profitability. However, Rex ran out of time.Other Marcellus and Utica OperatorsRex is not the only Marcellus and Utica operator with this trend. CNX Resources, Eclipse Resources and EV Energy Partners all have stock charts with similar trends. Diversified Gas and Oil is the only publicly traded Marcellus and Utica focused producer with a stock price trend bucking the macro environment. They are also relatively new to the publicly traded scene, having been publicly traded for less than two year.CNX Resources, Eclipse Resources and EV Energy Partners have seen price declines on the order of 50% to 100% since mid-2014. Eclipse Resources, for example, experienced a rapid fall in its stock price after raising $818 million in a U.S. initial public offering. Its stock price has fallen by nearly 100% and last month Eclipse announced that they were evaluating different options to maximize company value such as engaging in accretive acquisitions or sale of the company.The performance of all the E&P companies named above is shown below.
Descriptions of each company are included below per their respective 10Ks.
CNX Resources Corporation, an independent oil and natural gas company, explores for, develops, and produces natural gas in the Appalachian Basin. As of December 31, 2017, it had 7.6 trillion cubic feet equivalent of proved natural gas reserves. The company also owns, operates, and develops natural gas gathering and other midstream energy assets in the Marcellus Shale in Pennsylvania and West Virginia. The company was formerly known as CONSOL Energy Inc. and changed its name to CNX Resources Corporation in November 2017.Eclipse Resources Corporation, an independent exploration and production company, acquires and develops oil and natural gas properties in the Appalachian Basin. The company holds interests in the Utica Shale and Marcellus Shale areas.EV Energy Partners, L.P., through its subsidiaries, engages in the acquisition, development, and production of oil and natural gas properties in the United States. Its properties are located in the Barnett Shale; the San Juan Basin; the Appalachian Basin; Michigan; Central Texas; the Monroe Field in Northern Louisiana; the Mid–Continent areas in Oklahoma, Texas, Arkansas, Kansas, and Louisiana; and the Permian Basin.Diversified Gas & Oil PLC engages in the production of natural gas and crude oil in the Appalachian Basin of the United States. It has interests in the oil and gas properties in Pennsylvania, Ohio, and West Virginia. As shown below, it has not experienced the same declines in price as many of the other producers in the region.ConclusionWhile these macro issues have been impacting the industry for years, many investors have expected supply to fall to the point of creating higher prices. As this Wall Street Journal article points out, many investors had to adjust their investment time horizon. Investments made during 2014 and 2015 have not been exited by hedge funds like Fir Tree due to lower than expected public demand. Fir Tree’s energy investment strategy included purchasing the debt of failing companies only to flip it into a controlling equity position in the “emerged from bankruptcy” company. While they have been somewhat successful in this strategy, their holding periods are longer than originally planned. It appears investor’s are salivating for more companies like Amazon and less for companies like Sandridge Energy. While the headlines are focused on Permian Basin winners, the rest of the oil and gas market is not as cheery. The mixed bag of winners and losers makes the industry tricky to operate within.We have assisted many clients with various valuation needs in the upstream oil and gas space in the Marcellus and Utica areas, other conventional and unconventional plays in North America and around the world. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
1Q18 Call Reports
After a strong start to the year driven by tax reform and global economic growth, markets reversed in February and March and volatility picked up significantly. While most publicly-traded asset managers posted negative returns for the quarter, the return of market volatility may be an opportunity for certain active managers. The first quarter also saw notable changes on the regulatory front, with the DOL Rule being struck down and the SEC proposing the new “best interest” standard for brokers. On the fixed income side, the yield curve continued to flatten during the first quarter, and higher short-term rates may pull cash off of the sideline and into fixed income products.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: The return of volatility to the markets offers opportunity for active managers.[W]hile we have started with the equity markets generally moving upward in January, the trend broke down in February and March as volatility increased as a dispersion across and within those markets. In this environment, the best active managers were able to outperform, and many of our Affiliates generated meaningful alpha. – Nathaniel Dalton, President & COO, Affiliated Mangers Group, Inc.Over the last year or so, we have seen correlations declining, and more recently, we have seen increased volatility and rising interest rates. We may be returning to a world in which investment returns are not overwhelmed by central bank policy. We believe that's an environment in which asset allocators will place greater importance on high value-added investing and an environment in which value-added should be more apparent. – Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset ManagementWe are optimistic that this higher level of volatility, combined with a gradual trend toward the normalization of monetary policy on the part of global central banks will continue to improve the investment backdrop for active managers. – Philip James Sanders, CEO, Chief Investment Officer & Director, Waddell & ReedTheme 2: The regulatory environment continues to evolve with the DOL Rule recently being vacated and the SEC’s recent “best interest rule” proposal.Obviously, we're at the very early beginning of [the SEC proposal], which will have a longer road ahead of it before it likely moves forward into any type of finalization of becoming a rule. But the early indications are based on it being more of a disclosure-based rule. It does provide for the additional flexibility with regard to the broker/dealer, not causing significant cost increase associated with the broker/dealer and the financial advisers that we support. So we're going to continue to monitor that. I don't expect at least in the initial stages that to hamper our ability to increase our advisers' overall annual productivity ranges, but we're going to continue to monitor what happens in this space with regard to the SEC rule proposal. – Shawn Michael Mihal, President, COO & Director, Waddell & Reed With the changes in the DOL rules, a lot of the financial advisers have been using index-like and ETF products to create model portfolios and build those model portfolios with the least expensive products. But as the cycles start to change, they will start to incorporate more active products in that both active fixed income and active equities. – Robert Steven Kapito, President & Director, Blackrock[T]he new … higher standard of conduct or new best interest standard that is under comment period with increasing the suitability requirements and disclosure. I think what's important in the proposal is that certainly, brokerage as it exists today, can survive and doesn't have to be modified to a level where you can't have differentiated commissions … And so I think it would slow down the acceleration of movement from brokerage to advisory accounts, and the urgency to do that would not be there. – Gregory Eugene Johnson, Chairman & CEO, Franklin ResourcesTheme 3: Rising yield curve may pull cash from the sidelines and into fixed income products.We see at least three broad opportunities for our fixed income business in a higher rate environment. First, higher rates are attractive for the retail investor and should increase flows. Second, higher rates create the need to rebalance into fixed income for many institutional investors. And third, regardless of the rate environment, the opportunity always exists with strong investment performance to take share. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason[W]e estimate there's over $50 trillion of cash that's sitting in bank accounts earning less than 1%, in some places, negative. So as rates go up, especially in the short end, that is going to attract a lot of this cash into the fixed income markets, of which we can manage that money rather directly into the normal fixed income products or into ETF fixed income products, which seem to be getting a lot of the new flows from rises in rates. – Robert Steven Kapito, President & Director, BlackrockWhile the prospects of rising rates tends to push investors away from long-dated fixed income, the flat curve is creating strong relative risk-return opportunities in short duration funds and cash management strategies, which we saw clients take advantage of in the first quarter. – Laurence Douglas Fink, Chairman & CEO, BlackrockMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Royalty Interests and the Importance of the Operator
In previous posts, we have discussed the market pricing implications of publicly traded royalty trusts to royalty and mineral owners. We have explained the importance of understanding the specifics underlying those trusts before using them as a pricing benchmark. In this post, we will delve further into market prices of royalty and mineral interests and the important role of operators. We will look into the three publicly traded royalty trusts operated by SandRidge Energy: SandRidge Mississippian Trust I, SandRidge Mississippian Trust II, and SandRidge Permian Trust.Market Observations1Over the previous two years, the performance of the 21 publicly traded royalty trusts has varied widely. Thirteen have experienced positive market value returns with an average of positive 57% and eight have returned market value losses during the previous two years with an average market value return of negative 39%.Clearly, there are some winners and losers, with more winners than losers. The royalty trust with the highest market value return was Whiting USA Trust II (WHZT) (+330%), which was discussed in a recent blog post. Mesa Royalty Trust (MRT) (47%) was another big winner covered in a previous blog post. However, the focus of this blog post will be on some of the underachievers: SandRidge Mississippian Trust I (SDT) (-76%), SandRidge Mississippian Trust II (SDR) (-61%), and the SandRidge Permian Trust (PER) (-21%).For comparison, the chart below shows the returns from PER, SDR, SDT, crude oil, natural gas, and the S&P 500.
Why has the value of these SandRidge Trusts depreciated so much over the past two years despite increasing commodity prices? Also, why has the Permian trust fared better than the Mississippian Trusts? Below is a discussion of the assets, underlying properties, and agreements of each Trust.
SandRidge Mississippian Trust IThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:90% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 36 wells producing at December 31, 2010, and one additional well undergoing completion operations at that time (together, the “Initial Wells”).50% of such proceeds from 123 “Trust Development Wells” drilled within an area of mutual interest (“AMI”)
Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill, or cause to be drilled, the Trust Development Wells by December 31, 2015. SandRidge fulfilled this obligation in April 2013. SDT’s Royalty Interests are in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Garfield, Grant, and Woods counties in northern Oklahoma.SandRidge Mississippian Trust IIThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 54 wells producing at December 31, 2011, and 13 additional wells awaiting completion at that time70% of such proceeds from 206 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”)
Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by December 31, 2016. SandRidge fulfilled this obligation in March 2015. SDR’s Royalty Interests are in specified oil and natural gas properties also located in the Mississippian formation in Alfalfa, Grant, Kay, Noble and Woods counties in northern Oklahoma, as well as Barber, Comanche, Harper, and Sumner counties in southern Kansas.SandRidge Permian TrustThe only asset of the Trust is the conveyance of the Royalty Interests by SandRidge Energy, Inc. The Royalty Interest entitles the Trust to receive:80% of the proceeds from the sale of oil, natural gas, and natural gas liquids ("NGL") production attributable to SandRidge’s net revenue interests in 517 wells producing at April 1, 2011, and 21 additional wells awaiting completion at that time70% of such proceeds from 888 horizontal “Trust Development Wells” drilled within an area of mutual interest (“AMI”)
Pursuant to a development agreement entered into between the Trust and SandRidge, SandRidge was obligated to drill the Trust Development Wells by March 31, 2016. SandRidge fulfilled this obligation in November 2014. PER’s Royalty Interests are in specified oil and natural gas properties in the Fuhrman-Mascho field in Andrews County, Texas, which is a part of the prolific Permian Basin. It should be noted that this is outside the two main Permian sub-basins (the Delaware Basin and the Midland Basin). Nevertheless, the Permian's attractive location and increased well count likely explains why the Permian Trust outperformed the Mississippian Trusts.
The following table shows important production and reserve data for the underlying properties, as well as SandRidge’s ownership in the Trusts’ units and other pertinent data.
The Trusts no longer have any hedging derivatives contracts, so they are exposed to oil and natural gas price volatility.
Analysis of TrustsDevelopment Wells and Area of Mutual InterestEach of the Trusts receives 80-90% of the proceeds from the sale of oil, natural gas, and NGLs (after deducting post-production costs and any applicable taxes). This is fairly common for publicly traded royalty trusts, but the Trust Development Wells are unique. At the IPO date for each Trust, well counts were relatively low. In fact, the initial wells made up less than 25% of the total well counts for the Mississippian Trusts and about 38% of the Permian Trust. This agreement allowed the Trusts to make distributions from currently producing wells in addition to offering growth opportunities with the future development wells.The “development” aspect of the wells would seem to cast doubt upon the production of each Trust if it did not end up developing the total number of wells required or in a timely manner. The development agreement offered protection to investors. It is important to note that SandRidge fulfilled its development obligation in plenty of time in each case. Investors were further protected with the clause ensuring wells would be drilled in an area of mutual interest (AMI). This means SandRidge could not drill wells in random locations to fulfill its obligation.DistributionsThe Trusts make quarterly cash distributions of substantially all of its cash receipts, after deducting amounts for the Trusts’ administrative expenses and cash reserves withheld by the Trustee. The price for oil peaked in 2014 near $108 per barrel and close to $8 for natural gas before declining sharply in the latter half of the year. The low point was seen in late 2015, early 2016, with prices of approximately $28 and $1.64, for oil and gas. Prices currently stand around $68 per barrel and $2.80 per MCF, respectively. The steep decline in oil and gas prices in mid-2014 had a crippling effect on distributions. The following chart tracks the quarterly distributions per share for the Trusts since 2012.Termination of the Trusts
The Trusts will dissolve and begin to liquidate on the “Termination Date” (noted in the table above). At the Termination Date, 50% of the Royalty Interests will revert automatically to SandRidge. The remaining 50% of the Royalty Interests will be sold at that time, and the net proceeds of the sale, as well as any remaining Trust cash reserves, will be distributed to the unitholders on a pro rata basis. SandRidge has a right of first refusal to purchase the Royalty Interests retained by the Trust at the Termination Date. There are certain provisions protecting investors in the case the Trust were to dissolve prior to the Termination Date, such as a requirement that cash available for distributions be above a certain threshold, as noted in the table above.
The Trusts are highly dependent on its Trustor, SandRidge, for multiple services including the operation of the Trust wells, remittance of net proceeds from the sale of associated production to the Trusts, administrative services such as accounting, tax preparation, bookkeeping, and informational services performed on behalf of the Trusts. For these administrative services, the Trusts pay SandRidge an annual fee (noted in the table above) which is payable in equal quarterly installments and will remain fixed for the life of the Trusts. SandRidge is also entitled to receive reimbursement for its out-of-pocket fees, costs, and expenses incurred in connection with the provision of any of the services under this agreement.
SandRidge Energy and the Importance of the OperatorSandRidge Energy (SD) is an oil and natural gas exploration and production company headquartered in Oklahoma City. According to SD's website, its principal focus is on developing high-return, growth-oriented projects in the US Mid-Continent and Niobrara Shale.SandRidge filed for Chapter 11 bankruptcy in May 2016 and emerged from bankruptcy in October 2016, as we discussed in a blog post around that time. SandRidge was relisted on the NYSE around $19.50 per share. Its performance has been volatile and generally negative since, as seen in the chart below.
Activist investor Carl Icahn spent $82 million in October and November 2017 to acquire about 13.5% of SandRidge stock. Since he became a shareholder, Icahn has had a large impact, causing directors to cancel their planned $746 million purchase of Bonanza Creek Energy and lay off 80 employees including their CEO and CFO. He also played a role in the rejection of an acquisition attempt by Tulsa-based Midstates Petroleum Inc. in February.
Icahn recently expressed "grave concerns" with the board, claiming it had “a history of making poor decisions on behalf of stockholders.” Market confidence for SandRidge Energy is very low, after having gone through a bankruptcy-related restructuring recently as well.
These concerns are significant to the SandRidge Trusts because operators play a vital role for royalty interests. They are responsible for production, without which, there are no distributions. If an operator is unable to produce or becomes less focused on a particular well or region, the royalty interests attached to them are worth significantly less.
In the case of the SandRidge Trusts, turmoil with the operator has put future production into question. The lack of control for the royalty interests means they are tied to the fortunes of the operator. Even for securities with yields above 20%, the unsustainability of these distributions does not inspire confidence in investors.
ConclusionThe operator is a key consideration for owners of royalty interests, particularly those interested in selling. As outlined in our post last week, offers received for royalty interests can be heavily dependent on operators and the uncertainty related to a change in operator.Owners of mineral interests typically receive offers as multiples of average monthly revenue received. These multiples are typically determined by commodity prices, quality of operators, growth opportunities, and market sentiment. While owners of royalty interests do not have much control over these factors, they provide important starting points when considering selling.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQ
What’s the Latest on Broker Protocol?
It’s been several months since Morgan Stanley and UBS departed from the Protocol for Broker Recruiting, and the industry is continuing to feel the ripple effects of their maneuver. Much remains to be seen, but many analysts expect more firms to abandon the protocol despite Wells Fargo’s and Merrill Lynch’s recent announcements to stick with it for now. All of these firms were early adopters of the protocol, which has grown to include nearly 1,800 firms today.A Changing TideHistorically, firms have joined the protocol with the expectation that they could maintain a lock on their advisors due to their distinct advantages in trading capabilities and investment offerings over the independent model. However, recent technological advancements make it easier for advisors to become registered and serve clients on their own. Advisors also now have the option of the consolidator route through which firms like Dynasty Financial Partners, HighTower Advisors, Focus Financial Partners, and United Capital provide them with liquidity options and greater autonomy to serve clients and recruit other advisors.There’s also the issue of vesting schedules and expiring contracts that were signed at the peak of the last financial crisis. Many of the brokers who signed retention deals at Merrill Lynch or UBS in 2009 are now fully vested and more incentivized to jump ship. Meanwhile, the FAs at Morgan Stanley who received retention deals as a result of the JV with Smith Barney in 2009 will become free agents at the end of this year.Another side effect of the protocol is the increasing consolidation of the IBD space. Many wirehouse FAs are turning to the IBD model to gain access to an RIA platform with the continued support and resources that a broker-dealer can provide. According to an InvestmentNews report, the three largest IBDs (Ameriprise, LPL Financial, and Raymond James) saw a 42% increase in FA recruitment during 2017. Simply put, the RIA/IBD hybrid model is a more appealing alternative over the wirehouse model in the eyes of many FAs looking for a change.The UndercurrentStill, firms like Raymond James that have used the protocol to successfully poach advisors from their competitors will likely stick around. The few net winners in the wirehouse recruitment saga over the last ten years have little or no reason to abandon protocol. Many have lost more advisors than they’ve recruited; therefore, it’s hard to stay with a program that clearly hasn’t helped them. One could certainly view the departure of Morgan Stanley and UBS as a concession of their own inability to effectively recruit and retain during the protocol era.Many FAs may find it more difficult to sell their book of business (or at least realize full value) in a post-protocol world. If it’s riskier and more expensive to join another broker-dealer, then current employers could use these circumstances to reduce payouts to their advisors. It could also be more challenging to transfer clients to another platform, thereby limiting the number of prospective buyers. In short, FA economics are not likely to improve when their employers decide to break protocol.Impact on RIA Valuations & DealsWhat about RIA valuations? Abandoning protocol should make it easier to retain FAs but also makes it harder to recruit from other firms that have done the same. We’ll call that a tie. If RIAs can use this to gain leverage over their advisors and offer lower payouts, then margins and profitability should improve. Valuations should improve on higher earnings, so, on balance, this could be bullish for RIAs and the wealth management industry (at least from the employer’s perspective). Still, not everyone will abandon protocol. Many RIAs do not recruit experienced hires and will likely be unaffected by recent events.The effect on sector deal making will likely be more nuanced. Matt Sonnen and his team at PFI Advisors see this as a major opportunity for RIAs to recruit from the wirehouses before the door shuts and more firms abandon protocol. It appears that we’ve already seen some of this take place:
This trend should continue until the dust settles at which point it will make the transition process riskier and more expensive. When this happens we could see a curtailment of the recent momentum though it seems unlikely that we would revert back to 2013-14 levels in the absence of another bear market. We’ll keep you apprised of how all this shakes out in future posts.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
WHITEPAPER | Valuing and Transacting Your Wholesale Beverage Distributorship
In Valuation and Transaction Advisory Considerations for Wholesale Beverage Distributors, Tim Lee offers important insights for principals of distributorships, their legal advisors, as well as wholesaler CFOs, board members, and lenders. This paper includes an in-depth discussion of industry rules of thumb, helps you understand basic valuation theory and how the realities of the industry reconcile to the fundamentals of financial valuation and M&A strategy. The paper also includes examples of differing transaction scenarios and tools for assessing how transaction values and deal financing translate to investment return.The author, Tim Lee, is an expert on valuation and transaction issues in the beverage industry. This comprehensive paper (45 pages) equips the reader with the knowledge to understand how valuation relates to big-picture decision making.
Royalty Trusts: I’m a Revenue Partner… No, Wait… That Looks Like Equity
In previous posts, we have discussed the existence of publicly traded royalty trusts & partnerships and their market pricing implications to royalty owners. Before using publicly traded royalty trusts as a pricing reference for your royalty interest, it is important to understand the economic rights and restrictions within those royalty trusts. Many publicly traded trusts have a set number of wells generating royalty income at declining rates for multiple years to come. In contrast, some trusts participate in a number of wells that have not been drilled, which represent upside potential for investors. Future growth and outlook potential for these publicly traded trusts are significantly different. A potential investor would want to know the details. The same is true for a privately held royalty interest.Market Observations1As of April 25, 2018, there are approximately 21 publicly traded oil and gas-focused royalty trusts and partnerships.Figure 1Over the previous two years, the performance of the 21 publicly traded royalty trusts has been a mixed bag. Eight have returned market value losses during the previous two years with an average market value return of negative 39%. Thirteen have experienced positive market value returns with an average of positive 57%.Contrast this wide return with the price of crude oil and natural gas which have both increased over the same period (Figure 2). Oil has consistently marched from $45 to $68, while dry gas has climbed from $1.88 to $2.79.Figure 2Clearly, there are some winners and losers among the 21 royalty trusts over the previous two years and, noticeably, more winners than losers. As seen in Figure 1, the royalty trust with the highest market value return was Whiting USA Trust II (WHZT) (+330%) over the previous two years, with MV Oil Trust (+69%) and VOC Energy Trust (+59%) coming in second and third, respectively.Why did Whiting USA Trust II outperform all other royalty trusts over the previous two years and what is the nature of its economic rights and restrictions?Whiting USA Trust II (WHZT)Recent Pricing ActivityOver the previous two years, WHZT's stock price has increased from $0.50 to $2.15, an increase of 330% (Figure 3). Much of this increase was a steady climb from $0.50 to $1.50 as of April 5, 2018, which represents an increase of 200%. The last movement of $0.65 occurred in the previous 20 days. WHZT released their most recent 8K and 10K on March 23 and March 22, respectively. It appears it took the market a few weeks to get around to reading it. Additionally, the pricing activity is functioning much more like a working interest versus a royalty interest. Digging deeper will help us learn why.Figure 3Description of Assets Owned by WHZTWHZT assets include “term net profits interest in the oil and gas producing properties located in the Permian Basin, Rocky Mountains, Gulf Coast, and Mid-Continent regions” as described in their latest 10K filing:[The term net profits interest (NPI)] represents the right for the Trust to receive 90% of the net proceeds from Whiting’s interests in certain existing oil, natural gas and natural gas liquid producing properties which are referred to as “the underlying properties”. The underlying properties are located in the Permian Basin, Rocky Mountains, Gulf Coast and Mid- Continent regions of the United States. The underlying properties include interests in 1,312 gross (376.7 net) producing oil and gas wells as of December 31, 2017.Overall, these positions look positive as the Permian Basin is the most popular North American play currently and the Rocky Mountains, Gulf Coast, and Mid-Continent have positive characteristics too.Is an NPI Closer to a Royalty or Working Interest?The NPI represents a 28.7% profits interest in the producing oil and gas wells of Whiting. Net proceeds are calculated in the following manner: (1) Quantity of oil, gas and natural gas liquids times the price of oil, natural gas or natural gas liquids; minus (2) lease operating costs and workover costs; minus (3) production and property taxes; minus (4) development costs, hedge payments and all such production and development costs; minus (5) a maximum reserve of $2 million for future development. If the result of this formula is positive, 90% is distributed to the unitholders of WHZT. If the result is negative, the unitholders of WHZT are not liable currently. Unitholders are quasi-liable with any future net profits as accumulated losses will be zeroed out with future gains until there is a gain greater than zero.It appears an NPI is a fancy term for working interest. If not for the protection of direct capital calls, there is not a significant difference between an NPI and working interest, or any material difference from what we read. Indirectly, the unitholders are making capital calls, in the form of the promise to pay off any accumulated losses with future income before receiving any distributions.On the positive side, the 10K does appear to communicate relief in the form of limited and capital expenditures deducted from the NPI calculation. As of January 2018, capital expenditures included in the net profits calculations were limited. The annual limitation, effective January 1, 2018, is the average annual capital expenditure amount for the previous three years. Therefore, the capital expenditure limitation for 2018 is approximately $4.0 million. This limitation is new for 2018.Based upon the NPI calculation, make whole provision for accumulated losses, and the limited capital expenditure protection, the unitholders of WHZT appear to own a working interest in the oil and gas properties versus a royalty interest.Distributions to UnitholderPerhaps part of the publicly traded price activity can be explained by considering the historical distribution pattern to unitholders (Figure 4). Distributions are based upon the NPI formula discussed above. Since its inception in 2012, distributions have been consistent during Q2 2012 through Q3 2014, at which point distributions decline for the remainder of 2014, 2016 and are non-existent for much of 2016. Based on the data available, future distributions appear to be uncertain, erratic and dependent on oil prices, operating expenses and capital expenditures, to name the large items.Figure 4Specific Time HorizonWHZT also has a specific time horizon before the trust will be terminated and shutdown. WHZT will be shut down when the first occurs:(a) the NPI termination date, which is the later to occur of (1) December 31, 2021, or (2) the time when 11.79 MMBOE have been produced from the underlying properties and sold (which amount is the equivalent of 10.61 MMBOE in respect of the Trust’s right to receive 90% of the net proceeds from such reserves pursuant to the NPI), or;(b) the sale of the net profits interest. The Trust is required to sell the NPI and liquidate if cash proceeds to the Trust from the net profits interest are less than $2.0 million for each of any two consecutive years. During the years ended December 31, 2017 and 2016, the Trust received cash proceeds of $6.7 million and $1.9 million, respectively, from the net profits interest.
As of the end of 2017, WHZT has received approximately 75% of the MMBOE attributable to the NPI. As of the latest reserve report (year-end 2017) the NPI is projected to receive 10.61 MMBOE prior to the December 31, 2021 date. A liquidation and termination of the trust appears to be within a four-year horizon.Underlying Property Description2The underlying properties consist of certain oil and natural gas producing properties located in the Permian Basin, Rocky Mountains, Gulf Coast, and Mid-Continent areas. The underlying properties include interests in 1,312 gross (376.7 net) producing oil and natural gas wells located in 47 mature fields with established production profiles.As of December 31, 2017, approximately 98.9% of estimated proved reserves attributable to the trust were classified as proved developed producing reserves and 1.1% were classified as proved developed non-producing reserves. For the year ended December 31, 2017, the net production attributable to the underlying properties was 1,168 MBOE or 3,199 BOE/d. Whiting operates approximately 65% of the underlying properties based on the December 31, 2017 reserve report standardized measure of discounted future net cash flows.Figure 5 summarizes estimated proved reserves and the standardized measure of discounted future net cash flows as of December 31, 2017 attributable to (i) the Trust based on the term of its NPI, and (ii) the underlying properties on a full economic life basis (dollars in thousands):Figure 5Trust Rights and RestrictionsSurprisingly, a unitholder within this trust can have significant power, compared to other comparable entities. The Trustee or a Trust unitholder, holding at least 10%, may call meetings of the unitholders. Each Trust unitholder is entitled to one vote for each unit owned and the majority of unitholders can:Dissolve the trustRemove the trustee or the Delaware trusteeAmend the trust agreementMerge or consolidate with another entityApprove the sale of assets in certain circumstances;Agree to amend or terminate the conveyance;AnalysisAccording to the IPO price on March 28, 2012, the net profits interest was given a market value of $418 million. The same properties are given a current market value of $39.6 million six years later. This change represents a decline of 90%. Furthermore, the current market value is approximately $10 million more than the most recent reserve report present value measures ($29.1 million).It is clear the market anticipates positive factors to push the underlying property cash flows higher compared to the 2017 reserve report. Based upon the latest 10K, we know the additional future cash flow will not come from new wells, as all wells within the property are classified as PDP or PDNP. No PUD’s or other classification of reserves has been identified. Therefore, the increase in cash flows is coming from higher commodity prices, lower operating costs or lower development costs.Either way, with over six years of production history, it appears optimistic that operations will become more efficient in years seven, eight and nine than they have been in years one through six. This leaves future commodity prices as the only logical lever left to base an increase. Additionally, with the market value holding close to $40 million dollars, an investment of approximately 51% or nearly $20 million, would allow for significant powers within the Trust. Given that the market value appears to be higher than the underlying asset value, a strong strategic case would need to be presented for that action to be logical.ConclusionThis discussion is an example of the importance of understanding the details about your royalty interest or in the case of WHZT, your net profits/working interest. Consideration must be given to the underlying assets, current and future wells, outlook for oil and gas prices, rights and restrictions of the mineral rights owner, lease terms, distributions, etc. WHZT is also an example of why some publicly traded royalty trusts are not appropriate to use for comparison. WHZT may best be used for a working interest comparable but definitely not a royalty interest comparable.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. As a disinterested party, we can help you understand the fair market value of your royalty interest and provide confidence that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.1 Capital IQ2 WHZT 2017 10K
Purchase Accounting Considerations for Banks Acquiring Asset Managers
As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients. Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired. As noted in the following figure, the acquired assets are measured at fair value.
Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions.
Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce.
Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction. The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name. This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base. However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction. Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base. Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price. If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely. Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Is There a Ticking Time Bomb Lurking in Your Family Business?
When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.
Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?
Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”
Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.
Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?
Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.
Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?
Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.
Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?
Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs. One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.
Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.
Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?
Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.
Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?
Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”
ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.
Eagle Ford – 2017/2018 Acquisition & Divestiture Commentary
Transaction activity in the Eagle Ford Shale has been fairly steady over the past 12 months, with the majority of transactions in the $100-300 million range. The seller’s rationale has most often been about balance sheet management and re-allocation to other plays, usually the Permian Basin. However, the Eagle Ford area has some quality economics of its own, which has been attractive to buyers. Many argue it has the best shale production economics in the U.S. next to the Permian Basin. These differing strategy based swaps have been at the heart of transaction flow. This has also led to consideration that Devon may sell its Eagle Ford division in search of returns elsewhere. The chart below, drawn from Mercer Capital’s newsletter, shows some details in regards to the transactions including some comparative valuation metrics.Magnolia – Blank Check Company forms a New South Texas ProducerThe largest transaction in the past year was the recent announcement of a special purpose acquisition entity (“SPAC”) coming to an agreement with certain Enervest controlled funds. The result of the merger is the creation of a pure play Eagle Ford and Austin Chalk company with 360,000 net acres in South Texas. The majority of that acreage is in what is known as the Giddings field which is an oil play in the Austin Chalk (mostly held by production).Break-evens are claimed to be in the low $30’s per barrel with one year (or less) paybacks in Karnes and Giddings field. Magnolia1 is led by a former Occidental Petroleum executive, Steve Chazen, who has both short and long-term optimism for the opportunity. Estimated EBITDA for 2018 is projected at $513 million including approximately $240 million of cash flow after capital expenditures.Highest and Best EconomicsDenver-based Sundance Energy Australia Ltd. struck a deal with Pioneer Natural Resource Co. to buy almost 22,000 acres and 1,800 boe/d of production in the Eagle Ford Shale, bolting on to an existing leasehold in South Texas.The pure-play Eagle Ford player agreed to pay $221.5 million for the leasehold, which runs through McMullen, Atascosa, LaSalle and Live Oak counties. The transaction would give Sundance 56,600 total acres in the play, with an inventory of 716 gross undrilled locations.Meanwhile, Pioneer was exiting to focus on the Permian Basin. Pioneer announced in February it would put most of its resources going forward into the Permian and planned to sell nearly all “non-Permian” projects, including in the Eagle Ford, Raton Basin, and West Texas Panhandle. The table below demonstrates why its desire to focus on the Permian was warranted. However, one thing to note is that purchasing acreage in the Permian is much more expensive than the Eagle Ford, so drilling most likely needs to be based on existing acreage positions.
Overall, the Eagle Ford’s economics are improving (Venado – a KKR backed Austin firm, made a $765 million purchase from Cabot that was based on this optimism).
About 61,500 net acres of the Venado position, which is located primarily in Frio and Atascosa counties in South Texas, is operated and about 9,400 net acres are non-operated. Production from the properties during third-quarter 2017 was 15,656 barrels of oil equivalent per day.
An interesting discussion on this acquisition can be found in this video:
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Have a great week!
Endnote1 In case one was wondering - Chip and Joanna Gaines are not involved.
RIA Stocks off to a Rough Start in 2018
A rocky first quarter was particularly volatile for publicly traded RIAs. After reaching record highs in late January, most categories of publicly traded RIAs ended the quarter with negative returns.First Quarter PerformanceThe weak performance of publicly traded RIAs during the first quarter comes on the heels of significant outperformance during 2017. Market gains apparently trumped fee compression, fund outflows, regulatory overhang, rising costs, and a host of other industry headwinds that have dominated the headlines in recent years. There is a simple explanation for the industry’s performance in recent years: the combination of market appreciation and operating leverage have precipitated significant improvements in profitability since the Financial Crisis, eliciting a favorable response from investors, despite everything we’ve been reading about the industry. However, the return of market volatility and the reintroduction of the idea that markets can, in fact, go down, have brought back into focus the industry headwinds, and investors have reacted accordingly.
As illustrated in the chart above, upward or downward trends in the broader market tend to have a magnified effect on the stock prices of asset managers. Market swings will have a magnified impact on earnings (and stock prices) for asset managers because top-line volatility is tied to AUM movements and some costs are fixed. While 2017 was a great year for the S&P and an even better year for most categories of RIAs, 2018 has been the complete opposite thus far. This reversal is no surprise, as historically corrections and bear markets have led to more precipitous declines in profitability, due to the presence of fixed expenses in most RIA’s capital structure, a fact illustrated by the significant underperformance of RIAs during 2008 and early 2009.
Taking a closer look at recent pricing reveals that traditional asset managers and trust banks have outperformed the S&P and other classes of asset managers throughout the first quarter. Traditional asset managers ended the quarter up 4.5% and were the only category of asset managers to post positive returns. Trust banks were down just 0.3% during the quarter, buoyed by a steadily rising yield curve, which portends higher NIM spreads and reinvestment income. Alternative asset managers were down 5.0% during the quarter as these businesses continue to find delivery on their value proposition (alpha net of fees) elusive. Mutual funds, which have been battered by active outflows and fee compression, were down 7.1% on the quarter.
The RIA size graph below shows that larger RIAs generally performed better than smaller RIAs during the first quarter. Asset managers with more than $500 billion in AUM were the only category to outperform the S&P, and asset managers with less than $100 billion in AUM had the worst performance. This is to be expected during periods in which the market declines, as smaller RIAs generally have narrower margins and profitability can shift wildly with small changes in AUM.
Market OutlookThe outlook for these businesses is similarly market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Mutual funds and traditional asset managers are more vulnerable to trends in active and passive investing. The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does over the next few months.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Capital Structure in 30 Minutes Whitepaper
In this post, we share a recent whitepaper: "Capital Structure in 30 Minutes." Capital structure decisions have long-term consequences for shareholders. Directors evaluate capital structure with an eye toward identifying the financing mix that minimizes the weighted average cost of capital. This decision is complicated by the iterative nature of capital costs: the financing mix influences the cost of the different financing sources. While the nominal cost of debt is always less than the nominal cost of equity, the relevant consideration for directors is the marginal cost of debt and equity, which measures the impact of a given financing decision on the overall cost of capital. The purpose of this whitepaper is to equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of the company.
This whitepaper is the second in the "Corporate Finance in 30 Minutes Series." Learn more about the whitepaper series below.
Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of their companies.Capital Budgeting in 30 MinutesCapital Budgeting in 30 Minutes assists directors and shareholders evaluate proposed capital projects and contribute to capital budgeting decisions that enhance value.Distribution Policy in 30 MinutesOf the three primary corporate finance decisions, distribution policy is the most transparent to shareholders. This whitepaper helps directors formulate and communicate a distribution policy that contributes to shareholder wealth and satisfaction.
Benefits of a Financial Expert in Family Law: Why & When to Hire
Most family law attorneys do not have a background in finance or accounting, yet are often confronted with complex financial issues in divorce matters. The services of an experienced financial expert can be vital to you and your client in such matters.In vetting financial experts, look for those who specialize in business valuation and forensic accounting. However, don’t pigeon-hole your expert. If your matter doesn’t require a business valuation or the tracing of dissipated assets, a financial expert can still be of great help to you in each phase of the process: discovery, deposition, and trial.Beyond valuation, tracing, and testifying, below is a list of services a skilled financial expert provides to help you uncover and understand financial issues:Determine financial documentation requests for subpoenaExamine submitted financial documentsEvaluate the accuracy of previously mentioned documentsAssess whether further support is necessaryAssemble relevant informationQuantify the financial elements of a caseIdentify and classify marital and nonmarital assets and liabilitiesAssist with interrogatory draftingSupport deposition questionnaire draftingAttend depositions for real-time financial support
In financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable.
To receive the highest benefit of financial expert services, hire the financial expert with ample time to assist with the various stages of the case and provide the expert access to pertinent documentation and information.
A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion.
For more information or to discuss your matter with us, please don’t hesitate to contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018
The Important Role of Personal Financial Statements in Divorce
High dollar, contested divorce litigation engagements often involve complex financial issues. In turn, those financial issues usually include business valuations and voluminous amounts of documents and financial information. How does an attorney or business appraiser determine what is crucial to the case and what is secondary information? One such piece of financial information that varies wildly in its interpretation and importance to the case is a personal financial statement.What Is a Personal Financial Statement?Depending on the jurisdiction, most family law attorneys are familiar with documents often referred to as Sworn Financial Affidavits, Asset/Liability Statements, Marital Balance Sheet or Divorce Financial Statements that are included with the filing of the divorce case.A personal financial statement is a similar document that is typically submitted to a bank or lending institution for the purpose of securing financing by representing an individual or couple’s financial position or net worth. In other words, it’s an asset and liability statement with estimates of value for each item akin to a balance sheet. Therefore, the couple’s or individual’s net worth is the sum of all assets, less the market value of all liabilities. For most liquid assets, such as cash/bank accounts, and investment/retirement accounts, the values can easily be obtained from the most recent account statement. Market value estimates for other assets, such as residential and personal real estate, can be obtained from recent appraisals, recent purchases, property tax assessments, and/or realtor websites. If the individual or couple owns a business, there generally is an estimate of value assigned to that asset. Since a business represents a non-liquid asset, the source of that value estimate can vary widely.Below, is a common example of a personal financial statement:
Generally, the following items are excluded from a personal financial statement:
Leased/Rented Items: These assets are excluded since they are not actually owned by the couple or individual. However, if the couple owns a piece of property that is rented to someone else, it would be included as an asset. Further, some personal financial statements include a summary of all forms of income and expenses, often expressed in the form of monthly or yearly amounts, if the personal financial statement is used to obtain credit or to show the couple’s or individual’s overall financial position in addition to their net worth.
Personal Property: Refers to items such as furniture and household goods. Generally, the value of these items is not readily known and they are generally not considered for credit as they are unable to easily be sold. If there is any personal property with significant value, such as jewelry, cars, antiques or collectibles, their value might be included with an appraisal as the source of value. Family law attorneys will note that values for personal property are also generally not listed on divorce filings. Opinions on value can widely vary and often the true value to an individual may be rooted more in sentimental reasons than actual value. Unfortunately, the allocation of value to these items or the selection as to who ends up with each item can be one of the last and most challenging aspects to settling a case.
Why Is a Personal Financial Statement Important?Family law attorneys, financial experts and business appraisers should ask for personal financial statements as part of their discovery or information request process. If one exists, how important is this document and how much weight should be given to it? Here’s where there are different views of the same document.One view of a personal financial statement is that no formal valuation process was used for business assets; so at best, it’s a thumb in the air, estimate of value of the business. Did the business owner complete the form without consulting any external data or did the business owner recently conduct a business valuation on the business or consult with a business appraiser? Chances are the spectrum of possibilities is generally closer to the former than the latter, but it might bear to ask questions regarding the circumstances of the personal financial statement.Another view is that the individual or couple submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in that document under penalty of perjury. Further, some would say the business owner is the most informed person regarding his/her business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.With such considerations, how do family law attorneys and business appraisers use personal financial statements? Dismiss them and throw them out? Use them as a gold standard and forego a formal business valuation? As usual, the two adages “it depends” and the “truth lies somewhere in the middle” are both probably accurate in this situation. Personal financial statements can be helpful in some cases or they can lack third party independent analysis as to the value of the business assets in other cases.Do You Like Surprises?Attorneys and business appraisers do not want to be surprised by not knowing about information or documents that exist. Therefore, ask for personal financial statements. They should then be used as another data point along with the other indications of value that a business appraiser is considering, such as an asset value, income value, market value, recent transactions within the Company’s stock, etc.As with recent transactions within the Company’s stock or other market indications of value such as prior company transactions or contemplated sales/mergers, consideration should be given to the following factors: First, what is the timing of submission for the personal financial statement or data point to either the date of filing or date of trial. In other words, a recently submitted personal financial statement or data point is more relevant than one from five or ten years prior. Second, what was the context, relevance and motivation involved in the event? Why was the personal financial statement submitted or did the event represent an arm’s length transaction between two unrelated parties, as opposed to family members. Finally, do the values submitted in the personal financial statement or other data points caused by events represent elements of fair market value or do they reflect strategic value. A recent issue of Family Law Valuation and Forensic insights, covers the definitions of some of these standards of value in the overall context of understanding and defining the assignment.If the value indicated for the business by the personal financial statement falls within a reasonable range of the estimates from the other methodologies, it could probably be given more weight. Be cautious if the value indicated for the business by the personal financial statement is materially higher or lower than a reasonable range indicated by the other methodologies. In which case, it may require the business appraiser to ask more questions regarding the thought process behind the estimate in the personal financial statement or why conditions might have changed drastically from the submission to current day.ConclusionBottom line, ask for personal financial statements, review them, but consider them along with other factors and methodologies before concluding on a value for the business. These documents can be helpful in the divorce process, but don’t let them become the smoking gun by not asking for them or by not being aware that they exist.
Observations of New Tax Reform Law on Personal Goodwill in Family Law Cases
Most professionals have seen countless reports of the 2017 Tax Cuts & Jobs Act (TCJA) on national news and been bombarded with requests to discuss the impact and various changes in the new law. For the family law community, obvious takeaways are the change in the deductibility, or lack thereof, in alimony payments after 2018, elimination of personal exemptions, and expanded use of 529 plans to include secondary and lower-level education expenses. Can a provision in the TCJA actually provide some insight into the presence of personal goodwill?Personal Goodwill Under Tennessee LawUnder Tennessee case law, personal goodwill is not a divisible marital asset. As discussed in the seminal case Koch, the Court reiterates the findings and definition of personal goodwill provided by the Wisconsin Court of Appeals in Holbrook. Holbrook describes personal goodwill as follows:“The concept of professional goodwill evanesces when one attempts to distinguish it from future earning capacity. Although a professional business's good reputation, which is essentially what its goodwill consists of, is certainly a thing of value, we do not believe that it bestows on those who have an ownership interest in the business, an actual, separate property interest. The reputation of a law firm or some other professional business is valuable to its individual owners to the extent that it assures continued substantial earnings in the future. It cannot be separately sold or pledged by the individual owners. The goodwill or reputation of such a business accrues to the benefit of the owners only through increased salary.”Section 199A of the TCJA and Personal GoodwillSo, what does personal goodwill have to do with the TCJA? Upon closer examination of the provision for a Section 199A deduction, some individual’s trusts and estates could be eligible for a 20% deduction on certain pass-through income. However, there are special limitations that apply to “specified service businesses.” According to the TCJA, “specified service businesses” are defined as follows:A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.Sound familiar? Both the Holbrook and “Specified Service Businesses” definitions have some common elements including reputation and skill of the employee. Under the TCJA, can tax returns now be used to assist attorneys and business appraisers to determine if the presence of personal goodwill exists? In other words, if an individual fails to qualify for a Section 199A deduction because of the “specified service businesses” limitation, does that illustrate that personal goodwill is present?We think the Section 199A provision and a person’s deductibility or exclusion of this deduction can provide another data point for attorneys and appraisers in determining whether personal goodwill is present. As with any thorough analysis of personal vs. enterprise goodwill, other important factors to consider are:Size of business and number of owners/practitionersPresence/lack of covenants not to competeDependence on owner(s) for selling feature with Company’s productsPresence/lack of ancillary incomeConclusionThe 2017 Tax Cuts & Jobs Act may assist attorneys and appraisers in determining if personal goodwill is present via the Section 199A deduction.As we’ve pointed out, this deduction/exclusion is just one of several data points that should be considered. It should also be noted, that determining whether personal goodwill is present or not is only the first step to an analysis. If personal goodwill is present, the second step is to determine or assign value to the personal goodwill. In other words, a company’s value could be comprised of both enterprise and personal goodwill. A qualified business appraiser is necessary to make this determination and to provide an allocation of the goodwill.Originally published in Mercer Capital's Tennessee Family Law Newsletter, First Quarter 2018
Asset Manager M&A Activity Accelerates in 2018
Asset manager M&A was robust through the first quarter of 2018 against a backdrop of volatile market conditions. Total deal count during the first quarter was up 32% versus the first quarter of 2017, though total disclosed deal value was down 25%. In terms of deal count, M&A is on pace to reach the highest levels since 2014, although we note that the quarterly data can be lumpy. Several trends which have driven the uptick in sector M&A have continued into 2018, including revenue and cost pressures and an increasing interest from bank acquirers.Notable TrendsThe underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, sector M&A has historically been muted. This is due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms."Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future. And I think a number of smaller-sized firms are finding that hard."
Martin Flanagan - President and CEO, Invesco Ltd. 1Q17 Earnings Call"You need to have, of course, the right product set. But you need especially to have underlying firms, which are positioned as best they can in terms of alignment and focus to sustain alpha generation. And in that respect, scale is the enemy, not the friend."
Sean Healey - 1Q17 Earnings Call, Affiliated Managers Group IncConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners (which itself was acquired by Stone Point Capital and KKR in a $2 billion deal last year), Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs over the last year. While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements. Despite a rising yield curve and the negative impact of goodwill on tangible book value, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities.The Market's ImpactRecent increases in M&A activity come against a backdrop of a bull market that continued unabated through 2017 but faltered during the first quarter of 2018. Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. While the first quarter of 2018 saw negative returns for most major indices, the gains seen during 2017 have yet to be eroded. At the end of the first quarter, the S&P was down nearly 10% from its peak in late January 2018, but the index is still only 2% below year-end 2017. As a result of increasing AUM and concomitant revenue growth (perhaps notwithstanding this last quarter), profitability has been trended upwards despite industry headwinds that seem to rationalize consolidation.ConclusionWith no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move during the remainder of 2018. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies. Expanding distribution and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger. More broadly, the recent tax reform bill is expected to free up foreign-held cash and increase earnings, which could further facilitate M&A’s upward trend during the rest of 2018.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Management Succession in Family Businesses
Next Man (or Woman) Up?Perhaps no group is as proficient at the art of clichéd answers as football coaches. When confronted with the season-ending injury of a star player, the coach will inevitably stare stoically into the camera and solemnly declare “Next man up.” Whether the coach truly believes that the replacement player will be adequate, the cliché is intended to convey the idea that the coach has created such a “culture of success” that the “Process” (two of the newer clichés) that the team’s performance will be unaffected.From the perspective of family business, “Next Man or Woman Up” is one approach that the board of directors can take to management succession. Perhaps for some family businesses, management succession is as simple as pulling the next available candidate from the management depth chart. But we suspect that approach falls short for most family businesses. The combination of business growth, generational dynamics, and intra-family relationships that make family businesses unique precludes one-size-fits-all solutions to management succession. The primary questions associated with management succession are (1) Who will be the next leader of the business? and (2) How will the transition occur?First Question: Who?In our experience, many succession struggles are rooted in a failure to distinguish between being a good family member, a good employee, and a good business leader. The combination of native ability, education, character, social IQ, technical skills, and strategic savvy necessary to run a large business successfully is rare. The often-unspoken assumption that, since Dick has been a good son, or Jane a good daughter, that he or she is entitled to run the business when his or her turn comes up is unfair to the shareholders and employees of the business, not to mention Dick or Jane. While there are abundant examples of capable and energetic second, third or later generation family members that are great business leaders, it is a mistake to think that management of the business should simply be a matter of inheritance.The second common myth is that since Bill and Suzie have demonstrated themselves to be great employees (in whatever functional area) that they will, therefore, be great leaders. Being good at one’s job does not guarantee success as the leader of a family business. Further, as companies grow, new challenges may require a different set of leadership skills than were required in the prior generation. The skills and personality traits that made Uncle Phil the ideal leader of the business twenty-five years ago may be different from what Cousin Carlton needs to possess for success in the same role today.If the family has successfully distinguished family membership from family business management, it may be easier for the board to cast a wider net to find the best candidate to assume leadership of the business. Having an “outside” CEO does not mean the company has ceased to be a family business any more than hiring the first non-family employee on the shop floor did. Rather, it simply means that the directors have fulfilled their responsibilities to shareholders, employees and the community by seeking the right candidate for the job. Family members are by no means ruled out from consideration, but directors must acknowledge that the requisite skills may not reside in the family. And that’s okay. Having “professional” management may actually help family cohesion – and therefore business sustainability.In many cases, the combination of outside perspective and family loyalty that make a successful leader can be found among the family’s in-laws. Such “married-ins” are often sufficiently removed from family dynamics that they can see business issues for what they are, uncolored by what may be decades’ worth of emotional baggage. At the same time, their membership in the family may give a head-start in aligning economic incentives. In other words, “married-ins” will likely have plenty of skin in the game.Second Question: How?In the long run, management succession is inevitable: the proportion of managers that are eventually replaced is 100%. In the short run, however, there are generally three circumstances giving rise to management succession.1. Planned Retirement: When the senior executive is approaching a natural retirement age, the directors should identify potential candidates to replace the retiring leader. With a multi-year planning horizon, the board can give due consideration to family candidates, develop mentoring opportunities for those candidates, and evaluate the performance of those candidates in areas of increasing responsibility. If it becomes apparent that no family candidates represent the right fit for the job, the board can extend the search to include existing non-family employees and non-employees.The appropriate retirement age for family business executives is a vexing issue. There simply is no one-size-fits-all for when a successful family business leader should step away. In our practice, we have seen examples of departures that – in hindsight – were premature, because the designated replacement was not yet ready to assume leadership. Perhaps more commonly, we see examples of businesses that plateau and stagnate because an aging senior executive refuses to move out of the corner office.2. Performance-Driven Transition: We wrote in a previous post about the unique challenges associated with management accountability in family businesses. If the directors determine an existing senior executive is not generating acceptable results, it may be appropriate to seek a replacement. Family dynamics can make this an extremely difficult decision, and the prospect that such a decision may be in the best interest of the principal stakeholders (family shareholders, employees, local community, customers, suppliers, etc.) is one good reason to include qualified independent non-family members on the board. The independent directors can provide an objective assessment of managerial performance uncolored by internal family dynamics. If a performance-driven transition is necessary, the ultimate replacement should not be selected hastily; the long-run health of the business may be better served by a deliberate selection process, during which an experienced executive can manage the company on an interim basis.3. Unexpected Vacancy: Finally, management succession may be forced upon the company because of an untimely illness, death, or other unforeseen circumstances. No business is immune to such circumstances, which underscores the need for directors to proactively think about management succession, even when the current leader is successful and expected to have a lengthy remaining tenure. When tragedy strikes, selecting the next leader should still be considered a measure-twice, cut-once project, with the long-term health of the organization taking precedence over the short-term desire to fill the position.As noted in the Harvard Business Review, recent research by Stephanie Querbach, Miriam Bird, and Nadine Kammerlander offers some interesting insights into best practices for management succession in family businesses. After studying over 500 management successions, they concluded the likelihood that successor-managers would be able to implement needed changes and improve the long-term sustainability of the family business was linked to three strategies: (1) limiting the power of the outgoing CEO subsequent to his or her retirement, (2) crafting a formal agreement regarding the how and when of power transfer, and (3) selecting a non-family successor. Of course, these observations reflect probabilities – they’re not absolute prescriptions for how every succession should occur. But they do provide a somewhat counter-intuitive perspective on the topic that family businesses would do well to consider.In the end, every management succession plan will be as unique as the family business it is designed for. But one constant for all family businesses is that now is the time to begin thinking and planning. “Next Man Up” may work in football, but your family business deserves better than that.
Was 2014 a Lesson Learned?
Overview of the Macro Oil and Gas Environment at the End of 1Q 2018The oil and gas market continued to show improvement in the first quarter of 2018. Positive momentum in production growth in the U.S. continued and prices increased from an average of $55 in Q4 2017 to an average of $63 in Q1 2018. Mercer Capital’s Senior VP, Grant Farrell, at the beginning of the quarter said, “a repeat of 2017 would be a welcomed event” and it appears we are on track. Oil prices are ticking up, domestic production has increased to a 50 year high, and the U.S. is exporting more crude oil than ever before.Too Good to be TrueIf you are like me, you can’t ignore the wary feeling in your gut that makes you ask, “Is it too good to be true?”According to Reuters, global inventories could increase due to the rapid increase in production in the U.S. which “could well outweigh any pick-up in demand.”
Rig counts in 2018 were expected to increase to 945 active rigs. [1] However, Baker Hughes reports that we have already met this target and currently have 993 active rigs versus 824 a year ago.
Have we already forgotten the lesson we learned in 2014: too much supply, too fast leads to a decline in prices? Additionally, what will happen to demand as transportation becomes more fuel efficient and we shift further away from oil in favor of renewable energy resources?
Easing ConcernsThankfully, I am not the only one asking these questions. A survey of oil and gas professionals in the February 2018 Issue of the Oil and Gas Journal showed that 63% of oil and gas senior professionals are optimistic about 2018. However, this optimism does not stem from a forecasted favorable price environment. Rather, their confidence is supported by the knowledge that they can now operate profitably in a $55 per barrel price environment.[2] Oil and gas exploration companies today are more cost-efficient than ever. The collapse in prices in mid-2014 gave companies two options: adapt to the new price environment or go away. Today we are left with a more cost-aware sector that has used technology to reduce risks and cut costs.Further, domestic E&P companies today have the ability to quickly adjust their operations in response to price changes. Jude Clemente, a recent contributor for Forbes recently wrote, “The U.S. has now become the world's swing oil producer and is the main factor that will limit how high prices can go.”BP Chief Economist Spencer Dale recently responded to similar questions asked across the energy industry: “Will oil and gas lose dominance to renewable fuels in the future?” BP argues that crude oil demand will continue to increase in the foreseeable future but will begin to reach a plateau in the next twenty years. While renewable energy is the fastest growing energy source, developing nations across the world will drive energy demand in the future. The mix of crude oil and renewable energy will shift, and crude oil will likely meet 85% of oil demand in 2040 instead of 94% of demand today. This does not, however, mean demand for crude oil will disappear.OverviewThe forecast for the oil and gas industry in 2018 was positive and we seem to be meeting or even exceeding investor expectations. The U.S. is expected to give up its title of the largest crude oil importer and exports are expected to continue growing as new pipelines and export terminals allow for increased capacity.The positive momentum in the industry is being reflected in private company valuations both as a result of improved earnings forecasts and reductions in risk. Growth in production and increases in price are increasing revenue, and more of the top line is flowing down to net income as companies have cut costs. Earnings improvement is being magnified by the recent tax cuts which have significantly increased net income. Further, the risk profiles of E&P companies have improved as companies are better equipped to handle price volatility and E&P companies are generally taking on projects with shorter payback periods.Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your oilfield service company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnote[1] US oil, gas industry capital spending to increase in 2018. US Oil and Gas Journal.March 2018.
[2] Survey: Oil, gas professionals express optimism for 2018 challenges. Oil and Gas Journal. February 2018
Volatile First Quarter Brings Asset Management Industry Headwinds Back Into Focus
Publicly traded asset managers had a rough first quarter, as volatility returned to the market and major indices posted negative quarterly returns for the first time in over two years. While the overall drop in the market was relatively modest, stock price declines of publicly traded asset managers were generally more significant. It is not surprising that most asset managers have underperformed during periods of declining markets, since the reverse was true during 2017, when most asset managers outperformed the major indices. To the extent top-line volatility is tied to AUM movements and costs are fixed, market swings will have a magnified impact on earnings (and stock prices) for asset managers.
The return of market volatility and the reintroduction to the idea that markets can, in fact, go down, have brought back into focus the industry headwinds which, at least for the last several years, have been allayed by a favorable market backdrop. Notably, outflows from higher cost funds have continued to increase, as shown in the following chart from Morningstar. During 2017, the chart shows accelerating outflows from the most expensive active funds and record inflows into the cheapest ones. These dynamics are problematic for many mutual fund companies and other asset managers that rely on active equity products, which are necessarily more expensive to implement than their passive counterparts.
There was one positive development related to asset flows for active managers during 2017: aggregate outflows for active funds in 2017 were stemmed considerably (in fact were nearly zero). Relative to the significant net outflows active funds have seen the last several years, 2017's low level of outflows seems like a win for the sector (if you count less of a bad thing as a good thing). Still, if stemming the outflows comes at the cost of lowering fees, the result will be lower revenue yields and profitability.
It appears that stemming outflows without significant fee cuts will be an uphill battle. Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies but also sector-wide underperformance against their applicable benchmarks. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers.
Active manager performance was better in 2017, although still, less than half managed to beat their passive peers on a net-of-fee basis. According to data from Morningstar, 43% of active managers outperformed passive peers in 2017 versus 26% in 2016.
It appears that as long as active managers are missing the mark on their value proposition (alpha net of fees), ETFs and other passive strategies will continue to gain substantial inflows from active managers, resulting in higher and higher allocations to index products. With improved performance relative to passive funds in 2017 and a volatile market so far in 2018, the opportunity is there to reverse this trend. However, it will take a sustained alpha generation before things start to go the other way, and in the interim, funds with a low active share and high fees are not likely to fare well. We’ve all read that consistently beating the market is nearly impossible, even for the savviest of stock pickers, but none of that research was compiled when passive strategies dominated the investment landscape.
We don’t foresee a huge shift back to active management any time soon, but we realize that we were probably overdue for some mean reversion. It is conceivable that the current market environment could be more conducive to stock picking, but we’ll need more time to judge whether this is truly the case. Regardless, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. This is why we say that active management may be down but is not out.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Before Selling Your Oil and Gas Royalty Interest Read This
There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.Before attempting to sell your mineral interest, understand these issues.Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.1Recognize Production and Price as Value DriversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well.Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.Proceed with CautionWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Beware of online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue. While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our post, Three Types of Mineral Interests.
Eagle Ford Q1 2018
Lower Breakevens Yet Some Plan Fewer Wells
A milestone worth noting: The EIA recently announced that 2017 marked the first time since 1957 that U.S. natural gas exports exceeded imports.
The economics of the Eagle Ford Shale have been steadily improving for the past year. While the Permian has been receiving the most attention given its low-cost economics and large well potential, the Eagle Ford (particularly its oil window) has increased well production whilst dropping its costs. However, based on recent announcements, many companies will be reducing the number of wells drilled in 2018 as compared to 2017.Breakeven PricesAs recently as a year ago, several companies and outlets reported breakeven oil price estimates in the low-to-mid $40s. Recently, several operators in the Eagle Ford are estimating breakeven as low as $28 and many around $35. This is a significant drop and points to anticipated efficiencies in drilling and completion costs.
This is positive, but the trend is generally moving away from the Eagle Ford relative to other plays. According to IHS Markit, “only 1,415 new wells were brought online in 2016 compared to 2,717 in 2015 and 4,040 in 2014". IHS also noted "the play’s overall annual base has been decreasing year-over-year as a result of production coming from older wells. The annual base decline in the Eagle Ford in 2016 was 46% compared to 49% and 50% in 2015 and 2014, respectively.”
IHS Markit also reported that a key reason for the decline in activity in the Eagle Ford is due to the rising interest in the Permian Basin and STACK/SCOOP plays, which have attracted the interest of key Eagle Ford players, including Pioneer Resources, Devon Energy, and Marathon Oil.
TPG AcquisitionIt is notable, and probably not a coincidence, that TPG, the most optimistic company per the Figure above, last week made one of the largest acquisitions in the Eagle Ford in the past few years (we will discuss this acquisition and other recent ones in more detail in a few weeks. Stay tuned.).2018 PlansTis the season for 2018 guidance and several of the major Eagle Ford shale operators have given theirs. As mentioned, several companies (Sanchez, Chesapeake, and Carrizo) are decreasing their estimates for new well compared to last year, but are increasing their capex budgets. Overall, EOG and Sanchez have increased their rig presence as of last week, but those figures fluctuate even week-to-week. EOG is leading the way in its activity from well count to acreage. In terms of new activity planned in 2018, it is the most aggressive of the four companies we follow (see Figure below). It’s also notable that EOG continues to test its position in the Austin Chalk formation – completing four wells in 4Q2017.Bill Thomas, the company's chairman and CEO, said last year was a success, considering lingering weakness in crude oil prices and headwinds from the series of hurricanes that hammered southern U.S. shale basins in late 2017."EOG emerged from the industry downturn in 2017 with unprecedented levels of efficiency and productivity, driving oil production volumes to record levels with capital expenditures approximately one half the prior peak," he said in a statement.
Carrizo’s strategy revolves around “multipads” wherever possible in the Eagle Ford. In 2018, Carrizo is completing a 16-well multipad utilizing three completion crews. In addition, Carrizo sees more than 700 remaining PUDs in the core of its Eagle Ford position at a 330-500 foot spacing profile (depending on the geology of the project area).
Chesapeake, meanwhile, continues to manage its balance sheet with asset sales and tempered activity which makes its activity profile a little harder to discern.
PerformanceWhat does this mean for performance? Well, the past week has been good to a number of producers, but it comes after a subpar stock price performance for everyone on this list not named EOG.However, if efficiencies compound for Eagle Ford players, this chart could look very different a year from now. Time will tell.Have a great week!
The Impact of the 2017 Tax Cuts & Jobs Act on the Investment Management Industry
The Tax Cuts and Jobs Act (TCJA) that was signed into law in December 2017 has already had, and will continue to have, a tremendous impact on the investment management community that warrants considerable attention from partners at RIAs. We won’t mince words – this tax bill is a blockbuster for the investment management industry.Taken as a whole, TCJA has already been especially beneficial to the RIA sector, as lower corporate tax rates have had a positive impact on equity markets, boosting AUM and earnings, which are now taxed at lower rates. Although most firms are still assessing the full impact of tax reform, the TCJA will likely impact capital management, M&A activity, and investments in technology.This whitepaper is a compilation of thoughts we have gathered at Mercer Capital in the early days of this new tax regime. We expect to learn more as the year rolls on, as the compliance and tax planning opportunities presented by the TCJA materialize and work through the system. We don’t suggest that this text is an exhaustive list of all of the implications of the tax bill on the investment management industry, but herein, we present what we think are the major issues that RIA partners should consider. Specifically:The tax bill has made investment management firms worth more by:Driving up AUMImproving RIA economicsMaking RIA pre-tax cash flows worth moreHowever, the tax bill has less of an impact on tax pass-through entities because:The tax advantage of S-corps and LLCs, relative to C corporation, is now mutedMany RIAs will not benefit from the QBI deductionYour RIA’s shareholder agreement probably needs to be revised because:Most buy-sell agreements value the business via formulaTCJA renders many RIA valuation rules of thumb obsoleteThe change in RIA valuations is potentially so significant that it calls into question the use of formula agreements entirelyThe tax bill may have a mixed impact on asset manager M&A because:Higher valuations will bring more sellers to the table, and buyers will feel more pressure to complete transactionsInternal succession, however, may be more difficult because individuals won’t enjoy the same increase in after-tax cash flows as corporate buyers
Download your copy of the whitepaper below and let us know if you have any questions on how these implications affect your firm.
WHITEPAPERThe Impact of the 2017 Tax Cuts & Jobs Act on the Investment Management CommunityDownload Whitepaper
How to Value an Oil and Gas Refinery
Because of the historical popularity of this post, we revisit it this week. Originally published last summer, this post helps you, the reader, understand the issues to consider when valuing an oil and gas refinery, as well as the appropriate valuation approaches.
When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of refineries is important in establishing a credible value for a business operating in the oil and gas refining space.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines)Downstream (Refineries)
Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Refiners convert raw crude and natural gas into products of value, such as transportation fuels.Oil and Gas Refinery OperationsCrude oil itself has little end use. Refiners create value by converting crude oil into various usable products. Transportation fuels, such as gasoline, diesel, and jet fuel, are some of the most commonly produced refined products. Other refined products include heating and lighting fluid, such as kerosene, lubricating oil and waxes, and asphalt. Refineries are capital intensive and their configuration depends largely on their physical location, available crude oils, product requirements, and environmental standards.Valuing an oil and gas refinery requires the consideration of a wide range of issues (far too many to list in full here), with primary considerations as outlined below.The price of inputs. The price of crude oil fluctuates due to changes in world demand and supply. Many refiners hold large volumes of crude inventory, but as the price of crude oil fluctuates, refiners face risk associated with the falling value of their inventory. Thus, in order to reduce risk refiners should shorten their timeline from purchasing crude oil to selling the finished product and/or use derivatives to hedge the risk associated with volatile oil prices.The price of refined products. There are four main components to refined product prices: (1) Crude Oil Prices, (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. However, President Trump has indicated that he hopes to lower corporate taxes.Crack spread. A refiner’s margins are generally determined by the crack spread, which measures the prices of refined products compared to the cost of crude oil. The price of transportation fuels generally moves in sync with the prices of crude oil, but the price of some refined products such as asphalt and lubricating oils is not as closely correlated with crude oil price changes.Environmental regulation. The refining industry has historically been heavily regulated. Regulations such as the RTR & NSPS aim to control air pollution from refineries and provide the public with information about refineries’ air pollution. President Trump is working to establish a more energy friendly environment and has signaled his intention to sign the repeal of many methane emission regulations if the repeal is passed through both Houses of Congress.Heavy vs. light crude. Most U.S. refineries were built to process heavy crude. However, the onset of U.S. shale drilling has led to a surplus of light sweet crude that U.S. refineries were not originally built to process. While the refining process of heavy and light crude is generally the same, the refining of light crude is less costly.Oil and Gas Refinery Financial AnalysisWhen valuing a business, it is critical to understand the subject company’s financial condition. A financial analyst has certain diagnostic markers that tell much about the condition of a business.Balance Sheet. The balance sheet of a refinery is dominated by inventory and fixed assets. According to RMA’s annual statement studies, 16.3% and 32.2% of petroleum refineries’ assets are inventory and fixed assets, respectively.1 Because refining is a capital intensive business, it is important to consider the current operating capacity of a company’s fixed assets in order to determine if future growth will require significant capital expenditures. If a refinery hopes to expand refinery throughput beyond the current refining capacity, it will have to invest in more equipment.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold account for approximately 75% of sales according to the RMA data. Thus it is important to consider possible supplier concentrations when analyzing the income statement because disruptions in the supply chain can have significant income statement impacts to oil refineries.How Does Valuation Work?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, and only look at assets as a source of rate of return. Oil and gas refineries are asset intensive businesses. They have distillers, crackers, cokers, and more. While an asset value consideration can be a meaningful component of the overall valuation of an oil and gas refinery, it is essentially the income generated by these assets that typically drives the value of a business. For this reason, the asset-based approach is typically not the sole (or even primary) indicator of value.The Market ApproachThe market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In the downstream oil and gas sector, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. Such options are Alon US Energy Inc., CVR Refining, LP, Valero Refining, and Western Refining. Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized to calculate a valuation multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. Additionally earnings multiples such as EV/ EBITDA can be used to calculate indication of values.The market-based approach is not a perfect method by any means. For example, industry transaction data may not provide for a direct consideration of specific company characteristics. Say a company is a market leader and operates in a prime geographic market. Since the market and the specific company are relatively more attractive than the average transaction, the appropriate pricing multiple for this company is likely above any median taken from a group of industry transactions. Additionally, many companies in the oil and gas industry are vertically integrated and have significant midstream or marketing operations in addition to their refining operations. For example, Marathon Petroleum Company is a leading refiner in the US, but is also a marketer of refined products and has significant midstream operations. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach can provide a helpful indication of value and should be used in determining the value of a refinery.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. When determining ongoing earnings historical earnings should be analyzed for non-recurring and non-normal income and expenses which will not affect future earnings. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate.Income is the main driver of value of a business; thus, the income approach should be considered when determining the value of your business.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue, earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.An owner who is contemplating any kind of transaction or agreement based on value needs to know what their business is worth. Whether you are selling out or selling in, knowing the fair market value of your business will let you evaluate whether or not an offer for your company is reasonable. Additionally, many business owners fail to understand the valuation implications of buy-sell agreements. If you have other shareholders in your business who are non-family, and maybe some who are, you probably have some kind of buy-sell agreement between the shareholders that describes how the business (or business interests) will be valued in the event of a shareholder dispute, death, or departure from the business (even on friendly terms). A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.Mercer Capital has long promoted the concept of managing your business as if it were being prepared to sell. In this fashion you promote the efficiencies, goals and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at 901.685.2120.End Note1 2016-2017 RMA Statement Studies. NAICS #324110. Companies with greater than $25 million in sales
Two Perspectives on RIA Transactions in the Wake of the Tax Bill
Mercer Capital’s marketing staff is trained to market valuation services, not perform valuations. Nevertheless, these folks have to read a lot about the practice in reviewing our articles, presentations, blogposts, books, and whitepapers, and I’ve wondered how much they absorb of what we write. I think I got my answer last week, when I showed our marketing director a photograph of an early-1960s Aston Martin DB4 and asked if she knew what kind of car it was.“Is it a Porsche?”Incredulously, I had to remind her that Porsche didn’t make GT cars in the 1960s, only rear-engine models like the 911, 356, and 912. The first Porsche with a front engine, grand-touring configuration was the 928, first produced in 1975. The 928 was supposed to be the replacement for the 911, which was expensive to build and difficult to drive (rear engine cars have an unrivaled penchant for oversteer). Porsche enthusiasts (a fandom like none other) balked, and the marque decided to build both the GT and their traditional rear-engine models until giving up on the 928 in 1995.The 928 was a brilliant car, but it wasn’t a game changer for Porsche. I suspect the jury is still out on the tax bill’s long-term impact on the investment management industry as well. One of the more interesting aspects of the 2017 Tax Cut and Jobs Act (TCJA) that is the bill’s potential impact on mergers & acquisitions. Most of the press assumes that the TCJA is going to be positive for M&A, although it cuts differently across different sectors. For the investment management community, the change in tax law is a mixed bag, and we’ve yet to see a compelling case to suggest that, overall, it will tend to encourage or to discourage transaction activity in RIAs on a net basis.Keep in mind that much of the TCJA did not apply to investment management firms. The new rules on expensing capital expenditures don’t matter for the asset manager that spends a few hundred thousand dollars (at most) per year on information technology equipment and licenses, plus a conference room table or two. Incentives to re-shore foreign capital doesn’t apply to most RIAs, and the limitations on interest deductibility won’t matter except for the most highly leveraged transactions. There is an argument to be made that the TCJA is bullish for RIA M&A, but there is a counter-argument as well.Point: New Tax Legislation Encourages RIA TransactionsMost commentators only see positives in the tax bill for M&A activity, and at least some of that extends to investment management firm transactions. We joined in this chorus, noting that rising asset prices have brought many RIAs a surge in AUM, which grows revenues similarly and profits even more, thanks to the magic of operating leverage.For RIAs structured as C corporations, the TCJA significantly improved after-tax cash flows since most firms pay high effective tax rates. And those higher after-tax cash flows are potentially even more richly rewarded by a market willing to pay higher multiples in a time of mostly bullish sentiment.All else equal, higher valuations usually encourage sellers to take advantage – which is important fuel to the RIA transaction community in which buyers usually outnumber sellers by a wide margin. And conglomerates with investment management firm divisions may be encouraged to make divestitures in a time when valuations are high and the taxes on gains they make in the sale would be relatively low.All in all, there are many reasons to believe that the tax act will spur more transaction activity for RIAs. However, there is another side to this story.Counterpoint: New Tax Legislation Does Nothing for RIA transactions, and Might Even Discourage ThemOne drawback of the TCJA is that it does little, if anything, for internal RIA transactions, the most common style of investment management firm transactions. While tax rates for C corporations were slashed, the top tax rate for individuals only declined modestly, from 39.6% to 37%. Most RIAs are structured as some kind of tax pass-through entity, either as an LLC or an S corporation. So taxes on investment management firm earnings are taxed as personal rates rather than corporate rates.Buyers in internal transactions at RIAs pay for their stock with after-tax cash flow (distributions), and purchasing capacity will be little improved by the TCJA (with a few exceptions). Without an improvement in after-tax distributions, internal buyers can’t pay more for their stock. So the tax bill isn’t really bullish for internal ownership transition. Further, to the extent that sellers now have expectations for higher prices, we may witness a widening of the bid-ask spread, which will discourage ownership transition altogether.Risky BusinessBack to my feature car – the 928 could have wound up on the engineering design floor had Porsche not decided to go ahead and produce it alongside the now (if not then) iconic 911. The legacy of the 928 – always a great GT – was eventually cemented onscreen by Tom Cruise in the 1983 film Risky Business. In the alternative, Porsche could have thumbed their nose at rear-engine aficionados and moved ahead with replacing the 911, but by being non-committal, they hedged their bet and ended up extending the brand. We recommend similar caution in assuming the TCJA is only good for RIA transaction activity. It might be, or it might not be. Risky business indeed.“…never driven in the rain.”
Fairness When the Price May Not Feel “Right”
Viewed from the prism of “fairness” in which a transaction is judged to be fair to shareholders from a financial point of view, many transactions are reasonable; some are very fair; and some are marginally fair. Transactions that are so lopsided in favor of one party should not occur absent a breach of corporate duties by directors (i.e., loyalty, care and good faith), bad advice, or other extenuating circumstances. Obtaining competent financial advice is one way a board exercises its duty of care in order to make an informed decision about a significant corporate transaction.The primary arbiter of fairness is the value of the consideration to be received or paid relative to indications of value derived from various valuation methodologies. However, the process followed by the board leading up to the transaction and other considerations, such as potential conflicts, are also important in the context of “entire” fairness.A tough fairness call can occur when a transaction price appears to be low relative to expectations based upon precedent transactions, recent trading history, management prognostications about a bright future, and/or when the value of the consideration to be received is subject to debate. The pending acquisition of commercial finance lender NewStar Financial, Inc. (“NewStar”; Nasdaq-NEWS) is an example where the acquisition price outwardly seems to be low, at least until other factors are considered.NewStar ExampleOn October 16, 2017, NewStar entered into a merger agreement with First Eagle Holdings, Inc. (“First Eagle”) and an asset purchase agreement with GSO Diamond Portfolio Holdco LLC (“GSO”). Under the merger agreement, NewStar will be acquired by First Eagle for (a) $11.44 per share cash; and (b) non-transferable contingent value rights (“CVR”) that are estimated to be worth about $1.00 per share if the transaction closes before year-end and $0.84 per share if the transaction closes in 2018. The CVR reflects the tax benefit associated with the sale of certain loans and investments at a discount to GSO for $2.37 billion.Also of note, the investment management affiliate of First Eagle is majority owned by an entity that is, in turn, partially owned by Corsair Capital LLC, which is the largest shareholder in NewStar with a 10.3% interest.Acquisition PriceAs shown in Figure 1, the acquisition price including all of the CVR equates to 83% of tangible book value (“TBV”), while the market premium is nominal. Although not relevant to the adequacy of the proposed pricing, NewStar went public in late 2006 at $17.00 per share then traded to around $20 per share in early 2007 before sliding to just about $1.00 per share in March 2009. “Feel” is a very subjective term; nonetheless the P/TBV multiple that is well below 100%, when combined with the nominal market premium, feels light. NewStar is not a troubled lender. Non-performing assets the past few years have been in the vicinity of 3% of loans, while net charge-offs have approximated 1% other than 2015 when losses were negligible. Further, the implied haircut applied to the loans and investments that will be acquired by GSO is modest.Transaction MultiplesWhile the P/TBV multiple for the transaction is modest, the P/E multiple is not at 26.5x (the latest twelve month (“LTM”) earnings) and 18.4x (the consensus 2018 estimate). The P/E could be described as full if NewStar were an average performing commercial bank and very full if it was a typical commercial finance company in which low teen P/Es are not unreasonable.What the P/TBV multiple versus the P/E multiple indirectly states is that NewStar has a low ROE, which has been less than 5% in recent years. The culprit is a highly competitive market for leveraged loans, a high cost of funds absent cheap bank deposit funding and perhaps excess capital. Nonetheless, management’s projections incorporated into the recently filed proxy statement project net income and ROE will double from $20 million/3% in the LTM period ended September 30 to $41 million/6% in 2020.In spite of a doubling of projected net income, the present value (assuming NewStar is worth 18.4x earnings in 2020 discounted to September 30 at a discount rate of 13%) is about $507 million, or about the same as the current transaction value to shareholders. Earnings forecasts are inherently uncertain, but one takeaway is that the P/TBV multiple does not appear so light in the context of the earnings forecast.Additional perspective on the transaction multiples is provided in Figure 2 in which NewStar’s P/TBV multiple based upon its public market price consistently has been below 100% the last several years while the P/E has been around 20x or higher due to weak earnings.Performance and TimingAs for the lack of premium there outwardly did not appear to be wide-spread expectation that a transaction was imminent (as was thought possible in 2013 when Bloomberg reported the company was shopping itself). There were no recent media reports; however, the shares fell by 17% between May 2–May 19 following a weak first quarter earnings report. The shares subsequently rebounded 19% between June 6–June 14. Both the down and then up moves were not accompanied by heavy volume. Trading during most of this time frame fell below the approximate 100 thousand daily average shares.Measured from June 14–October 17, the day after the announcement, NewStar’s shares rose about 10% compared to 8% for the SNL Specialty Finance Index. Measured from May 19, when the shares bottomed following the weak first quarter results the shares rose 34% compared to 12% for the index through October 17. The market premium relative to recent trading was negligible, but it is conceivable some premium was built into the shares for the possibility of a transaction given the sharp rebound during mid-June when negotiations were occurring.Other Support for the TransactionFurther support for the transaction can be found in the exhaustive process that led to the agreements as presented in the proxy statement. The proxy confirmed the Bloomberg story that the board moved to market the company in 2013. Although its investment bankers contacted 60 potential buyers, only two preliminary indications of value were received, in part because U.S. banking regulators tightened guidelines in 2013 related to leverage lending by commercial banks. The two indications were later withdrawn.During 2016 discussions were held with GSO regarding a going-private transaction, in addition to meetings with over 20 other parties to solicit their interest in a transaction. By the spring of 2017, consideration of a going-private transaction was terminated. Discussions then developed with First Eagle/GSO, Party A and Party B that eventually led to the announced transaction. Given the experience of trying to sell NewStar in 2013 and go private in 2016, the board elected not to broaden the marketing, calculating the most likely bidders would be alternative asset managers (vs. banks with a low cost of funding).Fairness considerations about the process were further strengthened through a “go-shop” provision in the merger agreement that provided for a 30-day “go-shop” period in which alternative offers could be solicited. If a superior offer emerged and the agreements with First Eagle and GSO were terminated a modest termination fee of $10 million (~2.5%) would be owed. Conversely, if NewStar terminates because GSO cannot close, then a $25 million termination fee will be owed to NewStar.The go-shop provision was activated, but to no avail. More than 50 parties were contacted and seven other unsolicited inquiries were received. NewStar entered into confidentiality agreements with 22 of the parties, but no acquisition proposals were received.Financial AdvisorsOther elements of the agreements that are notable for a fairness opinion include the use of two financial advisors, financing, and director Thornburgh, who was recused from the deliberations given his association with 10% shareholder Corsair, which holds, with Blackstone, a majority interest in First Eagle. Financing was not a condition to close on the part of the buyers because GSO secured $2.7 billion of debt and equity capital to finance the asset purchase. First Eagle will use excess funds from the asset purchase and existing available cash to fund the cash consideration to be paid at closing to NewStar shareholders. While two financial advisors cannot make an unfair deal fair, the use of two here perhaps gave the board additional insight that was needed given the four-year effort to sell, take the company private, or affect some other corporate action to increase value.The Lesson from the NewStar ExampleWhile the transaction price for NewStar seems low, there are other factors at play that bear consideration. When reviewing a transaction to determine if it is fair from a financial viewpoint, a financial advisor has to look at the entire transaction in context. Some shareholders will, of course, focus on one or two metrics to support a view that is counter to the board’s decision.ConclusionEvery transaction has its own nuances and raison d’etre whether the price “feels right” or not. Mercer Capital has significant experience helping boards sort through valuation, process and other issues to determine what is fair (or not) to shareholders from a financial point of view. Please call if we can help your board make an informed decision.Originally published in Mercer Capitals Portfolio Valuation: Private Equity Marks Newsletter: Fourth Quarter 2017
2018 Trends to Watch in the Banking Industry: Acquire or Be Acquired Conference Recap
For those readers unable to escape the cold to attend Bank Director’s Acquire or Be Acquired (AOBA) conference in Scottsdale, AZ, we reflect on the major themes: bank M&A and scarcity, tax reform and valuation, and FinTech. For those unfamiliar with the three-day event, over 1,000 bankers, directors, and advisors gather to discuss pertinent industry issues.Bank M&A and ScarcityThere are fewer than 5,500 banks today, which is roughly half from only 10 years ago when we first attended AOBA. This scarcity was top-of-mind for several panelists who noted variations on the same theme: Scarcity matters to both buyers and sellers as the number of banks dwindles at a rate of 3-4% per annum.Unlike the 1990s and even the pre-crisis years when a seller could expect multiple offers, banks that sell today often have just one or two legitimate suitors. In our view, this means that sellers need to think more strategically about their valuation today and prospectively if their most logical suitor(s) is acquired. Even if the logical acquirer is unlikely to be acquired, board planning for some institutions should consider the potential to strike a (cash) deal with a credit union. For buyers, scarcity may translate into less desirable banks in targeted markets. If so, scarcity may mean greater emphasis on expansion through lift-outs from other banks, or even a push into non-traditional bank acquisitions/investments such as wealth management that could serve as a nucleus around which traditional banking services are bolted. One key question to watch: Will scarcity impact the pace of consolidation and the valuation of transactions? The short answer is seemingly “yes,” but rising acquisition valuations over the past couple of years correspond to the rising value of acquirers’ publicly traded shares.Tax Reform and ValuationThe banking sector was revalued higher in the public markets following the November 2016 elections, reflecting four attributes that would favor banks: regulatory reform, tax reform, faster GDP growth, and therefore, higher interest rates. While the impact (thus far) of regulatory reform and higher interest rates is limited, passage of the Tax Cuts and Jobs Act of 2017 is a highly tangible benefit for banks and customers. With the stroke of a pen, ROE for many banks will rise to or above the institution’s cost of capital, returning to pre-financial crisis levels. However, tax reform is not a cure for strategic issues such as whether FinTech may radically disrupt the “core” in the deposit relationship between customers and their banks.One panelist summed up the debate by noting that management teams who achieve a 10-15% increase in earnings and ROE in 2018 from tax reform are not geniuses; rather, they are around to cash the check. The real winners, as it relates to tax reform, will be banks that leverage the enhanced cash flows to make optimal capital budgeting and strategic decisions. Bankers will have to allocate the additional earnings before some of it is competed away among investments in staff, technology and/or higher dividends, share repurchases and acquisitions. Perhaps in the ideal world, the incremental capital to be created would be used to support faster loan growth, but few at the conference indicated their institution had seen an increase in loan growth as a result of tax reform.A related theme that emerged in several sessions was the dichotomy in valuations between the “haves” and “have-nots” along key metrics such as size, profitability, core deposits, location, management team, and operating strategy/niche. This divergence could widen further following tax reform as the “haves” effectively take their higher cash flows and reinvest/deploy them more profitably than the “have-nots.” Ultimately, these strategic decisions and the trajectory of the bank’s performance will drive whether tax reform leads to sustainably higher bank valuations, likely varying case-by-case. For those interested, we discuss implications of tax reform for banks in greater detail here.FinTechWhile FinTech wasn’t even on the agenda when we first made the trip to Scottsdale for AOBA in the mid-2000s, it was all over this year’s schedule. One panelist humorously compared bankers’ reactions to FinTech with the “Seven Stages of Grief” noting that bankers seemed to have finally progressed beyond the early-stages of anger and denial toward the latter-stage of acceptance. Bankers are considering practical solutions to incorporate FinTech into their strategic plans. Sessions included panel discussions on the nuts and bolts of structuring FinTech partnerships and creating value through leveraging FinTech to enhance profitability. (For those interested in FinTech, learn more about our book on the topic.) Niches of FinTech that garnered particular attention included digital lending, payments (both consumer and business), blockchain, and artificial intelligence. AI in particular was top-of-mind, and one panel noted it as an area of FinTech offering strong potential for banks in the next few years.We look forward to discussing these three themes with clients in 2018 and monitoring how they evolve within the banking industry over the next few years. As always, Mercer Capital is available to discuss these trends as they relate to your bank – feel free to call or email.Originally published in Bank Watch, February 2018.
Diversification and the Family Business
The following is an installment in our series “What Keeps Family Business Owners Awake at Night”
Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham“Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make: There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk – or variability of returns – of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice, in this case, should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Diversification to Whom?Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough – or so the theory seemed to go – you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a – you guessed it – “core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets). Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions – ready liquidity and absolute shareholder freedom in constructing one’s portfolio – simply does not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.We wrote in a previous post about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only distribution and reinvestment policy, but also the role of diversification in the business. So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.
The 2018 Outlook for the Refining Industry
Over the last six months of fiscal 2017, changes in the oil & gas market led to increasing refinery revenues and the expansion of margins. Earnings in the refining industry increased in fiscal 2017 as refined product prices increased, the crack spread widened, and volumes sold increased as demand rose. With recent gains in the industry and the effect of the Tax Cuts and Jobs Act of 2017, refiners should sail steadily through 2018. However, the future impact of many regulations surrounding the oil & gas industry is still uncertain.Factors Providing Positive Momentum in 2018Tax Cuts and Jobs Act of 2017We start with the obvious. The Tax Cuts and Jobs Act of 2017 will increase net earnings. Many clients have called to ask, “What is the impact of the tax cuts on my company? If taxes decrease, will the value of my company increase?”As Travis Harms, Senior VP at Mercer Capital, said in his recent presentation on the tax reform.“Simply put, we can say, yes a lower corporate tax rate will make corporations more valuable, all else equal. Will all else always be equal? No. Appraisers will need to carefully consider the effect of the new tax law not just on rates, but on growth expectations, reinvestment decisions, use of leverage, operating margins, and the like for individual companies.”As noted by George Damiris, CEO and President of Holly Frontier, on HFC’s fourth quarter earnings call, “The reforms to the U.S. tax code encourage capital investments and lower the corporate rate to better enable manufacturers to compete in the global market.”Price of Crude OilEven if OPEC maintains production cuts, rising U.S. shale oil output is thought to temper the results of OPEC’s reduction in supply. This will likely result in falling or stable oil prices. Because refined product prices often lag crude oil, the crack spread should widen or at least remain steady in 2018.Gregory Goff, CEO of Andeavor explains, “Last year, primarily because of rising crude prices throughout the year, we didn't have any periods of time where the market was impacted by having a declining crude price and the lag effect of that. So, organically, the growth was muted a little bit by the weaker margin environment.”Analysts polled by Reuters believe that oil prices will not continue to rise past the first quarter of 2019, because U.S. production will offset production declines by OPEC. We believe that oil price decreases could lead to higher margins in the refining industry over 2018. Holly Frontier, in their fourth quarter earnings call, provides an outlook of crude spread and product crack improvements in 2018.Friendly Environment for Oil & Gas CompaniesPresident Trump is positioning the U.S. to offer a more energy-friendly environment. The deregulation of the oil & gas industry was generally applauded on earnings calls at the beginning of 2018 and industry executives believe it will provide a more efficient marketplace for refiners.Factors Providing Negative Momentum in 2018The Future of the RFS is Still UncertainThe final Renewable Fuel Standards (RFS) for 2018 were released on November 30, 2017 and contained a slight reduction in volume requirements. This will provide some relief for refiners. However, refiners have made it clear that a long term solution regarding the RFS is needed. While large integrated refiners have the capability to blend their own petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price. The cost of RINs has hurt the profits of merchant refiners over the last few years and will continue to do so unless the standards are reworked or repealed.Potential Tariffs Could Hamper Exports and Increase CostsAs noted in the EIA’s Annual Energy Outlook 2018, domestic consumption of petroleum products is expected to decline due to increases in fuel efficiency. However, refinery utilization is expected to remain stable due to expected increases in petroleum product exports in the future. The imposition of tariffs on steel and aluminum imports does not directly affect U.S. oil refineries. However, steel is one of the most wildly used metals in the oil & gas industry. If the impacts of tariffs are passed onto the consumer, then the oil & gas industry could realize higher costs of steel.Further, there is concern of retaliation and trade wars which could hamper growth in the industry if tariffs on U.S. products are imposed by retaliating countries. Over 33% of U.S. exports of refined products are sent to Mexico and Canada, who are currently except from the tariffs. However, growth in demand from other countries could be dampened by the soon-to-be enforced tariff.What Does This Mean for Refinery Valuations?Consistent with the view that markets are generally efficient, the new lower corporate tax rates seem to have been priced into the market shortly after election day. Thus when the tax plan passed, the expected increase in after-tax earnings did not come as a surprise to the market. Additionally, there has been talk of crude price decreases since U.S. production broke a production record 10 million bpd in November 2017. This was the first time the U.S. broke this record in 48 years. Since then it has been thought that the U.S. is on track to surpass Saudi Arabia and Russia in crude oil production, making OPEC’s production cuts less impactful.Much of the positive momentum in the refining industry was expected by industry analysts. Valuation multiples have remained relatively stable over the last six months. EV multiples are trending between 7.5x to 8.5x EBITDA. According to Moody’s, “Outlook for the refining and marketing sector is stable, with earnings likely to increase 5-7% in 2018.” As earnings increase, company valuations will likely increase. However, refiner’s profit margins are highly dependent on management decisions. The degree of the effects of the new tax plan on your business depends on many company-specific decisions, such as the use of operating leverage. Further, management decisions regarding inventory management and price hedging can be the “make or break” in unexpected downturns. In order to understand the impact of these factors on the value of your refinery, you should contact an industry valuation specialist.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Our oil & gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil & gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil & gas valuations and associated oil & gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Your RIA May Qualify for the QBI Deduction, But Don’t Get Your Hopes Up
The Tax Cuts and Jobs Act (TCJA) introduces the Qualified Business Income (QBI) deduction as a partial offset to the bill’s reduction in the relative tax efficiency of pass-through entities (S corporations, limited liability companies, and partnerships) versus C corporations. Still, many RIAs will not be eligible for the deduction, and those that do will have a lot to keep in mind as it pertains to reasonable compensation levels and investment income. We’ll try to sort it all out for you in this week’s post.
On balance, the TCJA has been very bullish for the RIA industry. A significant reduction in C corporation tax rates has helped precipitate a steady rise in the stock market over the last several months, so AUM balances are on the rise. Operating leverage in the business model compounds this effect, expanding margins as earnings growth outpaces gains in AUM and fee income. RIA market caps have responded accordingly:
However, not all aspects of the bill are favorable to the industry. The relative tax efficiency of the pass-through structure has been reduced by the bill as personal tax rates have not declined nearly as much as rates for C corporations, and most RIAs are LLCs or S corps (therefore, taxed only at the shareholder/personal level). For RIAs with low dividend payouts (which is somewhat rare in our experience), it may actually make more economic sense to be structured as a C corp in the wake of the tax bill. At least one alt manager has already done so already.
RIA’s ExclusionTo compensate for the narrowing S corp tax advantage, the TCJA introduced the Qualified Business Income (QBI) deduction that allows certain S shareholders to deduct 20% of their pass-through income. Oddly enough, the QBI deduction is not available to RIAs (above a certain income limit, discussed later). Congress decided to exclude certain “specified service trade or business,” defined as “any trade business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities.”It’s not abundantly clear to us why the investment management exclusion (and the limitation on the deductibility of financial planning fees) was specifically included in the bill. Perhaps this exclusion was an offset for carried interest miraculously avoiding a tax hike from the TCJA. Maybe Congress didn’t feel any sympathy for an industry that has performed so well since the Financial Crisis and enjoys relatively high levels of compensation. Whatever the reason, it’s in there, but like many features of the TCJA, it includes a loophole.QBI EligibilityDespite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315,000 for married couples or $157,500 for individuals and is partially available for married couples and individuals up to $415,000 and $207,500, respectively. Industry consultant Michael Kitces helps us keep this all straight:
If you’re the owner of an investment management firm and make over $207,500 as an individual or $415,000 if you’re married, the QBI deduction is not for you. While a good problem to have, it means many RIA owners will not be eligible for the deduction. If you find yourself in this category and do not distribute a high percentage of your earnings (that would still be subject to double taxation for C corporations), you might want to consider a C election. Otherwise, the S or LLC status probably makes the most economic sense even with the relative reduction in tax efficiency.
Nuances to ConsiderEven if you’re at or below the income threshold, there are still a few nuances you need to consider in determining eligibility. One potential hurdle is the prohibition of “reasonable compensation” being classified as QBI, so certain RIA owners will now be incentivized to pay (or at least determine) a market rate for his or her salary and bonuses. We know firsthand that this is easier said than done and could require consultation with an industry advisor (like ourselves) or compensation expert to make such a determination. It’s also important to keep in mind that the income must also be domestic and not attributable to securities investments to qualify as QBI (even though REIT income not attributable to capital gains or qualified dividends is allowable).Regardless of eligibility, the QBI and its random countenances are not likely to be a game changer for your RIA. It is, however, worth understanding these features if you can take advantage of (one of the few) benefits from the TCJA on pass-through entities like S Corps and LLCs. Otherwise, you can take comfort in not having to keep track of all this.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
What Is a Reserve Report? (Part II)
This is the second of multiple posts discussing the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].In our first post, we discussed the purpose of a reserve report, why they are important, how they are prepared and what is contained in the report. In this post, we discuss two of the most important inputs that go into every reserve report: production and pricing and why it may be appropriate to make adjustments to these inputs for purposes of Fair Value or Fair Market Value.What Is a Reserve Report?To recap, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible.The estimate is “as of a given date.”The reserve “is formed by application of development projects to known accumulations.” In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas.”There must also be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner.
In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.ProductionIn our first post, we summarized 12 significant assumptions made in a reserve report. Production is an important input that goes into every reserve report. Production revolves around the estimate of current and future oil and gas removed from the resource play. To organize the certainty of future production forecasts, the SEC requires the use of three categories: (1) Proved, (2) Probable, and (3) Possible. These categories have the following definition:Proved: An estimate that is reasonably certain. There must be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate. Therefore, economic producibility: proved oil and gas reserves are those quantities which can be estimated with reasonable certainty to be economically producible from a given date forward from known reservoirs and under existing economic conditions, operating methods and government regulations. Economic producibility must be based on existing economic conditions.Probable: An estimate that is as likely as not to be achieved and when using a probabilistic method, there must be at least a 50% probability that the actual quantities recovered will equal or exceed the estimate.Possible: An estimate that might be achieved, but only under more favorable circumstances than are likely and, when using a probabilistic method, there must be at least a 10% probability that the actual quantities recovered will equal or exceed the estimate.
The production assumptions might be the most important assumption within the reserve calculation. Careful attention should be utilized in the estimation of future production. Use of a certified reserve engineer is highly encouraged for this assumption.
If the production and decline curves are prepared in an appropriate manner, no adjustment to this input is needed for Fair Value or Fair Market Value, unless hypothetical conditions are to be applied. In which case, adjustments need to be made for matching the valuation date with the production forecast date.PricingReserve reports allow for two types of pricing assumptions for the future estimate at which the minerals are assumed to be sold in the market place. The first SEC rule states (1) companies should use the average of the first day of the month price for the previous 12 months; therefore, an average of the previous year (historical pricing); and (2) the SEC also allows for use of contract prices if future production is contractually guaranteed at certain pricing. This type is forward-looking.For the most part, reserve reports use historical prices in their analysis. This assumption should be challenged for possible replacement in Fair Value or Fair Market Value analysis.In these types of situations, future expectation is appropriate to utilize in the reserve calculation. Therefore, a forward-looking price assumption, frequently called a “price deck,” should be considered.Forward-looking price assumptions come in the form of futures contracts which are based on certain amounts of crude oil/natural gas delivered in certain future months. These types of futures contracts are traded daily on various exchanges[3] and include contracts for delivery as far out as 60 months or longer in some instances.Therefore, with the available information and forward-looking purpose of Fair Value and Fair Market Value analyses, strong consideration should be made to replace a historical price deck with a forward-contract price deck. Additionally, incorporation of differentials and local pricing should also be considered when using a price deck based on futures contracts.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)[3] Chicago Mercantile Exchange, New York Mercantile Exchange, Intercontinental Exchange
Valuing Oil & Gas Reserves (Part II)
Don Erickson, Managing Director of Mercer Capital, educates the public on valuation methodologies and trends impacting various industries. One such industry is Oil & Gas. In the second part of this two-part slide deck, he discusses the basics of how to value oil & gas reserves.
Structured in two parts, this slide deck was originally presented to notable professionals in the valuation industry and is designed as a high level overview of the technological and production method changes currently employed by the oil and gas industry.
Mercer Capital’s goal with this slide deck is to give the public a vocabulary and conceptual framework for thinking about valuation issues and challenges within the industry given it is prone to volatile swings in commodity prices.
Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.
Valuing Oil & Gas Reserves (Part I)
Don Erickson, Managing Director of Mercer Capital, educates the public on valuation methodologies and trends impacting various industries. One such industry is Oil & Gas. In this slide deck, he discusses the main drivers impacting the oil and gas pricing environment over the previous decade and the implications to valuing reserves.
Structured in two parts, this slide deck was originally presented to notable professionals in the valuation industry and is designed as a high level overview of the technological and production method changes currently employed by the oil and gas industry.
Mercer Capital’s goal with this slide deck is to give the public a vocabulary and conceptual framework for thinking about valuation issues and challenges within the industry given it is prone to volatile swings in commodity prices.
Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.
Q4 Call Reports
Triadic Effects of the New Tax Law
Publicly traded asset managers were up nearly 13% last quarter, driven by tax reform and strong equity markets. The Tax Cuts and Jobs Act has been especially beneficial to the RIA sector, as lower corporate tax rates have had a positive impact on equity markets, boosting AUM and earnings, which are now taxed at lower rates. Many firms are still assessing the full impact of tax reform, but what is clear is that lower corporate tax rates in 2018 will give asset managers increased flexibility in capital management, M&A activity, and technology investment. On the fee side, tailwinds for low-fee passive products remain strong, but recent strength in equity markets has shifted the asset mix for many firms towards higher-fee equity products, which may increase realized fees in the short term.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Recent corporate tax reform could spur M&A and other investing activity as firms have increased flexibility in capital management and strategic investment decisions.We're excited by the options created by corporate tax reform and are currently discussing how we can best serve all stakeholders. These options include committing resources to further develop our financial technologies and investment data science expertise; obviously, M&A activity; investing to optimize our global distribution efforts; and introducing and seeding new products and services. We also plan to make investments that directly benefit employees and the communities where they do business. – Greg Johnson, Chairman and CEO, Franklin ResourcesI think the difference [post tax reform] is that everything's fairly equal as we look at the world. [I]n the past, if it was captive offshore cash, and before any tax reform, you may have had a bias to try to do something outside of the U.S. I think, today, the U.S., it's all fungible cash around the world. So we would look openly to opportunities as much here in the U.S. as abroad. I think that the net-net would be you have an opportunity to do a larger acquisition in the U.S. than you did in the past. That would be the only real change, I think, as far as how we look at the M&A landscape. – Greg Johnson, Chairman and CEO, Franklin ResourcesClearly, an increase in incremental cash flow from tax reform could impact likely favorably our capital management decisions, and that reflects both potential dividends and buybacks. And our plan is to – I mean, given the tax reform is basically three weeks old – our plan is to effectively reassess our latest capital management recommendations probably around mid-year once we kind of finalize the impact the tax reform is going to have on BlackRock. And there's going to be lots of additional guidance that's going to be forthcoming as well as making sure that we are looking at all of the balance sheet, if you will, opportunities that we have over the next several months, including more aggressively seeding and co-investing in new products. – Gary Shedlin, CFO, BlackRockTheme 2: Technology investment and acquisitions will continue to play a key role in expanding product breadth and enhancing client experience; BlackRock makes several FinTech acquisitions.We accelerated the expansion of our technology portfolio during 2017 with the acquisition of Cachematrix and minority investments in iCapital and Scalable Capital. Our investments in technology and data will enhance our ability to generate alpha and more efficiently serve clients, resulting in growth in both base fees and technology revenue. – Greg Shedlin, CFO, BlackRockTechnology is enabling more productive engagements with more financial advisers than ever before, driving accelerated asset and base fee growth across our platform. BlackRock is using better data and technology to scale our own wealth advisory sales teams and equipping them with a better insight about our clients, about their portfolios, and giving a much better texture about markets. – Laurence Fink, CEO, BlackRockIn the area of technology, we expect approximately $1 million of additional run-rate costs in 2018 and an extra $4 million of onetime upfront expenses related to the implementation costs for risk management and regulatory initiatives, mostly to further support expanding degrees of investment freedom. We also plan to implement a new client reporting system, which will enhance the client experience. – Charles Daley, CFO, Artisan Partners Asset ManagementTheme 3: Tailwinds for passive products remain strong, and significant net inflows into low-fee passive products have continued in both the retail and institutional channels. Despite ongoing fee pressure from passive products, some firms have seen modest fee increases due to market-driven shifts in AUM composition towards higher-fee equity products.Global iShares generated a record $245 billion of new business for the year, representing full year organic growth of 19% with flows split nearly evenly between core and higher-fee noncore exposures. Since BlackRock launched the iShares core funds 5 years ago, we have seen over $275 billion of net inflows, including $122 billion of net inflows in 2017 alone. Three of the industry's top five ETFs, in terms of net new assets globally this year, were iShares core ETFs; IBV, our S&P 500 Fund; IEFA for developed international market exposure; and IEMG, our core emerging markets fund. – Gary Shedlin, CFO, BlackRockThe rotation from active to passive has accelerated. Risk-based asset allocations continue to gain popularity at the expense of the style box approach, and the demand for ETFs and other efficient investment vehicles has grown. – Eric Colson, CEO, Artisan Partners Asset ManagementThe fourth quarter open-end fund fee rate increased to 50 basis points from 48 in the prior quarter due to the impact of lower fund expense reimbursements as a result of the consolidation of service providers and an increase in average assets and higher fee equity products due to market appreciation. – Michael Angerthal, CEO, Virtus Investment Partners, Inc.
Dividend Policy and the Meaning of Life (Or, At Least, Your Business)
The following is an installment in our series “What Keeps Family Business Owners Awake at Night”
Our multi-generation family business clients ask us about dividend policy more often than any other topic. This should not be unexpected, since returns to family business shareholders come in only two forms: current income from distributions and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.
In other words, distributions are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. As discussed below, the “meaning” of the business has implications for the role of distributions.Meaning #1 - The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, distributions are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.Meaning #2 - The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Distributions are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.Meaning #3 - The family business is a source of wealth accumulation. Alternatively, the business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use distributions from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Distributions are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.Meaning #4 - The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Distributions are not expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance.
From a textbook perspective, distributions are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the distribution policy alternatives available to the directors. For example, eliminating distributions in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be.
The following table illustrates the relationship between “meaning” and distribution policy:
The textbook perspective on distribution policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal distribution policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in distribution policy will more naturally follow.
A distribution policy describes how the family business determines distributions on a year-to-year basis. A consistent distribution policy helps family shareholders understand, predict, and evaluate distribution decisions made by the board of directors. Potential family business distribution policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion.
Family shareholders should know what the company’s current distribution policy is. As evident from the preceding table, knowing the distribution policy does not necessarily mean that one will know the dividend for that year. However, a consistently-communicated and understandable distribution policy contributes greatly to developing positive shareholder engagement.
So what should your family business’s distribution policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the distribution policy that is appropriate to the company can be determined by the board and communicated to shareholders.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
What RIA Owners Need to Know About the New Tax Law
For this week’s post, we’re offering the slides and recording from our recent webinar on the tax bill’s impact on the investment management community. On balance, we believe most RIAs are better off as a consequence of the legislation, but there are nuances to the “win.” Specifically, the webinar covers the following observations on the recent bill:U.S. equities have, overall, benefited from the tax billHigher valuations have driven ongoing revenues higher at investment management firmsMany RIA margins will expand as a consequence of improved economicsInvestment management firm valuations will grow in many cases because of stronger cash flowRIAs structured as tax pass-through entities (S corps, LLCs, Partnerships) may want to consider reorganizing as C corporations
So feel free to tune in or scroll through if any of these topics are pertinent to you or your firm.
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WHITEPAPER | Financial Basics for Family Business: A Roadmap for Directors and Shareholders
Effective communication between management and shareholders is a key component of the long-term sustainability and success of any family business. The cornerstone of a thoughtful and effective shareholder relations program is education.Apart from a shared vocabulary and understanding of basic corporate finance concepts, family business managers will struggle to communicate the company's strategy and financial results to shareholders clearly.We have combined these whitepapers to help family businesses make strategic financial decisions and communicate those decisions to their shareholders.
The Oilfield Services Industry Is Still Struggling and What This Means to Valuation
Lately, talk of the domestic oil and gas market has been especially positive. But the oilfield services industry is still struggling to recover from the collapse of oil prices in mid-2014 and the subsequent reduction in capital spending by upstream companies.We look at how the downturn in crude prices in 2014 still affects the oilfield service industry and consider the impact on company valuations.What Happens to Oilfield Services Companies When Oil Prices Are LowOilfield service companies provide support services to oil and gas production companies – leasing drilling rigs, repairing wells, manufacturing drilling equipment, processing seismic data, and more.When oilfield production companies cut capital expenditures and delayed drilling projects after oil prices fell in mid-2014, demand for oilfield service companies plummeted. They were no longer needed to drill new wells because new drilling activity essentially stopped when prices fell, and they were not needed to perform routine maintenance as many companies delayed repairs in order to cut costs.When oil prices fell, some regions were deemed uneconomical by many players, while other regions, such as the Permian Basin, experienced a rush to grab land while it was still available. While oilfield service companies operating in the Permian were better off than others, even these companies struggled as oil producers played the game of survival of the fittest where only those who could cut costs and increase efficiency could win.In order for drilling to remain economical in the new low oil price environment of 2015 and 2016, production companies invested in cost savings measures. Technological advancements, like multiwell pad drilling, reduced costs for the oil producers which in turn decreased revenue for oilfield service companies. As Dan Eberhart, contributor to Forbes wrote recently in “Revenge Of The Oil Services Sector in 2018”:"Make no mistake, when producers boast of 'efficiency gains' made to outlast low prices, they are primarily referring to cost-cutting achieved by squeezing contractors for lower day rates on services like drilling and well completions, providing fracking sand and connecting new wells to pipeline systems."Where Do Oilfield Companies Stand Today?Although earnings in the E&P sector have improved over the last year, earnings in the oilfield service industry have taken a beating over the last few years. Three of the top four players had negative LTM EBITDAs until mid-year 2017.Per the chart below, EBITDA has varied as compared to 4Q12. Of the four companies that released 2017 year-end financials (most oilfield service companies have not yet released 4Q17 data), EBITDA for two is significantly down from the previous quarter, one is stable, and one is up. EBITDA at 4Q17 has stabilized around 80% to 100% lower than EBITDA in 4Q12.
Making matters worse, the oilfield service industry is highly capital intensive. The RMA average capital intensity ratios for companies that drill oil and gas wells (NAICS 213111) and companies that support activities for oil and gas operations (NAICS 213112) are $1.67 and $0.91, respectively.[1]
To fund the massive amounts of capital needed, oilfield service companies can either use debt or cash. After the downturn in price, over 150 oilfield service companies filed for bankruptcy. The high number of bankruptcies in the industry has demonstrated that oilfield service companies may not be able to rely on debt as heavily as they have in the past in order to fund future capital expenditures.
While bankruptcies in the E&P sector slowed in 2017, bankruptcies continued in the oilfield service industry.
What Are the Appropriate Approaches to Value Oilfield Service Companies Today?In down cycles such as this, valuations are hard to understand because earnings alone cease to become particularly reliable indicators of value.Public multiples provide less insight as negative earnings multiples make little sense. Reliance on the multiples of companies that are currently profitable is questionable because the low profitability can artificially inflate the multiples and not provide a holistic view of value.Instead of using current earnings as indicators of value, the use of forward earnings and their associated forward multiples is considered. This is consistent with a forward-looking discounted cash flow method, but the valuation is then heavily dependent upon the reasonableness of the projections. The oilfield service industry is not expected to see a full recovery in 2018 so forward multiples may appear inflated even for fiscal 2018.During down cycles of asset intensive industries, such as oilfield services, investors often rely on an asset-based approaches. The net asset value method is an asset-based approach that develops a valuation indication in the context of a going concern by adjusting the reported book values of a subject company’s assets to their market values and subtracting its liabilities (adjusted to market value, if appropriate).Valuations Remain Challenging to InterpretUnderstanding the value of your oilfield services company in the context of the broader oil and gas marketplace can be difficult during times like these.Many think that the industry has recovered, or at least is on the way, but the oilfield service sector still appears to have a ways further to go.Until rates and/or utilization for services companies begin increasing and E&P companies begin sharing the gains they have made since oil prices have recovered, valuations could remain challenging to interpret.Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your oilfield service company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnote[1] Ratios provided for companies with over $25 million in Sales per RMA 2017-2018 Annual Statement Studies
S Corp RIAs Disadvantaged by the Tax Bill
New but Unimproved
In 1973 Ford Motor Company committed brand espionage by replacing its reigning muscle car, the Mustang, with a slow and cramped economy box as an alleged successor: the Mustang II. Whereas earlier versions of the Mustang were fitted with a reasonably powerful V-6 and much more powerful V-8 motors, the best the “II” could boast was a smallish V-6 from the Capri. With all of 105 horsepower, the V-6 enabled Mustang II could meander to 60 miles per hour in about 13 seconds (given level pavement and favorable winds).We covered much of what we think the new tax bill will mean to RIA valuations in last week’s blogpost – and it’s mostly good news. The “rest of the story” involves the bill’s impact on shareholder returns for RIAs structured as tax pass-thru entities (S corporations, LLCs, Partnerships), for which the news is not so buoyant.As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good. The S corporation was a fairly brilliant innovation from the 1950s, allowing certain small businesses to benefit from the limited liability of a being a corporation yet file their taxes as partnerships. S corporations (and LLCs) “pass-through” the tax liability on profits to their shareholders rather than pay one layer of tax at the corporate level on company profits and another at the shareholder level on dividends.Why Many RIAs are Structured as Tax Pass-Through EntitiesBefore the Trump Tax Bill, it often made sense to structure investment management firms as tax pass through entities – usually S corporations or LLCs. As shown in the table below, given taxable income of, say, $1 million, a C corporation would only have $650 thousand to distribute after paying federal corporate taxes at a rate of 35%. Even though the same $1 million of taxable income would be taxed at a higher personal rate for S corporation shareholders, the after-tax distribution of $604 thousand would have a higher economic value when you consider S corp shareholders skip the dividend tax (paid at 23.8%) that would accrue to the C corporation shareholder. After grossing up the after-tax dividend to the S corp shareholder at the C corporation dividend tax rate, the S corporation shareholder earns a C corporation equivalent dividend of nearly $800 thousand. Assuming the RIA in this example is valued at 8x pre-tax income, the S corp shareholder experiences a distribution yield that is 180 basis points higher than if his or her RIA were structured as a C (all else equal). The example above assumes a fully distributing RIA, since many if not most RIA clients we’ve encountered over the years dividend out something close to 100% of their net income. But the S corporation yield advantage also exists if, say, an RIA only distributes half of the C corp equivalent after-tax income (or, conversely, retains half of net income). Tax Cuts and Jobs Act Mutes S Corp AdvantageThe new tax legislation has a big impact on C corporation taxes, a more modest impact on personal income taxes, and no effect on capital gains taxes. As a consequence, the economic advantage of organizing as an S corporation or LLC has been whittled away to almost nothing in some cases, and is arguably disadvantageous in other cases.The table below depicts the comparative consequences of the new tax bill on RIAs organized as C corporations and S corporations. For C corporations, the fourteen percentage point drop in corporate tax rates improves the after tax income available for distribution considerably. In our example, a fully distributing C corporation with $1 million in pre-tax income would have $790 thousand in after-tax income to distribute to shareholders – a substantial improvement over the $650 thousand available under the old tax rates. For S corporations and LLCs, however, the taxes on pass-through income are still substantial, as the after-tax distribution only improves from $604 thousand to $630 thousand (yes, it still improves). If you gross this up for taxes that would be owed on the C corporation dividend, you arrive at a C corporation equivalent dividend of $827 thousand, or not much more than the $790 thousand dividend available for the C corporation. The dividend yield advantage narrows from 180 basis points before the tax legislation to 40 basis points after the tax legislation (assuming some improvement in the valuation multiple – as discussed in last week’s blogpost). The comparison is even worse for investment management firms structured as tax pass-through entities but don’t distribute all of their net income. Going back to the example of the firms that distribute half of their after tax earnings (on a C corp equivalent basis), the dividend yield for the C corporation improves under the new legislation from 4.1% to 4.5%, even with a higher valuation. The S corp yield drops, however, assuming the same earnings retention as the C, from 4.6% to 3.5%, notably lower than the dollar amount and percentage distribution yield for the C corporation. (Probably) No QBI Deduction for YouKnowing that they were trimming back the S corporation advantage, the tax bill introduced a new concept, the Qualified Business Income deduction, that allows certain S shareholders to deduct 20% of their pass-through income and, therefore, maintain more of the S corporation differential in tax rates. However, in a very interesting and possibly more revealing move, the QBI deduction is NOT available for investment management firms.Congress decided to exclude certain “specified service trade or business” income from qualifying for the deduction. One excluded business is investment management: “The term ‘specified trade or business’ means any trade or business – (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” Of note, Congress had never, to our knowledge, previously singled out investment management for specific treatment as a “specified service trade or business.” Like the limitation on the deductibility of financial planning fees mentioned last week, it appears this administration is taking aim at the RIA community (while inexplicably allowing QBI deductions for architects and engineers).Despite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315 thousand; the deduction phases out until it is completely unavailable at incomes greater than $415 thousand. As a result, many RIA shareholders will not get the benefit of the Qualified Business Income deduction.Final Thoughts and Parting ShotsSo, like the Mustang II, the tax bill is new but not necessarily improved for owners of RIAs structured as S corporations or LLCs (excluding the impact of generally higher AUM balances discussed in last week’s post). The Trump administration didn’t aim its product at the investment management community any more than Ford was looking after driving enthusiasts in the early 1970s. It could be worse, though. In the mid-1980s Ford tried to ruin the Mustang’s reputation again with a version that was also underpowered and, this time, front wheel drive. Mustang fans balked, and Ford released the car as an entirely separate product: the Probe, a name that may suggest how some RIA partners feel about the new tax law after they file their 2018 return.1988 Ford Probe: You know the marketing folks in Dearborn loved working with that name (photo: favcars.com)
Mercer Capital’s Value Matters® 2018-02
Dividend Policy and the Meaning of Life
Making Shareholder Communication a Family Business Priority
The following is an installment in our series “What Keeps Family Business Owners Awake at Night”
Communication determines the success of any relationship, and the relationships among shareholders of multi-generation family businesses are no exception. In the early years of a family business, communication is generally informal (and continual), since the dining room often doubles as the board room. As the business and family grow, the shareholder relationships become more complicated, and formal communication becomes more important.
For a multi-generation family business, communication is not optional. A failure to communicate is a communication failure. When communication is lacking, the default assumption of shareholders – especially those not actively involved in the business – will be that management is hiding something. Suspicion breeds discontent; prolonged discontent solidifies into rancor and, in some cases, litigation.
In light of the dire consequences of poor communication, how can family business leaders develop effective and sustainable communication programs? We suggest that public companies can provide a great template for multi-generation family businesses. It is perhaps ironic that public companies – to whom their shareholder bases are largely anonymous – are typically more diligent in their shareholder communications than family businesses, whose shareholders are literally flesh and blood. While public companies’ shareholder communications are legally mandated, forward-thinking public companies view the required shareholder communications not as regulatory requirements to be met, but as opportunities to tell their story in a compelling way.
There are probably only a handful of family businesses for which shareholder communication needs to be as frequent and detailed as that required by the SEC. The structure and discipline of SEC reporting is what needs to be emulated. For family businesses, the goal is to communicate, not inundate. At some point, too much information can simply turn into noise. Family business leaders should tailor a shareholder communication program along the following dimensions:Frequency. Public companies communicate results quarterly. Depending on the nature of the business and the desires of the shareholder base, less frequent communication may be appropriate for a family business. The frequency of communication should correspond to the natural intervals over which (1) genuinely “new” information about the company’s results, competitive environment, and strategy is available, and (2) shareholders perceive that the most recent communication has become “stale”. As a result, there is no one-size-fits-all frequency; what is most important is the discipline of a schedule.Level of detail. Public company reports are quite detailed. Family business leaders should assess what level of detail is appropriate for shareholder communications. If the goal is to communicate, the appropriate level of detail should be defined with reference to that which is necessary to tell the company’s story. The detail needs to be presented to shareholders with sufficient supporting context regarding the company’s historical performance and conditions in the relevant industries and economy. A dashboard approach that focuses on key metrics, as illustrated below, can be an effective tool for focusing attention on the measures that matter.Format/Access. The advent of accessible webcast and data room technology makes it much easier for family businesses to distribute sensitive financial information securely. Use of such platforms also provides valuable feedback regarding what is working and what is not (since use of the platform by shareholders can be monitored). Some families may have existing newsletters that provide a natural and existing touchpoint for communicating financial results.Emphasis. The goal of shareholder communication should be to help promote positive shareholder engagement. To that end, the emphasis of the communication should not be simply the bare reporting of historical results, but should emphasize what the results mean for the business in terms of strategy and outlook for the future. It is probably not possible to re-tell the company’s story too many times. Shareholders that are not actively involved in the business will be able to internalize the company’s strategy only after repeated exposure. What may seem like the annoying repetitions of a broken record to management will for shareholders be the re-exposure necessary to “own” the company’s story.
Shareholder communication is an investment, but one that in our experience has an attractive return. To get the most out of the investment, family business leaders must provide the necessary training and education to shareholders so that they will be able confidently to assess and interpret the information communicated. With that foundation in place, a structured communication program can go a long way to ensuring that family shareholders are positively engaged with the business.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
It’s Tax Time: Implications of Tax Reform for Banks
A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).1 The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.2C Corporations & The ActIn 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1).
The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates.
Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion.
ImplicationsThe preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:“Allocation” of Tax SavingsLendingMiscellaneousImplication #1: “Allocation” of Tax SavingsWe know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.3 The allocation between these groups remains unknown, though.CustomersJamie Dimon had a succinct explication of the effect of the Act on customers:And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.4The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.Renasant Corporation has noted already potential pressure on its net interest margin.Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.5EmployeesAn early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.ShareholdersMr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.Implication #2: LendingThe Act potentially affects loan volume with future possible effects on credit quality.VolumeLooked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.QualityWhile we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.6 Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property.
Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.Implication #3: Miscellaneous ConsiderationsAdditional considerations include:Effect on Tangible Book ValueTable 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs.
From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway.
Regulatory Capital7The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.8Business InvestmentsAn emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.9Mergers & AcquisitionsOur understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.Permanence of Tax ReformOne parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?S Corporations & The ActAt the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).10 That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.11 Simple.The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6).
S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.12ConclusionFor banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.13 We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.This article originally appeared in Mercer Capital's Bank Watch, January 2018.End NotesLest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.Floor plan financing is exempt from this provision.See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.In addition, §179 allows entities to expense the cost of certain assets.The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.We recognize that the risk of exploding heads is acute with reference to §199A.Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.Suffice to say, §199A is considerably more complex than we have described.It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.Interested in more SSTB arcana?Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.
What Is a Reserve Report?
This is the first of multiple posts discussing the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].Why Is a Reserve Report Important?A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner.
In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies." Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells currently producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10.
The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)
Are RIAs Worth More Under the New Tax Bill?
Absolutely (Well…Probably)
My seventeen year old daughter is getting pretty deep into her college search; she’s narrowed it down to a handful of schools that are between 1,000 miles from home and 4,000 miles from home, if that tells you anything. A few weeks ago she told an admissions officer from a really fine school in California that she is “interested in politics,” but that she doesn’t want to be a politician; instead she’s interested in “economics as they relate to public policy, especially tax policy.” I learned this over dinner one night.I know I should have teared up with pride, but instead I lost my appetite.Having my creative, funny, yet also quantitatively astute daughter sell her soul not just to the dismal science of economics but in particular Washington’s never ending quest to pervert the dismal science...feels a little like an act of betrayal - like her telling me that her dream car is a Saturn. At least it hasn’t come to that.For Once, Taxes Are Not BoringBecause we like our readers, the RIA team at Mercer assiduously avoids talking about tax policy in this blog. The Trump tax bill, however, can’t go without mention. We won’t mince words – this tax bill is a blockbuster for the investment management industry. Whatever your politics, you can’t ignore the magnitude of the change that is afoot.Among the issues presented by the tax bill is that advisor fees are no longer a line-item deduction for clients, an interesting shot at investors by this administration that doesn’t line up very well with the tax treatment of other professional services. While this is peculiar, David Canter recently published an interview with industry leaders Brent Brodeski and Michael Nathanson that cautions against making too much of this.We’re staying focused on the implications of the tax bill for investment management firm valuations, and there’s much to consider.The Tax Bill Has Driven Up AUM (for Most)Investment management revenue is a function of AUM, and the impact of the tax bill on valuations across a spectrum of asset classes is significant. While the impact of this on anyone who derives fee income from managing equities (fixed income shops are a different story) is clear, we don’t think it’s sufficient to just take the increase in market valuations at face; it’s more useful to unpack the issue and consider why.One of our colleagues here at Mercer, Travis Harms, did some research on the impact of the tax bill on valuation multiples to consider not just the what but also the why. Notably, Travis looked at the impact on pre-tax multiples, such as EBITDA, to interrogate whether or not a dollar of pre-tax cash flow is indeed worth more if it is less burdened with tax liabilities. Travis is interested in the change in multiples because he works heavily in the portfolio valuation space. We saw broad implications to his modeling exercise for the investment management community.Travis pulled monthly forward EBITDA multiples for the S&P 1000 (ex financials). The S&P 1000 is a combined mid and small cap index, consisting of company #501 through #1500. As shown in the following chart, the median multiple for such firms was approximately 9.0x to 9.5x during the fall of 2016, when a Clinton administration, and tax status quo, seemed inevitable. By late 2017, the median multiple had expanded by almost a full turn, to about 10.3x.Forward EBITDA multiples for sample equity index (S&P 1000 ex financials) shows movement in multiples that appear to correlate with changes in the outlook for corporate tax reductions.
Valuation multiples are, of course, a function of three factors: 1) cash flow, 2) risk, and 3) growth. To determine whether or not the change in multiples is indeed attributable to a change in tax rates, Travis investigated whether or not there had been an effective change in the cost of capital (risk) or an expectation of increased growth in earnings. Travis’s analysis inferred an aggregate cost of capital (supply side weighted average cost of capital, or WACC) for his equity basket in September of 2016 as an anchor point, and then looked at the change in the cost of capital over the same period that resulted from a change in interest rates (holding the assumed equity risk premium constant).
The risk-free rate (the interest rate on long dated treasuries) gapped up from close to 2.0% in September of 2016 to something on the order of 2.8% in December of that year, pushing the implied supply side cost of capital up to about 9.2%.
Doing some fancy footwork, Travis ran a DCF model on his equity basket, letting the tax rate float. His DCF model suggests that the market priced in effective tax rates of approximately 20% by the end of 2017. Significantly, the early expectations for rate reduction seem to have waned a bit over the summer months as the Trump administration experienced a series of legislative failures. Also significant is that the model assumes there are no changes in the expected growth outlook for the companies in the sample basket, consistent with statements from the Federal Reserve suggesting no material uptick in GDP growth consequent from the tax bill. Travis didn’t modify expected growth because there is no robust way to review earnings estimates for a broad array of companies on a month by month basis. Of note, Aswath Damodaran, a finance professor at NYU, thinks the tax bill may in fact increase the sustainable growth rate for U.S. companies.
Using a DCF model framework to evaluate the impact of a change in tax expectations on valuation multiples, we can let the cost of capital float with interest rates and hold growth expectations constant, such that the change in valuation multiples can be attributed to the change in tax rates.
The implication of Travis’s analysis is that the market repriced as a consequence of lower tax rates, and not because of changes in the cost of capital (which, with higher interest rates, would have caused multiples to fall), nor expectations of higher earnings growth (of which there is little evidence).
Put another way, the tax bill appears to have, indeed, inflated equity valuation multiples by reducing the tax burden on corporate profits. On one level, this is obvious, but the implications of this are interesting if it also suggests that current equity valuations are more sustainable than some believe. Perhaps valuation multiples gapped higher, as they should have, and will remain higher than they would otherwise be, so long as corporate tax rates persist at these levels. That would certainly be good news for the asset management community.
The Tax Bill Has Improved RIA Economics (for Many)Taking this one step further, the tax bill would seem to have improved returns for many subsectors of the investment management industry. If public market valuations gapped up 10% or so, would we expect to see nearly a 10% increase in assets under management across the equity space in the industry? More AUM means more revenue and more profitability? In short, yes, as we can show in the example below.
This table is fairly self-explanatory. Assuming an RIA with $5 billion under management, of which 80% is managed equities and 20% is fixed income, a 10% increase in equity valuations would have a corresponding 8% increase in overall AUM, ceteris paribus.
If the same investment management firm realized fees of 65 basis points on equities and 20 basis points on fixed income, the leverage on the higher AUM attributable to equities would increase revenue a bit more than total AUM, or 9.3%. One potential problem with this aspect of the model is the assumption that clients with higher AUM balances won’t pass through breakpoints that will lower overall realized fees. For purposes of this example, however, we have assumed that the fee schedule isn’t progressive with the increase in AUM.
When we consider the leverage on operating expenses, however, things really get interesting. Higher AUM balances can lead to a correspondingly higher expense base if the increase comes from more accounts or assets that are more expensive to manage. In this instance, however, AUM is simply inflated because of market activity. We might not assume G&A costs would rise at all, nor would, necessarily, salaries. Incentive compensation, however, would probably increase. Assuming bonus compensation to be 30% of pre-bonus EBITDA, we see an almost 20% increase in incentive compensation resulting from higher assets under management. Even with higher bonuses, however, total expenses only increase about 4%. The consequence of this is an increase in earnings before interest, taxes, depreciation, and amortization of almost 20%, and a cash flow margin increase of three percentage points.
If you’re an asset manager, your reality may (will) be different than our example. If interest rates continue to rise, our sample RIA might experience some diminution in income from managing fixed income portfolios. Clients may rebalance to maintain the same allocation between stocks and bonds. Clients are, on the whole, more fee sensitive than they once were, and may want some betterment of their fee schedule as a consequence of this moment of good fortune. And your staff will probably notice that there is more cash flow available for compensation. The market may bid up the cost of talent, or at least salaries and bonuses will increase more than we show here in an effort to “keep a good thing going.” In any event, if your AUM increases nearly 10% and margins don’t widen, it would be worth looking through your numbers some to assess why. The opportunity for a significant increase in profitability at many RIAs appears to be on offer.
The Tax Bill Has Improved RIA valuations (for Some)Taking this one step further, RIAs may not only benefit from a repricing of market multiples of their clients’ assets, but also of the value of their own returns. In our example firm, EBITDA increases 18.6% as a direct consequence of the tax bill. Valuations of RIAs would be expected to increase similarly, if there were no change in the valuation multiples for the RIAs themselves.
If, however, appropriate multiples for RIAs gap-up 10% like Travis Harms observed happened in the public equity market, then the combination of that plus improved profitability produces a 30% increase in enterprise values for RIAs, and a corresponding 20% expansion in the implied AUM multiple. The reason for the increase in RIA multiples is the same as the increase in the market basket of equities Travis studied: a dollar of pre-tax cash flow is worth more when the tax burden on that dollar is less (assuming no change in the cost of capital or earnings growth).
Your Results May (Will) DifferWhatever you do, don’t run out of your office and tell your partners that I’ve just proven your firm is worth 30% more than it was two months ago. There are many variables that affect firm valuation – some discussed in this post, some I’ve left out, and some I probably haven’t thought of yet. One issue in comparing movement in the public market multiples and private RIAs is that public companies are C-corporations whereas many, if not most, private RIAs are some kind of tax pass-through entity like an S corporation or an LLC. I’ll be back next week to talk about how the tax bill treats tax pass through enterprises, and it’s not nearly as generous as conferred upon C corps.In any event, the tax bill is bullish for the RIA community. There may not be a Saturn in my driveway, but a friend of mine who, like me, was born under the astrological sign of Capricorn says that Saturn is in our house this year (cosmologically, a favorable thing). I don’t know what the “Saturn” effect is for the markets, but for now it appears that the stars are aligned for the RIA community, an augur of good things to come.If you have questions as you wrestle with the valuation implications of the new tax bill on your RIA, give us a call to discuss your situation in confidence and/or register for our upcoming webinar addressing the matter.
M&A in Appalachia: Moving Day in the Neighborhood
This week we look back at transaction activity and trends in the Marcellus & Utica plays in 2017. When I reflect about what happened, for whatever reason, images resembling something out of an episode of Desperate Housewives come to mind whereby the prying eyes of the marketplace peer out of their windows, surveilling old competitors that pack up and leave whilst new, and sometimes mysterious, neighbors move in.But first, we point out recent articles that forecast that the U.S. may challenge Saudi Arabia and Russia in total oil production sometime in the next two years. For someone who has followed and worked within energy markets for many years, including before the shale fracking revolution, this is something I wasn’t sure I’d ever read. Of course it is likely a temporary surge once the OPEC/non-OPEC agreement expires, but it's still fascinating to contemplate.The Appalachian BasinOK, now back to the subject at hand. Transaction activity in the Marcellus & Utica shale was generally steady throughout the year and individual transactions were typically smaller in size. Rationale for these deals were varied, from bankruptcy sales, to consolidation of acreage, strategy changes to more liquid rich plays, leverage reduction, and more. The chart below, drawn from Mercer Capital's forthcoming 4Q17 Marcellus & Utica-focused newsletter, provides transaction detail and comparative valuation metrics.Back Up the Truck, Dear! We're Moving onto Bigger and Better Things.In one of the few large transactions last year, Noble Energy exited the Marcellus in order to focus on more liquid rich regions with its $1.2 billion sale to HG Energy. David L. Stover, Noble Energy's Chairman, President and CEO, commented, "The Marcellus has been a strong performer for Noble Energy over the last few years, which is a direct result of the success of our employees' efforts. During the same time period, we have also significantly expanded the inventory of investment opportunities in our liquids-rich, higher-margin onshore assets, which has led us to now divest our Marcellus position."In a similar vein, Carrizo Energy, a Houston-based producer, exited the play, utilizing the familiar "non-core" term to describe its position in the Appalachia region. S.P. "Chip" Johnson, IV, Carrizo's President and CEO, commented, "With the announced sale of our Marcellus package, we have continued to execute on the divestiture program we outlined earlier this year. We expect to close the sale of both of our Appalachian packages during the fourth quarter and remain on track to reach our divestiture program goals." Carrizo has stated its desire to focus on liquid plays and reduce leverage which these sales went towards achieving.Look Honey, Those Folks Are Moving Out … and Their Wells Are Just Perfect for Us!Looking at the other end of the rationale spectrum, there were a number of buyers that were enthusiastic about the opportunities that companies like Noble & Carrizo left behind. Kalnin Ventures, a Thai-based coal and power generation company, made their 5th acquisition in the play in the past two years by buying positions from Carrizo's and Reliance Marcellus II, LLC. They also made a 6th in December by taking out Warren Resource's entire Northeast Marcellus position for $105 million. In strategic contrast to Carrizo's sentiment, Kalnin thinks these assets fit within their strategy of acquiring profitable, consolidated, low-risk assets that provide strong cash flow yields.Believe it or not, Kalnin's activity actually did not top the acquisition charts in 2017. That distinction belonged to EQT, beginning with EQT's $527 million bankruptcy auction bid of Stone Energy's Marcellus and Utica acreage in February 2017. EQT, who made nearly $9 billion of Marcellus & Utica acquisitions in 2017, went on to highlight the year by its merger with Rice Energy in June 2017. Steve Schlotterbeck, EQT's president and chief executive officer said, "This transaction complements our production and midstream businesses and will deliver significant operational synergies to help us maintain our status as one of the lowest-cost operators in the United States." For a more in-depth valuation oriented discussion on the Rice Energy transaction, a prior Mercer Capital blog post breaks down the deal.Are You Watching This, Sweetie? So, What Kind of Deal Did They Get?Valuations for these transactions were relatively spread out depending on the metric observed, but were within an observable range. Kalnin appeared to pay more than other buyers in a few deals from a $/Acre perspective (over $19,500/Acre), but it can be argued that they baked in economies of scale in light of their overlapping positions and infrastructure. EQT appeared to buy in a very tight range from a $/Mcfe/Day perspective ($6,300-$6,600). That said, due to the steady activity and universe of buyers and sellers, pricing and values appeared to be fairly consistent. We shall see if that continues in 2018, and speaking of that - we wish you all a happy 2018!A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Trust Banks Underperform in 2017 Despite Rising Equity Markets & Yield Curve
All three publicly traded trust banks (BNY Mellon, State Street, and Northern Trust) underperformed other categories of asset managers during 2017, and only State Street outperformed the S&P 500. While all three benefited from growth in Assets Under Custody and Administration (AUCA) and Assets Under Management (AUM) due to strong equity markets in 2017, the trust banks performed more in line with U.S. banks generally during 2017. The exception is State Street, which performed comparably to the SNL Asset Manager Index due in part to its large ETF business (State Street is one of the three largest ETF providers globally). The other two trust banks have less significant ETF business (Northern Trust) or none at all (BNY Mellon). Due in part to its strong ETF inflows, State Street is on track to pass BNY Mellon as the largest trust bank in terms of AUCA.
Throughout 2017, trust banks tended to underperform other classes of asset managers like alternative asset managers, mutual funds, and traditional asset managers. To put this in historical context, trust banks have lagged the broader indices since the financial crisis of 2008 and 2009, although in 2016 our trust bank index was the highest performing category of asset manager. With the exception of trust banks, all classes of asset managers outperformed the S&P 500, as rising equity markets and operating leverage combined to increase the profitability of these businesses.
Despite the relative underperformance during 2017, trust banks saw increases in their two largest sources of fee revenue (servicing and investment management fees) due primarily to strengthening equity markets. Trust banks also saw improved net interest margins due to higher U.S. market interest rates. Trading services revenues, which are a less significant component of fee revenue than servicing and management fees, were generally down in 2017 due to low volatility in the equity markets. Trust bank trailing multiples have expanded in line with other categories of asset managers since last year, so their underperformance suggests that earnings haven’t kept pace.
So have these securities gone from overbought to oversold? A quick glance at year end pricing shows the group valued at 14-16x (forward and trailing) earnings with the rest of the market closer to 25x, so that alone would suggest that they aren’t too aggressively priced. Still, the three companies are all trading near 52 week highs, so it’s hard to say they’re really all that cheap either.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
How to Promote Positive Shareholder Engagement
The following is an installment in our series “What Keeps Family Business Owners Awake at Night”
Based on discussions with family business leaders from across the country at the most recent Transitions conference, we wrote an article addressing themes among attendees, and we continue the discussion in this article. One challenge noted by leaders of multi-generation family businesses was how to promote positive shareholder engagement.Why is Shareholder Engagement Important for Family Businesses?As family businesses mature into the third and subsequent generations, it becomes less and less likely that extended family members will be both shareholders and active participants in the business. As families grow numerically, they tend to become more geographically dispersed. Lack of professional involvement in the business, combined with geographic separation, can result in family shareholders feeling disconnected and becoming disengaged from the family business. A successful multi-generation family business can promote healthy family cohesion, but when shareholders are not positively engaged, the business can quickly turn into a source of stress and family strife.Some families choose to eliminate the existence of disengaged shareholders by limiting share ownership to those members that are actively involved in the business. While this may be an appropriate solution for some families, it can have the unintended consequence of creating distinct classes of economic haves and have-nots within the family. When that occurs, the business quickly ceases to be a center of family unity.For most businesses, there simply is no necessary link between share ownership and active involvement in the company. If public companies can function well with non-employee owners, surely it is possible for family businesses to do so as well. But to do so, family businesses will need to be diligent to promote positive shareholder engagement.What are the Marks of an Engaged Shareholder?It might be tempting to label non-employee shareholders as “passive”, but we suspect that term does not do justice to the ideal relationship between the company and such shareholders. “Actively non-controlling” hits closer to the mark but doesn’t exactly trip off the tongue. If “passive” is not the ideal, the following characteristics can be used to identify positively engaged shareholders.An appreciation of what the business means to the family. Engaged shareholders know the history of the family business in its broad outline. Few things promote a sense of community like a shared story. A successful family business provides a narrative legacy that few families possess. Engaged shareholders embrace, extend, and re-tell the story of the family business.A willingness to participate. Full-time employment is not the only avenue for participating in the family business. Engaged shareholders understand their responsibility to be active participants in the groups that are appropriate to their skills, life stage, and interests, which may include serving as a director, sitting on an owners’ council, or participating in a family council.A willingness to listen. Positively-engaged non-employee shareholders recognize that there are issues affecting the family business, the industry, and the company’s customers and suppliers of which they are unaware. As a result, they are willing to listen to management, regardless of whether management consists primarily of non-family professionals or their second cousins.A willingness to develop informed opinions. A willingness to listen does not mean passive acceptance of everything management is communicating. A competent and confident management team recognizes that non-employee shareholders have expertise, experiences, and insights that members of management lack. Engaged shareholders acknowledge their responsibility to develop and share informed opinions, not just gut reactions or prejudices.A willingness to consider perspectives of other shareholder groups. Engaged shareholders do not seek the benefit of their own branch of the family tree to the detriment of the others. Multi-generation family businesses inevitably have distinct shareholder “clienteles” with unique sets of risk tolerances and return preferences. Privileging the perspective of a single shareholder clientele is a sure way to promote discord.A commitment to deal fairly. Fairness needs to run in both directions: non-employee shareholders should not be penalized for not working in the business, and shareholders that do work in the business need to be fully and fairly compensated for their efforts. Fairness also extends to distribution and redemption policy, both of which can be used to this disadvantage of one group within the family. Engaged shareholders are committed to fair dealing in transactions with the business and within the family.How to Develop an Engaged Shareholder Base?The family business leaders we spoke with at the conference were eager to share and learn best practices around promoting shareholder engagement. The “how” of shareholder engagement is closely related to the characteristics of engaged shareholders noted above.Develop mechanisms for appropriate involvement. Not everyone can have a seat at the board, but family and owner’s councils can be great ways to broaden opportunities and prepare family members for greater involvement.Emphasize the privilege/responsibility of being a shareholder. This will look different for every family, but a visible commitment to charitable contributions and service opportunities can be a powerful signal to the family that being a shareholder involves a stewardship that transcends simply receiving dividends.Basic financial education. Family members will have many different talents, interests, and competencies. Offering rudimentary financial education (i.e., how to read a financial statement, and understanding how distribution policy influences reinvestment) can empower the healthcare professionals, educators, and engineers in the family to develop and communicate informed opinions on family business matters.Actively solicit shareholder feedback. While it is true that the squeaky wheel gets the grease, it is often the un-squeaky wheels that have the most valuable insight. Periodic shareholder surveys can be an effective tool for promoting positive shareholder engagement.Demonstrate a commitment to fair dealing. Shareholders who are also managers in the business need to be wary of the tendency to pursue empire-building activities at the expense of providing appropriate returns on the shares in the family business.
Most of the intra-family shareholder disputes we have seen (and we have witnessed too many) are ultimately traceable to shareholders that over time became disengaged from the business. Family business leaders who focus on positive shareholder engagement today can prevent a lot of grief tomorrow.
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
What Keeps Family Business Owners Awake at Night?
We recently attended the Transitions West conference hosted by Family Business Magazine. The event brought together representatives from nearly 100 family businesses of all sizes. Through the educational sessions and informal conversations during breaks, we came away with a better appreciation of the joys, stresses, privileges, and responsibilities which come with stewarding a multi-generation family business.While every family is unique, a few common themes and/or concerns stood out among the attendees we met:Shareholder engagement: How many of your second cousins do you know? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.Communication: Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders was a common objective for conference attendees.Distribution policy: Hands down, the most frequent topic of conversation was establishing a distribution policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.Investing for growth: The flip-side of distribution policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the selected goal, family business leaders are concerned about identifying and executing investments to support the growth of the family business.Diversification: A striking number of the family businesses represented at the conference had diversified rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?Management accountability: Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we spoke with were eager to develop and implement effective management accountability structures.Management succession: Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business. By our unofficial count, most of the family businesses in attendance were still led by a family member (often enough by so-called “married-ins”). A meaningful minority, however, had professional (i.e., non-family) management teams.Next Gen development: Rising generations are naturally more diffuse than prior generations, with regard to geography, interests, skill sets, and desires. Family leaders were interested in identifying appropriate pathways for next generation leaders to engage, learn, and grow in their contribution to, and impact upon, the family business.Generational transfer/estate planning: Attendees were keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.Evaluating acquisition offers: There’s a definite selection bias at a family business conference: attendees are necessarily shareholders of family businesses that have not been sold. Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. Family business representatives were interested in learning how best to evaluate and respond to such offers.Share redemption/liquidity programs: There are many reasons family members may want to sell shares: desire for diversification, major life changes (such as divorce), funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank?
Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.
Industry Consolidation Drives Further Gains in RIA Dealmaking
Asset manager M&A remained robust in 2017 against a backdrop of rising markets and higher AUM balances for most industry participants. Total (disclosed) transaction value was up 6% from 2016 levels despite a 6% reduction in the number of deals. Several trends, which have driven the uptick in sector M&A, have continued into 2017, including revenue and cost pressures and an increasing interest from bank acquirers.The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Consolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017. While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements. Despite a rising yield curve which should make banks a little more comfortable with their core business, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities.
Recent increases in M&A activity come against a backdrop of a now nine-year-old bull market. Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. As a result of increasing AUM and concomitant revenue growth, profitability has been steadily rising despite industry headwinds that seem to rationalize consolidation.
It is unclear whether this positive market movement has been a boon or a bane to M&A activity. On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go. In that case, better to sell sooner rather than later (and vice versa from a buyer’s perspective). On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore. In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market (as was the case in 2008 and 2009).
With no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move in 2018, although a protracted bear market, should it materialize, could highlight consolidation pressures and provide a catalyst for a larger wave of M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger. More broadly, the recent tax reform bill is expected to free up foreign-held cash, which could further facilitate M&A’s upward trend into 2018.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
Economics of Drilling in the Marcellus & Utica
The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market.Appalachian BasinThe Marcellus formation and the underlying Utica are two large shale layers in the Appalachian basin. The Utica is the larger and denser of the two layers and rests a few thousand feet below the Marcellus. Producers must use techniques such as hydraulic fracturing, horizontal drilling, and pad drilling to make wells economically viable.As shown in the chart below, the region produces more than 2.5x as much natural gas as any other region in the U.S. The Marcellus is already the second most prolific natural gas producer in the world after the Pars/North Dome field in Iran. Additionally, since the productivity of both plays is newly discovered, most of the recoverable gas is still in the ground. It appears as though the region will remain the center of natural gas production in coming years.
As production in the region multiplied, however, regional well-head prices fell. The amount of natural gas being produced in the Northeast far exceeded the infrastructure available to move supplies across the U.S. resulting in a supply surplus. This supply surplus caused the price of natural gas in the region to fall below the already depressed price of natural gas across the U.S.
Midstream oil and gas companies recognized the need for pipeline capacity in the Northeast, and many companies are in various stages of completion of new pipelines and/or existing pipeline reversals. These projects have already proven successful at transporting low-cost Marcellus shale gas out of the region. The EIA reported in August 2017 that the difference between the price of Henry Hub (the national benchmark for natural gas) and the price at hubs in Appalachia has narrowed as new pipeline projects and expansions are completed.
Further, the lack of refining and cracking capacity in the region has kept prices low and hampered growth. In June 2016, Shell announced that it would invest $3-$4 billion building an ethane cracker plant and petrochemical complex in Beaver County. Shell estimates that 70% of North American polyethylene consumers are within 700 miles of this facility. They began construction in late September 2017 and have signed 10-20 year supply agreements with 10 natural gas producers in Appalachia.
According to a presentation by the United States Department of Energy (USDE) at the NARO Appalachia conference, there have been four crackers announced to date in the region, bringing a combined capacity of 4.0 million metric tons to the region.
Natural gas producers have been dealing with low prices for over ten years. However, there is now hope of some relief in the next few years as new infrastructure in the region helps to reduce the supply glut. Additionally, demand for natural gas has been increasing as electricity generation fueled by coal has decreased and natural gas has taken its place.
Valuation ImplicationsOver the past few years valuation multiples have been falling in the region as enterprise values have remained relatively constant and production has been increasing. As infrastructure projects near completion and the possibility of higher regional natural gas prices starts to materialize, we expect valuation multiples in the Marcellus and Utica to increase.
Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
What a Steady Oil and Gas Industry in 2017 Points to in 2018
“Steady as she goes.”
At least that is what I think captains of most vessels say…except maybe a car. For captains navigating the 2018 oil and gas industry, a repeat of 2017’s relatively calm waters is vocal wish.
2017 in ReviewOil prices closed the year reaching $60 per barrel, WTI futures prices returned to backwardation, and oil price volatility was relatively calm as the price moved within an $18 band all year ($42 - $60). Natural gas, on the other hand, continued its woes of declining prices, transportation constraints, and oversupply. Hope remains that increased natural gas exports will change the narrative, but that is still undetermined. For the oil industry, a repeat of 2017 would be a welcomed event, making the theme for the year ahead – “Steady as she goes.” Before projecting trends of 2018, let’s review 2017, starting with oil and gas commodity prices.Oil and Gas Commodity PricesIf bottom needs to be found before rebound can happen, 2015 and 2016 provided a solid foundation for the oil and gas price gains in 2017. This past year brought about the feeling of stability for oil prices and continued woes for natural gas. For the year, WTI increased 11% and Henry Hub natural gas decreased 20%. This is the second consecutive year-over-year increase for WTI.Additional PerspectiveIn a commodity-focused industry, commodity prices set the overall framework. With last year’s oil and gas prices as the framework, here are a few posts that provide additional color to the 2017 oil and gas industry.Are S&P Energy Stock Valuations Really Crazy Right Now?
The Wall Street Journal published an article discussing what the author described as “crazy” stock valuations, and in particular the inflated valuations of oil and gas stocks from the perspective of operating earnings ratios. While we certainly are believers that value is driven by future operating earnings, and that earnings in the energy sector have fallen precipitously since 2014, is this all that determines the market’s pricing of the S&P 500 energy sector? As we reflect on this for a moment, a few additional considerations came to mind that may explain these “crazy” valuations more fully.Are Oil and Gas Bankruptcies a Thing of the Past?
The worst of bankruptcies are over. Since the start of the oil downturn, more than 120 upstream and oilfield service companies declared bankruptcy. However, the decision to file for bankruptcy did not always signal the demise of the business. Now more prepared, many E&P companies who reorganized are looking to grow.Oil and Gas Investors Note Move Away From Contango
The movement in the future spread away from a contango environment and toward backwardation is positive from a supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher. However, the exact cause of this change is unknown. While this shift is good news for the industry, company specific risk and investor's fickle attitudes create volatile equity markets.Current Regulatory Environment Affecting the Oil and Gas Industry
As business valuation experts, we have to consider the outlook for the economy, industry, and business in every valuation; therefore, we pay attention to the oil and gas regulatory environment to assess what it means for our clients. Given the new administration, there is much to consider.WTI Futures and Inventories
U.S. oil inventories decline as oil exports surge. In this post we address why the shift in oil futures from contango pricing to backwardation is a bearish sign for those in crude oil storage.Outlook for 2018The positive momentum for the oil industry should continue as long as prices hold steady or increase. With the futures curve currently in backwardation and the backwardation spread getting stronger, the upward trend in price should continue. Other resource plays, like the Bakken, Eagle Ford, and Canadian Oil Sands will become more attractive and active as the price of oil inches higher. Natural gas, on the other hand, continues to sort out its oversupply and distribution constraints which have continued to push prices down. Reorganization, consolidation, and operational efficiency in the Marcellus and Utica players are anticipated going forward. This focus will continue until gas price relief is a reality, at which point the companies still operating will be well positioned to thrive.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Five Things Bitcoin Tells Us About the RIA World in 2018
When’s the last time you thought about Esperanto? Not being an “esperantist” myself, it had been a while. Yet I was searching for some kind of metaphor for bitcoin: a fictional and entirely artificial currency without state backing and having a value tied strictly to facilitating global peer-to-peer transactions when I remembered the fictional and entirely artificial language without state backing and having a value tied strictly to facilitating global peer to peer conversations. Esperanto still exists, but today it is more known by teenage boys everywhere as a fictional car similar to a mid-70s Cadillac El Dorado in the video game Grand Theft Auto (or so Google tells me – this author loves cars but is no gamer).Esperanto was developed in the late 19th century to be a universal second language. The idea was simple and appealing: everyone would maintain their native language and learn Esperanto, such that wherever one traveled he or she could converse with the locals. There would be no need to learn the local language of where you were traveling, and an esperantist could, theoretically, travel anywhere and converse with anybody. Esperanto was based on an amalgamation of several romance languages with a rigid set of phonetic and grammatical rules that would be easy to learn. Esperanto’s algo, as they say, was robust. It sort of caught on, but mostly as a niche skillset. Today, Esperanto is spoken by between two million and ten million people worldwide – approximately the same number of people who have accounts holding cryptocurrency.We’ve put off writing about bitcoin in this blog, partly because we really don’t understand it, few of our clients invest in it, bitcoin’s performance has little to do with whether the RIA industry performs well or poorly, and we desperately wanted to avoid making allusions to tulips. The attention that cryptocurrencies received in late 2017 got our attention, though, as a barometer for trends that will buffet the investment management industry in 2018. Our cursory understanding of bitcoin suggests:1. This Market Craves VolatilityThe financial market experience of 2017 felt like standing in the Whitney Museum watching all eight hours of Andy Warhol’s film, “Empire.” We kept expecting something – anything – to happen, but it never did. Despite a raucous political landscape, global instability popping up everywhere, and pinched cultural nerves at home, the financial markets in the U.S. were very nearly sleepy. With little of interest going on, the market needed a narrative that only a fictive asset with an uncertain purpose could supply. We have, it seems, made it full circle from the credit crisis, when the only asset class in vogue was cash, to a market in which the only asset in vogue is fake cash.2. Traders Want Their Revenue Share BackIt’s difficult to overstate the degree to which trading revenues have been decimated by technology. I’m old enough to remember the “5% rule” being a topic on the Series 7 exam. The thought, today, that prime brokers could ethically charge commissions as high as 5% on each side of a trade is beyond laughable. Suffice it to say, though, that trading used to command a much higher share of investment management revenues. Trading was a valued skill. Technology has destroyed that, as have placid markets and pricing transparency. Bitcoin is a mysterious asset with an unproven market and substantial bid-ask spreads; traders can exploit it so they love it. Look for new products that have pricing inefficiency and arbitrage opportunities that can generate trading revenue.3. The Lines Between Asset Classes Are BlurringWe haven’t fully left the 60/40 world where asset allocation meant choosing capitalization brackets in domestic and foreign equities, mixing fixed income investments across different maturities and different ratings, and throwing in some cash for a rainy day. However, portfolio construction isn’t as simple as it once was, and it probably won’t be again anytime soon. Bitcoin wasn’t the first shot fired at this way of thinking about diversification, but over time the investment community has become littered with categories of investments and some blurring of lines (i.e. large cap domestic companies tend to generate material amounts of profit overseas – so are they “domestic” or “global”?). What bitcoin suggests is that investors have come a long way from having to be talked into investing in something other than treasuries and the S&P 500. “Buying what you know” seems to have lost favor in a world where speculative upside has, at least for some, become more sought after than returns which are measurable and knowable.4. Investors Are Becoming ComplacentAn old and true Wall Street maxim is “every bull market climbs a wall of worry.” Does it feel like we’ve run out of worry? From a practical perspective, it appears that the “wall of worry” is lower than normal. Short interest is in retreat, reserve cash is being depleted, the yield curve is flattening, and nobody cares. Bitcoin is interesting as a gauge of the market’s appetite for speculation. A short nine years ago we were in the throes of the credit crisis, interest rates were going negative throughout the world, investors were shunning equities, and my favorite metaphor for the chaos was uttered (I just don’t remember by whom): “We’ve lost the buoys that mark the deep channel.” Now we’ve swung to the other extreme. I haven’t wandered down to the office library to blow the dust off our copy of “Dow 36,000”, but I’m getting close.5. Finance Evolves Slowly, But It Also Evolves ConstantlyCryptocurrencies are less than a decade old, but the concept has gained ground rapidly. Yet the big banks have largely stayed out of the fray, with Jamie Dimon being openly dismissive of bitcoin in October, and Goldman Sachs only recently announcing that it would open a desk to trade cryptocurrencies; even that won’t be operable until the summer of 2018 (!). So if you feel like you’re being left out of the party, you have good company. What this all demonstrates is that the financial services community changes slowly, which explains the pushback against the fiduciary standard and the mixed response to large broker dealers leaving the protocol. Markets move more rapidly than the people and the firms that serve the markets.Final Thoughts on BitcoinAre cryptocurrencies an asset class? Is bitcoin speculation or a hedge? Will bitcoin have a permanent place in finance or will the magic fade? Is it going to $100,000 or zero? We have no idea.The idea of a universal second language should have worked. Esperanto still exists, but possibly because it doesn’t reflect the life and culture of any particular subset of humanity, it’s really just an effect for the erudite. This makes us wonder about the future of bitcoin. Because it is not state sponsored, it also does not reflect any particular segment of the global economy (except perhaps for that part of the economy that lurks in the shadows).125 years or so after the development of Esperanto, the universal second language is English. Eight years after the development of bitcoin, the universal reserve currency is the dollar.We don’t expect a revolution from cryptocurrencies in 2018, but the follow-through on the 2017 hype should make for a good show.As always, feel free to reach out to us if you’d like to talk further.
Benefits of a Financial Expert in Family Law: Why & When to Hire
Most family law attorneys do not have a background in finance or accounting, yet are often confronted with complex financial issues in divorce matters.
Mercer Capital’s Value Matters® 2018-01
Six Different Ways to Look at a Business
Mercer Capital Releases Whitepaper on Valuation Issues with Corporate Venture Capital
Our colleagues down the hall who focus on the portfolio valuation side of our services to the asset management community have an extensive new study on the Financial Accounting Standards Board’s guidance for recognizing the fair value of corporate venture capital, or Accounting Standards Update 2016-01. ASU 2016-01 doesn’t exactly roll off the tongue, but it does represent an important step in the continued trek toward financial statements based on the fair value of assets and liabilities, rather than cost. As more investment activity takes place on the private side, more needs seem to accumulate to assess the market value of investments. The placid market of the past few years has made this task relatively easy, but we all know that’s not going to last.In any event, enjoy the read. It goes especially well with eggnog.Read Whitepaper
Corporate Venture Capital and ASU 2016-01: Best Practices for Equity Investments
Corporate venture capital has increased as an investment activity for large corporations in recent years. By one count, the top ten corporate venture capital groups made 1,640 investments between 2010 and 2016.Intel Capital, the most active corporate venture capital investor over the past six years, made investments in 34 new companies totaling $455 million in 2016 alone.With corporate venture capital activity on the rise, a keen eye is being turned to public company reporting of equity holdings, as well. Valuations of VC-backed startups have grown rapidly in recent years, making many early venture investments worth well in excess of original cost. For example, Google Ventures (GV) invested in AirBnB in late 2010 at a valuation of $71.8 million. In March 2017, less than seven years later, AirBnB completed a $448 million financing round at a reported valuation of $29.3 billion, an increase in post-money value of more than 400x since the 2010 investment. [Source: VC Experts]Yet, many corporate balance sheets carry minority investments at cost – the value originally paid for the interest. Current U.S. GAAP does not require disclosure of the gains (and occasional losses) attributable to minority investments held at cost. While the incumbent accounting methodologies provide some information about deterioration in investment value, large valuation increases remain largely hidden from view. Unlike an asset for which replacement cost similar to the original outlay may be a reasonable estimate of worth, the value of investments in fledgling investee startups can change dramatically as these companies develop into successful businesses. With startups remaining private longer in the absence of exit events like IPOs, rising valuations of the underlying companies can diverge significantly from the cost basis of early investments. ASU 2016-01 seeks to provide more transparency and relevance to financial statement users, as well as decrease the complexity of equity investment impairment testing for financial statement preparers. The guidance applies to all equity investments that are not consolidated with the investor or accounted for under the equity method.1 That is, investments that represent less than 20% ownership or for which the owner lacks influence over investee operations. While the update has applications to both financial assets and financial liabilities, in this whitepaper we focus on the former, specifically minority equity interests. The update divides these investments into securities with readily determinable fair values and those without readily determinable fair values.Under current GAAP, unconsolidated equity investments are accounted for using either the cost or equity method. Investments with a readily determinable fair value (such as a share of public company stock) will be carried at fair value. For equity investments without a readily determinable fair value, entities can choose to apply a new Measurement Alternative. “An entity may elect to measure an equity security without a readily determinable fair value [and that does not qualify for the ASC 820 practical expedient2] at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.”3 Elections to measure a security using this guidance may be made on an investment-by-investment basis. However, once an entity elects to measure an equity security using the Measurement Alternatively, it should be applied consistently unless the alternative is no longer permitted.Observable price changes mean those resulting from orderly transactions, including those that are known or can reasonably be known at the date of measurement. However, it is important to note that the transactions must involve identical or similar investments from the same issuer. Determining the similarity of a new security issuance to one held by the reporting company should take into consideration the specific rights and obligations of the issuance, such as voting rights, distribution rights and preferences, and conversion features. While simplifying the process of determining changes (both upward and downward) to the reported value of equity investments, the Measurement Alternative does not eliminate the need to test for impairment. However, it does allow for the use of a single-step qualitative assessment at each reporting period. Qualitative indications of impairment include, but are not limited to, the following.4 A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee.A significant adverse change in the regulatory, economic, or technological environment of the investee.A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates.A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment.Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.If a qualitative impairment is identified, the reporting entity should estimate the fair value of the investment and recognize an impairment loss equal to the difference between the carrying amount of the investment and its fair value. Although the intended result of ASU 2016-01 is to increase the scope of decision-useful information reported on corporate balance sheets, it also has the potential to complicate reporting for entities with investments in venture-backed startups. Re-measuring fair value of ownership interests in companies that have become significantly more valuable since the reporting entity’s initial investment could result in higher volatility of reported income (from non-core business sources). Beginning in their quarterly 2017 filings, a few major corporate investors – including Google, Salesforce, and Cisco – acknowledged an increase in income and expense volatility is expected as a result of this transition. The portion of the investment landscape inhabited by corporate venture players continues to increase. Industry participants have begun adapting to the resulting changes of corporate participation. Both founders and investors will likely keep close watch as industry changes continue to unfurl and as corporate VCs begin to adopt these new requirements.
A Tale of Two Bakkens: Cashing Out or Doubling Down
Transaction activity in the Bakken shale was both busy and revealing in the second half of 2017. Many of these deals marked the departure of a number of companies that were known to be active in the play, particularly Halcon Resources. Other companies, however, have remained. The table below, drawn from Mercer Capital’s 3Q17 Bakken-focused newsletter, shows some details in regards to recent transactions, including some comparative valuation metrics.Cashing OutThe first major transaction was Halcon’s $1.4 billion sale of the majority of its North Dakota operations to Bruin E&P Partners LLC (a private company). Through this sale, as expected while resurfacing from bankruptcy, Halcon shifted focus to the Permian Basin. In addition, the Company cited the possibility of an outright sale as well. Two months later, Halcon sold its remaining Bakken assets (about 2,300 boe/day of production) for $110 million.In addition Earthstone Energy, and more notably, Linn Energy exited the Bakken in the past several weeks. Linn entered the Bakken play in 2011 by buying out a position previously held primarily by Concho Energy for $434 million. They exited for $285 million which was approximately a 1.5x multiple of the PDP value of $186 million as of YE 2016. It appears that Linn struggled with maximizing its production profile in light of the major price shift in 2014. Earthstone Energy also left, with a small $27 million non-operating sale. They, too, are shifting their focus to the Permian Basin.Valuations for these transactions were relatively tight. The Linn and larger Halcon sales were priced around approximately $14,000 per acre. The Earthstone deal was much smaller, and its valuation on a per acre basis was much smaller as well at around $1,100 per acre.Doubling DownHowever, amid the struggles of these other operators, Whiting and Continental demonstrated signs of commitment and improvement in the Williston Basin. Whiting sold its acreage position in Dunn County, North Dakota for $500 million. This amounted to a pricing of around $17,000 per acre, a premium to the Linn and Halcon sales. This, of course, is a relative bargain on a per acre basis compared to the pricing in the Permian these days. Then again, the economics between the two basins at current pricing is also a far cry from each other, with the Permian having clearly superior characteristics. Nonetheless, this did not signal an exit for Whiting, but was a signal to reduce leverage and give it balance sheet flexibility for its remaining Bakken acreage. Whiting is optimistic that recent improvements in oil pricing differentials and improved enhanced completion techniques will press to its advantage going forward in the play.While Whiting has not yet been able to scale its optimism, Continental has surprised many in the past year with its recent performance. In light of the challenges of the play, Continental has continued to improve its drilling and completion techniques, while elements they can’t control (such as oil prices) begin to swing back in their favor. As such, they have dropped LOE's and G&A to the lower end of their peer range, while netbacks are rising. All of this has happened, while many peers (as demonstrated above) have struggled or are leaving the area.
Not all is the same. Performance and valuations in the Bakken appear to be mixed and right now it appears that the operator’s skill and knowledge is as important a value driver as the acreage they drill on.
Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Valuing an Offer for Your RIA
The Devil’s in the Details
When we value an asset management firm, we do so in cash equivalent terms, as if someone were to pay that amount, on a given date, for a given firm or interest therein. On many occasions, clients have asked us how our estimate of value compares with an offer they received for the same firm or an interest in the same firm. It isn’t unusual for the offer to be ostensibly higher than our valuation, but it is unusual for the offer to be made in cash equivalent terms. As a consequence, we often have to look beyond the face value of the offer to determine what the economic value of the offer is, which may be much less than the headline number.In this final blogpost on evaluating unsolicited offers for your RIA, we take on this issue of valuing an offer. Valuing the offer for your RIA can be more difficult than valuing the firm itself.Similar Assets, Priced DifferentlySometimes, things which look similar are actually worth very different amounts of money – so one has to be careful making comparisons. The headliner offering at RM Sotheby’s latest auto auction in New York was a 1959 Ferrari 250GT California Spider built in full racing spec for Bob Grossman. The car is, of course, beautiful, but the story behind it is even better. The apogee of sports car racing was the 1950s and early 1960s, when well-healed amateurs could enter major races against established professional teams and often do very well. Bob Grossman was a successful sports car dealer and amateur racer in New York. He ordered the Ferrari pictured above and had it delivered straight to the track to race in the highly competitive 24 hours of Le Mans in 1959. The car had an aluminum alloy body (one of only eight made that way by Ferrari) and a race tuned V-12 with external plugs. Grossman had never driven at Le Mans before, was unfamiliar with the car, and had a co-pilot for the race whom he’d never met and who didn’t speak English. Grossman entered with the 250GT anyway and took third in his class.The car went on to perform very well in subsequent competitions before Grossman sold it. It doesn’t have leather seats or a radio, but still sold for $18 million. A similar 1961 Ferrari 250GT convertible, freshly restored but lacking racing heritage, was available at the same auction. Despite a pre-auction estimate of less than one-tenth the sale price of the Grossman Ferrari, the ’61 failed to sell. Two very similar cars offered at the same time in the same market; two wildly different valuations.Comparing Offers for Your RIAIf all RIA offers were all cash, this wouldn’t make much of a blogpost. RIAs rarely sell on simple terms in all cash transactions, however, so converting offer pricing and terms to cash equivalents is critical to determining whether an offer is reasonable or not. Because investment management is often a relationship intensive business, transacting an RIA often involves performance based payments like earn-outs, compensation arrangements tied to client transition, non-compete agreements, and other terms which effect the value of the transaction to the seller. Oftentimes cash consideration may only constitute two-thirds or so of total consideration offered.A selling client of ours a few years ago was counseled by a friend to assume that the cash he was paid up front would be the only consideration he ever got for his company, and not to take the deal if that wasn’t enough for him. That’s a little extreme, but the maxim that “cash is cash and nothing else is cash” does establish a hierarchy to think about the value of other forms of consideration.Trading Your Stock…for StockTaking stock in another asset management firm in exchange for some of all of your shares isn’t necessarily a bad idea, but it does double the complexity of the transaction. In addition to having to determine an appropriate value for your firm, you have to think about what the buyer’s stock is worth. Sellers can take this issue for granted, but it has a huge impact on the value transacted.Think, for example, about the relative merits of two shares of stock. If the selling firm’s stock is valued at 8x earnings, and the acquirer values their own stock at 10x earnings, then essentially for every dollar of earnings being given up by the seller, it now has a claim on 80 cents. There may be reasons why the acquiring firm’s stock is worth more – higher quality earnings, lower risk profile, better growth opportunities, etc. The trouble for most sellers, though, is that they understand the potential upsides and downsides of their own company, while having much less visibility into the relative merits of the acquirer’s stock.Does a stock for stock transaction involve giving up control of the selling company and taking an illiquid, minority position in the acquiring company? What is the dividend policy of the buyer versus that of the seller? Is the acquiring company a C corporation and how does that affect shareholder returns if the seller is a tax pass through entity like an S corporation or an LLC?Rolling your interest into the stock of your acquirer may be a good way to stay in the game. The question becomes: whose game is it?Is Selling Your Firm Just an Advance on Your Salary?One thing that is very likely to change when you sell your investment management firm is your compensation package. This is probably something you want to happen – within limits. If you’re currently taking out, say, $1 million per year in total compensation and you could be replaced (at least in theory) for half of that, then your earnings are understated by $500 thousand. At a multiple of 8x, that’s a difference in value of $4 million. You would probably rather pay capital gains tax rates on $4 million today than receive an extra $500 thousand per year, taxed at ordinary income rates, for several years.That said, if there is no clear correlation between compensation give-ups and the value being received from the transaction, it may start to feel like the buyer is paying you for your stock with your money. In some cases, that may even be true. If post-transaction compensation is set too low, you and your partners may have little incentive to perform after the ink dries on the purchase agreement, which doesn’t lead to good outcomes for anyone.We usually counsel acquirers to agree to normal compensation levels with their seller as part of transaction negotiations. If you do that, you’re much more likely to have a common understanding of the profitability of your RIA, and, thus, the negotiation is really about the multiple being paid.Performance Compensation as Risk SharingMany larger and more sophisticated acquirers use bonus compensation as a way to manage their risk. The typical arrangement we’ve seen is for acquirers to take something equivalent to a preferred stake in an RIA – taking their pro rata piece of the upside and little, if any, of the downside, or holding a stake in which management gets more benefit from increases in earnings and more detriment from declines in earnings. RIA consolidators seem particularly fond of this arrangement, and while it’s difficult to “value” the offloading of risk from buyer to seller (or continuing minority partner), it isn’t difficult to see who’s getting the better side of the deal.Earn-out Consideration is Never a GivenEarlier this year we had a whole series of blogposts about earn-out consideration, so I won’t rehash that here (Why Earns-outs Matter, Five Considerations in Structuring Earn-outs, and An Example of Structuring Earn-outs). Suffice it to say that earn-outs are common in RIA transactions and often are necessary to ensure that the value of client relationships and investment products are effectively transferred from seller to buyer. But an earn-out is only worth as much as it is likely to be earned, and this has to do with the target performance and terms associated with the earn-out. The time value of money must also be considered, particularly in earn-out arrangements of three years or more.One thing to keep in mind, as a seller, is how likely you are to reach the targets set by the earn-out. If the minimum growth target is, say, 15%, and your historical growth is less than that, consider how far markets have run to date and how you expect them to perform over the term of the earn-out. Modest earn-out requirements after a lull in the equity markets are one thing, but robust expectations after a long bull run are quite another. This issue is particularly poignant given where markets stand today.Don’t Forget to Value the TermsNon-compete agreements, office buildings, life insurance policies, working capital, contingent liabilities – there are a few dozen other issues that can change the economics of your offer. We can’t cover everything in a blogpost, but I will end with a simple piece of advice that many of these issues should be isolated and dealt with on their own merits – as opposed to being interactive with the operating value of the company. Even if the buyer wants to treat the transaction as an “all-in” or prix fixe price, you should know the breakdown of the offer on an a la carte basis.It isn’t always easy to determine whether an offer is too good to pass up, or too good to be true. If you’re considering a proposal to buy your investment management firm – especially one that came in over the transom – let us take a look at it. Whether you need a sounding board or an advocate, we can help.
WTI Futures and Inventories
Back in August 2017, we discussed the significant and bullish shift in the oil futures market from contango pricing to backwardation. This shift marked the first time backwardation would enter the market since 2014 and oil and gas investors were taking note. This was a bullish sign for many, including producers and oil field services, but a bearish sign for those in crude oil storage. Possible reasons for this include the following.Crude Oil ExportsThe U.S. has never exported more crude oil than right now. Latest data from EIA indicates the export of 1.4 million barrels per day in the month of September; nearly double the August daily export figures. Since the unrefined crude oil export ban was lifted in early 2016, the total average daily export figures have exploded. The average number of barrels exported in 2015 was 465,000 while 2017's average is 960,000 barrels per day.The top five nations receiving U.S. crude oil include 1) Canada; 2) China; 3) Korea; 4) United Kingdom; and 5) India. This group represents 65% of total exports in the month of September, with Canada leading the way with 23% of all U.S. exports while China is a close second at 17%.Interestingly, South Korea has surged its imports of U.S. crude. For reference, the average daily oil exports to Korea between June 2000 and August 2016 was 6,200 barrels per day. In the last 12 months, that number has surged to 50,000 barrels per day (more than 8x the average for the 2000's).Crude Oil Exports Takeaway: With the export ban rescinded, crude oil exports are increasing overall and specifically to eastern Asia.2017 Hurricane Season ImpactAs we wrote in our September 25, 2017 post, Hurricane Harvey, which made landfall in Houston, Texas, shut down more than 20% of the oil production from the Gulf of Mexico with additional onshore volumes shut-in. Four terminals in Corpus Christi were closed to tanker traffic. Nearly 50% of the nation’s refining capacity is located along the Gulf Coast and at least 10 refineries were shut down before the storm’s arrival.In response to the impact of hurricanes during 2017, U.S. refineries have been processing record seasonal volumes of crude to rebuild stocks of gasoline and especially diesel which were depleted by hurricanes and strong consumption at home and in export markets.As a result, crude stocks along the East, West, and Gulf Coasts have all fallen since the summer and are well below last year's levels and appear tight. Hurricane Season Takeaway: Refiners are running hard trying to replenish the stock lost during demand surge and shutdowns caused by the 2017 hurricane season. This results in higher demand for crude oil in the current market. Much of this demand is immediately filled by crude oil in storage.US Oil Inventories – Weekly Petroleum Status Report, EIACrude storage inventories hit their highest level ever in March 2017 with 1.2 trillion barrels of crude oil. Since that time, inventories have declined by 117 million barrels, according to information available from the EIA. Storage levels play a significant role in futures prices. U.S. crude futures, such as West Texas Intermediate (WTI), are based on crude delivered into the tank and pipeline system around Cushing, Oklahoma.Futures prices are, therefore, very sensitive to anything that affects the regional supply-demand balance in the Midwest (PADD 2) as Cushing's falls under the Midwest reporting region.Overall, commercial crude oil storage inventory levels across the U.S. are down 8% year-over-year. The largest single storage facility of commercial crude in the U.S. is stored in Cushing, Oklahoma. Cushing's inventory is down (15%) year-over-year, while the largest PADD area for crude oil storage (the Gulf Coast – PADD 3) was down (12%) year-over-year.Crude Oil Inventory Takeaway: The inventory levels of crude oil are falling all across the nation in response to higher exports of crude oil, the impact from 2017 hurricane season, and the backwardation trend in WTI future prices which encourages selling rather than storage of crude oil.Trend in WTI Future CurveThe table shows the future contract spread for the previous 12 months. The most recent data (December 1, 2017) returns the third month in a row of backwardation spreads since 2014.
In addition, the trend movement from contango to backwardation can be seen while watching the shrinking spread from August 2016, when the market had a wider contango spread of ($5.72), to backwardation in October 2017 to a significantly wider backwardation spread in December 2017.
ConclusionThe movement in the future spread toward backwardation is positive from an economic supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher, leading to more exploration and production activity, more active selling to refiners and the broader market, and less demand for storage. While this shift is good news for the overall industry, company specific risk and investors' fickle growth and risk attitudes create volatile public equity markets.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Should RIAs Care About Broker Protocol?
As noted last week, much has been written about some of the major wirehouse firms abandoning protocol these last few months. This week we explore what the implications are for RIAs and how it could impact their value in the marketplace.
There was a time when broker protocol made a lot of sense to the wirehouse firms. In an effort to avoid countless hours and company funds on litigation, the major brokerage firms at the time, Smith Barney (now part of Morgan Stanley), Merrill Lynch, and UBS signed the Broker Protocol Agreement in August 2004 to avoid the threat of lawsuits for financial advisors switching firms or setting up their own shop. At the time, the logic was that talent poaching was happening anyway, and the only parties benefiting from fighting the poaching were litigators. Several attorneys we’ve spoken with about the potential demise of protocol echoed this sentiment.
For years it appeared that broker protocol worked pretty well; today over 1,600 RIAs and broker-dealers voluntarily participate in the de facto cease fire over talent between the brokerage houses. All was quiet on this issue until late October when Morgan Stanley announced it was abandoning protocol, emphasizing its commitment to training and retaining brokers rather than poaching them from rival firms. One month later UBS followed suit, similarly citing the firm’s focus on retaining existing advisors over recruiting them from other shops. From a numbers perspective, these moves aren’t surprising as larger wirehouses have been net losers for several years as protocol made it easier for FAs to switch firms or start their own. Interestingly enough though, Bank of America Merrill Lynch recently announced that it would be sticking to protocol in favor of advisor flexibility in serving client needs.
Merrill’s decision seems counterintuitive until you consider that it uses certain exclusions to the agreement to selectively poach other advisors while punishing those trying to leave; therefore, it is less incentivized to break protocol. ML allows advisors who generate their own business to be covered by the protocol while those that use firm referrals to do so are exempt. Similarly, JP Morgan’s commission-based brokers are under protocol while those who receive a salary and bonus to service clients are not. Smaller independent firms and RIAs have also gamed the system by joining protocol to recruit advisors before exiting the agreement to make it harder for them to leave.
Moves by UBS and Morgan Stanley to abandon recruitment will make it much more risky and costly for RIAs to recruit their advisors. It also limits the market for whom these advisors can sell their book to if many of the prospective buyers are on a different platform, which could compress valuations for advisory firms built under broker-dealers. In fact, we’ve already seen a bit of a dampening effect on M&A activity as the last quarter tallied the lowest level of RIA dealmaking and advisor breakaways in three years – just 29 such transactions compared to 40 in Q2, according to a new report by DeVoe & Company. Devoe also attributes the decline to the prior surge created by the expiration of many forgivable loans to wirehouse advisors during the financial crisis and the potential passage of the fiduciary rule in late 2016 or early 2017:Source: Devoe & Company, wealthmanagement.com
On balance, RIAs and financial advisors looking to add brokers or sell in the foreseeable future should care about broker protocol. Sector transaction activity has already taken a hit, and we may be on the brink of another wave of firms abandoning protocol. Experienced advisor recruitment will also become more challenging as firms continue to exit the agreement. If, on the other hand, the remaining wirehouses stand firm, we could see a stabilization in M&A and possible mean reversion for broker recruitment. Wells Fargo’s pending decision on broker protocol could have a major impact on the industry as a whole, so we’ll be watching that announcement very closely.
The epitaph for wirehouse brokerage operations has been written repeatedly over the past twenty-five years or more, but Morgan Stanley’s move to exit protocol has opened a whole new chapter in the saga, suggesting that RIAs are indeed making more than a dent in brokerage firm revenues. We suspect this will remain a major topic in 2018 and will keep you posted on what we think the impact will be to investment management firms.
In the interim, feel free to reach out to us if you’d like to talk further.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
The Importance of Size, Profitability, and Asset Quality in Valuation
The question for most financial institutions is not if a valuation is necessary, but when it will be required. Valuation issues that may arise include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Thus, an understanding of some of drivers impacting your bank’s value is an important component in preparing for these eventualities.Data Analysis & Quantitative Factors Affecting Your Bank’s ValueDetermining the value of your bank is more complicated than simply taking a financial metric from one of your many financial reports and multiplying it by the relevant market multiple. However, examination of current and long term public pricing trends can shed some light on how certain quantitative factors may affect the value of your bank.To analyze trends, we focus our discussion on P/TBV ratios since this is one of the most commonly cited metrics for bankers. While all banks can be affected by overall macroeconomic trends like inflation rates, employment rates, the regulatory environment, and the like, we explore relative value in light of three factors we consider in all appraisals – size, profitability, and asset quality.SizeSize differentials generally encompass a range of underlying considerations regarding financial and market diversity. A larger asset base generally implies a broader economic reach and oftentimes a more diverse revenue stream which can help to mitigate harmful effects of unforeseen events that may adversely affect a certain geographic market or industry. Furthermore, larger banks tend to have access to more metropolitan markets which have better growth prospects relative to more rural markets. Figures 1 and 2 on the next page illustrate that, to a point, larger size typically plays a role in value, as measured by price / tangible book value multiples. The sweet spot for asset size seems to be between $5 and $10 billion in total assets. Banks in this category traded at the highest P/TBV multiple as of September 30, 2017 and have generally outperformed all other asset size groups over the long term.ProfitabilityTo examine how profitability affects the value of your bank, we compare median P/TBV multiples for four groups of banks segmented by return on average tangible equity (Figures 3 and 4 on the prior page). A bank’s return on equity can be measured as the product of the asset base’s profitability (or return on assets) and balance sheet leverage. Balancing these two inputs in order to maximize returns to shareholders is one goal of bank management. A bank’s return on equity measures how productively the bank invests its capital, and as one would expect, the banks with the highest returns on equity trade at the highest P/TBV multiple.Asset QualityInferior asset quality increases risk relative to companies with more stable asset quality and may limit future growth potential, both of which may negatively impact returns to shareholders. In addition, it makes sense that a bank with high levels of non-performing assets might trade below book value. Book value of the loans (or other non-performing assets) may not reflect the true market value of the assets given the potential for greater losses than those accounted for in the loan loss reserve and the negative impact on earning potential. Figure 5 illustrates how pricing is affected by higher levels of non-performing assets. As shown in Figure 6, P/TBV multiples plummeted at the start of the economic recession and have yet to recover to pre-crisis levels.ConclusionSize, profitability, and asset quality are factors to consider in your bank’s valuation. From an investor’s perspective, your bank’s worth is based on its potential for future shareholder returns. This, in turn, requires evaluating qualitative and quantitative factors bearing on the bank’s current performance, growth potential, and risk attributes.Mercer Capital offers comprehensive valuation services. Contact us to discuss your valuation needs in confidence.This article originally appeared in Mercer Capital's Bank Watch, November 2017.
Current Regulatory Environment Affecting the Oil and Gas Industry
The oil and gas industry is heavily regulated by the Environmental Protection Agency (EPA), the Federal Energy Regulatory Commission (FERC), Bureau of Land Management (BLM), and the Department of the Interior (DOI).As business valuation experts, we have to consider the outlook for the economy, industry, and business in every valuation; therefore, we pay attention to the regulatory environment to assess what it means for our clients. Given the new administration, there is much to consider.Review of Recent Regulatory ReformStreamlining Federal ReviewsOn August 15, President Trump signed an executive order which aims to speed up the process for federal environmental reviews of energy and other infrastructure projects and holds agencies accountable if they fail to do so. Jack Gerard, President of the American Petroleum Institute (API), praised the order for its focus on speeding up projects, saying “We also look forward to President Trump as he signs an executive order aimed at streamlining the permitting process for infrastructure projects.” The API had previously called for significant improvements to be made to the permitting process.Federal Energy Regulatory CommissionsIn August, the Senate confirmed two appointees to the Federal Energy Regulatory Commission, which is an independent agency that regulates the interstate transmission of electricity, natural gas, and oil, among other things. Prior to the appointments, the commission did not have quorum (the first time in its 40-year history), holding up projects worth $50 billion in private capital according to the Electric Reliability Coordinating Council. FECR is now ready to address the backlog of projects.North American Free Trade Agreement (NAFTA)Negotiations of NAFTA began in the third quarter of 2017 and remain unresolved. President Trump has indicated on multiple occasions that the U.S. could simply pull out of the agreement, which worries many in the oil and gas industry. The API, CAPP, and AMEXHI are the top trade groups in the United States, Canada, and Mexico, respectively, and they issued a joint position paper on August 2 hoping to keep current policies intact and “Do No Harm.” As early as 2020, North America could achieve energy self-sufficiency and has made significant strides since the agreement was signed 23 years ago. The paper goes on to claim that a change in trade that reduces investment protections or increases tariffs or trade barriers could have a significant negative impact on the industry and risk tens of millions of jobs that depend on trade in North America.Tax ReformTowards the end of the third quarter 2017, Congressional Republicans introduced the outlines of their plans for tax reform. On December 2, the Senate passed the tax reform bill. The next step is for the House and Senate to agree on the same version of the bill. In general the bill has the goal of reducing the corporate tax rate and simplifying the overall tax code. The energy industry will likely see aspects that are both good and bad. A corporate income tax rate decrease from 35% to 20% would be great news for the oil and gas industry. On the other hand simplifying the tax code will likely lead to a decrease in tax exemptions of over $4 billion for the industry. The biggest of these, “intangible drilling costs,” or IDCs, could actually be expanded, with a provision in the reform that allows for the immediate expensing of new investments.Renewable Fuels Standards Program (RFS)The Renewable Fuels Standards Program continues to have a significant impact on the refining industry. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. Renewable Identification Numbers (RINs) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. While large integrated refiners have the capability to blend their own petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price.The new RFS for 2018, which were released in mid-July, displayed a slight reduction in the volume requirements. A public hearing was held on August 1 and on October 17. The EPA provided a public notice and an opportunity to comment on potential reductions in the 2018/2019 biomass-based diesel, advanced biofuel, and total renewable fuel volumes. The final rule should be available in December. A coalition of independent refiners and marketers has urged President Trump to move forward with this review. According to the November issue of the Oil and Gas Journal, the Fueling American Jobs Coalition (FAJC) said, “The need for significant reform has only grown over the last year as the cost of purchasing Renewable Identification Numbers (RIN) to comply with the RFS has skyrocketed, threatening some refiners’ survival.”RTR & NSPSIn December of 2015 the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS) rule was passed in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations ranged from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The EIA estimates the rule will cost refineries a total of $40 million per year, while the American Petroleum Institute (API) argued that the annual cost would exceed $100 million. The rule was expected to be fully implemented in 2018 however President Trump’s attention to the needs of deregulation of the oil and gas sector makes us to question the future implementation of the rules.SummaryThese are just a few of the regulations that affect the day-to-day operations of companies in the oil and gas industry. Changes in the regulatory environment have led to increased uncertainty in the oil and gas sector. Overall, however, outlooks for the industry appear favorable. While this post mainly outlines domestic oil and gas policy, it is important to remember that the domestic oil and gas market is affected by global oil supply and demand. On Thursday November 30, OPEC decided to extend production cuts through December 2018. This decision came one year after OPEC originally decided to make across the board production cuts in order to realize more stable oil prices around $50 per barrel.Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
What We’re Reading About Broker Protocol
Most of the sector’s recent press has focused on broker protocol, so we’ve highlighted some of the more salient pieces as a preface to our take on the matter in next week’s post.UBS Exits Protocol, Creating “New World” for Advisors, Clientsby Janet Levaux
ThinkAdvisor offers differing takes on UBS’s recent decision to leave the Protocol for Broker Recruiting. Many believe a wave of advisor departures from the wirehouse firms is imminent while some contend that the rule wasn’t sustainable in the first place.UBS Broker-Protocol Exit Shows Independent Channel is Bleeding Wirehouses of Advisersby Bruce Kelly
Smaller RIAs and, to a lesser degree, independent broker-dealers, have been taking market share from the big four BDs for the last several years. UBS and Morgan Stanley have broken protocol to stymy this momentum and retain advisors that were previously given a pass on being sued if they jumped ship to another broker-dealer.How UBS Exited the Broker Protocol and Why the Aftereffects May Surpass Those of Morgan Stanley's Earlier Departureby Brooke Southall
RIABiz predicts that Merrill Lynch will be the next to abandon protocol, leaving Wells Fargo with a big decision to make in the coming weeks.B/D Advisor Valuations to Compress as the Broker Protocol Unravelsby Michael Kitces
The Nerd’s Eye View blog predicts a complete unraveling of broker protocol in the coming weeks as few incentives remain for Wells and Merrill to stay on board now that Morgan and UBS have left the agreement. Mr. Kitces also expects the break to compound the decline in broker-dealer valuations as their market will likely be limited to a more captive audience of other brokers on the same platform. Breakaway Broker Deals a Drag on M&A Activity in Third Quarterby Jeff Benjamin
The impact on sector M&A is more unclear though many industry observers foresee a short-term spike in breakaway acquisitions but an overall reduction in deal-making over the long run.Broker Hiring Pact Hurt by Defections Expected to Surviveby Neil Weinberg and Katherine Chiglinsky
Many analysts believe the protocol will endure for some firms due to the high cost of litigating and the need for guardrails in handling sensitive client data. Raymond James, for example, has vowed to remain a member if it were “the last firm standing.” In summary, there seems to be a general consensus that Merrill (and possibly Wells) will abandon protocol in the coming weeks. Less certain is the impact on sector deal-making and valuations though it doesn’t seem particularly bullish for either. Stay tuned to next week’s post for more perspective on how we think this will all shake out for the RIA community.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
How to Value an Oil & Gas Mineral Royalty Interest
Well-informed buyers and sellers are critical to an efficient market for royalty interests because there is a specialized and relatively complex body of knowledge to consider in the transfer of these types of assets.Often called a net revenue interest (NRI), royalty interests do not bear the costs of production and only participate in the potential upside of a resource. The value of a royalty interest, however, is often difficult to observe because they are typically closely held. In addition, once discovered and drilled, the natural resources are physically depleted, resulting in a declining asset as opposed to a growing one.A lack of knowledge regarding the worth of a royalty interest can be very costly. A shrewd buyer may offer a bid far below the interest’s fair market value, opportunities for successful liquidity may be missed, or estate planning could be incorrectly implemented based on misunderstandings about value.Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.This blog post summarizes our whitepaper – providing an informative overview of the valuation of mineral royalty interests within the oil and gas industry. While there are a myriad of factors (mostly out of a royalty holder’s control) impacting the economics of a royalty interest, this blog post focuses on valuation methodology.What Does the Valuation Process Entail?Valuation approaches refer to the basis upon which value is measured.There are three commonly accepted approaches to determining value:Asset-based ApproachMarket ApproachIncome Approach
In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value of a given entity.
Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration. However, due to fundamental structural differences between businesses and assets, the available valuation methodologies tend to be utilized differently when valuing royalty interests. (1)The Asset-Based ApproachThe asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets. While the asset-based approach can be useful when valuing companies operating within the oil and gas industry, this approach is not typically employed to determine the value of a royalty interest.Oftentimes a mineral royalty owner purchased land which included the mineral rights and an allocation of surface vs mineral rights was not performed. Additionally, considerable time may have passed between the time the surface and mineral rights were purchased and the valuation date. Adding to the ambiguity of the cost basis of the asset, mineral royalty interests are often family assets that are handed down for generations. For this reason, the asset-approach is rarely used to determine the market value of mineral royalty interests unless the mineral rights were recently purchased.The Market ApproachThe market approach utilizes transaction pricing from guideline transaction data or valuation multiples from a group of publically held companies to determine the value of a privately held enterprise or asset. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. This data can be derived from direct transactions of mineral royalty interests or from publically traded royalty trusts and partnerships.Direct comparable transactions of mineral royalty interests are often the best indication of fair market value. However, the data with which to benchmark a subject mineral royalty interest against is often unavailable. If it is available, a careful comparative analysis must be made. Royalty trusts and partnerships hold various mineral royalty interests in wells operated by large exploration and production companies. Royalty trusts and partnerships tend to have very low, if any, operating expenses and can be an investment to provide exposure to oil and gas prices.Acquisition data from these trusts can be utilized to calculate valuation multiples on the subject royalty’s performance measure(s). This will often provide a meaningful indication of value as it takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.Traditional oil and gas earnings multiples, such as EV/ EBITDAX, should not be used to calculate indication of values because royalty trusts do not have high operating costs and operational earnings margins are not a necessarily meaningful indication of performance for a royalty owner. Rather, a royalty trust's performance can be better understood by its distribution yield and potential for future revenue streams from new, undrilled wells.In many ways, this approach goes straight to the heart of value: a mineral royalty is worth what someone is willing to pay for it. However, the market approach is not a perfect method by any means for businesses or for mineral royalties.Royalty trust transaction data may not provide for a direct consideration of specific mineral royalty characteristics; it is imperative that the value conclusion be adjusted for differences in value level and in well economics, potential future drilling locations, among other factors. In any valuation, the more comparable the transactions are, the more meaningful the indication of value will be.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of a cash flow or ongoing earnings figure and the application of a multiple to those earnings based on market returns. For mineral royalty interests, however, we oftentimes perform a discounted cash flow analysis. This approach allows for the consideration of characteristics specific to the subject mineral royalty, such as its well economics making it the most commonly used approach for mineral royalty interest valuations.To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price values. The stream of revenue is then discounted back to present value using a discount rate that accounts for risk in the industry.Because revenue cash flows are the main driver of mineral royalty values, the income approach is the most reasonable and supportable valuation approach when determining the value of a mineral royalty interest.ConclusionA proper valuation of a mineral royalty interest will factor, to varying degrees, the indications of value developed utilizing the market-based and income-based approaches outlined above. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of the mineral royalty and its unique characteristics that provide relevance and credibility to these calculations. This is why industry "rules-of-thumb" are dangerous to rely on in any meaningful transaction.Such "rules-of-thumb" fail to consider the specific characteristics of an interest and, as such, often fail to deliver insightful indications of value. A mineral royalty owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the interest.Mercer Capital's Oil & Gas team has extensive experience valuing mineral royalty interests. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the interest. We hope this information, which admittedly only scratches the surface, helps you better shop for royalty valuation services and understand valuation mechanics.We encourage you to extend your wealth planning dialogue to include valuation of any mineral interests because, sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at (901) 685-2120 or (214) 468-8400.End Note(1) Treasury Regulations 1.611-2(d) asserts that the income approach will not be used if the value of a mineral property can be determined using the cost-approach (under the asset approach) or the market approach. However, those circumstances are rare and not consistent with industry norms. The income approach is most often employed to estimate the fair market value of mineral properties such as this.Mercer Capital's Energy Valuation Insights BlogThe Energy Valuation Insights Blog presents a weekly update on issues important to the Energy Industry. Follow us on Twitter @MercerEnergy.
Culture is King, So Why Isn’t It Mentioned in the Purchase Agreement?
Mercer Capital is headquartered in Memphis, where Elvis Presley lived most of his life. It occurred to me recently that I’ve never written about Elvis's passion for cars, a pretty huge oversight for this blog. Elvis bought a lot of cars – estimates number his purchases in the hundreds – for himself, family, employees, friends, and occasionally strangers. A friend of mine who owns a few auto dealerships now was a young car salesman at the local Lincoln/Mercury dealer in the 1970s when he got a call in the middle of the night to "come on down to the dealership…Elvis wants to look at cars." He and the other salesmen took scores of cars to Elvis's home, Graceland. Elvis sat in a chair on the front porch while they drove the cars, one at a time, past him in the circular driveway. Elvis would either say "yes" or wave them off. By sunrise, he had agreed to buy a dozen cars – mostly as gifts.If you visit Graceland, you’ll get a strong sense of how the extravagant culture of Elvis Presley's entertainment enterprise was built around him: dozens of cars, customized jet aircraft, strings of horses, collections of firearms, fried peanut butter and banana sandwiches, all night jam sessions in a Hawaiian-themed den with carpet on the ceiling, and a racquetball house with a running track on the roof.Graceland is a perfect study in corporate culture at the extreme. On the Graceland tour, you’ll quickly understand that Elvis was a "package-deal"; you couldn't get the same entertainer from a person who lived a life of moderation. While most RIA founders aren't as "unique" as Elvis, investment management firms tend to be built around the peculiar interests and desires of their founders, and separating the firm from the founder is easier said than done.Culture Is KingCulture is the most glaring omission of any purchase agreement. We may not have any clients who show up to work at their RIA in white jumpsuits, but we have some who wear board shorts and flip-flops to the office, and others who dress so formally we suspect they wear neckties with their pajamas. Some keep rigid office hours and some are always someplace else. Some like a team approach to investment management and others act strictly on their own instinct. Some drive flashy sports cars and others prefer run-of-the-mill SUVs. None of them wants to change just because they're selling their firm, but what's not written in the purchase agreement is the difficulty in maintaining cultural identity for a seller after the transaction.Transitioning culture wouldn't be such a big deal if founding members of RIAs could just walk away after the transaction. As we all know, though, even when an asset manager transacts, there are relationships to hand off and successor managers to groom and earn-outs to earn – such that partners usually have to stick around for three to five years after selling. As a consequence, founders have to undergo a cultural change at the firm they founded, which can be galling.For folks who are considering offers for their investment management firm, we usually counsel them to remember a few things that aren't outlined in the LOI:You're not going to be the boss anymore. One seller was apoplectic when the bank that purchased his wealth management firm changed the color of his firm's logo to match that of the bank. It's going to happen.You're going to have a boss. Sellers often seem surprised that there is a reporting structure of which they are a part, in spite of being assured that the buyer will give them "maximum autonomy." Autonomy doesn't mean you get your own island.Your employees are going to have a new boss. And they might like that boss more than they like you. You think that you want that for them, but it won't do much for your ego.Your clients may question your commitment after the sale. If you start to enjoy your reduced responsibility and increased liquidity too much, your clients will assume you are "calling in rich" – and take their assets elsewhere. Best to keep the overt transition low key until the earn-out period is complete.The same “founder's syndrome” that helped you build the firm will now fuel your frustration. Founders are driven by senses of identity and autonomy that are completely undermined by selling. So when you get up from the closing table, head straight for the therapist's couch.
Elvis Presley's posthumous hit single, "A Little Less Conversation," pleads for actions instead of words. On the contrary, we suggest that founders think about what makes their firm unique and what aspects of that uniqueness you are, and are not, willing to give up in a transaction. Then have a little more conversation with the buyer about their post-transaction expectations for your firm's culture. If you can agree to how you're going to work together before the deal closes, everyone will be more successful after the deal closes.
As always, feel free to reach out to us if you'd like to talk further.
Underpayments, Overpayments, Lost Opportunities and Bankruptcies: Trends and Happenings in Energy Litigation
At recent conferences, dialogue on trends and notable cases in litigation were an integral part of several presentations and discussions. Although not typically a preferable option for litigants, these cases can bring light and insight to a number of areas. Our experiences as expert witnesses can attest that these cases can have a broad-reaching impact for the litigants involved as well as for interested observers and even the community at large.Over the last five years, or so, there has been an overall uptick in cases. New royalty disputes, while rising steadily overall since 2012 took a big jump in 2015 and then came back down somewhat in 2016 and this year. Cases having to do with land and lease rights have also risen overall in the past several years. A recent notable case in this area has been Escondido Resources II, LLC v. Justapor Ranch Company, LLC (Webb County Trial Court 2013-CV7-0011396-D1).Lastly, as we have written about in the past, bankruptcy cases also rose in 2015 and 2016, as the price of oil fell and many operators were unable to pay off large sums of debt. While the number of oil and gas bankruptcies has since dropped, there are a number of companies that could still be described as distressed that have been unable to solve their balance sheet issues.Three Main Royalty Dispute IssuesIn regards to royalty disputes, there are generally three kinds of issues: (i) failure to pay, (ii) underpayment, and (iii) overpayment.The trend in recent years has been centered mainly on underpayment issues. Underpayment issues have often times revolved around disputes with post production costs in various lease clauses. Historically, some notable cases here include Heritage Resources v. Nations Bank (939 S.W. 2nd), Hyder v. Chesapeake (04-12-0769-CV), and French v. Oxy (11-10-00282-CV).In addition, there have been lost opportunity cases that are of note.One such case is Spring Creek et al. v. Hess Bakken IV (14-CV-00134-PAB-KMT). Both underpayment and lost opportunity issues are present in that case. In that case Hess Bakken (and later Statoil) was required to pay ORRI’s to Spring Creek, but there were several disputes as to the Defendants’ requirements to pursue new leases and drill additional wells in the area (known as the “Tomahawk Prospect”) which would be subject to payments made to the Plaintiff. Plaintiffs claimed damages in two areas: (i) the discounted present value of overriding royalty interest on areas of mutual interest (damages ranging between $24.2 million and $59.3 million), and (ii) the potential working interest in the same area ($182-403 million). The court granted a partial summary judgment for the defense denying working interest damages.ConclusionRoyalty underpayment cases are anticipated to remain steady in the current pricing environment. There is an understandable tension between mineral owners' concern over shrinking payments and operators' concern over profitability and favorable drilling economics.Mercer Capital’s professionals have consulted and testified in a wide variety of energy litigation matters. We have extensive experience in damages and valuation-related litigation support and assist our clients through the entire dispute process by providing initial consultation and analysis, as well as testimony and trial support. To discuss a matter in confidence, please call one of our team members.
3Q17 Call Reports
Despite gaining 5% last quarter, publicly traded asset managers are still coping with a low fee, passive environment and challenges associated with a ramp up towards full implementation of the DOL fiduciary rule. The DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and accelerate the shift from commission-based to fee-based accounts. While net inflows into passive products are a secular trend (particularly on the retail side), the passive inflows seen thus far during 2017 may be unnaturally high due to flows that have been pulled forward from next year by brokers in response to the DOL rule as an effort to avoid litigation. Still, against this backdrop, many industry participants see opportunity, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Pricing pressure and the DOL fiduciary rule have continued to drive flows into low fee passive products, particularly in the US retail channel."Third quarter long-term net inflows of $76 billion, representing 6% annualized organic asset growth, were positive across client type, investment style and region. Global iShares generated quarterly net inflows of $52 billion, representing 14% annualized organic growth with strength across both core and non-core exposures." —Gary Shedlin – CFO, BlackRock"Total net flows were positive $0.2 billion in the quarter, an improvement from net outflows of $0.2 billion in the prior quarter, as positive flows in structured products, retail separate accounts and ETF more than offset net outflows in institutional." —George Aylward, CEO, Virtus Investment PartnersTheme 2: Changes in the regulatory environment and client expectations have prompted many traditional asset managers to consider expense caps or variable fees tied to performance."I think that our view [on fees is that] as the industry continues to evolve due to a variety of issues, not the least of which are both regulatory and changing client trends, there are a number of active managers thinking about new ways to evolve fee structure. So we've seen a bunch of announcements of intentions to introduce a new performance-based model. I think we saw one change more recently in the United States, including the fulcrum fee, which has actually been in use in the U.S. for some time." —Gary Shedlin"With regard to the FlexFee Fund Series … [c]onversations are ongoing with our major distributors; I think they're going well. We're sort of working up to beginning in earnest at the beginning of the first quarter to begin the process of marketing the [FlexFee Fund Series]. And it will be our focus for the first half of 2018. We think there's significant potential here to gather additional assets. We think it realigns client expectation of share of excess returns that managers are taking versus what they, our clients, are keeping. We think it's a credible alternative to those who are incredibly fee-conscious today." —Seth Bernstein - President, CEO, AllianceBernstein Corporation"We have opened to fulcrum fees with many of our clients, specifically in the separate account space, and [they are] open to it." —Eric Colson, CEO, Artisan Partners Asset ManagementTheme 3: The trend towards fee-based accounts (as opposed to commission-based) has been accelerated by the DOL rule, and product offerings are under pressure to adapt accordingly."I think what we do know is that as you transition from a brokerage to a fee-based account, it's—you may have 1 out of 3 of your products on that lineup instead of all of them, and that's a general statement. But one that it makes it difficult to capture the assets that you had. So anybody with multiple products, with one relationship, is going to be under pressure as those assets transition. But I do think the pressure of the transition could be alleviated somewhat if we have a standard that allows those 2 to coexist." —Gregory Johnson - CEO, Franklin Resources, Inc."[P]art of it is you have to adjust the product line and make sure that you have mandates and styles and sleeves that are cost-competitive that can fit into solutions. You have solutions that differentiate, whether it's target date funds or multi-asset funds, that we can build. And part of that is having now ETFs that we can use in a lower cost way as part of that solution and have open architecture solutions that we've done around the globe with other partners. Those are the, I think, things that we continue to try to adapt to, but we're certainly not sitting around waiting to get back to the old brokerage model because, I think, at the end of the day, we recognize that the fee-based side is going to continue to be the driver going forward." —Gregory Johnson"And as you point out, one of the things we did effectively concurrent with [the launch of the MAP Navigator product] was to add some sub-advised funds that are passive/smart beta-ish. Yes, the uptake of those has been pretty good, I think about $300 million in AUM to-date." —Thomas Butch, CMO, Waddell & Reed Financial"In the U.S., there are 2 major shifts converging in wealth management. First, in one of the largest asset movements, fee-based advisory assets are expected to double by 2020 in the shift from brokerage to fee-based accounts. The second, digital technologies are disrupting traditional wealth advisory practices, which create competition for client assets and provide leverage for fast-growing advisory practices." —Larry Fink, CEO, BlackRock"We spoke earlier in the year about having the strong balance sheet and the financial flexibility, to be patient as we acknowledge what the DOL rules will do for our company, and as we open up gradually, open up the architecture in the broker-dealer, I think we're getting a little better read on kind of where those things are settling out. Product development is something where it's an ongoing process for us internally." —Philip Sanders, CEO, Waddell & Reed FinancialMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
What Every Estate Planner Should Know About Buy-Sell Agreements
Unless your client has had their buy-sell agreement reviewed from a valuation perspective, they don’t know what it says. This comes as a surprise to many – an often unpleasant surprise as too many find themselves caught up in unexpected and costly legal wrangles or personal turmoil.Originally presented by Z. Christopher Mercer, FASA, CFA, ABAR at the 2017 Southern Federal Tax Institute, this session provides you with information from a valuation perspective that will help ensure that your clients’ buy-sell, shareholder, or joint venture agreement results in a reasonable resolution and is not a ticking time bomb set to explode upon a triggering event. In other words, you will leave this session understanding how your clients’ buy-sell agreement will work - before a trigger event occurs.
Coping With Deal Fatigue?
Keep Your Eyes on the Prize
In this continuing series on RIA partners responding to unsolicited offers, we thought it would be worthwhile to spotlight the number one killer of worthwhile transactions: deal fatigue.Transaction negotiations frequently take longer than anyone expects and often start and stop multiple times. The process has a tendency to terminate negotiations on bad transactions, but it also takes down many that should happen.Watching deal-making reminds me of car chase scenes in movies: unnecessarily long, fast-paced, often suspenseful, and with the potential for multiple fatalities – or at least bruised egos.The car chase scene that set the standard for the past fifty years was Bullitt, in which Steve McQueen, playing the role of Frank Bullitt, drove a 1968 Ford Mustang GT Fastback equipped with a 390 cubic inch V-8 and a four-speed manual transmission through the streets of San Francisco in pursuit of some hitmen in a Dodge Charger. Fiction being what it is, Bullitt catches the bad guys in his Mustang, even though in reality the Charger was faster. The car scene took three weeks to film, destroyed two Dodge Chargers and one Mustang, and ultimately resulted in a chase sequence lasting almost ten minutes that won the film’s editor, Frank Keller, an Oscar.Three weeks of filming for a ten-minute scene is about the ratio of time it takes to negotiate and finalize an RIA transaction relative to how long people think it ought to take. Many sellers believe that once a term sheet is agreed to or an LOI is signed, the rest is just papering the deal. Not so. Transaction negotiations, even drafting the purchase agreement, take months and sometimes years – but never merely weeks. I’ll spare you dozens of war stories, but I do have a few things to keep in mind if you find yourself going through the process.Have a Real Reason to Sell Your RIAStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? When deals involving asset management firms fall through, I often hear things like “they just wanted to use our money to buy our firm from us.” Translation: the seller gives up shareholder returns (distributions and maybe bonus compensation) and agrees to work through a transition period (often three to five years) while the buyer capitalizes those same returns and uses them to finance or at least justify the purchase price.Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! On top of that, most investment management firm transactions have substantial earn-out payments included as part of the deal, such that the sellers may go from being masters of their own universe to singing for their supper.RIAs are professional service firms and the cash flow that creates value transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe they are selling because they want or need to retire. Maybe they are selling because they want to consolidate with a larger organization, or need to bring in a financial partner to diversify their own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.Be Aware of Your Own PsychologyOne reason why we enjoy working with investment managers is that they are the kind of client who is wired like we are: analysts who think they can reduce most everything in life to an excel spreadsheet. Finance and much of economic theory are grounded in a neoclassical approach that can be expressed in logarithmic equations in which decisions are based on some logical assessment of marginal benefits. The reality of evolutionary neurobiology and the recent development of behavioral economics suggests that real life is much messier than that. People reason out dilemmas to the best of their ability, and then make a decision largely based on emotion.Even earning your CFA charter doesn’t enable you to escape your own humanity. People don’t refer to their firms as their “baby” for no reason – you will be emotional while you contemplate things like handing your relationships with clients and colleagues to a stranger for adoption, so be ready for it. It’s a normal feeling, and if you have the right acquirer, it will subside to relief that someone can carry on these relationships on your behalf, and is willing to pay you for the right to do so.A good analyst can justify his emotional impulse using financial analysis; a great analyst can prove it.One way to manage this through the deal process is to have an impartial counselor be a sounding board while you’re negotiating. This might be a friend or business colleague, but keep in mind you’re going to need a lot of counseling. Ideally, this is the same person who is representing you in the sale, and thus who knows you and the setting for the transaction. Getting this from your advisor requires a financial arrangement in which you can feel comfortable that he or she is representing you and not the transaction.Remember That Money Is Fungible and Value Is RelativeGive up on the notion of absolutes in transaction valuations or deal terms. The eleventh commandment is not 10 times EBITDA nor 3% of AUM, and neither one is engraved on any stone tablets in human history.Everyone wants to sell at the top of the market, but the top of the market for RIAs is usually the top of the market for other assets as well, so if you sell at the top you’ll pay more taxes and your after-tax proceeds will be reinvested in a fully priced market. It’s highly unlikely that your investment management firm will fetch top dollar in a bear market; so in many regards, the purchase price you exact in transaction negotiations only has merit relative to your reinvestment opportunities.This, again, is an argument for looking at the sale of your RIA through a strategic lens rather than a financial lens. Maybe you can do better than the market in selling your firm, but if you’ve been in the business long enough to have built a successful advisory business, you know how difficult it is to beat the market.Conclusion: Keep Your Eyes on the PrizeSo, if you’re entering into negotiations to sell your RIA, buckle up, stay composed, and be mindful of your goals. Steve McQueen was notoriously focused on managing his own career, which enabled him to drive even faster cars in real life, like his Ferrari 250 GT Lusso, shown below.Steve McQueen’s car in real life, a Ferrari 250GT Lusso (gentlemensjournal.com)As always, if you'd like to continue the conversation before our next post, give us a call.
Do You Know What is in Your Royalty Trust?
In previous posts, we have discussed the existence of royalty trusts & partnerships and their market pricing implications to royalty owners. To summarize our previous posts, it is important to understand the economic rights and restrictions within the publicly traded royalty trust being used as a “benchmark” before using it as a pricing reference for a royalty interest.For example, many of these publicly traded trusts have a set number of wells generating royalty income at declining rates for multiple years to come. In contrast, some of these trusts participate in a number of wells that have not been drilled, which represent upside potential for investors. The future growth and outlook potential for each of these two example publicly traded trusts is significantly different and a potential investor would want to know the details. The same is true for a privately held royalty interest.Market Observations1There are approximately 21 oil and gas-focused royalty trusts and partnerships publicly traded, as of October 31, 2017.
Over the previous two years, the performance of the 21 publicly traded royalty trusts has been a mixed bag. Fourteen have returned market value losses during the previous two years with an average market value return of negative 31%, six have experienced positive market value returns with an average of positive 33% and one has been flat.
Contrast this wide return with the price of crude oil and natural gas which have both increased over the same period.
Clearly, there were some winners and losers among the 21 royalty trusts over the previous two years and, noticeably, more losers than winners. Of the winners, the royalty trust with the highest market value return was Mesa Royalty Trust (MRT) (+49%) over the previous two years, with ECA Marcellus Trust I (+36%) and Permian Basin Royalty Trust (+33%) coming in second and third, respectively.
Why did Mesa Royalty Trust outperform all other royalty trusts over the previous two years and what is the nature of its economic rights and restrictions?
Mesa Royalty Trust (MRT)Description of Assets Owned by MRTThe only asset of MRT includes an overriding royalty interest (ORRI) as described in their latest 10K filing:[MRT owns] an overriding royalty interest (the "Royalty") equal to 90% of the Net Proceeds (as defined in the Conveyance and described below) attributable to the specified interests in properties conveyed by the assignor on that date (the "Subject Interests"). The Subject Interests consisted of interests in certain oil and gas properties located in the Hugoton field of Kansas, the San Juan Basin field of New Mexico and Colorado, and the Yellow Creek field of Wyoming (collectively, the "Royalty Properties")As the 10-K refers, MRT’s asset is an overriding royalty interest in three oil and gas fields within the United States. [For more information on overriding royalty interests, see our post]. These properties are primarily natural gas and natural gas liquid plays in the San Juan Basin2 of New Mexico/Colorado, and the Hugoton Field of Kansas, Oklahoma and Texas3. The Yellow Creek field in Wyoming is not described further in the documents and is assumed to be immaterial in comparison to the San Juan Basin and Hugoton Field assets.Commodity PricesThe price for oil peaked in 2014 near $108 per barrel and close to $8 for natural gas before the collapse of both commodity prices during the 2nd half of the year. The nadir of the decline was during 4Q2015 and 1Q2016 for both oil and gas. Prices currently stand around $53 per barrel and $3.60 per mcf.Asset ProductionThe following charts tracks the quarterly production for MRT since 2010, as well as a rolling latest twelve month (LTM) production figure. Each chart shows increasing production through 3Q2014 and subsequent decline in production from 4Q2014 through 1Q2016. Quarterly production increased 174% from 1Q2016 to 2Q2017. Much of the increase in market value could be due to the increase in MCFE volume produced by the properties over the previous five quarters.
We note that the production decline in MRT followed the commodity price decline. Additionally, the subsequent ramp up in production during 2Q2016 through 2Q2017 followed the stability and increase in commodity prices.
The combination of production and commodity price increases during the previous five quarters resulted in increases of distributions to unit holders in MRT by approximately 375% from 1Q2016 to 2Q2017.
This type of activity is rare for an overriding royalty interest. While commodity prices can be very volatile, production is normally a steady decline except for improvements from existing well workovers. It is not normal to see ORRI’s impacted by the addition of new wells. Judging by the significant increase in production, more research is needed to understand exactly what is impacting the ORRI owned by MRT. To do that, first consider the details within 10K regarding the ORRI owned by MRT and the economic rights and restrictions afforded.
Economic Rights and Restrictions for a Unit Holder in MRTThe following is excerpted from the 2016 Annual Report.The Trust was created on November 1, 1979. On that date, Mesa Petroleum Co., predecessor to Mesa Limited Partnership ("MLP"), which was the predecessor to MESA Inc., conveyed to the Trust an overriding royalty interest (the "Royalty") equal to 90% of the Net Proceeds (as defined in the Conveyance and described below) attributable to the specified interests in properties conveyed by the assignor on that date (the "Subject Interests"). …Under the Conveyance, the Trust is entitled to payment of 90% of the Net Proceeds (as defined in the Conveyance), realized from Subject Minerals (as defined in the Conveyance), if and when produced from the Royalty Properties…The Conveyance provides for a monthly computation of Net Proceeds. "Net Proceeds" is defined in the Conveyance as the excess of Gross Proceeds, received by the working interest owners during a particular period over operating and capital costs for such period. "Gross Proceeds" is defined in the Conveyance as the amount received by the working interest owners from the sale of Subject Minerals, subject to certain adjustments. Subject Minerals mean all oil, gas and other minerals, whether similar or dissimilar, in and under, and which may be produced, saved and sold from, and which accrue and are attributable to, the Subject Interests from and after November 1, 1979. Operating costs mean, generally, costs incurred on an accrual basis by the working interest owners in operating the Royalty Properties, including capital and non-capital costs. If operating and capital costs exceed Gross Proceeds for any month, the excess plus interest thereon at 120% of the prime rate of Bank of America is recovered out of future Gross Proceeds prior to the making of further payment to the Trust. The Trust, however, is generally not liable for any operating costs or other costs or liabilities attributable to the Royalty Properties or minerals produced therefrom. The Trust is not obligated to return any royalty income received in any period.To chart the above narrative, here is the “waterfall” from mineral production to MRT Income.
In addition to the above “waterfall,” MRT is not obligated to return any royalty income received in any period for any purpose, including losses incurred in future periods. Based on the “waterfall” analysis and the limited liability of future losses, it appears the asset owned by MRT functions more closely with a “profits interest” and less like an ORRI. ORRI’s typically participate at the revenue level and take a percentage off the top. They function much like royalty interests except for certain restrictions on the length of time they can receive royalties and a defined set of wells to which they have rights to production. In contrast, a “profits interest” is defined thusly:
The award consists of receiving a percentage of profits from a partnership without having to contribute capital to the partnership.As the revenues available to MRT must go through several layers of cost for operations, capital expenditures and adjustments for losses incurred in prior periods before flowing through to MRT, the similarities are more akin to a profits interest versus an interest in the revenues (i.e. ORRI).ConclusionThe discussion above is the first of several key differences to understand before using MRT as a comparable company for royalty interest holders. We will discuss the other differences related to MRT in a later blog post, most notably the full reason for the increase in production over the previous five quarters.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.End Notes1 Capital IQ
2 http://durangoherald.com/articles/1773963 http://www.bizjournals.com/houston/print-edition/2014/08/08/linn-energy-snatches-up-hugoton-basin-assets-for.html
Unsolicited Offers for Your RIA
Is the First Bid the Best?
After a fifty-year film collaboration with the James Bond franchise that started with Sean Connery piloting a DB5, Aston Martin pulled out all the stops and created a special model, the DB10, for the 2015 Bond movie, Spectre. At the time, rumors abounded in the car community that the DB10 would go into production as shown in the movie, but it was not to be. Aston Martin only built ten copies of the DB10, made from a stretched wheelbase Vantage and lots of custom sheet metal. Like most concept cars, though, elements of the DB10 design eventually showed up in Aston Martin’s next production car, the DB11.As a rule, concept cars are marketing pieces as much as design studies, rendered to get attention and hold it until the production model (which may bear little resemblance to the concept) is available for purchase. In the case of the DB10, this method worked, as Aston Martin’s launch of the DB11 has been the marque's most successful in history ("success" is relative; Aston Martin has sold fewer cars in its 104-year history than Toyota typically sells in two days).When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer?
"Price" is a sticky wicket that we'll cover in a later post, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes. The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer. And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller. In many cases, though, the initial offer is above what the buyer ultimately wants to pay ("bid it to get it") and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller. If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms. We don't want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements? Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionBond’s DB10 wasn't what it seemed to be. It wasn't the prototype of a production car. It wasn't equipped with Aston Martin's most potent powertrain (what was Q thinking?). It wasn't even built on a "DB" series chassis. It was a movie car, and ultimately a design exercise for Aston Martin to whet the public's appetite for their next production release. That the concept was only a suggestion of the ultimate product is a reasonable metaphor for the relationship between an unsolicited offer and a closed transaction. The offer gets the process started, but it's the process that creates the deal.Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place. The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy. As with most things in life, if something looks too good to be true, it usually is.
Congratulations! Someone Wants to Buy Your RIA. Now What?
A few weeks ago, I spotted a red Alfa Romeo Duetto Spider and my mind immediately wandered to Dustin Hoffman driving a Duetto in the film that launched his career, The Graduate. Of all the small, four-cylinder convertible sports cars produced in the late 1960s, the Alfa Romeo stands out because of its prominence in the film. Fifty years after it was released, The Graduate is still relevant because the plot captures a common theme: life is full of moments of great accomplishment that summarily dissolve into concern over what follows.Hoffman plays Ben Braddock, a newly minted college graduate returning home to Los Angeles. In spite of his successes thus far in life, Ben is disillusioned and nervous about the future. In the midst of his uncertainty, Ben is propositioned by the wife of his father's business partner, Mrs. Robinson. The movie sorts out the ensuing affair between Ben and Mrs. Robinson, and Ben coming to terms with his romantic preference for the Robinsons' daughter, Elaine. About the time he realizes he's in love with Elaine, Ben finds out she's getting married to someone else. He races to the church (the Alfa characteristically runs out of gas before he gets there), interrupts the wedding, and escapes with Elaine on a city bus. In the closing scene, Ben and Elaine sink into their seats and relish their victory, until satisfaction gives way to dread: now what?Around the time I spotted the Duetto, we were working with a client who had received an unsolicited offer to acquire their wealth management firm from one of the many consolidators trying to build national scale in the RIA space. The offer was calibrated to get our client's attention, with language that focused on “unlocking” value and projections of other-worldly financial returns from agreeing to the transaction. Irrational buyers with capacity don’t come along every day, so when a suitor presents themselves as "the one," you better decide if they are genuine or not. If so, say “yes” before they change their mind. If the offer is too good to be true, take a pass. This case was more of the latter.I know this particular consolidator has managed to convince numerous RIAs to join them over the years, so I can’t argue with their approach. Indeed, some of our client's partners seemed more than intrigued by the overture, while others weren't convinced. We were asked to review the offer from a dispassionate perspective and make recommendations to the partners about how to proceed.This wasn't the first time we've been asked to review an unsolicited offer to buy an asset management firm, and it surely won't be the last. As such, we thought it would be worth taking a few blog posts to talk about unsolicited offers, how to approach them, evaluate them, and decide whether to pursue or reject them.Over the course of the next few weeks, we'll cover topics relevant to dealing with overtures from acquirers, including:Be mindful of your own psychology. Selling an asset management firm is an emotional episode disguised with numbers. Don't confuse your own fears and desires with what may be the largest financial decision you'll make in your career.Just because they want you doesn't mean you have to want them back. There is a strategic approach to selling an investment management firm just as there is a strategic approach to acquiring one. Are they solving your problem or are you just solving theirs?Know what you are selling. You will be expected to give things up in exchange for the acquirer's check – and some of the most significant items transacted aren't listed in the purchase agreement.Be ready to value the offer. RIA transactions often include contingent consideration and terms that affect the cash equivalent proceeds of a deal. It is almost unheard of for an RIA acquirer to make payment, take the keys, and be done with the deal.Think about using an intermediary. A third party, compensated to represent you instead of the transaction, can be a powerful way to achieve the best outcome in any transaction.
Like young Ben Braddock, looking back on a successful life so far as a student but not knowing what adulthood will bring, partners in mature asset management firms can simultaneously feel both a sense of great accomplishment at what they've built and a great sense of discomfort at what lies ahead. An unsolicited offer is usually intriguing and sometimes presents a bona fide path forward, but it may also be a threat to everything you value.
We'll be covering more on this next week, but feel free to give us a call if you'd like to talk sooner.
How to Value Overriding Royalty Interests
Given that our own Taryn Burgess is attending the 7th Annual National Association of Royalty Owners (NARO) Appalachia Conference in West Virginia today, we decided to revisit this post (originally published in April 2017). Enjoy!What is a Royalty Interest?Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing or any other expense associated with drilling and producing an oil and gas well.What is an Overriding Royalty Interest (ORRI)?A percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.ORRI’s typically do not own a perpetual interest in the mineral rights. Typically they are structured to have rights to royalties for the term of the lease period. Royalty interests, on the other hand, generally have mineral ownership into perpetuity, even after a lease expires. Thus the main difference between royalty interests and ORRI’s is that royalty interests are tied to the ownership of the mineral rights below the surface, and ORRI’s are tied to the lease agreement and ceases to exist once the lease expires.Some may find it surprising that the popular publicly traded Permian Basin Royalty Trust (PBT) only owns ORRI’s, not royalties, in various oil and gas properties in the United States. PBT owns a 75% net ORRI in the Waddell Ranch properties comprising Dune, Judkins, McKnight, Tubb, University-Waddell, and Waddell fields located in Crane County, Texas. As of December 31, 2016, its Waddell Ranch properties contained 349 net productive oil wells, 64 net productive gas wells, and 102 net injection wells.The company also holds a 95% net overriding royalty in the Texas Royalty properties that consist of various producing oil fields, such as Yates, Wasson, Sand Hills, East Texas, Kelly-Snyder, Panhandle Regular, N. Cowden, Todd, Keystone, Kermit, McElroy, Howard-Glasscock, Seminole, and others located in 33 counties in Texas. Its Texas Royalty properties consist of approximately 125 separate ORRI’s containing approximately 51,000 net producing acres.Over the past four years, crude oil and gas prices have fluctuated significantly. While this is creating significant volatility on the E&P side of the industry on both an operational and investment decision level, many look at royalty trusts as a way to bypass the complexities of an operating E&P and attempt to “pure play” the price of oil and gas. Based on this assumption, we will analyze the changes PBT has endured over the past four years.Production
PBT derives revenue from ORRI’s which cover approximately 382,000 gross acres (85,205 net acres) in west Texas. Since the ORRI’s that PBT owns were not derived from a 100% working interest, their gross acreage differs from their net acreage. Net acreage is calculated as the company’s percentage interest multiplied by its gross acreage. Over the past four years, the amount of acreage has not changed. Production, on the other hand, has changed significantly as shown in the table below.
Comparing the production levels to the price levels of oil and gas indicates that even after the decline in oil and gas prices during 2014, production increased during 2015. Oil production increased 3% while gas production increased 44%. The increased production was in part due to the 3 new wells drilled during 2014, 3 workovers completed during 2014 and 29 wells completed during 2014 and 2015.
During 2016, investment activity was significantly different which resulted in a 28% decline in oil production and 33% decline in gas production. No wells were drilled and completed during 2016. Only 1 workover was performed. Clearly, the operators were holding back capital as they waited for more price certainty in the future.
Reserves
The change in reserves tells the same story. After investing in the drilling and completion of new wells, and workover wells, the proved reserves increased from 2014 to 2015 for both oil and gas. The increase is significant as reserves are impacted by (1) investment in new/existing wells and (2) future prices of oil and gas. The price utilized in the 2015 reserves was significantly lower than what was used in the 2014 reserves. Therefore, the increase in reserves is significant as the additional proved reserves more than countered the reduction in the commodity prices in the reserve model.
For 2016, the reserves declined due to the lack of investment in current and future wells. And while pricing stayed relatively the same from 2015 to 2016, the loss in proved reserves was directly attributed to the lack of investment in new and existing wells.
Distributions
PBT is at its lowest yield in the last four years. While the price was lower at the end of 2015, the dividend as a percentage of price was higher in 2015 relative to 2016. The above chart shows the impact of (1) changes in oil and gas prices; as well as (2) changes in production levels. These two areas are directly related to the dividend per share. The price, however, is directly related to the movement of buyers and sellers of PBT securities. While the dividend is “trailing” information, because it is the result of the previous 12 months of activity, the price factors in forward-looking information. For example, as of 2013, buyers and sellers of PBT were expecting higher dividends in 2014 due to the high price of oil and gas, PBT’s investment in wells and increasing proved reserves1. When commodity prices declined during 2014, the price quickly reflected the new pricing environment, the impact on reserves, and the shift in management’s investment attitude for new and existing wells. All of these factors pressured prices downward while the trailing dividends showed strength, resulting in a higher than normal yield. During 2015 and 2016, the price, dividend, and yield settled to relatively tempered levels. All data points above have had enough time to reflect the current environment and as such, are communicating a similar story.
Finishing ThoughtWhen valuing a royalty interest or ORRI, here are a few items to keep in mind:Understand the rights and restrictions of the subject royalty interest:
Royalty interests may have value into perpetuity as it is a direct ownership in the minerals;ORRI’s typically only have value for the life of the lease;Understand the differences between the subject ORRI and a publicly traded security that owns ORRI’s and make adjustments for the differences;Understand the historical, current and future outlook for commodity prices relating to the subject ORRI;Understand the historical, current and future outlook for reserves;Utilize publicly traded yields to assess the market's attitude for investments in similar securities; andAdjust for the differences between a publicly traded security and a non-marketable security.
When comparing a royalty interest to an ORRI, it is critical to understand the subtle nuances of the rights and restrictions between the two. Owners of royalty interests utilizing PBT as a valuation gauge should adjust for such differences as well as other differences between publicly traded and non-marketable securities. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
End Note1 Although not shown in the above chart, proved reserves increased 32% between 2012 and 2013 for PBT
ASU 2016-01: Recognition and Measurement of Financial Assets and Liabilities
It’s Not CECL, But It Could Affect YouComplying with the revised disclosure requirements of ASU 2016-01 may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. In listening to presenters at the recent AICPA National Conference on Banks & Savings Institutions, we gathered that some banks are taking their first fitful steps toward implementing the pending accounting rule governing credit impairment. Bankers should not lose sight, however, of another FASB pronouncement that becomes effective, for most banks, in the first quarter of 2018. Accounting Standards Update No. 2016-01 addresses the recognition and measurement of financial assets and liabilities.History of ASU 2016-01A long and winding history preceded the issuance of ASU 2016-01. In 2010, the FASB drafted a predecessor to ASU 2016-01, which required that financial statement issuers carry most financial instruments at fair value. As a result, assets and liabilities presently reported by banks at amortized cost, such as loans, would be marked periodically to fair value. This proposal was almost universally scorned, satisfying neither financial statement issuers nor investors. The FASB followed with a revised exposure draft in 2013, which maintained amortized cost as the measurement methodology for many financial instruments. Stakeholders objected, however, to a new framework in the 2013 exposure draft that linked the measurement method (fair value or amortized cost) to the nature of the investment and the issuer’s anticipated exit strategy. The FASB agreed with these concerns, eliminating this framework from the final rule on cost/benefit grounds.The final pronouncement issued in January 2016 generally maintains existing GAAP for debt instruments, including loans and debt securities. However, the standard modifies current GAAP for equity investments, generally requiring issuers to carry such investments at fair value. Restricted equity securities commonly held by banks, such as stock in the Federal Reserve or Federal Home Loan Bank, are excluded from the scope of ASU 2016-01; therefore, no change in accounting for these investments will occur. Excluding these restricted investments, community banks typically do not hold equity securities, and we do not discuss the accounting for equity investments in this article. Interested readers may wish to review a previous Mercer Capital article summarizing certain changes that ASU 2016-01 makes to equity investment accounting.Entry vs. Exit PricingWhile ASU 2016-01 maintains current accounting for debt instruments, it does contain several revisions to the fair value disclosures presented in financial statement footnotes. Originally issued via SFAS 107, these requirements were codified in ASC Topic 825, Financial Instruments. Although ASU 2016-01 makes several changes to the qualitative and quantitative disclosures that are beyond the scope of this article, the most significant revisions are as follows:“Public Business Entities” must report the fair value of financial instruments using an “exit” price concept, rather than an “entry” price notion.1Non-Public Business Entities are no longer required to present the fair value of financial instruments measured at amortized cost, such as loans, in their footnote disclosures. Current GAAP is ambiguous regarding whether the fair value of financial instruments measured at amortized cost should embrace an “entry” or “exit” price notion. According to the FASB, this has led to inconsistent disclosures between issuers holding otherwise similar financial instruments. Certain sections of ASC Topic 825, which carried over from SFAS 107, could be construed as permitting an “entry price” measurement. For example, existing GAAP provides an illustrative footnote disclosure describing an entity’s fair value estimate for loans receivable:The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. [ASC 825-10-55-3, which is superseded by ASU 2016-01]By referencing “current rates” on “similar loans,” the guidance implicitly suggests an “entry” price notion, which represents the price paid to acquire an asset. Instead, ASC Topic 820, Fair Value Measurement, which was issued subsequent to SFAS 107, clearly defines fair value as an exit price; that is, the price that would be received upon selling an asset.Limitations of ALCO ModelsIn our experience, banks often use fair value estimates derived from their asset/liability management models in completing the fair value footnote disclosures for loan portfolios. Reliance on ALCO models suffers from several weaknesses when viewed from the perspective of achieving an exit price measurement:The discount rates applied in the ALCO model to the loan portfolio’s projected cash flows utilize current issuance rates on comparable loans. In certain market environments, the entry price for a loan portfolio developed using this methodology may not differ materially from its exit value. However, this approach becomes problematic when economic or financial market conditions suddenly change or the bank ceases underwriting certain loan types.The treatment of credit losses is not directly observable. Instead, the ALCO model implicitly assumes that the discount rates applied to the portfolio’s projected cash flow capture the inherent credit risk. However, this process does not necessarily correlate the fair value measurement to underlying credit risk. For example, a bank’s automobile loans underwritten in 2015 may be underperforming expectations at origination and also performing poorly compared with 2016 and 2017 originations. The fair value measurement should not apply the same discount rate to each vintage, given the disparate credit performance.Compliance GuidanceComplying with the revised disclosure requirements of ASU 2016-01, therefore, may necessitate that banks adopt new methodologies to determine the fair value of the bank’s loan portfolio. Mercer Capital has significant experience in determining the fair value of loan portfolios from which we offer the following guidance:ASC 820 emphasizes the use of valuation inputs derived from market transactions, but such transactions seldom occur among loan portfolios similar in nature to those held by community banks. If available, market data should take precedence.Absent market transactions, banks will rely on a discounted cash flow analysis to determine an exit price. To a limited extent, this is consistent with current ALCO modeling, but achieving an exit price requires additional considerations. While valuation should be tailored to each portfolio’s characteristics, certain common elements are embedded in Mercer Capital’s determinations of a loan portfolio’s exit value:Contractual cash flows. Consistent with current ALCO forecasting models, contractual cash flow estimates should be projected using a loan’s balance, interest rate, repricing characteristics, maturity, and borrower payment amounts.Loan Segmentation. To create homogeneous groups of loans for valuation purposes, the portfolio should be segmented based on criteria such as loan type and credit risk. Credit risk, as measured by metrics such as delinquency status or loan grade, can be manifest in the fair value analysis either through the credit loss forecast or the discount rate derivation.Prepayments. The contractual cash flows should be adjusted for potential prepayments, based on market estimates, as available, or the bank’s recent experience.Credit Losses. If not considered in the discount rate derivation, the projected cash flows should be adjusted for potential defaulted loans. In a fair value measurement this is a dynamic, forward-looking concept. It also is consistent with the notion in the Current Expected Credit Loss model—which underlies the recent FASB pronouncement regarding credit losses—that credit losses should be measured over the life of the loan.Discount Rate. The discount rate should be viewed from the perspective of a market participant, given current financial conditions and the nature of the cash flow forecast. Mercer Capital often triangulates between different discount rate approaches, depending on the strength of available data. For example, we may consider (a) a weighted average cost of funding the loan, (b) market yields on traded instruments bearing similar risk, or (c) recent offering rates in the market for similar credit exposures. Mercer Capital has developed fair value estimates for a wide variety of loan portfolios, on an exit price basis, ranging in size from under $100 million to over $1 billion, covering numerous lending niches, and possessing insignificant to severe asset quality deterioration. We have the resources, expertise, and experience to assist banks in complying with the new requirements in ASU 2016-01. This article originally appeared in Mercer Capital's Bank Watch, September 2017.End Note1 The definition of a “public business entity” is broader than the term may suggest. A registrant with the SEC is clearly a PBE, but the definition also includes issuers with securities “traded, listed, or quoted on an exchange or an over-the-counter market” (emphasis added). A number of banks “trade” on an over-the-counter market and therefore would appear to be deemed PBEs, even if they are not an SEC registrant. The following entities are also deemed PBEs:Entities filing Securities Act compliant financial reports with a banking regulator, rather than the SEC.Entities subject to law or regulation requiring such institutions to make publicly available GAAP financial statements, if there are no contractual restrictions on transfer of its securities.
Trends in the Refining Industry Display Cautious Optimism
A general theme across refiners' earnings calls and updates over the last few months was a story of cautious optimism. In this blog post, we outline prevalent general themes in the downstream oil market that have given refiners hope for 2018 as well as those that cause skepticism about the future.Sweet & Sour DifferentialThe price differential between light, sweet crude and heavy, sour crude has been shrinking since the fall of oil prices in 2014. From a max differential of $42.50 in December 2012, the differential has fallen to an average of $11 over the last month."OPEC cuts have impacted the available supply of medium and heavy sour grades resulting in narrow feedstock differentials which is a challenge to our complex refining system." – Thomas J. Nimbley, Chairman and CEO at PBF Energy on Second Quarter Earnings Call
The differential has been shrinking as the global supply of oil has remained high causing crude benchmark prices to converge. Since the price of light, sweet U.S. crude has fallen, the cost savings that companies used to realize when purchasing heavy feedstock cannot make up for the higher costs of cracking it.Retrofitting RefineriesAs explained by Canada Oil Sands Magazine, "Refineries typically blend different grades of crude with varying quality specifications. Depending on the configuration of the refinery, each facility has a limited ability to handle heavy grades of crude and Sulphur." U.S. refineries were traditionally retrofitted to handle heavy crude because it allowed for higher refining margins. The U.S. traditionally has more complex refineries than Europe and Canada, which allows them to better crack heavy molecules into light, value-add products, such as jet fuel.However, starting in mid-2014, US refiners began struggling to keep up with the amount of light sweet crude available for sale in the US markets since most refineries were not built to handle such light crude. It was thought that the initial relaxation and eventual elimination of the crude oil export ban would relieve US refiners from this pressure. But the over-supply of oil across the globe dampened this effect.Because the price of light, sweet crude and heavy, sour crude has started to converge, there is potential for higher margins from light crude. Even if refiners have to pay the upfront investment costs to retrofit their facilities to handle lighter crude, they can face lower operating expenses going forward as it is easier to refine light crude than heavy crude into higher margin products."We expect to see improved margin capture as we are now able to upgrade components of our gasoline pool into higher octane, low sulfur finished product."
-Thomas J. Nimbley, Chairman and CEO at PBF Energy on Second Quarter Earnings CallWidened Crack SpreadThe crack spread is the price differential between crude oil and its refined oil products. The 3-2-1 crack spread approximates refinery yield using the industry average for refinery production. For every three barrels of crude oil the refinery processes, it makes two barrels of gasoline and one barrel of distillate fuel.
The crack spread is a good indication of refiners' profit margins. As shown in the chart above, the WTI crack spread increased over the first half of the year giving the downstream markets optimism about the rest of the year to come. The crack spread peaked at the end of August as many refiners were forced to shut down due to damage caused by Hurricane Harvey and the price of refined products spiked. The spread has since fallen to approximately $17 per barrel of WTI.
"The decrease to refining margin was primarily driven by the higher RINs cost, which were partially offset by the increase in the Group 3 2-1-1 crack spread."
– Susan M. Ball, CFO & Treasure of CVR Refining GP LLC on CVRR’s Second Quarter Earnings CallHigher RIN CostsThe Renewable Fuels Standards (RFS) Program has continued to have a significant impact on the refining sector over the last year. The RFS were signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. RINs (Renewable Identification Numbers) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA’s Moderated Transaction System. While large, integrated refiners have the capability to blend their petroleum products with renewable fuels, small- and medium-sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price.RIN expenses have remained high and although President Trump promised to help small- and medium-sized merchant refiners who were disadvantaged by RFS, he also spoke fondly of the RFS program during his campaign.On July 5, 2017, the EPA issued proposed volume requirements under the Renewable Fuel Standard program, which are summarized below.
A public hearing was held on August 1, 2017, and on October 17, 2017, the EPA provided a public notice and an opportunity to comment on potential reductions in the 2018/ 2019 biomass-based diesel, advanced biofuel, and total renewable fuel volumes. The final rule should be available in December.
ConclusionRefiners were generally optimistic about their performance over the first six months of 2017. Higher crack spreads have allowed margins to increase and many believe that the Trump administration will help relieve some of the pressure caused by the RFS. Additionally, it is possible that the RFS volume requirements could be reduced further which would relieve margin pressure for merchant refiners.The quote below from HollyFrontier’s second-quarter earnings call appropriately summarizes the current state of the industry."Our refining outlook for 2017 remains cautiously optimistic. We anticipate solid economic growth will continue to support refined product demand and sustained growth in domestic crude oil production will lead to improved crude differentials. We are also optimistic that a more favorable regulatory environment could provide a tailwind for both the refining industry and the economy as a whole. With a large portion of our scheduled maintenance behind us, we are poised for strong financial and operational performance for the remainder of the year."
– George J. Damiris, CEO, President, & Director at HollyFrontier – on Second Quarter Earnings CallMercer Capital has significant experience valuing assets and companies in the energy industry, throughout the upstream, midstream, and downstream sectors. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Asset Manager Deal Activity Accelerates, Still Room to Run
RIAs have long faced structural headwinds and consolidation pressure from increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers. While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation. Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Current Consolidation ConsiderationsConsolidation pressures appear to have reached critical mass in the last several years, and M&A activity has picked up notably as a result. M&A activity in 2017, in particular, is on track to reach the highest level in terms of deal volume since 2009.
For publicly traded asset managers, at least, the market seems to view recent M&A activity favorably. Amundi has returned 46% year-to-date (as of October 20) after announcing the acquisition of Pioneer Investments last December. Aberdeen was up 15% through May 31 after agreeing to be acquired by Standard Life in March. KKR shares have risen 20% since April 19, when an investor group led by Stone Point Capital and KKR agreed to buy a majority stake in RIA aggregator Focus Financial Partners.
Recent increases in M&A activity come against a backdrop of a now eight-year-old bull market. Steady market gains, particularly in 2017, have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years. In 2016, for example, active mutual funds’ assets grew from $10.7 trillion to $11 trillion, despite $400 billion in net outflows according to data from Bloomberg. As a result, profitability has been steadily increasing despite industry headwinds that seem to rationalize consolidation.
It's unclear whether this positive market movement has been a boon or a bane to M&A activity. On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go. In that case, better to sell sooner rather than later. And vice versa from a buyer’s perspective. On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore. In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market.
We saw the effect a market downturn can have on M&A activity during 2009 when deal volume reached record levels as many distressed firms were sold. The M&A activity spurred by the 2009 downturn was short-lived, however. Deal volume was largely subdued between 2010 and 2013. The fallow period ended in 2014, and deal activity has accelerated since then while broad market indices have marched higher.
ConclusionIt seems likely that asset manager deal activity will continue to gain speed regardless of which way the markets are moving, although a market downturn could certainly expedite consolidation. Asset managers face secular trends that threaten lower revenue and higher costs. On the top line side, assets continue to flow into low fee passive funds at a good clip. On the cost side, an evolving regulatory environment threatens increasing compliance costs. Consolidation allows asset managers to spread compliance costs over a larger AUM base and increase distribution channels and product offerings, thereby combating revenue and cost pressure.But if a protracted bear market does materialize, margins will face pressure not only from the evolving industry dynamics but also from evaporating AUM. A significant market downturn may highlight the consolidation pressures in the industry and catalyze a larger wave of M&A activity.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
What Kind of Value is Statutory Fair Value?: Kentucky Supreme Court Provides Guidance
In 2012, Chris Mercer, CEO, wrote about a recent appellate level case in Kentucky addressing the question of statutory fair value in Kentucky. Given several recent conversations with Kentucky clients, a revisit of that case is appropriate.For further information about statutory fair value, see this e-book by Chris Mercer.In the case, Shawnee Telecom Resources, Inc. v. Kathy Brown, the Kentucky Supreme Court provides a number of interesting insights into the evolution of statutory fair value in the various states, and, in this matter, in Kentucky.A Bit of Kentucky HistoryKentucky has had an interesting history regarding statutory fair value. For many years, the leading case on the issue was a Court of Appeals decision in Ford v. Courier-Journal Job Printing Co., 639 S.W.2d 553 (Ky App. 1982). This case allowed the application of a 25% marketability discount, and was the reigning precedent for nearly thirty years.The Ford case was overruled by another Court of Appeals decision in Brooks v. Brooks Furniture Mfgrs., Inc. 325 S.W.3d 904 (Ky. App. 2010). The Court of Appeals explicitly overruled Ford with respect to the application of the marketability discount. However, the Court of Appeals also rejected the use of the net asset value method. Enter the Kentucky Supreme Court:The case before us presents squarely the broad issue of "fair value" and the more specific issues of the continuing viability of a marketability discount in a dissenters' rights appraisal action and the appropriateness of valuing closely held corporate stock under the net asset method. Having thoroughly considered the statute [Subtitle 13 of the Kentucky Business Corporation act, Kentucky Revised Statutes (KRS) Chapter 271B] and its underlying purpose, we conclude that "fair value" is the shareholder's proportionate interest in the value of the company as a whole and as a going concern. Any valuation method generally recognized in the business appraisal field, including the net asset and the capitalization of earnings methods employed in this case can be appropriate in valuing a given business....[emphasis added]Fair Value Is Enterprise ValueWhat is fascinating about this case is that the Kentucky Supreme Court seems not only to have understood the concepts underlying what we in the business appraisal profession call the levels of value, but also reflected that understanding in clearly written prose. The levels of value charts are shown below:
The traditional, three-level chart is shown on the left. The chart that is generally recognized by most writers in the field now is the four-level chart on the right. The levels at (or) above that of the marketable minority level are referred to as enterprise or entity levels of value. Values at the enterprise levels are developed based on the expected cash flows, risks and expected growth of the enterprises, or as noted above, "the value of the company as a whole and as a going concern."
The level below that of marketable minority is the nonmarketable minority level of value. This is the shareholder level of value. Value at this level is based on the expected cash flows, risks and expected growth pertaining to a particular shareholder's interest in the business. Intuitively, most people recognize that the value of an illiquid minority interest in a business is most often worth less than that interest's proportionate share of enterprise value.
The Kentucky Supreme Court understands the distinction, as is clear in the following:
As for applying a marketability discount when valuing the dissenter's shares, we join the majority of jurisdictions which, as a matter of law, reject this shareholder-level discount because it is premised on fair market value principles which overlook the primary purpose of the dissenters' appraisal right -- the right to receive the value of their stock in the company as a going concern, not its value in a hypothetical sale to a corporate outsider. However, generally recognized entity-level discounts, where justified by the evidence are appropriate because these are factors that affect the intrinsic value of the corporate entity as a whole. [emphasis added]Fair Value Is Not Shareholder Level ValueThis language regarding entity level valuation is consistent with the recent case I wrote about from the South Dakota Supreme Court. The post was titled Statutory Fair Value (South Dakota): Customer Risk Consideration is not a Valuation Discount. The point of that case was that it is inappropriate to lump entity-level adjustments into so-called valuation discounts like the minority interest discount or the marketability discount.The Kentucky Supreme Court reviewed a good bit of history pertaining to statutory fair value. In so doing, a number of important points were made to clarify the meaning of fair value in Kentucky.Because an award of anything less than a fully proportionate share would have the effect of transferring a portion of the minority interest to the majority, and because it is the company being valued and not the minority shares themselves as a commodity, shareholder level discounts for lack of control or lack of marketability have also been widely disallowed.
Fair value should be determined using the customary valuation concepts and techniques generally employed in the relevant securities and financial markets for similar businesses in the context of the transaction giving rise to appraisal (quoting Principles of Corporate Governance: Analysis and Recommendations § 7.22(a) (ALI 1994))
...[W]e find a broad consensus among courts, commentators, and the drafters of the Model Act that "fair value" in this context is best understood, not as a hypothetical price at which the dissenting shareholder might sell his or her particular shares, but rather as the dissenter's proportionate interest in the company as a going concern.
Because a hypothetical market price for the dissenter's particular shares as a commodity is thus not the value being sought, market adjustments to arrive at such a price, such as discounts for lack of control or lack of marketability, are inappropriate.An Amicus Brief was filed by the Kentucky Chamber of Commerce that suggested that dissenting shareholders might obtain a windfall in an appraisal proceeding if the typical valuation discounts were not applied. The logic was that there would be a likelihood that the minority shareholder purchased his or her shares at a discounted level and that if they were bought out at undiscounted levels, there could be a windfall to them. This logic was dismissed by the court. Dissenters are not voluntary participants in transactions, and therefore need to be protected.The court also found that the net asset value method, appropriately considered in the value of an enterprise, was an appropriate valuation method.Entity-Level Discounts Are AppropriateThe Kentucky Supreme Court was specific that entity-level discounts, where supported by the evidence, are acceptable. Shawnee argued that, if a marketability discount was not allowable at the shareholder level, one should be available at the entity level. The court was wary of this argument, stating:We agree [that a marketability discount at the entity level could be applicable] but with the strong caveat, that any entity level discount must be based on particular facts and authority germane to the specific company being valued, i.e., there can be no automatic 15-25% discount of the whole entity's value simply because it is closely held and not publicly traded.The court listed a number of "recognized entity-level discounts" that could be appropriate in specific circumstances, including a key manager discount, a limited customer [see the South Dakota Supreme Court's analysis of this one] or supplier base discount, a built-in capital gains discount, a "portfolio" discount, a small size discount or a privately held company discount.The court referred to Shannon Pratt's book, Business Valuation Discounts and Premiums when discussing this list of discounts.Immediately following this list of entity-level discounts, the court emphasized the distinction between entity-level and shareholder-level discounts, which I quote because of the importance of the discussion:As noted above, the distinction between entity-level and shareholder-level discounts is recognized in the business valuation literature, Shannon P. Pratt, Business Valuation Discounts and Premiums, p. 3 (2001) [linked above], and was referred to in Cavalier, where the Court observed that shareholder-level discounts, such as those for lack of control and lack of marketability, tend to defeat the protective purpose of the appraisal remedy by transferring a portion of the dissenter's interest in the company to the majority. Entity-level discounts, on the other hand, take into account those factors, such as a company's reliance on a key manager, that affect the value of the company as a whole..."Cavalier authorized corporate level discounting as a means of establishing the intrinsic value of the enterprise." Where such entity-level adjustments are proper, they should be incorporated into the valuation technique employed, and the appraiser should be able to cite the relevant facts and authority for making the adjustment. (emphasis added)The Court then discussed the Delaware Chancery Court's rejection of "the sort of marketability discount that the court applied." Borruso v. Communications Telesystems International, 753 A.2d 451 (Del. Ch. 1999). While holding that an appraiser might properly support a discount based on privately held companies selling at lower multiples than publicly traded companies, the court found that there was insufficient evidence to support the discount applied. The court cited, among other things, my article "Should Marketability Discounts Be Applied to Controlling Interests in Companies?" in the June 1994 edition of Business Valuation Review [subscription required. Email me if you'd like a copy].As if to hammer the point home, the Court stated:On remand, Shawnee is free to present evidence tending to show that its going concern value is lessened by such factors as its small size and its private nature, but otherwise it is not entitled to a discount based simply on the generally perceived lack of marketability of closely held corporate shares.ConclusionThe conclusion of Shawnee is instructive:In sum, we agree with the Court of Appeals that Ford [applying a marketability discount] has outlived its usefulness and does not provide a suitable interpretation of the appraisal remedy currently available under KRS Subchapter 271B.13. under that subchapter, a properly dissenting shareholder is entitled to the "fair value" of his or her shares, which is the shareholder's proportionate interest in the value of the company as a whole as a going concern. Going concern value is to be determined in accord with the concepts and techniques generally recognized and employed in the business and financial community. Although the parties may, and indeed are encouraged to, offer estimates of value derived by more than one technique, the trial court is not obliged to assign a weight to or to average the various estimates, but may combine or choose among them as it believes appropriate given the evidence. If the particular technique allows for them, adequately supported entity-level adjustments may be appropriate to reflect aspects of the company bearing positively or negatively on its value. Once the entire company has been valued as a going concern, however, by applying an appraisal technique that passes judicial muster, the dissenting shareholder's interest may not be discounted to reflect either a lack of control or a lack of marketability....A careful reading of this case indicates that the Kentucky Supreme Court warns courts (and appraisers) that shareholder-level discounts disguised as entity-level adjustments are not appropriate.In terms of the levels of value chart above, fair value in Kentucky could be interpreted to be the functional equivalent of fair market value at the entity-, or enterprise level. What is not clear, however, is whether the Kentucky Supreme Court would embrace valuation in dissenters' rights matters at the strategic control level. The case addressed protections afforded by the Kentucky statute to dissenting, generally minority, shareholders. There was no discussion of taking into account any potential synergies that might occur in a strategic or synergistic sale of the business.Perhaps, the answer lies in the language used in a conclusory statement noted above:... we conclude that "fair value" is the shareholder's proportionate interest in the value of the Company as a whole and as a going concern.If a company is valued "as a whole" and as a "going concern," it may be difficult to argue that the implied combination with another entity in a strategic valuation is appropriate.The Court is clear that there can be no downward bias from entity-level valuation to the shareholder level of valuation in Shawnee. However, the issue of any upward bias in statutory fair value determinations was not addressed in the case.Originally published on ChrisMercer.net | October 19, 2017
What's My RIA Worth?
It is important to know the current value of your investment management firm and understand valuation concepts in order to:Know how to build the value of your investment management firm;Know how to evaluate opportunities to sell your firm; and,Have a basis for discussing internal ownership transition issues.In this 60-minute webinar, Matt Crow and Brooks Hamner, who work with RIAs throughout the country on valuation-related issues, will address the following:How to normalize cash flow to determine the profitability of a RIAHow to compare different investment management firms to determine what risk-adjusted valuation multiples to applyHow to evaluate the growth potential of one firm relative to the industry or relative to other firmsWhat public company multiples say about how a private RIA is valuedAre industry transaction multiples a useful benchmark in valuing an investment management firm?
Held (or Held Up?) by Production
Oftentimes differences are a matter of perspective. Put another way – one person’s loss can be another person’s gain. One of the thematic differences between producers and mineral owners is their perspective on "Held By Production." It elicits very different reactions depending on what side of the term one is on, and has a leverageable impact on value. In this post, we decided to spend some time exploring this concept and its impact on the energy industry.What Is "Held By Production"?Held By Production ("HBP") is a mineral lease provision that extends the right to operate a lease as long as the property produces a minimum quantity of oil and gas. The definition of HBP varies contractually by every lease it governs which is often misunderstood. We have had discussions with a number people, including peers (as well as knowledgeable industry participants) who did not have a clear grasp of HBP and its exact meaning. Some people thought HBP was governed by state law, regulatory agencies, or even accounting rules. However, the truth is that the facts and circumstances that shape a lease as it pertains to HBP are all negotiable. Therefore, by extension, the outcome of lease negotiations can have a spectrum of results: from being deemed balanced, to favoring the lessor (i.e., the mineral owner) or the lessee (i.e., the producer).
When we attended the NAPE Expo this summer, presenters from Wood Mackenzie pointed out that a trend on recent analyst calls was for management teams of operators to highlight the percentage of their leases that were HBP (they mentioned that the Permian Basin was about 95% HBP due to decades of prior drilling). Operators want investors to note this and (hopefully) be more attracted to their stock.
Why might someone be more attracted to an operator’s stock that has a large percentage of leases HBP? Investopedia puts it this way:The "held by production" provision enables energy companies to avoid renegotiating leases upon expiry of the initial term. This results in considerable savings to them, particularly in geographical areas that have become "hot" due to prolific output from oil and gas wells. With property prices in such areas generally on an upward trend, leaseholders would demand significantly higher prices to renegotiate leases.What Does "Held By Production" Mean to Mineral Owners (Lessors)?Mineral owners should have an understanding of how their lease terms impact drilling activity (and by extension – royalty payments) on their properties (a thematic element of the summer NARO conference). Lessors are challenging operators’ decisions not to drill on their land, even if prospects appear to be good. As a result, mineral owners are more interested in how certain clauses and term structures function in their leases. A session at the NARO conference centered on how mineral owners could legally terminate their lease in order to re-lease their property to a more "motivated" or even "competent" operator.Therefore, it is important for mineral owners to understand two lynchpin concepts as they pertain to defining HBP: the Pugh Clause and the Implied Covenant to Develop.Pugh ClauseThe Pugh Clause is named after Lawrence Pugh, a Crowley, Louisiana attorney who developed the clause in 1947, apparently in response to the Hunter v. Shell Oil Co., 211 La. 893 (1947). In this case the Louisiana Supreme Court held that production from a unit, including a portion of a leased tract, will maintain the lease in force as to all lands covered by the lease even if they are not contiguous.
This clause is most often cited in today in pooling for horizontal wells. There have been situations (depending on the clause’s language) whereby one well might maintain a large area (thousands of acres) defined as HBP. This is to an operator’s advantage and a mineral holder’s chagrin.
However, this can be negotiated to the mineral holder’s favor – particularly in active markets and basins. For example, we had a client that had a large tract of land in the Eagle Ford shale and was being courted by a number of eager operators. Ultimately, they negotiated a lease with an operator who contractually obligated the company to drill three wells per year on the property for the duration of the lease. Not too long after the lease was negotiated, the price of oil dropped in half and the operator was much less enthusiastic about having to drill three wells per year.
There are a number of nuances and factors to Pugh clauses (and similar lease clauses) that we won’t explore here, but suffice to say, it is a critical factor to defining a property as HBP or not.Implied Covenant to DevelopAnother aspect of lease law is centered around the concept called "Implied Covenant to Develop." Sometimes a lessors' alternative is to attempt to find remedy through the implied obligation that the lessee failed to develop and operate the property as a reasonably prudent operator. Forcing an implied obligation generally occurs through a lawsuit and is difficult to prove. However, implied covenants have been addressed by courts from all producing states as well as the Supreme Court of the United States.There are several potential examples One example is discussed on a Gas & Oil Law blog:Consider an oil and gas lease taken on 200 acres. Let’s say that thirty years ago one well was drilled on the 200 acre lease, and that this well unit only included 40 acres. Under the implied covenant to reasonably develop, a judge may very well cancel the lease to the remaining, unused 160 acres (200 acres – 40 acres = 160 acres). How could a judge do that? The basic question that needs to be answered is whether or not the oil and gas producer has behaved as a reasonable oil and gas producer would in similar circumstances. If any reasonable producer would have drilled more than one well on the 200-acre lease, then a reviewing judge might void the lease to the remaining 160 acres. However, if the existing well was not a very good well, then it might be that the producer did behave reasonably when they decided not to drill additional wells.ConclusionDepending on which side of the negotiation one is on, HBP can be a favorable (or unfavorable) contributor to value. As such, it's crucial to have an analyst who possesses knowledge from all sides of industry negotiations.Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.
Recent Trends in Asset Management
This week, we’re sharing some recent media on trends in asset management, including the breakaway broker phenomenon, M&A activity, and the ongoing shift towards passive products. Most industry observers foresee a continued flight from traditional wirehouses, an uptick in M&A activity spurred by increasing competitive pressures, and further fee pressure from passive products as we move towards a new equilibrium. Switching From Wirehouse to RIA – AUM And Revenue Requirements To Break AwayBy Michael Kitces
We wrote last month about advisors shifting from traditional wirehouses to independent RIAs, and this post by industry consultant Michael Kitces offers a deep dive into the economics of the switch from an advisor’s perspective.RIAs Poised to Land Wirehouse RecruitsBy Dan Jamieson
Going independent doesn’t have to mean starting from scratch: wirehouse advisors are increasingly a recruiting channel for existing independent RIAs, according to this piece by industry observer Dan Jamieson.Advisor Platform Comparison: Wirehouse vs RIA Aggregator vs Independent RIABy Aaron HattenbachIn this guest post which appeared on Michael Kitces’ blog, industry insider Aaron Hattenbach offers perspective gleaned from his own experience on the relative merits of wirehouses, RIA aggregators, and fully independent RIAs, each of which he has worked at.UBS is ‘Constantly Approached’ About Asset-Management UnitBy Patrick WintersThis article from Bloomberg underscores the potential for a new wave of deals in the asset management space: UBS Chief Financial Officer Kirt Gardner indicates that UBS is “constantly approached” regarding its asset management unit.Path to Growth: Why RIA firms leverage M&A as a growth strategyBy Christopher V. Gunderson
Increasing operational and compliance costs combined with downward fee pressure may be forcing consolidation in an industry where historically M&A activity has been sparse: according to a survey by InvestmentNews, 44% of RIAs plan to pursue M&A deals over the next five years.Why Critics of Passive Investing Are WrongBy: Kent Smetters
Somewhere there’s equilibrium between active and passive asset management, and wherever that equilibrium may be, we are not there yet according to this WSJ piece by University of Pennsylvania Wharton School Professor Kent Smetters.
How Do Post-Production Deductions Affect the Value of Your Oil and Gas Royalty Interest?
I recently attended the National Association of Royalty Owners (NARO) National Convention in Dallas, Texas. The seminars on lease negotiations, mineral management, shale drilling, and more were all interesting and informative, but there was one topic that was brought up in almost every session: Post-Production Deductions (PPDs).From the first Board Meeting to the last session of the conference, post-production deductions were discussed in great detail. Why were these deductions brought up time and time again? Because post-production deductions affect the value of a mineral owner’s interest yet the regulations surrounding them is somewhat unclear and exists mainly on a contractual basis.What are Post-Production Deductions?The Marcellus Shale Coalition defines post-production deductions (PPDs) as “the expenses incurred in order to get the gas from the wellhead to market.” These costs include gathering, compression, processing, marketing, dehydrating, transportation, and more. PPDs vary significantly between operators and between oil fields because the quality of the products and the distance to market differ.In its raw form, natural gas has little value. In order to make it more marketable, the gas has to be processed so that it is ready to be transported and sold. When an operator markets the product so that it can be sold at a higher price, the royalty owner also benefits if the new net price is greater than the price they would have received.Are PPDs legal?Royalty interests represent a share of net revenue, which means that royalty owners get their share of gross revenue and their share of appropriate expenses. “But,” you say, “I thought royalty owners don’t share in the costs of production!” That is true. Royalty owners are not responsible for costs associated with research, exploration, drilling, or any other aspects of production; but they can be liable for their share of expenses generated post-production.In December 2016, the West Virginia Supreme Court decided that EQT (and therefore other operators) can “not deduct from that (royalty) amount any expenses that have been incurred in gathering, transporting or treating the oil or gas after it has been initially extracted, any sums attributable to a loss or beneficial use of volume beyond that initially measured or any other costs that may be characterized as post-production”. However, in May of this year, the West Virginia Supreme Court reversed its previous decision from last year, allowing post-production deductions for gathering, transporting, or treating gas after extracted. As summarized in WV Supreme Court Reverses Itself, Post-Production Deductions OK, the court said that, “oil and gas companies may use “net-back” or “work-back” methods to calculate royalties owed but that the “reasonableness” of those expenses in specific instances may be decided by future court cases.”In general, the matter of post-production deductions is generally a contractual one between the lessee and lessor. The Louisiana law review says that in general there are three kinds of royalty clauses: (1) the proceeds clause, (2) the market value clause, and (3) the market price clause. The proceeds clause requires that royalty owners be paid a percentage of the actual amount of proceeds, net proceeds, or gross proceeds that the company received. Unless otherwise specified the owner should be paid proceeds determined at the well not at the place of sale. According to Louisiana state law the market value clause allows the owner to determine the hypothetical price that a willing buyer would pay a willing seller for the product while the market price clause requires the operator to pay the royalty owner the actual price received at market. Both, however, allow the royalty owner to be charged for transportation and marketing costs.Future court cases will likely better define the level of post-production deductions that are considered to be fair to both the royalty owner and the operator. But it is important that royalty owners familiarize themselves with the current laws surrounding mineral rights and post-production deductions in the states in which they own mineral rights.How Do PPDs Affect the Value of Your Royalty Interest?The effect that PPDs have on royalty interests can be explained by one of the fundamental concepts of business valuation: value is a factor of cash flow, growth, and risk.
PPDs directly reduce cash flow which reduces the value of a royalty interest as shown by the equation above. Additionally, the lack of a “no-deducts” clause in a lease agreement increase the risk associated with an interest. Even if a royalty owner does not currently pay post-production deductions, there is the possibility that the operator could charge PPDs in the future which increases risk. In our white paper titled, “How to Value an Oil and Gas Royalty Interest,” we explain how market and the income approach together can give a complete picture of value.
ConclusionThe National NARO convention had educated speakers who talked on a broad range of topics. The organization encourages royalty owners to ask questions and continue learning no matter how long they have worked in the industry. The convention reminded me why industry expertise is so important in the field of business valuation. In order to fully understand the operations of a business, an analyst must have knowledge of all aspects of the industry. Mercer Capital has over 20 years of experience valuing assets and companies in the oil and gas industry. We have valued companies and minority interests in companies servicing the E&P industry and assisted clients with various valuation and cash flow issues regarding royalty interests. Contact one of our oil and gas professionals today to discuss your needs in confidence.
Impact and Perspective on Hurricane Harvey’s Aftermath: Transforming
Some friends and neighbors of ours drove down to Houston this past weekend to assist with the recovery and cleanup effort in the wake of Hurricane Harvey (we were left with the much easier job of watching one of their children for a few days).They used to live in Houston and were moved to go down and help in relief efforts. They, along with a group from their church, came back yesterday with stories and photos of mold from floor to ceiling, throwing housefuls of furniture to the curb, and dead fish that managed to find their way through the floodwaters into people’s living rooms. To add to the loss, the majority of people affected were not covered by flood insurance.However, one thing that was not lost was unyielding dignity, hope, and courage that pulsated throughout the city. This was the most uplifting news to emerge out of the wreckage. As our friends described it, the experience was “transforming” on many levels.The Immediate and Residual Impact of HarveyDon Stowers – Chief Editor of the Oil & Gas Financial Journal recently wrote an editorial on the impact of Hurricane Harvey from an industry perspective. It too was transforming.According to the editorial - companies now are only beginning to assess the damages. More than 20% of the oil production from the Gulf of Mexico was taken offline with additional onshore volumes shut-in. Four terminals in Corpus Christi were closed to tanker traffic. Nearly 50% of the nation’s refining capacity is located along the Gulf Coast and at least 10 refineries were shut down before the storm’s arrival. This was felt here in Dallas as long lines and gas shortages were common for some days after the storm. However, this is anticipated to be more widespread. NYMEX gasoline contracts spiked to their highest levels in two years. Analysts say this will continue for months following the storm.The good news is that the industry will recover in a matter of months. Terminals will re-open. Shipping will resume and gas prices will likely return to lower levels. However, it will take longer for a number of other people to recover.Yet we remain encouraged by the resilient spirit of the people affected and the scores of inspiring people who are continuing to demonstrate the transformative power of the golden rule: Do to others what you would wish for them to do to you. Have a great week.
Additional Considerations for Leaving a Wirehouse or Brokerage Firm
Piggybacking off of our post from last week, we discuss the various options one faces when leaving a wirehouse firm, including the various pros and cons to doing so. The advisory profession has evolved significantly over time, so we’re writing this post to keep you apprised of your options as you consider the big leap.
The industry has come a long way over the last couple of decades if you think about it. The client visits we go on today thankfully bear no resemblance to The Wolf of Wall Street or Boiler Room depictions of life as an “advisor” at a brokerage firm in the 80s and 90s.
While Hollywood undoubtedly dramatized this reality for entertainment purposes, these films reinforce the rationale for all the change that has taken place over the last twenty years. Ongoing technological and regulatory shifts suggest that the profession will continue to evolve.
All these iterations and alterations to the profession mean that advisors now have a variety of different platforms and businesses models to choose from. The three primary options include RIA aggregators and their network platforms, traditional wirehouse firms / broker-dealers, and independent RIAs.
Michael Kitces’s blog, Nerd’s Eye View, includes a recent guest post from Aaron Hattenbach, who worked as an advisor under all three of these models and provides valuable insight on which path makes the most sense.The Evolution of RIAsAs a recent two-year participant in Merrill Lynch’s Practice Management Division (PMD), Hattenbach estimates the program’s failure rate to be 99% (other industry observers have estimated 95%; the wirehouse firms do not publish these statistics for obvious reasons). This sad reality is something an aspiring financial advisor should keep in mind when considering employment at one of the major wirehouse or brokerage firms.It also explains why the industry has such a tough time recruiting millennials to the business. Those who do succeed tend to be aggressive networkers and champions of the wirehouse brand and the breadth of services it can offer clients.Even if you are part of the 1% (or 5%) who make it through the program, the independent or aggregator RIA routes can be enticing. As noted last week, the sheer economics justifies the move to the independent route if you can transition most of the clients and manage overhead efficiently.Independence also breeds creativity and customization as the wirehouse firms tend to be more bureaucratic while offering firm approved, templated solutions to clients on behalf of advisors across their entire network. Hattenbach noted that most of his advisor colleagues at Merrill placed more emphasis on “being compliant” than sharpening their craft, advising clients, or growing their book of business.But independence isn’t the only option. Fortunately, there’s a compromise or go-between for total independence and the wirehouse route.The Tenets of RIA IndependenceThe RIA aggregator model allows its advisors to maintain some degree of autonomy without having to manage an actual business. Aggregators will purchase books of business from advisors and offer an ongoing payout structure after the deal.Aggregators like LPL Financial and Focus Financial have gained popularity in recent years as these businesses did not suffer the reputational (and financial) fallout of their wirehouse counterparts during the last financial crisis. Also, like their wirehouse competitors, RIA aggregators can use their massive scale to negotiate better terms for things like custody fees and trading costs than independent RIAs.Still, a lot of advisors have left the RIA aggregator network, perhaps one of the reasons behind Focus’s delayed plans for an IPO. Perhaps once the advisors get a taste of freedom, they will want full independence and start their own RIA. Even after operating under an RIA aggregator, the transition to independence can be quite the leap, and Hattenrach advises that the following attributes are needed:Operating experience in the investment advisory channelNiche specialty that allows for differentiation from the competition to compensate for the lack of brand recognitionA client base large enough to sustain itself or the financial flexibility and patience to grow it from scratchEntrepreneurial attitude and willingness to put in the many hours necessary to succeedThe ability to effectively multi-task and prioritizeAn advisory study group or professional group of colleagues that can from your “unofficial advisory board”
Anecdotally, we’ve heard (and generally observed) that it often takes $500 million in client assets to create an independent RIA that is consistently profitable, depending upon fee structure, location, and headcount, among other things. This may be a bit conservative, but could be what it takes to breakeven in an environment dominated by passive investing, fee compression, evolving regulatory requirements, and rising compliance and compensation costs.
We’ve seen profitable RIAs at lower levels of AUM, but to build consistent profitability in the face of all the aforementioned industry headwinds and a potential market downturn, you’re probably going to need a few hundred million in client assets.ConclusionThis is a lot to think about as each route has its own risks and rewards. If the solution were obvious, it’d be the only option. We see the independent and aggregator RIA model continuing to gain client assets and advisors from wirehouse firms, but think the Wall Steet firms and other broker-dealers are too heavily entrenched (and dedicated to fee income) to be totally wiped out anytime soon. Whatever the outcome, as asset management models continue to evolve the relative merits of independence and affiliation will too.
Video: Corporate Finance Basics for Directors and Shareholders
Below is the transcript of the above video, Corporate Finance Basics for Directors and Shareholders. In this video, Travis W. Harms, CFA, CPA/ABV, senior vice president of Mercer Capital, offers a short, yet thorough, overview of corporate finance fundamentals for closely held and family business directors and shareholders.
Hi, my name is Travis Harms, and I lead Mercer Capital’s Family Business Advisory practice. I welcome and thank you for taking a few minutes to listen to our discussion, “Corporate Finance Basics for Directors and Shareholders.”
Corporate finance does not need to be a mystery. In this short presentation, I will give you the tools and vocabulary to help you think about some of the most important long-term decisions facing your company.
To do this, we review the foundational concepts of finance, identify the three key questions of corporate finance, and then leverage those three questions to help think strategically about the future of your company.
Let’s start with the fundamentals of finance: return and risk.
Return measures the reward for making an investment. Investment returns come in two different forms: the first, distribution yield, is a measure of the annual distributions generated by an investment. The second, capital appreciation, measures the change in the value of an investment over time. Total return is the sum of these two components.
This is important because two investments may generate the same total return, although in very different forms. Some investments, like bonds, emphasize current income, while others, like venture capital, are all about capital appreciation. Many investments promise a mix of current income and future upside.
The most basic law of corporate finance is that return follows risk.
The above chart compares the expected return required by investors and the risk of different investments. Since investment markets are generally efficient, higher returns are available only by accepting greater risk.
But what is risk?
Simply put, risk is the fact that future investment outcomes are unknown. The wider the distribution of potential outcomes, the greater the risk.
While both investments represented above are risky, the dispersion of outcomes for the investment on the right is wider than that on the left, so the investment on the right is riskier. Because it is riskier, it will have a higher expected return. Now, whether that higher return actually materializes is unknown when the investment is made – that’s what makes it risky.
For a particular company, the expected return is referred to as the company’s cost of capital. From a corporate finance perspective, the company stands between investors (who are potential providers of capital) and investment projects (which are potential uses of the capital provided by investors). The cost of capital is the price paid to attract capital from investors to fund investment projects.
When evaluating potential investment projects, corporate managers use the cost of capital as the hurdle rate to measure the attractiveness of the project.
Next, we will move on to the three essential questions of corporate finance.
Corporate managers and directors should always be thinking about three fundamental corporate finance questions:
First, what is the most efficient mix of capital? This the capital structure question – what is the mix of debt and equity capital that minimizes the company’s overall cost of capital?Second, what projects merit investment? This is the capital budgeting question – how does the company identify investment projects that will deliver returns in excess of the hurdle rate?And third, what mix of returns do shareholders desire? This is the distribution policy question – what is the appropriate mix of current income and future upside for the company’s investors?
Let’s start with the first question: what is the most efficient mix of capital?
You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet. The right side of the balance sheet tells us how the company has paid for those investments. The only two funding options are debt and equity. Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.
You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet. The right side of the balance sheet tells us how the company has paid for those investments. The only two funding options are debt and equity. Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.
If debt is cheaper than equity, you might assume that a company could reduce its cost of capital by simply issuing more and more debt. That is not the case, however. As the company uses more debt, the risk of both the debt and the equity increase. And, as we said earlier, greater risk will cause both debt and equity investors to demand higher returns.
Eventually, because the cost of both components is increasing, the overall blended (or weighted average) cost of capital increases with increasing reliance on debt. The goal of capital structure analysis is to identify the optimal capital structure, or the mix of debt and equity that minimizes the company’s cost of capital.
Now let’s move on to the second question: what investment projects should the company devote capital to? At the strategic level, management’s job is to survey the landscape of potential investment projects, choosing those that are strategically compelling and financially favorable.
From a financial perspective, a potential investment project is attractive if the return from the expected cash flows meets or exceeds the hurdle rate, which is the cost of capital.
The appropriate pace of investment for a company is therefore related to the availability of attractive investment projects.
If attractive investment projects are abundant, the company should reinvest earnings into new projects, and, if yet more attractive projects are available, borrow money and/or issue new equity to fund the investment. If attractive investment projects are scarce, however, the company should return capital to investors through debt repayment, distribution of earnings, or share repurchase. We can now begin to see how the three questions are related to one another. Capital structure decisions are always made relative to the need for investment capital.
This inter-relationship is illustrated above within the context of the two components of total return we discussed earlier. Distribution yield provides a current return to shareholders from cash flow not reinvested in the business, while the cumulative impact of reinvested cash flows is manifest in the capital appreciation component of total return.
This leads us to the final corporate finance question, which relates to distribution policy: what mix of returns do shareholders desire?
While the operating performance of the business ultimately determines total return, the board can tailor the components of that return to fit shareholder preferences better.
We’ve primarily been looking through the rearview mirror to assess what the company has done in the past; now it’s time to look through the windshield and think prospectively about capital structure, capital budgeting, and distribution policy going forward.
First, capital structure. In the long-run, the optimal capital structure will balance the cost of funds, flexibility, availability, and the risk preferences of the shareholders. Now, that last factor – shareholder preferences – should not be overlooked. Family businesses should not be managed for some abstract textbook shareholder, but rather for the actual family members that own the business.
For example, while an under-leveraged capital structure reduces potential return on equity, it also reduces the risk of bankruptcy. Some shareholders may view this tradeoff favorably even if it can be demonstrated to be “sub-optimal” from a textbook standpoint.
Second, capital budgeting. The attractiveness of investment opportunities should be evaluated with reference to future – and not past – returns. Beyond the threshold question of whether such opportunities are in fact available, managers and directors should also consider financial and management constraints under which the company is operating and the desire of shareholders for diversification.
Since family business shareholders lack ready liquidity for their shares, they may have a greater desire to diversify their investment holdings away from the family business. In other words, they may favor foregoing some otherwise attractive investment opportunities in order to increase distributions that would help shareholders diversify.
Third, distribution policy. The appropriate form and amount of distributions should reflect shareholder preferences within the context of capital budgeting and capital structure decisions. Perhaps most importantly, a clearly communicated distribution policy enhances predictability for shareholders, and shareholders like predictability.
Family business shareholders should know which of the four basic options describes their company’s distribution policy.
Finally, to recap, each of the three questions relates to one another.
The company’s capital structure influences the cost of capital, which serves as the hurdle rate in capital budgeting decisions. The availability of attractive investment projects, in turn, determines whether earnings should be retained or distributed. Lastly, distribution policy affects, and is affected by, the cost and availability of marginal financing sources.
For a deeper dive into some of the topics we talked about, we have several whitepapers and other resources that you can download from our website.
The good news is that you do not have to have an advanced degree in finance to be an informed director or shareholder. With the concepts from this presentation, you can make relevant and meaningful contributions to your company’s strategic financial decisions. In fact, we suspect that a roomful of finance “experts” can actually be an obstacle to the sort of multi-disciplinary, collaborative decision-making that promotes the long-term health and sustainability of the company. Our family business advisory practice gives directors and shareholders a vocabulary and conceptual framework for thinking about and making strategic corporate finance decisions.
Again, my name is Travis Harms and I thank you for listening. If you’d like to continue the discussion further or have any questions about how we may help you, please give us a call.
Travis W. Harms, CFA, CPA/ABV(901) 322-9760harmst@mercercapital.com
How to Value an Oil & Gas Royalty Interest
A lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.The purpose of this whitepaper is to provide an informative overview regarding the valuation of mineral royalty interests within the oil and gas industry.
How to Value Your Exploration and Production Company
A lack of knowledge regarding the value of your business could be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help you understand how to grow the value of your business and maximize your return when it comes time to sell.The purpose of this whitepaper is to provide an informative overview regarding the valuation of exploration and production (E&P) companies operating in the oil and gas industry.
Options for Today's Financial Advisors
Should I Stay or Should I Go?
Ever since the Financial Crisis, wirehouse advisors have been pondering this question as the independent model continues to lure wealth managers from the big banks and brokerage firms. This post discusses the various options that financial advisors (FAs) are faced with today and when it makes sense for them to stick around or do their own thing.
It seems unlikely that English punk rock artist Mick Jones could empathize with future financial advisors when he unleashed his hit single, "Should I stay or Should I go" in 1981. Rather, he was probably referring to his own pending departure from The Clash (though he would later deny that contention). Either way, it seems oddly applicable to many FAs' current predicament as they contemplate the pros and cons of staying with their current employer or forming their own RIA.Considerations for Financial AdvisorsPerhaps the most obvious consideration is compensation. Though it varies by firm and location, wirehouse firms generally pay out 35% to 55% of fee income to their FAs, with the larger producers typically taking home a bigger cut of the business, according to industry consultant, Michael Kitces. Larger RIA firms, on the other hand, tend to pay their FAs 40% to 50% of fee income, 20% to 30% in non-compensatory overhead costs with the residual 20% to 30% in profits, depending again on size and location and dozens of other factors. This means that a solo practitioner could earn as much as 80% of his or her fees by starting their own firm, collecting all the fee income net of overhead expenses.Based on this math alone, it's hard to comprehend why over 50,000 advisors and $7 trillion assets have remained at Bank of America Merrill Lynch, UBS, Morgan Stanley, and Wells Fargo alone, according to the InvestmentNews Advisers on the Move database. IN attributes this phenomenon to signing bonuses at the wirehouse firms, the security they offer, increasingly higher compensation packages for top producers, and appealing retirement deals for senior FAs looking to cash out. Or it may be that capturing that margin for oneself is easier said than done.Kitces contends that "end advisors are often able to keep 10% to 20% more of their gross revenue after making the switch" even after considering all the perquisites that the bulge bracket firms are offering. So from a sheer economics perspective, it appears that going independent makes more sense, but there are still other factors to keep in mind. For one, you have to get client consent, which is not always a given, especially if the client identifies more with the bank than the broker, which is often the case with elderly investors. You'll also have to invest time and money in technology, personnel, and other overhead charges that were previously provided by the brokerage firms. In addition, you'll be suddenly responsible for practice management unless you pay someone else to do that for you, which can also be costly. Indeed, if you go, there could be trouble, as Mick Jones warned us.Don't leave without first thinking about your employment agreements, non-compete agreements, non-solicitation agreements, etc. The only thing worse than starting a business with plenty of overhead and no clients is starting a business with plenty of overhead, a few clients, and a lawsuit from your former firm.The obvious advantage of staying with a wirehouse is the plug-and-play platform that allows financial advisors to concentrate on client service and selling, rather than running a business. We hear plenty of grumbling about the big firms being run by lawyers instead of business development staff, spending so much time on defense that there's no time left for offense.Compliance issues are rising in the independent RIA space as well, though, and when you're in charge of your RIA, you're also in charge of the compliance department. Oddly enough, at the same time brokers are weighing leaving big banks to go out on their own so they aren't constrained by back-office regulations, independent RIAs are consolidating to allow their top people to focus on clients instead of practice management.ConclusionThere are plenty of tradeoffs to being independent. But staying could be even more problematic. The independent model allows you to better take advantage of the inherent operating leverage of the asset manager business. Rather than earning a fixed percentage of the fee income from client assets, an independent RIA owner/operator can achieve significant levels of profitability to augment fee income by growing AUM with more modest increases to overhead expenses. We've seen larger wealth management firms (client assets over $500 million) achieve EBITDA margins of 25% or greater when overhead costs remain relatively contained. Potential returns do appear to be commensurate with the risk involved in most of these situations – which is, after all, kind of the theme of investment management.Mick Jones ultimately decided to go, and has enjoyed something of a post-Clash career (although you could be forgiven for not being able to name any songs by Big Audio Dynamite). If you're considering going independent, we just hope you keep this all in mind.
How to Use Reserve Reports When Determining Fair Market Value
Last week, Lucas Paris analyzed the SEC’s $6.2 million settlement with a Big 4 audit firm relating to auditing failures associated with Miller Energy Resources, an oil and gas company with activities in the Appalachian region of Tennessee and in Alaska. In late 2009, Miller acquired certain Alaskan oil and gas interests for an amount the company estimated at $4.5 million. The company subsequently assigned a value of $480 million to the acquired assets, resulting in a one-time after-tax bargain purchase gain of $277 million. Following the deal, the newly acquired assets comprised more than 95% of Miller’s total reported assets.The SEC order determines that the Big 4 audit firm did not properly use the reserve reports conclusion of PV-10 (present value at 10%).This post considers the proper use of reserve reports and risk adjustment factors when determining fair market value.What Is Fair Market Value?The American Society of Appraisers defines the fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1Treasury Regulation Section 1.611-1(d)(2) provides guidance in determining the fair market value of oil and gas properties. It similarly provides that “the fair market value of an [oil and gas] property is the amount which would induce a willing seller to sell and a willing buyer to purchase.” Additionally, Section 1.611-2(g) outlines some considerations that a valuation of mineral properties must include for tax-oriented appraisals. A summary of these considerations is shown in the chart below.A review of Treasury Regulations 1.611-2(g) clearly demonstrates that an analyst must do more than rely on reserve reports when determining fair market value.What Is a Reserve Report?The SEC defines reserves as “estimated remaining quantities of oil and gas and related substances anticipated to be economically producible, as of a given date, by application of development projects to known accumulations.”A reserve report is prepared by a petroleum engineer who estimates the remaining quantities of oil and gas and categorizes them based on the likelihood that they will be produced. There are three main categories of proved reserves (P1) which are distinguished in a reserve report. Proven reserves are defined to have at least a 90% probability of being recovered.Proved Developed Producing (PDP) reserves are defined by the OJFG as “the estimated remaining quantities of oil and gas anticipated to be economically producible, as of a given date, by application of development projects to known accumulations under existing economic and operating conditions.”Proved Developed Non-Producing (PDNP) reserves are proven reserves “that can be expected to be recovered through existing wells and existing equipment and operating methods.”Proved Undeveloped (PUDs) reserves are proven reserves “that are expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for completion.”
Other reserve categories include probable (P2) and possible (P3) reserves, which must exceed 50% and 10% probability of recovery, respectively.
Reserve reports estimate future production of all proved reserves. From this, they predict future revenue and future expenses and discount the net income using a 10% standard discount rate. PV-10 is the resulting estimate of the present value of the company’s cash flow from proved oil and gas reserves. It is standardized value which provides consistency across public companies filings. However, PV-10 is not necessarily an accurate representation of fair market value.
PV-10 assumes that all categories or proved reserves are equally risky. In reality, a potential buyer would not pay as much for an interest in PUD acreage as they would for PDP acreage because there is substantially more risk associated with the PUD acreage.
If a valuation expert had been hired to do a purchase price allocation for Miller Energy’s acquisition of oil and gas interest in Alaska, PV-10 would not have been used as the fair market value. Rather, a valuation specialist with industry expertise would have performed a discounted cash flow analysis and evaluated how certain risks that pertain to each asset affect the value.How to Use a Reserve ReportThe income approach is generally accepted among industry professionals as the most accurate representation of fair market value of oil and gas interests, and the reserve report can be used as one of the main sources of information for the inputs of the discounted cash flow. Treasury Reg 1.611-2(e)(4) provides a straightforward outline of how the approach should be used. In general, a discounted cash flow analysis is the method of choice.In practice, the income approach requires that:The appraiser project income, expense, and net income on an annual basisThus, revenue and expense projections used in the income approach can be directly harvested from this report.Each year’s net income is discounted for interest at the “going rate” to determine the present worth of the future income on an annual and total basisThis is where a reserve report and a calculation of fair market value differ. While a reserve report uses a standard 10% discount rate, when determining fair market value a discount rate which considers potential risk factors should be developed. An analyst could add a risk premium for each reserve category to adjust a baseline WACC or they could account for this risk in a separate adjustment. The total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value.PV-10 treats PDP, PDNP, and PUDs the same. However, there are uncertainties and opportunities associated with PUDs that are not captured in the discount rate used for all proved reserves. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). What About Probable and Possible Reserves?Reserve reports only account for proven reserves; they do not estimate the value of possible and probably reserves which are less likely to be recovered. While less certain, there is still some potential upside of the Probable and Possible reserve categories. In order to estimate the value of probable and possible reserves the market approach can be used.The market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold. Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity.If transactions show premiums over the value of proven reserves, then the buyer likely was paying for something else in addition to the proved reserves; he was likely paying for the less certain upside potential of probable and possible reserves. Through these transactions, the value of these reserves can be understood as they vary by basin and between fields. In many basins probable and possible reserves may currently be worthless because the price of oil may not rebound to a point where it would be economical to explore for and drill these reserves; however, in fields such as the Delaware and Midland Basins in the Permian recent transactions tell a different story.The valuation implications of reserves and acreage rights can swing dramatically in resource plays. While a reserve report is helpful, it does not measure fair market value or fair value. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.
Emerging Community Bank M&A Trends in 2017
As summer came to an end, the U.S. was treated with a historic event as the first total solar eclipse crossed the country since 1918. The timing of the event had social media and news outlets buzzing in a traditionally sleepy news month. For many, the event exceeded all expectations; for others, it was a dud that didn’t live up to the hype. My personal experience was a bit of both. The minutes of darkened skies were definitely memorable, but things returned to normal quickly as the sun shone brightly only minutes after.Traditional M&A TrendsCommunity bank M&A trends also seem mixed. Rising regulatory burdens, weak margins from a historically low interest rate environment and heightened competition have crimped ROEs for years. Many pundits have predicted a rapid wave of consolidation and the demise of community banks in the years since the financial crisis. However, the pace of consolidation the last few years is consistent with the past three decades in which roughly 3-4% of the industry’s banks are absorbed through M&A yearly. The result is many fewer banks—5,787 at June 30 compared to about 15,000 in the mid-1980s when meaningful industry consolidation got underway.Somewhat surprisingly, the spike in bank stock prices following the November 2016 national elections did not cause M&A to accelerate. As would be expected, acquisition multiples increased in 2017 because publicly traded acquirers could “pay-up” with appreciated shares. As seen in the table on the next page, the median P/E and P/TBV multiples and the median core deposit premium increased for the latest twelve months (LTM) ended July 31, 2017 compared to the year ago LTM period. The ability of buyers—at least the publicly traded ones—to more easily meet sellers’ price expectations seemingly would lead more banks to sell. However, that has not happened as the pace of consolidation declined slightly to 132 transactions in the most recent LTM period compared to 140 in the year ago LTM time frame.FinTech’s Impact on M&AAnother emerging M&A trend is the presence of non-traditional bank acquirers, which include private investor groups, non-bank specialty lenders, and credit unions. While a FinTech company has not yet announced an acquisition of a U.S. bank this year, several FinTechs have announced they are applying for a bank charter (SoFi, VaroMoney), and in the U.K., Tandem has agreed to acquire Harrods Bank.So far, FinTech acquisitions of banks have been limited to a few acquisitions by online brokers and Green Dot Corporation’s acquisition of a bank in 2011. While FinTech companies have yet to emerge as active buyers, there have been some predictions that could change if regulatory hurdles can be navigated. Some FinTech companies are well-funded or have access to additional funding that could be tapped for a bank acquisition. In addition, an overlay of enhancing financial inclusion for the under-banked could mean bank transactions may not be as far-fetched as some may think.Beyond serving as potential acquirers, FinTech continues to emerge as an important piece of the community banking puzzle of how to engage customers through digital channels as the costly branch banking model sees usage decline year-after-year. Many FinTechs are eager to partner with banks to scale their operations for greater profitability, thereby better positioning themselves for a successful exit down the road.Consistent with this trend, we have also seen some acquirers (and analysts) comment on FinTech as a benefit of a transaction, as opposed to (or at least in addition to) the historical focus on geographic location, credit quality, asset size, and profitability. We will be watching to see if FinTech initiatives, whether internally developed or acquired, become a bigger driving force in bank M&A. If so, acquisitions of FinTech companies by traditional banks may increase (as discussed more fully in this article).As these trends grow in importance, buyers and sellers will have to grapple with unique valuation and transaction issues that require each to fully understand the value of the seller and the buyer, assuming a portion of the consideration consists of the buyer’s shares. Whether that buyer includes a traditional bank whose stock is private or a non-bank buyer, such as a specialty lender or FinTech company, we have significant valuation and transaction expertise to help your bank understand the deal landscape and the strategic options available to it.If we can be of assistance, give us a call to discuss your needs in confidence.This article originally appeared in Mercer Capital's Bank Watch, August 2017.
Fairness Opinions Do Not Address Regrets
Sometimes deals can go horribly wrong between the signing of a merger agreement and closing. Buyers can fail to obtain financing that seemed assured; sellers can see their financial position materially deteriorate; and a host of other “bad” things can occur. Most of these lapses will be covered in the merger agreement through reps and warranties, conditions to close, and if necessary, the nuclear trigger that can be pushed if negotiations do not produce a resolution: the material adverse event clause (MAEC). And MAEC = litigation.Bank of America’s (BAC) 2008 acquisition of Countrywide Financial Corporation will probably be remembered as one of the worst transactions in U.S. history, given the losses and massive fines that were attributed to Countrywide. BAC management regretted the follow-on acquisition of Merrill Lynch so much that the government held CEO Ken Lewis’ feet to the fire when he threatened to trigger MAEC in late 2008 when large swaths of Merrill’s assets were subjected to draconian losses. BAC shareholders bore the losses and were diluted via vast amounts of common equity that were subsequently raised at very low prices.Another less well-known situation from the early crisis years is the acquisition of Charlotte-based Frist Charter Corporation (FCTR) by Fifth Third Bancorp (FITB). The transaction was announced on August 16, 2007 and consummated on June 6, 2008. The deal called for FITB to pay $1.1 billion for FCTR, consisting 30% of cash and 70% FITB shares with the exchange ratio to be set based upon the five day closing price for FITB the day before the effective date. At the time of the announcement FITB expected to issue ~20 million common shares; however, 45 million shares were issued because FITB shares fell from the high $30s immediately before the merger agreement was signed to the high teens when it was consummated. (The shares would fall to a closing low of $1.03 per share on February 20, 2009; the shares closed at $25.93 per share on July 14, 2017.) The additional shares were material because FITB then had about 535 million shares outstanding. Eagerness to get a deal in the Carolinas may have caused FITB and its advisors to agree to a fixed price / floating exchange ratio structure without any downside protection.A more recent example of a deal that may entail both buyer and seller regrets is Canadian Imperial Bank of Commerce’s (CIBC) now closed acquisition of Chicago-based Private Bancorp Inc. (PVTB). A more detailed account of the history of the transaction can be found here. The gist of the transaction is that PVTB entered into an agreement to be acquired by CIBC on June 29, 2016 for 0.3657 CIBC shares that trade in Toronto (C$) and New York (US$), and $18.80 per share of cash. At announcement the transaction was valued at $3.7 billion, or $46.20 per share. As U.S. bank stocks rapidly appreciated after the November 8 national elections, institutional investors began to express dismay because Canadian stocks did not advance. In early December, proxy firms recommended shareholders vote against the deal. A mid-December shareholder vote was then postponed.CIBC subsequently upped the consideration two times. On March 31, 2017, it proposed to acquire PVTB for 0.4176 CIBC shares and $24.20 per share of cash. On May 4, CIBC further increased the cash consideration by $3.00 to $27.20 per share because its shares had trended lower since March as concerns intensified about the health of Canada’s housing market. On May 12, shareholders representing 66% of PVTB’s shares approved the acquisition. Figure 1 highlights the trouble with the deal from PVTB shareholders’ perspective. While the original deal entailed a modest premium, the performance of CIBC’s shares and the sizable cash consideration resulted in little change in the deal value based upon the original terms. On March 30 the deal equivalent price for PVTB was $50.10 per share, while the market price was $59.00 per share. The following day when PVTB upped the consideration the offer was valued at $60.11 per share; however, the revised offer would have been worth nearly $69 per share had CIBC’s shares tracked the SNL U.S. Bank Index since the agreement was announced on June 29. On May 11 immediately before the shareholder vote the additional $3.00 per share of cash offset the reduction in CIBC’s share price such that transaction was worth ~$60 per share, while the “yes-but” value was over $71 per share had CIBC’s shares tracked the U.S. index since late June. Fairness opinions do not cover regret, but there are some interesting issues raised when evaluating fairness from a financial point of view of both PVTB and CIBC shareholders. (Note: Goldman Sachs & Co. and Sandler O’Neill & Partners provided fairness opinions to PVTB as of June 29 and March 30. The registration statement does not disclose if J.P. Morgan Securities provided a fairness opinion as the lead financial advisor to CIBC. The value of the transaction on March 30 when the offer was upped the second time was $4.9 billion compared to CIBC’s then market cap of US$34 billion.)Fairness is a Relative ConceptSome transactions are not fair, some are reasonable, and others are very fair. The qualitative aspect of fairness is not expressed in the opinion itself, but the financial advisor conveys his or her view to management and a board that is considering a significant transaction. When the PVTB deal was announced on June 29, it equated to $46.35 per share, which represented premiums of 29% and 14% to the prior day close and 20-day average closing price. The price/tangible book value multiple was 220%, while the P/E based upon the then 2016 consensus estimate was 18.4x. As the world existed prior to November 8, the multiples appeared reasonable but not spectacular.Fairness Does not Consider 20-20 Hindsight VisionFairness opinions are qualified based upon prevailing economic conditions; forecasts provided by management and the like and are issued as of a specific date. The opinion is not explicitly forward looking, while merger agreements today rarely require an affirmation of the initial opinion immediately prior to closing as a condition to close. That is understandable in the context that the parties cut a deal that was deemed fair to shareholders from a financial point of view when signed. In the case of PVTB, the future operating environment (allegedly) changed with the outcome of the national election. Banks were seen as the industry that would benefit from a combination of lower corporate tax rates, less regulation, faster economic growth, and higher rates as part of the “reflation trade.” A reasonable deal became not so reasonable if not regrettable when the post November 8 narrative excluded Canadian banks. Time will tell if PVTB’s earning power really will improve, or whether the move in bank stocks was purely speculative.Subtle Issues Sometimes MatterAlthough not a major factor in the underperformance of CIBC’s shares vis-à-vis U.S. banks, the Canadian dollar weakened from about C$1.30 when the merger was announced on June 29 to C$1.33 in early December when the shareholder meeting was postponed. When shareholders voted to approve the deal on May 12 the Canadian dollar had eased further to C$1.37. The weakness occurred after the merger agreement was signed and the initial fairness opinions were delivered on June 29. Sometimes seemingly small financial issues can matter in the broad fairness mosaic, but only with the clarity of hindsight.Waiting for a Better Deal is not a Fairness ConsiderationAlthough a board will consider the business case for a transaction and strategic alternatives, a fairness opinion does not address these issues. The original registration statement noted that Private was not formally shopped. The deal was negotiated with CIBC exclusively, which twice upped its initial offer before the merger agreement was signed in June. It was noted that the likely potential acquirers of PVTB were unable to transact for various reasons. The turn of events raises an interesting look-back question: should the board have waited for a better competitive situation to develop? We will never know; however, the board is given the benefit of the doubt because it made an informed decision given what was then known.The Market Established a Fair PriceInstitutional shareholders had implicitly rejected what became an unfair deal by early December when PVTB’s shares traded well above the deal price. The market combined with the “no” recommendation of three proxy firms forced PVTB to delay the special meeting. The increase in the consideration in late March pushed the deal price to a slight premium to PVTB’s market price. CIBC increased the cash consideration an additional $3.00 per share in early May to offset a decline in CIBC’s shares that had occurred since the consideration was increased in March. The market had in effect established its view of a fair price. While CIBC could have declined to up its offer yet again, it chose to offset the decline.Relative Fairness from CIBC’s Perspective FluctuatedWhat appeared to be a reasonable deal from CIBC’s perspective in June became exceptionally fair by early December, if the market is correct that the earning power of U.S. commercial banks will materially improve as a result of the November 8 election. CIBC’s financial advisors can easily change assumptions in Excel spreadsheets to justify a higher price based upon better future earnings than originally projected, but would doing so be “fair” to CIBC shareholders whether expressed euphemistically or formally in a written opinion? So far the evidence of higher earning power is indirect via the market placing a higher multiple on current bank earnings in expectation of much better earnings that will not be observable until 2018 or 2019. That as a stand-alone proposition is an interesting valuation attribute to consider as part of a fairness analysis both from PVTB’s and CIBC’s perspective.ConclusionHindsight is easy; predicting the future is a fool’s errand. Fairness opinions do not opine where securities will trade in the future. Some PVTB shareholders may have regrets that CIBC was not a U.S. commercial bank whose shares would have out-performed CIBC’s after November 8. CIBC shareholders may regret the PVTB acquisition even though U.S. expansion has been a top priority. The key, as always in any M&A transaction, will be execution over the next several years rather than the PowerPoint presentation. Higher rates, a faster growing U.S. economy and the like will help, too, if they occur.We at Mercer Capital cannot predict the future, but we have over three decades of experience in helping boards assess transactions as financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not. Please call if we can assist your company in evaluating a transaction.This article originally appeared in Mercer Capital's Bank Watch, July 2017.
$475 Million Bargain Purchase Leads to a SEC Settlement
Originally published on Mercer Capital's Financial Reporting Blog, Lucas Parris analyzed the SEC’s $6.2 million settlement with a Big 4 audit firm relating to auditing failures associated with Miller Energy Resources, an oil and gas company with activities in the Appalachian region of Tennessee and in Alaska.In late 2009, Miller acquired certain Alaskan oil and gas interests for an amount the company estimated at $4.5 million. The company subsequently assigned a value of $480 million to the acquired assets, resulting in a one-time after-tax bargain purchase gain of $277 million. Following the deal, the newly acquired assets comprised more than 95% of Miller’s total reported assets. Was it a bargain purchase or not?Paris’ post examines the particulars of the case and provides some observations on fair value accounting that can be gleaned from the SEC settlement order.Bargain Purchase BackgroundA bargain purchase results when the fair value of the assets acquired exceeds the purchase price. If a transaction is determined to be a bargain purchase, the acquirer must recognize a gain on its income statement. Bargain purchases can be the result of a distressed seller or the lack of recognition of a contingent liability. In practice, bargain purchases are uncommon, and typically require a reassessment of the identifiable assets acquired, liabilities assumed, and consideration transferred to confirm that such a transaction has occurred.Miller’s Acquisition of the AssetsAccording to the SEC Order, Miller went public via a reverse merger in 1996. Between 2002 and 2009, its stock price regularly traded below one dollar per share and the firm reported net losses in all years. In late 2009, Miller learned that certain oil and gas interests located in Alaska (the “Alaska Assets”) were in the process of being legally “abandoned” in connection with a bankruptcy proceeding. The Alaska Assets included leases covering 602,000 acres of mostly unproven exploratory oil and gas prospects, five operative oil and gas wells located mainly on two fields, two major facilities, and an offshore platform.The prior owner had marketed the assets for nearly a year, culminating in a court-sponsored auction that produced bids of $7.0 million and $8.1 million. However, neither bidder closed on the bids. A second competitive auction occurred, in which Miller outbid a competing entity whose parent company was, at the time, the largest land drilling contractor in the world. Miller’s winning bid was $2.25 million in cash plus the assumption of $2.2 million in liabilities. The transaction closed December 10, 2009.Accounting for the AcquisitionIn its quarterly SEC filing following the transaction, Miller assigned a fair value of $480 million to the acquired assets. The primary assets were the oil and gas properties ($368 million) and fixed assets ($110 million).Oil and Gas Properties – To establish the fair value of the oil and gas assets, Miller relied upon a reserve report prepared by a third-party petroleum engineering firm under the guidelines for supplemental oil and gas disclosures (ASC 932). The SEC Order stipulated that this was improper because the report itself expressly disclaimed that any of its estimates were estimates of fair value. In other words, the report was prepared for another purpose and with a different accounting/valuation premise than is required under the fair value guidance of ASC 820 and ASC 805. The SEC Order noted that the reserve report estimates were improper from a fair value perspective because the report failed to incorporate an appropriate discount rate and risk adjustments for certain speculative reserve categories. The report was also alleged to contain understated and unsubstantiated cost forecasts, which had been originally provided to the engineering firm by Miller.Fixed Assets – Miller valued the acquired fixed assets (facilities and ancillary pipelines) at $110 million. However, the SEC Order noted that the basis for the $110 million figure was an insurance report that actually contained no third-party analysis – the figure was actually provided to the insurance broker by Miller and then referenced as if it was independently derived by the broker. Furthermore, the SEC indicated that the recording of a separate $110 million fixed asset was double-counting, because these assets were necessary to produce the oil and gas reserves and were already included in the $368 million reserve report value.Role of the Audit FirmMiller Energy replaced its prior independent audit firm in February 2011 (about a year after the acquisition of the Alaska Assets). The new Big 4 firm provided audit reports for Miller, with unqualified opinions, for fiscal 2011 through 2014. The SEC Order states that the firm failed to comply with certain auditing standards, including the requirement to analyze the impact of Miller’s opening account balances (including the value of its oil and gas properties) on the current year financial statements.The SEC Order alleges that the auditors failed to obtain sufficient competent evidence regarding the impact of the opening balances on the current year financial statements, despite knowing that no proper fair value assessment had been performed by management in the prior year. While the audit firm did undertake some audit procedures, it failed to appropriately consider the facts leading up to the acquisition including the competitive bidding process and the “abandonment” of the assets by the prior owner. The SEC Order also noted that the auditor failed to detect the double-counting of fixed assets in the opening balances.Fair Value ObservationsThe SEC Order contains extensive discussion of the auditing and review process as it relates to Miller’s Alaska Assets, which we will not attempt to summarize here. Instead, we will discuss a few of the key themes that emerge from our reading.Bargain Purchases Should Require Additional Scrutiny – It should go without saying, but if a $4.5 million purchase results in a $472 million gain on the income statement (over 100x), there should be a healthy dose of professional skepticism from all sides (management, auditors, and valuation specialists). Every transaction is unique, and perhaps the facts and circumstances support it, but one should be wary if the magnitude of the bargain is large. As an aside, one would think that potential investors would be wary of such an accounting treatment as well, without adequate and supportable disclosures.Proper use of valuation reports – The reserve reports relied upon by Miller management did not contain fair value measurements. Perhaps they were entirely appropriate for the purpose for which they were prepared, but that purpose was not fair value for ASC 805 compliance.Industry Expertise – The partner-in-charge and senior manager on the Miller engagement had no prior experience with oil and gas companies, which the SEC Order indicates resulted in departures from professional standards during the audit process. The SEC Order, citing an AICPA Auditing & Accounting Guide, states that when a client’s business involves unique and complex accounting, as in the case of the oil and gas industry, the need for the engagement partner to understand the client’s industry is even more important. In our opinion, the importance and benefit of industry expertise extends to the valuation specialist as well.
Mercer Capital has performed purchase price allocations for clients across a variety of industries and transaction structures, including those giving rise to bargain purchases. We also have significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Related LinksA Buyer’s Market: Accounting for Bargain PurchasesIn the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value MarksMisleading Purchase Accounting Results in SEC Complaint and Fines for CVSSEC Signals Increased Focus on Financial ReportingThe Fair Market Value of Oil and Gas Reserves
Recent Trends in Asset Management
This week, we’re sharing some recent media on trends in asset management and the outlook for M&A activity. Most industry observers foresee an uptick in asset manager dealmaking as rising costs, asset outflows, and a heightened interest from consolidators incent many firms to pull the trigger on a sale or business combination with another RIA. Global Asset Management 2017 – The Innovator’s Advantageby The Boston Consulting Group
BCG provides a detailed profile of the RIA industry, M&A trends, growth opportunities in a passive environment, and optimizing investment management for the digital age.Latest Mercer Move Highlights Hot M&A Demand for Smaller Firmsby Charles Paikert
Though no relation to our firm, Mercer Advisors recently announced its fourth asset manager deal of the year, underscoring the desirability of smaller RIAs in a seller’s market.Skill through Scale? The Role of M&A in a Consolidating Industry – Investment Management M&A Outlookby Casey Quirk, a practice of Deloitte Consulting LLP
Casey Quirk sees brisk M&A activity continuing in 2017 and beyond as a result of deteriorating economics, distributor consolidation, the need for new capabilities, and a shifting value chain.Asset Manager Deal Wave Has Just Begunby Aaron Black
This Wall Street Journal piece predicts continued consolidation in the RIA space as struggling active managers combine to stem the tide of asset outflows.Minority Stake Sales Prop Up Investment Management Dealmaking Activityby Joe Mantone
This recent piece by S&P Global Market Intelligence examines the heightened level of minority investments in asset managers in the context of slowing M&A volume for the sector.Renewed Appetite – Alts Manager M&A Heats Upby KPMG
With the continued “bar-belling” of investors’ portfolios and strong demand for alternative strategies in the current low-growth, low-yield environment, KPMG sees renewed appetite for dealmaking involving hedge funds and private equity firms.
As always, we are available to continue any of the above discussion further. Don't hesitate to call us.
An Example of Structuring Earn-outs for RIAs
Risk is enigmatic to investing. While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly. If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk-free rate, with no premium return attached. Uncertainty creates opportunity for investors, because opportunity is always a two-way street.Pricing uncertainty is another matter altogether. Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of unlikelihood for the performance of a given asset with the value of that asset. In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the real world, there can be genuinely differing opinions of what the future holds. Some think the future is all about batteries, with considerably stronger environmental regulations on the horizon (at least in Europe) not to mention the relative simplicity of battery power. This sentiment bid Tesla’s share price to a larger market capitalization than Ford. Others have equally questioned the wisdom of this, noting the reluctance of consumers, and many governments, to phase out the use of fossil fuels in transportation. Naysayers note that Tesla’s 400 thousand plus pre-orders for the Model 3 pale in comparison to, say, the over 16 million Ford F150 pickup trucks sold over the past 20 years. What would break that trend now?In the vacuum sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections. The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability. The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty. In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections. With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction. Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank, or HSB. HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought. HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring a RIA.Following a search, HSB settles on Typical Wealth Management, or TWM. TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor). TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm. TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin. Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins.
Given what it represents to be very conservative projections, and which don’t take into account any cross selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence.
The Buyer’s PerspectiveThe bankers at HSB don’t really understand wealth management, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management frequently do not mix well, and they worry whether or not TWM’s clients will stay on if the senior staff starts to retire. Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors. They create a much less sanguine projection to model their possible downside.
Based on this, HSB management wants to offer about $40 million for Typical, which is about six times run rate EBITDA. This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction.
The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster. Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM. The rest of the payment, if any, will come from an earn-out. Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division. As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if by steady marketing appeal or strong market returns, AUM is significantly enhanced after the transaction. The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA. As long as management of Typical can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out. Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition / non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both buyer and sellers are enthusiastic participants in the joint success of the enterprise.
As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for Typical after the transaction to see what the payout structure will look like per the agreement. This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Structuring Earn-Outs Is the Key to a Successful TransactionMy very limited understanding of neuroscience has led me to a cursory knowledge of the shortfalls of human decision making. As much as we might like to believe we think analytically, we mostly act on impulse, responding emotionally to our environment faster than we can reason.This capacity kept us alive when rapid escape from a predator was a more reliable reaction than stopping to think about what was happening. This same brain function causes sellers to focus too much on the headline number offered in a deal negotiation and not enough on the terms surrounding the price.In RIA transactions, those terms frequently include large earn-out payments based on performance outlooks that are highly unlikely, or that at least should be discounted significantly. As a rule, buyers get more protection from contingent consideration than sellers, and frequently have more experience offering earn-outs than sellers have living with them. Seller beware!If you’re considering an offer for your firm that includes earn-out consideration, think about having some independent analysis done on the offer to see what it might ultimately be worth to you. If you’re working the buy-side, prepare to spend lots of time fine-tuning the earn-out agreement – you won’t get credit if things go well for the seller, but you will get blamed if it doesn’t.
WHITEPAPER | Basics of Financial Statement Analysis
Football coaching legend Bill Parcells famously said, “You are what your record says you are.” Adapting that thought to the corporate world, one could say, “Your company is what its financial statements say it is.”Although we would not deny that there are important non-financial considerations in business, the remark strikes close enough to the truth to underscore the importance of being able to read financial statements.Accounting is the language of business, and financial statements are the primary texts to be mastered.Corporate directors need to be able to read financial statements to discharge their fiduciary duty to shareholders effectively.The ability to analyze financial statements gives shareholders the confidence to independently assess the company’s performance and the effectiveness of management’s stewardship of shareholder resources.The purpose of this whitepaper is to help readers develop an understanding of the basic contours of the three principal financial statements.The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.After reviewing each statement, we explain how the different statements relate to one another.Finally, we provide some guidance on how to evaluate projected financial statements.
How to Value Proven Undeveloped Reserves (PUDs)
One of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing proven undeveloped reserves (PUDs) and unproven reserves. While the market approach can sometimes be used to understand the value of PUDs and unproven reserves, every transaction is unique. Additionally, many transactions that we see today are still a result of the crash in oil prices in 2014; and in some sales of non-core assets, PUDs and unproven reserves have been deemed worthless. Why then, and under what circumstances, might the PUDs and unproven reserves have significant value?Optionality ValueThe answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is often most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.PUDs are typically valued using the same discounted cash flow (DCF) model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in lower oil price environments like we face today, a raw DCF would suggest little to no value for PUDs or unproven reserves in a number of plays and basins.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage.Adaptation of Black Scholes Option ModelThe PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. The Black Scholes option model is a widely used model used to develop the value of European-style options. The adaptation is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in the table below.
When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the lower end of historic cycles for a commodity. In a high oil price environment, adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and, thus, will not be exploited immediately.
If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by the pool of buyers of this optionality upside.
ConclusionWe caution, however, that there can be limitations in the model’s effectiveness, as we describe in Bridging Valuation Gaps, Part 3. Specific and careful applications of assumptions are needed, and even then Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace.Today’s marketplace is particularly murky, and a quality appraisal is extremely valuable, since establishing reasonable and supportable evidence for PUD, probable and possible reserve values may assist in a reorganization process that determines the survival of a company, or the return profile for a potential investment, or simply standing up to third-party scrutiny. Given these conditions we feel that the benefits of using option pricing far outweigh its challenges.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Webinar: How to Value an Early-Stage FinTech Company
Do you have a clear picture of your company’s value and do you know if you are creating value in your early-stage FinTech company?
Hidden behind the veil of the private market, an early-stage FinTech company’s value can seem complex and obscure. In valuing a FinTech company, attention need be given to external factors such as unique industry dynamics and the regulatory environment as well as internal company factors such as risk exposure and shareholder preferences. Comparing to high-profile competitors is difficult, as reported values can be skewed if calculated from investors’ stock prices that omit layers of investment preferences. While a rule-of-thumb may be appealing, its simplicity does not adequately capture the company’s risk profile and growth potential.
A clear picture of a company’s value offers notable opportunities for both entrepreneurs and investors. Measuring value creation over time is vital for planning purposes, and an awareness of valuation drivers can propel the company to higher growth. In addition, the knowledge gleaned from the valuation process provides insights and identifies key risk and growth opportunities that can improve the company’s strategic planning process–a process that might build to a successful liquidity event (sale or IPO) or the development of a stable company that can operate independently for a long time.
Hosted by Jay D. Wilson Jr., CFA, ASA, CBA, this webinar identifies the key value drivers for an early-stage FinTech company for investors, entrepreneurs, and potential partners.
A complimentary copy of Jay’s new book, Creating Strategic Value Through Financial Technology (MSRP $65), will be included with the registration fee of $79.
TO REGISTER for this webinar, click here. About the Speaker:Jay D. Wilson Jr. heads Mercer Capital’s Financial Technology industry team and publishes research related to the FinTech industry in the bi-annual newsletter Value Focus: FinTech. Jay is also the author ofCreating Strategic Value Through Financial Technology(John Wiley & Sons, 2017).Mercer Capital's Financial Reporting BlogMercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter at @MercerFairValue.
Five Considerations for Structuring Earn-Outs in RIA Transactions
As covered in last week’s post, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Just as the financial press never writes about periods of “heightened certainty,” so too buyers of RIAs are justifiably concerned about the ongoing performance of their acquisition target after the ink dries on the purchase agreement.Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against downside for the latter. In asset manager transactions, they are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of seller and buyer in a contractual understanding.Twenty years ago, Toyota considered whether the future of automobiles would involve gasoline or batteries and developed a similar middle way, the hybrid engine. A hybrid motor uses regenerative braking to charge batteries that recapture power to augment or substitute for the car’s conventional internal combustion engine. Similar technology has been deployed in supercars like the Porsche 918 Spyder, but the Prius is responsible for helping shape the future of automotive transportation by making hybrid technology prevalent.As hybrids go, though, earn-outs are even more prevalent in asset manager transactions than Priuses are in Whole Foods parking lots, and it’s easy to understand why.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price up front (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.1. Define the continuing business acquired that will be the subject of the earn-outDeciding what business’s performance is to be measured after the closing is easy enough if a RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make determining success or lack thereof fairly easy.If a RIA is being rolled into an existing, and similar, investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, how additions and losses to staff will be treated, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As my neighbor’s father used to say: “fair is just another four letter word.”2. Determine the appropriate period for the earn-outWe have seen earn-out periods (the term over which performance is measured and over which contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defined investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally speaking, buyer-seller relations can get very strained during an earn-out measurement period, and after they’re done no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.3. Determine to what extent the buyer will assist or impede the seller’s performance during the earn-outDid the buyer lure the seller in with promises of technology, products, back-office support, and marketing? Did the buyer promise the seller that they would be able to operate their business unit independently and without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives to get contingent consideration.We have seen bad deals saved by good markets, but counting on false confirmation is not a sound deal strategy. Instead, buyer and seller should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, under what circumstances, and what the particulars are of their mutual obligations to shared success look like. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from their counterparty on the front end.4. Define what performance measurements will control the earn-out paymentsIt is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers, ultimately, want to see profit contributions from the seller, and so some measure of cash flow is a natural way to pay for the kind of desired performance from an acquired investment management operation. There are at least two problems with this, however, which suggest maybe another performance metric would be more effective for the buyer (and the seller).First, profitability is at the bottom of the P&L, and is therefore subject to lots of manipulation. To generate a dollar of profit at a RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success all be sufficiently isolated and defined in an earn-out agreement? It’s more difficult than it looks.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If the rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine success, over time, nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added, net of assets withdrawn), given a certain aggregate fee schedule (so nobody’s giving the business away just to pad AUM).5. Name specific considerations that determine payment termsIs the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years in the earn-out term underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith”?Because these specific considerations are usually unique to a given transaction between a given buyer and a given seller, there are too many to list here. I have two quick thoughts on that: 1) transaction values implied by earn-out structures are often hard to extrapolate to other parties to other transactions. 2) The earn-out can address many of the concerns and hopes of the parties to a transaction about the future – but it cannot create the future. Earn-outs manage uncertainty; they don’t create certainty.ConclusionAbove all, we would emphasize that a plan for contingent consideration be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed based on buyer and seller considerations. A bridge that doesn’t successfully link two points is not a bridge, it’s a pier. A pier will eventually leave either buyer or seller in deep water.We’ll talk more next week about the structuring of earn-outs for RIAs, but drop us a line in the meantime if you’d rather not wait.
Why Earn-outs Matter in Asset Management M&A
Pity the senior auto executive these days: their product is bearing much of the blame for killing the planet, but gas is so cheap they can’t even sell boring fuel efficient cars to the local chapter president of the Sierra Club. The Economistran a cover story last week calling the internal combustion engine “Roadkill,” and repeated the estimate that car emissions kill more Americans every year than traffic accidents – yet the political climate in America doesn’t suggest that regulatory standards for burning fossil fuels of any kind will be tightening soon.Predicting what kinds of cars people will want to buy next year, let alone five years from now, has never been easy. Today, there are too many options. Will car buyers want all-wheel-drive pickups with huge internal combustion engines, or battery-powered autonomous-driving cars? Will people even own cars in 20 years or will we all be driven around by some Uber-like service, making car ownership, parking lots, and garages obsolete? Do you test the market with an expensive, limited production high-performance car like the BMW i8, or do you make a more affordable, mass market car like the Toyota Prius? If you invest heavily in technology, will the market shower you with orders like it did for the Tesla Model 3, or spurn you like the doomed Fisker Karma?M&A in the RIA Community Wouldn’t be Possible Without Earn-outsAs the saying goes (which has been attributed to at least a dozen famous figures), it’s difficult to make predictions, especially about the future. This reality is the single most difficult part of negotiating a transaction in the investment management industry. The value of an RIA acquisition target is subject not only to a large number of variables, but also a wide range of possible outcomes:The performance of financial markets (standard deviation varies)The skill of the investment management staff (difficult to measure)The sustainability of the acquired firm’s fee schedule (not as much a given as in the past)The retention of key staff at the acquired firm (absolutely necessary)The retention of key staff at the acquiring firm (absolutely necessary)The motivation of key staff (absolutely necessary)The retention of client assets (depends entirely on third party behavior)The marketing strength of the merged enterprise (tough to predict)
Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe equity value to an RIA. But actually buying an asset manager is making a bet on all of the above, and most people don’t have the stomach.
Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty. Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role of contingent consideration in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.
This blog kicks off a series which we’ll ultimately condense into a whitepaper to explore and maybe demystify some of the issues surrounding earn-outs in RIA transactions. If nothing else, earn-outs make for great stories. Some of them go well, and some wind up like this:From Earn-out to Burn-out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 1.0% of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.” The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three-year earn-out. Disagreements after the deal closes cause a group of twelve advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one-third of the earn-out was paid.In the end, Fictional Financial sold for about 6.5x EBITDA, much less than the selling partners wanted for the business. Other potential acquisition targets are ultimately disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.Earn-outs and Transaction StrategyMost post-deal performance doesn’t get reported, other than AUM disclosures in public filings. If the acquired entity is folded into another RIA, you can’t even judge a deal by that. Thus, we don’t have comprehensive data on ultimate deal value in many investment management firm transactions. One example we have reported previously was the disastrous post-transaction performance of Killen Group after it was acquired by Tri-State Capital. Killen missed by so much that it cut the total consideration paid by almost half and reduced the effective EBITDA multiple paid from nearly 11x to around 6x. Which multiple represents the real value of Killen? No doubt the buyer in this case, as in most others, would rather see the kind of performance that would justify paying the full earn-out, and the seller would prefer that as well.ConclusionSometimes bad deals can be saved by good markets, but that’s not much of an acquisition strategy. As a consequence, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better than working knowledge of them. We’ll talk more next week about the structure of contingent consideration in investment management firm deals, but drop us a line in the meantime if you’d rather not wait.
Oil and Gas Investors Note Move Away From Contango
The Wall Street Journal recently published an encouraging article, “Oil Prices Flash a Buy Signal,” explaining that futures contracts are trending to a flat curve. Ever since the fall in crude oil prices in mid-2014, the market has remained in contango, signaling that the industry still faced rough times ahead. The current movement away from contango and toward backwardation is the first positive forward price estimate since 2014 and oil and gas investors are taking note. Before we jump into the details, let’s review the possible commodity market conditions.
What is Contango/ Backwardation?ContangoF < E(S)A contango market simply means that the futures contracts are trading at a premium to the spot price. Contango is the result of an “oversupplied market with abundant inventories.” For example, if crude oil is trading at $45 per barrel right now, and the six month contract is trading at $50, the market is said to be in contango. For the last three years, we have been operating in a contango market.BackwardationF > E(S)Backwardation (or normal backwardation), on the other hand, is a symptom of an “undersupplied market with tight stockpiles.” If crude oil is trading at $45 per barrel right now, and the six month contract is trading at $40 per barrel, then that market would be said to be in a backwardation.It currently appears that pricing in the future contracts are moving closer to backwardation. The table below shows the future contract spread for the previous 13 months. The most recent data returns the narrowest spread since 2014 of ($0.73) compared to one year ago when the market had a wider contango spread of ($5.72).
To break down the significant change over the previous three years, the chart below shows the 2014, 2016, and 2017 WTI futures curve for 24 months and the spread between Month 1 and Month 24. Positive spread indicates backwardation, while negative spread indicates contango.
What is not clear, however, is the cause for the flattening curve. Is the cause on the supply side or demand side?
Barron’s recently highlighted the improved economic outlook for the industry. Their investment strategists pointed at two factors which are helping keep crude oil prices steady and may lead to increases in the future. First, inventories are lower at this year than they were last year at this time. Second, the value of the dollar is falling which could cause the price of crude to rise.
However, their optimism was accompanied by cautiousness. After Pioneer’s recent losses, we are reminded that even the Permian Basin is not protected from difficulties. Many investors have started to worry about the fate of the Permian Basin. Some companies have reported that they are producing more natural gas and natural gas liquids than previously expected and as oil wells age, they tend to produce more natural gas.
ConclusionThe movement in the future spread away from a contango environment and toward backwardation is positive from a supply and demand perspective. Expectations are a backwardation environment will move crude oil prices higher. However, the exact cause of this change is unknown. While this shift is good news for the industry, company specific risk and investor's fickle attitudes create volatile equity markets.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 auditors. These oil and gas-related valuations have been utilized to support valuations for IRS estate and gift tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
What’s Got Our Eye
Current RIA Trends
This week, we’re sharing some recent media on trends in the RIA space. We’ve blogged about asset flows, bank interest in the RIA space, the plight of active management, and the fiduciary rule, but these articles represent a deeper dive into each of these topics."ETFs, ETPs Record Robust Asset Flows in First Half"by Michael S. Fischer of InvestmentAdvisor. The march of passive products continued full force in June, which saw record inflows of $63.6 billion to ETFs and ETPs around the globe, bringing year-to-date inflows to an impressive $347.7 billion, compared to net inflows of only $123.6 billion in the first half of 2016."Switching From Wirehouse to RIA"by Michael Kitces. Amidst the wave of advisors transitioning from wirehouses to independent firms, Kitces takes fifteen minutes to discuss the factors advisors should examine when considering making the transition."Banks Gobbling up RIAs as Consolidator Field Shrinks"by Janet Levaux of Investment Advisor. Though the year-to-date number of transactions in the RIA M&A space is up over 10% from 2016, fewer transactions were seen in Q2 compared to Q1 and the average AUM of RIAs involved in these transactions has fallen to $700 million, compared to an average of $1 billion over the last four years. DeVoe & Co. attribute this trend to the falling number of consolidators in the business."ETFs Now Have $1 Trillion More Than Hedge Funds"by Sarah Krouse of The Wall Street Journal. Assets in ETFs first surpassed investment in hedge funds two years ago and have accelerated ever since as investors continue to shun active products."Active Can Be Fiduciary; The Value of an Advisor"by Bob Veres of Inside Information. Bob discusses his vision of an active manager’s role in a post fiduciary rule investment environment as the enforcement date draws nearer. He also explores the many ways active managers can add value to clients outside of traditional money management.
If you have valuation questions regarding your RIA firm or if you would like to continue any of the above discussion further, give us a call.
3 Things to Know Before Selling Your Oil and Gas Royalty Interest
There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.We believe there are three points you need to understand before attempting to sell your mineral interest.1. Understand What You Are SellingA royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.12. Recognize Production and Price as Value driversThe value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.Production: The Decline Curve’s ImpactAs oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.Price: Local and Global Market ForcesOil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well. For example, natural gas in the Marcellus and Utica sells at a substantial discount to the NYMEX due to the lack of infrastructure carrying gas out of the region.3. Understand Location’s ImpactDrilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.What to Look Out ForWhile there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.Since the crash in oil prices, many royalty owners stopped receiving royalty checks; however, this does not mean your royalty interests are worthless. One warning sign to be aware of is online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue.While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.End Note1 For more information on mineral interests see our recent post, Three Types of Mineral Interests.
2Q17 Call Reports
The More Things Change, the More They Stay the Same
Established trends from prior call reports continued into the second quarter of 2017. Capital continues to flow into ETFs and other passive investment products at a rate such that AUM and revenues are increasing despite the ongoing struggle of actively managed products. The trend towards fee-based compensation models continues as managers strive to maximize transparency and compete with passive products being offered at much lower rates. In addition, the DOL rule—having taken effect as of June 9—is set to start being enforced in January 2018. Resistance from members of the asset management industry, however, has some asset managers hoping for additional delays on the rule’s enforcement.As we do every quarter, we take a look at some of the earnings commentary on pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: After a tough year for some asset managers in 2016, many firms are enjoying sustained net inflows quarter-over-quarter, with some experiencing record inflows and peak levels of AUM.“Net inflows for the last 12 months totaled $336 billion as organic growth accelerated in the second quarter. Total quarterly flows exceeded $100 billion and were positive across client types, asset classes and investment styles…second quarter long-term net inflows of $94 billion were a record for BlackRock and represented an annualized organic growth rate of 7%.” – Gary Shedlin,
BlackRock CFO and Senior Managing Director“We ended the quarter with $33.5 billion in assets under management, the highest level of AUM in the firm’s history. Net flows have been positive, reflecting inflows from a range of existing clients and new relationships, and the lowest level of outflows we’ve experienced during the period since the global financial crisis.” – Richard Pzena, Pzena Investment Management Chairman and CEO“Open-ended funds had record assets under management of $21.6 billion, an increase of $1.3 billion or 6% from last quarter and an annualized growth rate of 9%. And assets under management in closed-ended funds increased to $149 million or 2% from last quarter. This marks the 11th consecutive quarter of net inflows.” – Matthew Stadler, Cohen & Steers CFO and Executive Vice PresidentBlackRock saw “$86 billion of net inflows to iShares and index funds in the second quarter. Global iShares momentum continued with a record $74 billion of net inflows for a total of $138 billion in net inflows year-to-date.” – Larry Fink, BlackRock Chairman and CEOTheme 2: The Department of Labor Fiduciary Rule officially took effect as of June 9, though the DOL has said it will not enforce the rule until after January 1, 2018. Uncertainty regarding the rule remains, however, as there is growing support for a further delay of the rules enforcement until January 2019.“I think, with the DOL, we’re in a comment period. It’s a little bit quiet right now. People are drafting responses to both the SEC and the DOL. Our sense is that the two now are talking and have been public in trying to work together. So our view is that the January 1 date will be pushed back. That’ll be the goal, I think, of most in the industry to try to give time to have a thoughtful overall standard developed with the two groups. And you also have momentum on the legislative front to do away with it completely. So I think that’s still a possibility. But I think the more probable is a delay and then the two groups working to come up with a workable standard.” – Greg Johnson, Franklin Resources Chairman and CEOTheme 3: Industry players embrace investment in technology and explore the applications of ETFs not simply as passive investment products, but as investing tools used by active managers.“The rapid growth we’re seeing in iShares and index funds is increasingly due to the fact that ETFs are no longer used only as a passive allocation, but by active investors to generate alpha in their portfolios. ETFs provide those investors targeting exposures without idiosyncratic risk of any one single stock or any one single bond.” – Larry Fink, BlackRock Chairman and CEO“Long-term net inflows were driven by iShares, which continues to benefit from the rapid adoption of ETFs as asset allocation tools and financial instruments by professional money managers.” – Gary Shedlin, BlackRock CFO and Senior Managing Director“Going forward, technology-enabled scale will be increasingly important for every aspect of an asset manager’s business, our client service, our asset generation and operational excellence. This year, we will be spending $1 billion on technology and data, and have over 3,500 employees working on technology and data-related roles.” – Larry Fink, BlackRock Chairman and CEO
Mercer Capital provides business valuation and financial advisory services to asset managers. If you’d like to discuss a valuation for transaction need in confidence, give us a call.
Corporate Finance in 30 Minutes Whitepaper
Travis W. Harms, senior vice president of Mercer Capital, wrote a series of whitepapers that focused on demystifying corporate finance for board members and shareholders. In this whitepaper, he has distilled the fundamental principles of corporate finance into an accessible and non-technical primer.
Structured around the three key decisions of capital structure, capital budgeting, and dividend policy, this whitepaper is designed to assist directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.
Mercer Capital’s goal with this whitepaper is to give directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. We also provide financial education services to family businesses. We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business. Contact a Mercer Capital professional today to discuss your needs in confidence.Click here to read Corporate Finance in 30 Minutes.
Trends in the Oil and Gas Industry
Then & Now
You don’t need an expert to tell you that the oil and gas industry has significantly changed over the past three years. Simply looking at crude oil and natural gas prices from 2014 versus today can confirm this. However, understanding how the change in oil prices has affected the value of your oil and gas business is a little more difficult.Looking Back at the Price TrendIn early 2014, a barrel of oil cost more than twice what it does today. Three years ago the oil and gas industry appeared to be on an upward trend. Industry revenues were expected to increase over the next several years, oil prices (which were holding around $100/barrel) were expected to rise, and futures prices had already jumped, indicating that oil would become more expensive. Some analysts even believed that if the Iraq crisis escalated, crude oil prices could surpass $120/bbl. U.S. production increased, and for the first time in four years, demand in developed nations was expected to increase as well. Although there was concern about political instability in Iraq, due in large part to Al Qaeda activity, many saw 2014 as a “great entry point” into the energy industry. In the Fortune article “Energy Bulls Are Ready for a Run,” Craig Hodges, CEO of Hodges Capital said, “The opportunities are fantastic, and we’re in the very early innings of a renaissance in the energy industry.”Looking back, we know that the oil and gas narrative strongly deviated from expectations. After peaking at $107.95/barrel on June 22, 2014 oil prices began to spiral downward, ultimately reaching record lows in the first quarter of 2016 at just over $26/barrel. As a result of this price crash, more than 120 upstream and oilfield companies were forced into bankruptcy over the next two years.Looking Beyond PriceAs exemplified by the collapse of oil prices in mid-2014, market shifts can be hard to anticipate. Our professionals closely track trends and events affecting the oil and gas markets, analyzing their value implications. Many focus only on the decline in prices, but countless other factors have also fundamentally changed the industry over the past three years affecting oil and gas valuations. While there are far too many to list in full here, some highlights are included below.The Export BanIn December 2015, Congress lifted an export ban that kept all domestic crude oil within the U.S. for the past 40 years (with the exception of exports to Canada). In January 2016, the first shipments of oil left U.S. ports for Europe. Many analysts saw this as “symbolic of the country’s newfound role as a lead producer of oil,” and noted that the U.S. could now serve as a stable supplier in an energy market where many suppliers are located in regions fraught with unrest. This trend has continued by supplying China with significant quantities of crude oil in recent months.Improved Drilling TechnologyAdoption of innovative drilling techniques, such as horizontal drilling and hydraulic fracturing, has made production quicker, easier, and cheaper, while also unlocking reserves that were previously regarded as unattainable. Due in large part to technological advances, U.S. crude oil production has risen 10% since prices began to recover in late 2016. By cutting producer costs, technology allowed producers to continue operations in low price environments, which would have previously forced them to shut down. According to Rystad Energy analysis, “Since 2013, the average wellhead breakeven price (BEP) for key shale plays has dropped from US$80/barrel to US$35/barrel. This represents a decrease of over 55%, on average.”U.S. ShaleLargely as a result of improved technology, the U.S. Shale Revolution greatly impacted the oil and gas industry. As mentioned above, various drilling technologies unlocked shale plays throughout the U.S., particularly in the Bakken and Marcellus regions. Increased shale production significantly added to the U.S. oil supply, which is expected to be 800 mb/d greater in 2017 than it was in 2016. U.S. shale survived the 2014 oil price crash with cost cuts and lower breakeven prices and emerged more resilient from the downturn. On a global scale, U.S. production gains have essentially counteracted OPEC’s production cuts. Because the breakeven price for many U.S. shale plays has dropped, uncertainty looms regarding how low commodity prices must drop before U.S. producers will scale back production. The following graph shows U.S. oil and gas production over the past ten years.Political InstabilityMany oil and gas suppliers are located in regions fraught with civil and political unrest. In 2014, analysts focused on what impact potential disruptions in Iraqi oil supply, due to Al Qaeda activity, may have on the global market. While no longer centered on Iraq, concerns about political instability persist within the industry. Today, analysts are looking to the Persian Gulf to determine if unrest, particularly in Qatar, will alter the industry’s trajectory.The simultaneous impact of each of the events discussed here (among countless others) has flipped the oil and gas industry on its head, allowing the U.S. to become more energy independent and to grow its market share. While this is great news for the U.S. from an economic, security, and defense perspective, it is threatening to other countries – notably to historically influential producers like Saudi Arabia and Russia. As the U.S. continues to garner market share, political relationships are due to shift, likely impacting the oil and gas industry.Implications on Oil and Gas ValuationsMercer Capital tracks the performance of exploration and production companies across different mineral reserves in order to understand how the current pricing environment affects operators in each region. The dramatic drop in price, by itself, materially impacted the value of all companies operating within the oil and gas industry – upstream, midstream, or downstream. Of 60 companies Mercer Capital tracks in the E&P oil and gas industry, 81% saw their market cap decrease over the past three years, by an average of 26.63% and a median of 46.85%. The graph below shows different regions stock performance over the past three years.
As shown above, as a result of the myriad of changes within the oil and gas industry, company values today are not what they were three years ago. Like many industries, the oil and gas industry not only changes quickly but it also changes dramatically. In order to set a proper context for the valuation, it is crucial to understand the industry climate as of your valuation date. Over the past three years, opening U.S. oil to exports, increasing driller productivity due to gains in technology, and the shale revolution have created an oversupply of oil, which has driven the price of oil down. While our analysts cannot say for certain what’s coming next for this industry, we invite you to follow these trends with us.
Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Our thanks to Paige Klump who drafted and did much of the research for this post in collaboration with our Energy Group.
RIA Dealmaking
What’s the Hold-Up?
We’re always perplexed by the lack of transactions in the RIA industry. Sure, there are some out there, but a typical year reports less than a hundred deals in a space with almost 12,000 federally registered advisors. This means that less than 1% of industry participants transact in a given year. How could that be in an aging profession with a highly scalable business model? We offer a few explanations in this week’s post.1. Most RIAs are not big enough to be consistently profitableAccording to the Investment Adviser Association, the “typical” SEC-Registered Investment Adviser has $317 million in AUM, between 26 and 100 accounts, nine employees, and is headquartered in New York, California, Florida, Illinois, or Texas. It’s hard to envision that a business of this size would generate enough revenue to cover overhead and professional staff expenses (likely in an expensive market) and yield much profitability, particularly during a market downturn, especially if you consider that many believe $500 million in AUM to be the breakeven point for many asset managers to generate consistent levels of profitability (depending on size, headcount, location, client type, etc.). If valuation is based on earnings, then the average RIA may not have much to sell.2. Many asset managers don’t have sustainable enterprise value beyond their owner(s)A lot of RIA principals have not taken the necessary steps to transition their client relationships, investing acumen, business development capabilities, and/or managerial responsibilities to other staff or the next generation of firm leadership. To a prospective buyer, this means there is significant risk that the RIA’s accounts and firm viability will not outlive its owners. This is part of the reason why so many asset manager transactions are structured as earn-outs – to protect the buyer against future declines in fees or earnings associated with a principal’s departure or reduced activity levels in the business after the deal.3. Asset managers are (currently) expensiveDespite what you’ve been reading about industry headwinds (fee pressure, competition from passive products, etc.), most RIAs are more valuable than ever. Since the market is trading at an all-time high, many asset managers’ AUM balances are as well, which means higher fees, earnings, and valuations. Such a high price tag makes them less appealing to prospective buyers looking to maximize ROI.4. Many RIAs have distinct cultures that don’t necessarily jive with prospective buyersThis is probably the case with many industries but seems especially true for asset managers. The business and its reputation have come a long way from the Wolf of Wall Street broker culture of the late 80s and early 90s. Still, these businesses tend to have unique attributes and identities that aren’t necessarily conducive to firms in different (or even the same) industries. Banks, for example, have recently taken an interest in the business for its high margins and low capital requirements. In our experience, though, bank and RIA cultures often don’t mesh; this can be an unforeseen hurdle in a deal that may make a lot of sense on paper.5. Asset managers value independence and often prefer to transition the business internallyMost RIAs are employee-owned, and that’s by design. To keep the company’s culture and investment/client relations teams intact, many principals looking to exit the business will often look to the next generation of firm leadership as prospective buyers for their interest. They do this to avoid outside influence and appease institutional investors who often seek independent RIAs wholly controlled by the firm’s principals. Buy-sell or shareholders’ agreements that allow younger principals to buy in at a discount to fair market value are not uncommon for asset managers looking to encourage employee ownership and remain independent.ConclusionOn balance, though, we think the outlook for asset manager M&A is promising. The industry is still fragmented and ripe for further consolidation. An aging ownership base is another impetus, and the recent market gains might induce prospective sellers to finally pull the trigger. Fee compression could also lead to more transactions if RIAs look to create synergies and cost efficiencies to maintain their profit margin. We haven’t come across much of this yet but are seeing more clients and prospects ask about succession planning and exit strategies. Perhaps this is a sign of more to come, which isn’t saying a whole lot.
The Fair Market Value of Oil and Gas Reserves
Oil and gas assets represent the majority of value of an E&P company. The Oil and Gas Financial Journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed before, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves, but none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations.The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus, the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that:
The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income.
Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below.
The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
End Notes1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.
Why TAMs (Traditional Asset Managers) Continue to Thrive Despite Industry Headwinds
The Memphis Tams from the 1970s and Mike Conley from the Memphis Grizzlies in a Throw-Back UniformCondensed History of the TAMS – An American Basketball Association FranchiseMemphis is home to the NBA franchise, the Memphis Grizzlies. One of the predecessor organizations to our hometown Grizzlies was the Memphis Tams. Aptly named for the only professional basketball team in the [T]ennessee, [A]rkansas, and [M]ississippi tri-state area, the Tams were a quick afterthought in the ABA’s history, enduring a lackluster 45-123 record in just two seasons in the early seventies. My dad was one of the few attendees of their home games, played at the now obsolete Mid-South Coliseum, which never saw attendance crest the 5,000 mark. He recalls a bizarre “mustache clause” in each of the player’s contracts, that offered a $300 bonus to those who would grow one and a rather dubious hat-shaped mascot (apparently “tam” is also short for a tam o’shanter, which is a traditional Scottish bonnet, similar to the one donned by Meg Griffin on Family Guy). It was one of Memphis’s most pathetic sports franchises.Fortunately, this is no longer the case. The current Memphis mascot, though equally dubious given the lack of grizzlies in the tri-state area, is far more intimidating and appropriate for a professional sports franchise. The Grizz are one the few teams to have made the playoffs in each of the last seven seasons and regularly contend for one of the top spots in the tough Western Conference. The club has quietly become one of the league’s most consistent and well-attended franchises, despite attracting virtually no national media coverage or superstar athletes in its 22-year history.Current Performance of TAMS – Traditional Asset ManagersMost traditional asset managers (also sharing the TAM initials), a similarly consistent, yet overlooked subset of the RIA industry, are in bull market territory over the last year in the face of fee compression and continued outflows from active equity products.While hedge funds and PE firms tend to dominate current RIA headlines, TAMs are quietly gaining market share as investors question performance fees and the lack of transparency offered by many alternative asset managers. Indeed, all five components of our publicly traded TAM group below are up over the last year, and four of them have bested the market by a fairly considerable margin.Why Are TAMs Performing Well?We would attribute the group’s gains to both systematic and non-systematic factors. That is, the market’s gain (a systematic force affecting all stocks, especially RIAs) has clearly helped the group’s collective AUM balance, while non-systematic forces such as solid investment performance (PZN), new account additions (BLK), and prior acquisitions (AMG/LM) account for much of the residual success of the individual components. In our experience, most well-established RIAs similarly attribute their success to systematic (market-related) and non-systematic (marketing-related) growth factors.ConclusionSo, despite their name, most TAMs have performed more in line with the Grizzlies rather than its predecessor over the last several years. In fact the last true bear market for the TAMs and the Grizz alike occurred in the 2008-09 downturn when the TAMs collectively lost over half their market cap, and Memphis lost over two-thirds of its games. Since then, the (RIA) TAMs have more than doubled in value, and the Grizzlies have had one of the highest winning percentages in the NBA. Of note, the only time the Grizz had a worse record than the Tams occurred in the 1998-99 season, when the team went 8-42 and played in Vancouver, which is an actual bear market.Mercer Capital provides business valuation and financial advisory services to traditional asset managers. If you’d like to discuss a valuation for transaction need in confidence, give us a call.
How to Value an Oil and Gas Refinery
When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of refineries is important in establishing a credible value for a business operating in the oil and gas refining space.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines)Downstream (Refineries)
Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Refiners convert raw crude and natural gas into products of value, such as transportation fuels.Oil and Gas Refinery OperationsCrude oil itself has little end use. Refiners create value by converting crude oil into various usable products. Transportation fuels, such as gasoline, diesel, and jet fuel, are some of the most commonly produced refined products. Other refined products include heating and lighting fluid, such as kerosene, lubricating oil and waxes, and asphalt. Refineries are capital intensive and their configuration depends largely on their physical location, available crude oils, product requirements, and environmental standards.Valuing an oil and gas refinery requires the consideration of a wide range of issues (far too many to list in full here), with primary considerations as outlined below.The price of inputs. The price of crude oil fluctuates due to changes in world demand and supply. Many refiners hold large volumes of crude inventory, but as the price of crude oil fluctuates, refiners face risk associated with the falling value of their inventory. Thus, in order to reduce risk refiners should shorten their timeline from purchasing crude oil to selling the finished product and/or use derivatives to hedge the risk associated with volatile oil prices.The price of refined products. There are four main components to refined product prices: (1) Crude Oil Prices, (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. However, President Trump has indicated that he hopes to lower corporate taxes.Crack spread. A refiner’s margins are generally determined by the crack spread, which measures the prices of refined products compared to the cost of crude oil. The price of transportation fuels generally moves in sync with the prices of crude oil, but the price of some refined products such as asphalt and lubricating oils is not as closely correlated with crude oil price changes.Environmental regulation. The refining industry has historically been heavily regulated. Regulations such as the RTR & NSPS aim to control air pollution from refineries and provide the public with information about refineries’ air pollution. President Trump is working to establish a more energy friendly environment and has signaled his intention to sign the repeal of many methane emission regulations if the repeal is passed through both Houses of Congress.Heavy vs. light crude. Most U.S. refineries were built to process heavy crude. However, the onset of U.S. shale drilling has led to a surplus of light sweet crude that U.S. refineries were not originally built to process. While the refining process of heavy and light crude is generally the same, the refining of light crude is less costly.Oil and Gas Refinery Financial AnalysisWhen valuing a business, it is critical to understand the subject company’s financial condition. A financial analyst has certain diagnostic markers that tell much about the condition of a business.Balance Sheet. The balance sheet of a refinery is dominated by inventory and fixed assets. According to RMA’s annual statement studies, 16.3% and 32.2% of petroleum refineries’ assets are inventory and fixed assets, respectively.1 Because refining is a capital intensive business, it is important to consider the current operating capacity of a company’s fixed assets in order to determine if future growth will require significant capital expenditures. If a refinery hopes to expand refinery throughput beyond the current refining capacity, it will have to invest in more equipment.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold account for approximately 75% of sales according to the RMA data. Thus it is important to consider possible supplier concentrations when analyzing the income statement because disruptions in the supply chain can have significant income statement impacts to oil refineries.How Does Valuation Work?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.The Asset-Based ApproachThe asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, and only look at assets as a source of rate of return. Oil and gas refineries are asset intensive businesses. They have distillers, crackers, cokers, and more. While an asset value consideration can be a meaningful component of the overall valuation of an oil and gas refinery, it is essentially the income generated by these assets that typically drives the value of a business. For this reason, the asset-based approach is typically not the sole (or even primary) indicator of value.The Market ApproachThe market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.In the downstream oil and gas sector, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. Such options are Alon US Energy Inc., CVR Refining, LP, Valero Refining, and Western Refining. Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized to calculate a valuation multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. Additionally earnings multiples such as EV/ EBITDA can be used to calculate indication of values.The market-based approach is not a perfect method by any means. For example, industry transaction data may not provide for a direct consideration of specific company characteristics. Say a company is a market leader and operates in a prime geographic market. Since the market and the specific company are relatively more attractive than the average transaction, the appropriate pricing multiple for this company is likely above any median taken from a group of industry transactions. Additionally, many companies in the oil and gas industry are vertically integrated and have significant midstream or marketing operations in addition to their refining operations. For example, Marathon Petroleum Company is a leading refiner in the US, but is also a marketer of refined products and has significant midstream operations. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach can provide a helpful indication of value and should be used in determining the value of a refinery.The Income ApproachThe income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. When determining ongoing earnings historical earnings should be analyzed for non-recurring and non-normal income and expenses which will not affect future earnings. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate.Income is the main driver of value of a business; thus, the income approach should be considered when determining the value of your business.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue, earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.An owner who is contemplating any kind of transaction or agreement based on value needs to know what their business is worth. Whether you are selling out or selling in, knowing the fair market value of your business will let you evaluate whether or not an offer for your company is reasonable. Additionally, many business owners fail to understand the valuation implications of buy-sell agreements. If you have other shareholders in your business who are non-family, and maybe some who are, you probably have some kind of buy-sell agreement between the shareholders that describes how the business (or business interests) will be valued in the event of a shareholder dispute, death, or departure from the business (even on friendly terms). A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.Mercer Capital has long promoted the concept of managing your business as if it were being prepared to sell. In this fashion you promote the efficiencies, goals and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at 901.685.2120.End Note1 2016-2017 RMA Statement Studies. NAICS #324110. Companies with greater than $25 million in sales.
A Rising Tide Lifts All Boats
All Classes of Asset Managers Up Over the Last Year
Favorable market conditions over the last twelve months have buoyed RIA market caps to all-time highs. This almost seems counterintuitive against a backdrop of fee compression, fund outflows, and generally negative press (some of it by us), but a rising market means higher AUM balances, leading to greater fees and profitability, regardless of other headwinds facing the industry - not a perfect storm by any means, but good enough to best the broader indices during a relatively strong stock market rally.
RIA Market Performance as of 6/1/17
Publicly traded custody banks (BNY Mellon, State Street, and Northern Trust) outperformed other classes of asset managers over the last twelve months, continuing their upward trajectory over the last few years but still lagging the broader indices since the financial crisis of 2008 and 2009. Placing this recent comeback in its historical context reveals the headwinds these businesses have been facing in a low interest rate environment that has significantly compressed money market fees and yields on fixed income investments. Their recent success may, therefore, be indicative of a reversion to mean valuation levels following years of depressed performance, rather than a sudden surge of investor optimism regarding future prospects. Further, pricing improvements for this group appear to be more relative to an improved banking environment than a change in circumstances for trust and custodial services.
Still, in recent quarters, most trust bank stocks outperformed other classes of asset managers, like mutual funds and traditional RIAs, as passive products and indexing strategies continued to gain ground on active management. A rising yield curve portends higher NIM spreads and reinvestment income, and the market has responded accordingly – our custody bank index gained 45% over the last year, surpassing the broader indices and all other classes of asset managers.
Publicly traded alternative asset managers have also performed well in recent months, but, like custody banks, are still reeling from poor investment returns over the last decade. The value-added proposition (alpha net of fees) has been virtually non-existent for many hedge funds and PE firms over this period despite the sector’s recent gains.
Once again, the RIA size graph seems to imply that smaller RIAs have significantly underperformed their larger peers over the last twelve months. The reality, though, is that this segment is the least diversified (only two components, Hennessy Advisors and US Global Investors, both of which are thinly traded) and certainly not a good representation of how RIAs with under $10 billion in AUM are actually performing. Specifically, Hennessy’s weakness is largely attributable to recent sub-par investment performance from its Cornerstone Growth Fund, and US Global’s focus on natural resource investing has taken a hit from softening commodity prices. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) haven’t lost half their value since August as suggested by this graph. Other sizes of publicly traded asset managers have performed reasonably in line with the market over this period.
Market OutlookThe outlook for these businesses is similarly market driven - though it does vary by sector. Trust banks are more susceptible to changes in interest rates and yield curve positioning. Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets. Mutual funds and traditional asset managers are more vulnerable to trends in active and passive investing. All are off to a decent start in 2017 after a strong end to 2016 as the market weighs the impact of fee compression against rising equity prices.
Creating Value at Your Community Bank Through Developing a FinTech Framework
This discussion is adapted from Section III of the new book Creating Strategic Value Through Financial Technology byJay D. Wilson, Jr., CFA, ASA, CBA.
I enjoyed some interesting discussions between bankers, FinTech executives, and consultants at the FinXTech event in NYC in late April. One dominant theme at the event was a growing desire of both banks and FinTech companies to find ways to work together. Whether through partnerships or potential investments and acquisitions, both banks and FinTech companies are coming to the conclusion that they need each other. Banks control the majority of customer relationships, have a stark funding advantage and know how to navigate the maze of regulations, while FinTechs represent a means to achieve low-cost scaling of new and traditional bank services. So one key question emerging from these discussions is: Who will survive and thrive in the digital age? As one recent Tearsheet article that I was quoted in asked: Should fintech startups buy banks? Or as another article discussed: Will banks be able to compete against an army of Fintech startups?Build, Partner, or AcquireBanks face a conundrum of whether they should build their own FinTech applications, partner, or acquire. FinTech companies face similar questions, though the questions are viewed through the prism of customer acquisition rather than applications. Non-control investments of FinTech companies by banks represent a hybrid strategy. Regulatory hurdles limit the ability of FinTech companies to make anything more than a modest investment in banks absent bypassing voting common stock for non-voting common and/or convertible preferred.While these strategic decisions will vary from company to company, the stakes are incredibly high for all. We can help both sides navigate the decision process.As I noted in my recently published book, community banks collectively remain the largest lenders to both small business and agricultural businesses, and individually, they are often the lifeblood for economic development within their local communities. Yet the number of community banks declines each year through M&A, while some risk loosened deposit relationships as children who no longer reside in a community where the bank is located inherit the financial assets of deceased parents. FinTech can loosen those bonds further, or it can be used to strengthen relationships while providing a means to deliver services at a lower cost.Where to StartIn my view, it is increasingly important for bankers to develop a FinTech framework and be able to adequately assess potential returns from FinTech partnerships. Similar to other business endeavors, the difference between success and failure in the FinTech realm is often not found in the ideas themselves, but rather, in the execution.Banks face a conundrum of whether they should build their own FinTech applications, partner, or acquire.While a bank’s FinTech framework may evolve over time, it will be important to provide a strategic roadmap for the bank to optimize chances of success. Within this framework, there are a number of important steps:Determining which FinTech niche to pursue;Identifying potential FinTech companies/partners;Developing a business case for those potential partners and their solutions; andExecuting the chosen strategy.
For a number of banks, the use of FinTech and other enhanced digital offerings represents a potential investment that uses capital but may be deemed to have more attractive returns than other traditional bank growth strategies. Community banks typically underperform their larger brethren (as measured by ROE and ROA) because fee income is lower and expenses are higher as measured by efficiency ratios. Both areas can be enhanced through deployment of a number of FinTech offerings/solutions.The Importance of a Detailed IRR AnalysisThe decision process for whether to build, partner, or acquire requires the bank to establish a rate of return threshold, which arguably may be higher than the institution’s base cost of capital given the risk that can be associated with FinTech investments. The range of returns for each strategy (build, partner, or acquire) for a targeted niche (such as payments or wealth management) provides a framework to help answer the question how to proceed just as is the case with the question of how to deploy capital for organic growth, acquisitions, and shareholder distributions. The same applies for FinTech companies, though often the decision is in the context of whether to accept dilutive equity capital.A detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course.While each option presents a unique set of considerations and execution issues/risks, a detailed analysis, including an IRR analysis, helps a bank determine the financial impact of each strategic decision and informs the optimal course. A detailed analysis also allows the bank to compare its FinTech strategy to the bank’s more traditional growth strategies, strategic plan, and cost of capital. See the table to the right for an example of a traditional community bank compared to a bank who has partnered with a FinTech company.Questions Regarding PartneringBeyond the strategic decisions and return analyses, some additional questions remain for community banks that consider FinTech partners, including:Is the bank comfortable with the FinTech company’s risk profile?What will the regulatory reaction be?Who will maintain the primary relationship with the customer?Is the FinTech partnership consistent with the bank’s long-term strategic plan (a key topic noted in the OCC’s whitepaper on supporting innovation)?Questions Regarding AcquiringShould the community bank ultimately decide to invest in a FinTech partner a number of other key questions emerge, such as:What is the valuation of the FinTech company?How should the investment be structured?What preferences or terms should be included in the shares purchased from the FinTech company?Should the bank obtain board seats or some control over the direction of the FinTech Company’s operations?How Mercer Capital Can HelpTo help both banks and FinTech companies execute their optimal strategies and create maximum value for their shareholders, we have a number of solutions here at Mercer Capital. We have a book that provides greater detail on the history and outlook for the FinTech industry, as well as containing targeted information to help bankers answer some of the key questions discussed here.Mercer Capital has a long history of working with banks. We are aware of the challenges facing community banks. With ROEs for the majority below 10% and their cost of capital, it has become increasingly difficult for many banks to deliver adequate returns to shareholders even though credit costs today, are low. Being both a great company that delivers benefits to your local community, as well as one that delivers strong returns to shareholders is a difficult challenge. Confronting the challenge requires a solid mix of the right strategy as well as the right team to execute that strategy.No one understands community banks and FinTech as well as Mercer Capital.Mercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategy. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech into it and Mercer Capital can help.We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution.We can identify which FinTech niches may be most appropriate for your bank given your existing market opportunities.We can identify which FinTech companies may offer the greatest potential as partners for your bank.We can provide assistance with valuations should your bank elect to consider investments or acquisitions of FinTech companies.
No one understands community banks and FinTech as well as Mercer Capital. We are happy to help. Contact me to discuss your needs.
This article first appeared in Mercer Capital's Bank Watch, June 2017.
EQT’s Acquisition of RICE Energy
Our Valuation Analysis of This Marcellus and Utica Mega Deal
Deal OverviewOn June 19, 2017, EQT announced the acquisition of Rice Energy (RICE) for approximately $6.7 billion. RICE will receive approximately $4.1 billion in EQT common stock and $1.1 billion in cash as well as be relieved from $1.5 billion in net debt that EQT is assuming.Based on EQT disclosures, the assets owned by RICE include (1) 255 wells currently producing 1,145 mmcfe per day (mmcfepd) which are expected to increase to 1,300 mmcfepd; (2) 252,000 in net Marcellus and Utica acres with more than 1,100 net locations remaining to explore; (3) 92% of RICE GP interest including the incentive distribution rights (IDR’s); and (4) 28% of Rice Midstream Partners (RMP). By all accounts, the location of the acreage is contiguous or nearby to EQT’s current acreage and the combination of the two companies will create the largest gas producer in the Marcellus and Utica.Reported Valuation Multiples Do Not Present the Whole PictureIn comparison to other operators in the Marcellus and Utica, the transaction is on the higher end of the range with Antero Resources Corp (AR) and Cabot Oil and Gas (COG) when considering an EV/Daily Production multiple and on the high end with the acreage multiple (See Table 2). However, the “reported” value multiples may not be the whole picture.
We have considered EQT’s offer to RICE shareholders, but RICE’s shareholders only own 28% of Rice Midstream and 92% of the GP interest. Due to the accounting rules for consolidation, the majority of the income statement and production figures capture activity for 100% ownership (the non-controlling interest is not taken out until the end). Therefore, by not including the non-controlling interest that is consolidated into Rice’s balance sheet, we previously compared less than 100% of the Company’s Enterprise Vale to 100% of the Company’s production, acreage, and EBITDA.
What Does the “All In” Enterprise Value Mean to Investors?The non-controlling interest on the balance sheet of RICE amounts to $2.4 billion as of the end of Q1 2017. The offer for $6.7 billion was for the interest RICE owns in the business' assets. Therefore, to compare production and acreage multiples to the publics, we would need to calculate an “all in” enterprise value as shown in Table 3.
Under the “all in” approach, the production multiple of 48,415x is well above the other operators in the area (see Table 2) and investors should be excited about the proposed transaction according to the surface data. The EBITDA multiple is not a great indication here as some companies in the guideline group were marginally profitable at the EBITDA level leading to abnormally high EBITDA multiples. In response to the announced transaction, the share price of RICE increased approximately 25% or $1 billion.
Based upon our experience in performing valuation services in the Appalachian play, the analysis above appears reasonable. Table 4 shows the previous 20 transactions in the area. Not all transactions could be broken down into producing and non-producing acres; therefore, it is shown as a total price to total net acres multiple. The EQT and Rice transaction shows as the most expensive price / acre transaction of the last 20 in the area.
In Chart 1, disclosed by RICE and EQT, shows the acreage position with the resource play for RICE. According to this map, RICE has acreage in some of the most prolific and hottest areas in the Marcellus and Utica.
Allocating Assets in This Transaction to Fair ValueConsidering the purchase price implications of the Rice Energy transaction, based upon the publicly disclosed information, the assets to allocate to fair value appear as found in Table 5.Does This Transaction Result in a Marcellus and Utica Mega-Producer?The result of this transaction is the potential creation of a Marcellus and Utica mega-producer with over 1.9 million acres, 591 barrels of daily flowing oil equivalent and a stronghold in the gathering pipelines that can transport gas to the East, Midwest, and South in the near future. The implied enterprise value of $24 billion would approximately double the enterprise value of the company next closest in size, Antero Resources.Further Reading on This DealOver the previous week there have been many articles written on this transaction. We found the following articles most helpful:Rice Energy News Release: EQT To Acquire Ricer Energy for $6.7 BillionEQT Investor Relations: EQT Corporation to Acquire Rice Energy for $6.7 BillionOil & Gas Financial Journal: EQT to Acquire Rice Energy for $6.7 BHow Four Brothers Survived the Gas Bust to Make Family a BillionEQT to Acquire Rice Energy for $6.7 Billion -- UpdateThe EQT Corporation Acquisition of Rice Energy is SmartWith $8.2B Acquisition, Pittsburg’s EQT Becomes America’s Biggest Natural Gas ProducerMercer Capital’s ExperienceMercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Risk and Return: Working Interests and Royalty Interests
The U.S. Mineral Exchange defines a mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Last week we reviewed the three types of mineral interests – royalty interests, working interests, and overriding royalty interests. This week we analyze the risks associated with working interests versus royalty interests. An overview of royalty interests and working interests is included below:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid.
Central to corporate finance is the principle that returns follow risk. As the risk of an investment increases, so do potential returns and potential losses; lower risk means less expectation for reward. The Oil and Gas Financial Journal illustrates oil and gas investment risk in the following graphic:
When valuing mineral interests, it is important to consider the nuances of the each type of mineral interest. Given that risk and asset values are indirectly related, it is important to keep in mind the various risk factors which pertain to the mineral interest. We’ll begin by examining the various risks surrounding both types of interests.
RiskBoth working interests and royalty interests are exposed to fluctuations in oil and gas prices. When crude oil prices fell in mid-2014, so did the value of working interests, whose worth is based on the present value of the cash flows generated from production, and the value of royalty interests, whose value is based on future payments of revenue. Further, both working interests and royalty interests face the risk of depletion as oil and gas wells are depleting assets. Even if the price of oil and gas is stable from one year to the next, a well may have 30% less production in its second year. This can dramatically decrease the yield of particular royalty and working interests.Holders of working interests can mitigate the risk of depletion by drilling new wells or improving production of existing wells. While this gives a working interest holder more flexibility, it also requires a substantial investment in CAPEX. Working interest holders accept all fiscal burdens associated with the drilling process.Royalty interest holders, on the other hand, bear no cost of production but are at the mercy of their operators. Only the working interest owner can decide to halt production when prices drop and to increase production when the drilling environment is favorable. The Oil and Gas Financial Journal compares buying a royalty interest to “buying an income strip in producing wells, and the risks are primarily price volatility and depletion.”Each type of interest has unique attributes, but the fact that working interest owners are responsible for operating expenses makes working interests inherently riskier than royalty interests which are characterized by monthly “mailbox money” precipitated by zero costs. We see this when examining the volatility of select E&P companies who spun off their royalty interests into royalty trusts structured as MLPs.
The royalty trusts above generally demonstrate less volatility, which is often used as a proxy for financial risk, than their parent E&P companies. The principles of risk and return, however, tell us that because there are fewer risks associated with royalty interests they will yield lower returns than their riskier counterparts. Royalty interests range in percentage ownership of revenues from 0.025%-25%, meaning that, at the highest royalty interest, at least 75% of revenue is still funneled to the working interest owners. Due to differences in risk, royalty interests are unlikely to generate the magnitude of returns that working interests can experience. At the same time, they are less likely to experience the same degree of loss.
ReturnThe standardized measure of investment performance for a given unit of time is return. Investment returns have two components. The first, yield, measures the current income (distributions) generated by an investment. Capital appreciation, the second component, measures the increase in value during the period. As shown below, total return is the sum of yield and capital appreciation.
Royalty trusts commonly make substantial distributions because they generate revenue as long as their operators are drilling and they have minimal operating expenses. Thus it is important to examine total return when comparing interests in E&P companies, who own working interests, and royalty trusts who own royalty interests. In the chart below we examine the total returns of the companies introduced above and their associated royalty trusts.
As expected, the E&P companies which hold working interests show higher returns and steeper losses than their associated royalty trusts.
We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
3 Types of Mineral Interests
The US Mineral Exchange defines mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Mineral interests are divided into three categories – royalty interests, working interests, and overriding royalty interests. Each is defined as follows:Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid.Overriding Royalty Interest (ORRI)– a percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.
A royalty interest is created when an exploration and production (E&P) company wants to extract gas, oil, or other minerals from privately held property. In this scenario, the E&P company could purchase the land, but it is generally much cheaper and more feasible to lease the rights to drill on the land. Under this type of agreement, the E&P company pays the landowner an up-front payment, called a lease bonus, as well as a monthly royalty payment – a specified percentage of all revenues generated by the minerals extracted from the land. Although the landowner profits from the drilling efforts on their property, they do not pay any production costs. A royalty interest is paid as long as minerals from the land generate revenue. Generally, if production stops so do royalty payments. Very rarely, however, some contracts specify certain levels of production which must be maintained.
In the aforementioned situation, while landowners have a royalty interest, the E&P company has a working interest. As a result of the leasing agreement, the E&P company acquires the rights to the minerals on the property. This means that they bear the costs of exploration, drilling, and production, but they have rights to future cash flows generated once the wells are completed. The working interest owner must pay royalty interests, overriding royalty interests, and expenses before receiving their share of these cash flows.
Overriding royalty interests are often used as an incentive for those who are affiliated with the drilling process but do not own the minerals or E&P company (a broker or geologist for, example). Owners of ORRI, like royalty interest owners, bear no cost of production but own a portion of the revenues generated by the drilling process. Unlike royalty interest owners, however, ORRI owners do not receive the royalty for the entirety of production; instead, they are bound by explicit leases, outlining the length of time in which the ORRI will be paid.Current Issues Surrounding Mineral InterestsStates also can receive royalties from oil production. Under the Gulf of Mexico Security Act of 2006, Texas, Louisiana, Alabama and Mississippi became part of a revenue sharing program from off-shore drilling royalties in the Gulf of Mexico. In his 2018 budget, however, President Trump has proposed to repeal this act in order to redistribute the funds to taxpayers. The White House believes that this will save approximately $3.6 billion over the next decade, but the proposal has been met with disapproval both from politicians and the oil and gas industry. Next year alone, the royalty disbursement to the four states is expected to total $275 million, which would be directed to support environmental protection, infrastructure improvements, and coastal restorations. It is unclear if this change will be approved, but the four states’ royalties, like many individual royalty interests, are enveloped in uncertainty in the current market.Valuations of Mineral InterestsAlong with the majority of the oil and gas industry, royalties were hit hard as a result of the oil price downturn beginning in 2014. Among other factors, the success of US shale drillers drove the supply of oil up and subsequently forced the oil price to decade-lows. As a result of shrinking margins for E&P companies, oil production drastically decreased. For some, oil production stopped completely and royalty payments were soon to follow. During the oil downturn, many royalty distributions shrank dramatically while others disappeared completely. Over 120 companies filed for bankruptcy since the crash of commodity prices and most royalty owners were left to fend for themselves while uncertainty encompassed their mineral interests.Trends in royalty trusts can be indicative of the value of individual royalty interests. Over the past two years, nineteen out of twenty royalty trusts have shown negative price performance. However, when focusing solely on the past year, this number shrinks to three of twenty trusts exhibiting negative price performance. This suggests that royalty trusts are on an upward trend, and by extension that royalty interests are recovering as well. However, no two royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix and the value of royalty interests vary due to these factors.We will explore the valuation implications of each kind of interest in an upcoming blog post.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.Our thanks to Paige Klump who drafted and did much of the research for this post in collaboration with our Energy Group.
IPO Supply and Demand
Past blog posts have covered the almost peculiarly sleepy IPO market in the United States, its causes, and its consequences. Megan Richards checks in this week to show that not much has changed despite the otherwise buoyant investment landscape. The steady erosion in the number of publicly traded equities has been a tailwind for the market, and by extension, the investment management industry so far. Longer term, we see challenges presented by the undercurrent of illiquidity brought about by the unavailability of public offerings as a reliable exit opportunity for private equity.
The stock market rallied in the first five months of the year, with the Dow Jones and S&P 500 reaching record highs and continuing to climb. Nevertheless, IPOs remain scarce compared to prior years. Just nine venture-backed technology companies have gone public through May, down from 14 IPOs through the same period in 2016. With the availability of favorable financing options that remain in the private market, the supply and demand balance is changing and companies choosing to go public aren’t following the traditional route anymore. Snap’s public offering and Spotify’s potential IPO rumblings are indicative of these trends.
Between the drought of new investment offerings and increasing support for passive investing that circulated in 2016, investors appear to be desperate to find the next big opportunity. So even though Snap announced that its public offering of Class A shares would be devoid of voting power, investors still jumped at the chance to own a portion of the company. Snap’s IPO, with its non-voting shares, was twelve times oversubscribed. The demand for new public offerings is there, but the supply side is lacking and this imbalance is tipping power away from investors.
Only 105 companies went public during 2016, the lowest number since 2009 and 65 fewer than 2015. Total dollar value of public offerings fell to $18.8 billion from $30.0 billion the prior year. Despite investor optimism earlier in the year, the IPO environment remains stagnant as we approach the halfway mark of 2017. Many companies are realizing they just don’t need an IPO. Opportunities for M&A exits still exist, public company oversight is arguably onerous, and alternative sources of funding that are more favorable to the company – and its founders – are becoming increasingly popular.
So when companies actually do decide to go public, they are finding ways that benefit the company – and founders – rather than investment banks or large investors. Spotify announced its consideration of offering public shares later this year, but bucked tradition by stating that it intended to do so through a direct offering. That means the company could bypass the investment bank, save on placement fees, and offer more of its shares to the general public, rather than to just large institutional investors. Doing so might mean that Spotify would lose out on a first day share price pop, but with $1 billion in debt financing, Spotify’s public offering could be as much a way to return capital to investors as a way to raise funds for growth.
These companies aren’t by any means committed to the IPO route. AppDynamics has been another widely discussed deal this year after it entered into a transaction with Cisco shortly after announcing its plan to IPO. With many competing options for startups and the declining appeal of traditional public offerings, public investors may have to settle for less than ideal terms. In an environment where investor desperation is high and other profitable avenues for startups exist, the startups may be gaining the upper hand when it comes to going public and they are starting to play by their own rules.Related LinksCompensating for Something: Facebook’s GAAP ChangeIf It Was Easy, We’d All Be RichNon-Traditional Venture Investors are Changing The Rules Of The GameHow to Value a Company Planning to IPOMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
How to Use an EV/Production Multiple
As of 6/5/2017Current PriceFuture Price
(12 months)% ChangeWTI$47.62$48.642.14%Natural Gas$2.84$2.871.06%Source: Capital IQOil and gas analysts use many different metrics to explain and compare the value of an oil and gas company, specifically an exploration and production (E&P) company. The most popular metrics (at least according to our eyeballs) include (1) EV/Production; (2) EV/Reserves; (3) EV/Acreage; and (4) EV/EBITDA(X). Enterprise Value (EV) may also be termed Market Value of Invested Capital (MVIC) and is calculated by the market capitalization of a public company plus debt on the balance sheet less cash on the balance sheet. In this post, we will dive into one of these four metrics, the EV/Production metric, and explore the most popular uses of it.DefinitionEV/Production is a commonly used valuation multiple in the oil and gas industry which measures the value of a company as a function of the total number of barrels of oil equivalent, or mcf equivalent, produced per day. When using this multiple, it is important to remember that it does not explicitly account for future production or undeveloped fields.Common UsesWhile the above definition was provided by Investopedia, the source goes on to explain the meaning of the multiple in the following way:All oil and gas companies report production in BOE. If the multiple is high compared to the firm's peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount. However, as good as this metric is, it does not take into account the potential production from undeveloped fields. Investors should also determine the cost of developing new fields to get a better idea of an oil company's financial health.While some of the above explanation may appear true; the detail, analysis, and reason is lacking. Let’s more fully investigate the above notes:BOE or MCFE. Not all oil and gas companies report in barrel of oil equivalent per day (BOEPD). Those that are primarily dry gas producers will choose to report in MCF equivalent per day (MCFEPD). On the other hand, majority oil producers will report in BOEPD. One take away analysis to consider is that many times the metric a company uses to report production communicates the core production activity of the company (i.e. a company that reports in BOE wants to communicate they primarily target oil, while a company that reports in MCFE wants to communicate they primarily target gas).Premium or Discount. If the multiple is higher compared to its peers, it only appears to trade at a premium, but it does not mean the market value of the company is at a premium or more expensive than its peers. If it trades at a discount to its peers, the same is also true; it does not automatically mean the MVIC of a company is cheaper than its peers. To draw that conclusion, one assumes each of its peers has the exact same future production outlook, the exact same well locations and the exact same management team, just to name a few. Making this assumption in isolation is in error. Instead, analysis should be performed to understand the why behind a perceived “premium” or “discount.”Current or Future Production. The metric uses current production as an indication of value for the company. Using this metric, it could be assumed that (1) the current oil/gas/natural gas liquids mix will stay the same; (2) the current production level will continue on its previously experienced decline rate; and (3) the equivalency formula to translate gas production into oil production (typically 6.1 mcf = 1 barrel of oil equivalent) will not change. This metric fails to account for visibility into future production. When analyzing an E&P company, future production should always be considered.ExperienceWhile this multiple is useful, it also has its shortfalls. As with all multiples, it should never be used as the sole indicator of value. As an example, using this multiple in isolation would give zero value for an E&P flush with acreage and no production.We had a client with investments in an oil and gas company that was facing a transfer of ownership decision. During negotiations certain parties involved were convinced the only way to value, and therefore the only way they would pay for, an E&P was to utilize an EV/Production multiple and nothing else. They backed their position with their transaction experience of buying oil and gas assets as well as their knowledge of industry participants. We believed utilizing that particular method significantly undervalued our client. While the company had very little production, the acreage rights were significant as well as the PV 10 reserve report. We assisted our client through the transaction process by utilizing multiple valuation approaches, not solely the one a potential suitor strongly suggested.Multiples such as EV/Production can provide context for market pricing in the form of a range. We would never recommend using one market multiple as the only value indication for a subject company, particularly a non-publicly traded company. Ideally, market multiples should be used as one of many value indicators during analysis. While there may be facts and circumstances that prohibit the use of multiple value indicators, it is always advisable to (1) understand the implications of using a specific multiple; (2) understand its weaknesses; and (3) use other value indications together. When observing the EV/Production multiple, reconcile the observations with other valuation multiples and valuation indications for a reasonable analysis. For assistance in the process or other valuation analysis for an energy company, contact a member of our oil and gas team to discuss your needs in confidence.
Corporate Finance Basics for Directors and Shareholders
To craft an effective corporate strategy, management and directors must answer the three fundamental questions of corporate finance.The Capital Structure question: What is the most efficient mix of capital?The Capital Budgeting question: Which projects merit investment?The Dividend Policy question: What mix of returns do shareholders desire?These questions should not be viewed as the special preserve of the finance team. To maintain a healthy governance culture, all directors and shareholders need to have a voice in how these long-term decisions are made. This presentation is an example of the topics that we cover in education sessions with directors and shareholders. The purpose of the presentation is to provide directors and shareholders with a conceptual framework and vocabulary to help contribute to answering the three fundamental questions.
5 Reasons to Conduct a Shareholder Survey
Of all the well-worn clichés that should be retired, “maximizing shareholder value” is surely toward the top of the list. Since private companies don’t have constant public market feedback, attempts to “maximize” shareholder “value” are destined to end in frustration. While private company managers are not able to gauge instantaneous market reaction to their performance, they do know who their shareholders are. Wouldn’t it be better to make corporate decisions based on the characteristics and preferences of actual flesh-and-blood shareholders than the assumed preferences of generic shareholders that exist only in textbooks? If so, there is no substitute for simply asking. Here’s a quick list of five good reasons for conducting a survey of your shareholders.A survey will help you learn about your shareholders. A well-crafted shareholder survey will go beyond mere demographic data (age and family relationships) to uncover what deeper characteristics owners share and what characteristics distinguish owners from one another. We recently completed a survey for a multi-generation family company, and not surprisingly, one of the findings was that the shareholder base included a number of distinct “clienteles” or groups of shareholders with common needs and risk preferences. What was surprising was that the clienteles were not defined by age or family tree branch, but rather by the degree to which (a) the shareholder’s household income was concentrated in distributions from company stock, and (b) the shareholder’s personal wealth was concentrated in company stock. The boundary lines for the resulting clienteles did not fall where management naturally assumed.A survey will help you gauge shareholder preferences. The results from a shareholder survey will help directors and managers move away from abstract objectives (like “maximizing shareholder value”) toward concrete objectives that actually take into account shareholder preferences. For example, what are shareholder preferences for near-term liquidity, current distributions, and capital appreciation? Identifying these preferences will enable directors and shareholders to craft a coherent strategy that addresses actual shareholder needs. Conducting a survey does not mean that the board is off-loading its fiduciary responsibility to make these decisions to the shareholders: a survey is not a vote. Rather, it is a systematic means for the board to solicit shareholder preferences as an essential component of deliberating over these decisions.A survey will help educate the shareholders about the strategic decisions facing the company. While a survey provides information about the shareholders to the company, it also inevitably provides information about the company to shareholders. In our experience, the survey is most effective if preceded by a brief education session that reviews the types of questions that will be asked in the survey. Shareholders do not need finance degrees to be able to understand the three basic decisions that every company faces: (1) how should we finance operations and growth investments (capital structure), (2) what investments should we be making (capital budgeting), and (3) what form should shareholder returns take (distribution policy). Educated shareholders can provide valuable input to directors and managers, and will prove to be more engaged in management’s long-term strategy.A survey will help establish a roadmap for communicating operating results to shareholders. Public companies are required by law to communicate operating results to the markets on a timely basis, and many public companies invest significant resources in the investor relations function because they recognize that it is critical that the markets understand not just the bare “what happened” of financial reporting, but the “why” of strategy. Oddly, for most private companies, there is no roadmap for communicating results, and investor relations is either ignored or consists of reluctantly answering potentially-loaded questions from disgruntled owners (who may, frankly, enjoy being a nuisance). A shareholder survey can be a great jumping-off point for a more structured process for proactively communicating operating results to shareholders. An informed shareholder base that understands not only “what happened” but also “why” is more likely to take the long-view in evaluating performance.A survey gives a voice to the “un-squeaky” wheels. A shareholder’s input should not be proportionate to the volume with which the input is given. While the squeaky wheel often gets the grease, it is prudent for directors and managers to solicit the feedback regarding the needs and preferences of quieter shareholders. Asking for input from all shareholders through a systematic survey process helps ensure that the directors and managers are receiving a balanced picture of the shareholder base. A confidential survey administered by an independent third party can increase the likelihood of receiving frank (and therefore valuable) responses.
An engaged and informed shareholder base is essential for the long-term health and success of any private company, and a periodic shareholder survey is a great tool for achieving that result. To discuss how a shareholder survey or ongoing investor relations program might benefit your company, give one of our senior professionals a call.
5 Reasons to Conduct a Shareholder Survey
Of all the well-worn clichés that should be retired, “maximizing shareholder value” is surely toward the top of the list. Since private companies don’t have constant public market feedback, attempts to “maximize” shareholder “value” are destined to end in frustration. While private company managers are not able to gauge instantaneous market reaction to their performance, they do know who their shareholders are. Wouldn’t it be better to make corporate decisions based on the characteristics and preferences of actual flesh-and-blood shareholders than the assumed preferences of generic shareholders that exist only in textbooks? If so, there is no substitute for simply asking. Here’s a quick list of five good reasons for conducting a survey of your shareholders.A survey will help you learn about your shareholders. A well-crafted shareholder survey will go beyond mere demographic data (age and family relationships) to uncover what deeper characteristics owners share and what characteristics distinguish owners from one another. We recently completed a survey for a multi-generation family company, and not surprisingly, one of the findings was that the shareholder base included a number of distinct “clienteles” or groups of shareholders with common needs and risk preferences. What was surprising was that the clienteles were not defined by age or family tree branch, but rather by the degree to which (a) the shareholder’s household income was concentrated in distributions from company stock, and (b) the shareholder’s personal wealth was concentrated in company stock. The boundary lines for the resulting clienteles did not fall where management naturally assumed.A survey will help you gauge shareholder preferences. The results from a shareholder survey will help directors and managers move away from abstract objectives (like “maximizing shareholder value”) toward concrete objectives that actually take into account shareholder preferences. For example, what are shareholder preferences for near-term liquidity, current distributions, and capital appreciation? Identifying these preferences will enable directors and shareholders to craft a coherent strategy that addresses actual shareholder needs. Conducting a survey does not mean that the board is off-loading its fiduciary responsibility to make these decisions to the shareholders: a survey is not a vote. Rather, it is a systematic means for the board to solicit shareholder preferences as an essential component of deliberating over these decisions.A survey will help educate the shareholders about the strategic decisions facing the company. While a survey provides information about the shareholders to the company, it also inevitably provides information about the company to shareholders. In our experience, the survey is most effective if preceded by a brief education session that reviews the types of questions that will be asked in the survey. Shareholders do not need finance degrees to be able to understand the three basic decisions that every company faces: (1) how should we finance operations and growth investments (capital structure), (2) what investments should we be making (capital budgeting), and (3) what form should shareholder returns take (distribution policy). Educated shareholders can provide valuable input to directors and managers, and will prove to be more engaged in management’s long-term strategy.A survey will help establish a roadmap for communicating operating results to shareholders. Public companies are required by law to communicate operating results to the markets on a timely basis, and many public companies invest significant resources in the investor relations function because they recognize that it is critical that the markets understand not just the bare “what happened” of financial reporting, but the “why” of strategy. Oddly, for most private companies, there is no roadmap for communicating results, and investor relations is either ignored or consists of reluctantly answering potentially-loaded questions from disgruntled owners (who may, frankly, enjoy being a nuisance). A shareholder survey can be a great jumping-off point for a more structured process for proactively communicating operating results to shareholders. An informed shareholder base that understands not only “what happened” but also “why” is more likely to take the long-view in evaluating performance.A survey gives a voice to the “un-squeaky” wheels. A shareholder’s input should not be proportionate to the volume with which the input is given. While the squeaky wheel often gets the grease, it is prudent for directors and managers to solicit the feedback regarding the needs and preferences of quieter shareholders. Asking for input from all shareholders through a systematic survey process helps ensure that the directors and managers are receiving a balanced picture of the shareholder base. A confidential survey administered by an independent third party can increase the likelihood of receiving frank (and therefore valuable) responses.
An engaged and informed shareholder base is essential for the long-term health and success of any private company, and a periodic shareholder survey is a great tool for achieving that result. To discuss how a shareholder survey or ongoing investor relations program might benefit your company, give one of our senior professionals a call.
Portfolio Valuation and Regulatory Scrutiny
Over the past decade, we have been retained by several investment funds to assist them in responding to formal and informal SEC investigations regarding fair value measurement of portfolio investments. Reflecting back on those engagements yields a couple observations and reminders for funds and fund managers as they go through the quarterly valuation process.First, fund managers should recognize that valuation matters, and it will really matter when something has gone awry. To that end, we recommend that funds:Document valuation procedures to follow (and follow them). Since valuation requires judgment, disagreements are inevitable. However, are you following the established valuation process? In hindsight, judgments are especially susceptible to second-guessing if established policies and procedures are not followed.Designate a member of senior management to be responsible for oversight of the valuation process. Placing valuation under the purview of a senior member of management demonstrates that valuation is an important function, not a compliance afterthought.Create contemporaneous and consistent documentation of valuation conclusions and rationale. No valuation judgment is “too obvious” to merit being documented. On the other side of the next crisis, what seems reasonable today may appear anything but. The middle of an investigation is not the best time to re-construct rationales for prior valuation judgments.Second, it is important for fund managers to stay abreast of evolving best practices (or know people who do). Fair value measurement for illiquid portfolio investments is an evolving discipline. We recommend that funds:Solicit relevant input from the professionals responsible for the investment, auditors, and third-party valuation experts. Relying on appropriate professionals demonstrates that the fund managers take compliance seriously and are committed to preparing reliable fair value measurements.Check your math. In the glare of the regulatory spotlight, few things will prove more embarrassing than elementary computational errors. The proverbial ounce of prevention is certainly worth the pound of cure.Disclose the valuation process and conclusions. Just like potential investors do, regulators take comfort in transparency.The best time to prepare for a regulatory investigation is before it starts. Call us today to discuss your portfolio valuation process in confidence.Originally published on Mercer Capital's Portfolio Valuation Newsletter: Second Quarter 2017
Are Oil and Gas Bankruptcies a Thing of the Past?
As of 5/22/2017Current PriceFuture Price
(12 months)% ChangeWTI$50.33$51.492.30%Natural Gas$2.59$2.8811.20%On June 20, 2014, the price for a barrel of crude oil on the NYMEX reached $107. Few, if any, expected oil prices to fall, and then, keep falling to a dip below $30. Even with hedges in place, this unexpected, sustained price drop crippled oil revenues. Many investments in oil and gas that were once projected to generate strong positive cash flows and profits could no longer generate enough cash to support the debts used to fund the project. Thus, as prices remained low, more and more companies ran out of cash to support once manageable debts. Since the start of the oil downturn, more than 120 upstream and oilfield service companies declared bankruptcy.However, as we described in a previous post, for these E&P and services companies, the decision to file for bankruptcy did not always signal the demise of the business. Despite the sense of doom often associated with the word “bankruptcy,” if executed properly Chapter 11 reorganization afforded these financially distressed or insolvent companies an opportunity to restructure their liabilities and emerge as sustainable going concerns.Many E&P companies who reorganized are “emerging from bankruptcy, looking to grow.” The Financial Times reported that 80% of oil and gas companies who filed for Chapter 11 have emerged from bankruptcy and are still operating. They even claim that this wave of bankruptcies made the industry stronger as companies were able to shed billions of dollars of debt and were forced to increase drilling efficiency in order to survive. In the low oil price environment, companies worked to lower breakeven costs by using new technology to get more oil out of already developed wells. Additionally, many companies sold off assets they could not afford to develop to those who had the ability to finance the necessary capital expenditures to bring new wells online.Thus, as OPEC and partners cut production at the end of 2016, U.S. shale drillers continued to increase production, which kept oil prices comparatively low. Now, almost a year after the peak in bankruptcy activity, oil prices have stabilized around $50 per barrel, and U.S. shale drillers are well positioned to ramp up drilling activity. The U.S. is estimated to have more recoverable oil than any other country, including Saudi Arabia and Russia. Additionally, President Trump’s administration is expected to be a proponent of fracking.For the past two years, OPEC tried to squeeze U.S. shale drillers out of the market by increasing production to flood the market and lower prices, but it looks like domestic shale producers came out as the winners in this competition. Earlier this year, Vauhini Vara, wrote in The Atlantic, “It has become clear that the shale-oil business is going to survive, at least for now.” Over the first four months of 2017, only nine producers filed for bankruptcy, compared to 29 companies that went bankrupt in the first four months of 2016. Although there may still be more bankruptcies to come, the trend of bankruptcies caused by the crash in oil prices has slowed, and companies are prepared to grow with leaner balance sheets than before.Mercer Capital has significant experience valuing assets and companies in the energy industry. To learn more about Mercer Capital’s experience in oil and gas and bankruptcy valuations contact a Mercer Capital professional today.
1Q Call Reports
Despite gaining 4% last quarter, publicly traded RIAs are still coping with a low-fee, passive investment environment and continued delays on the Fiduciary Rule implementation. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests, and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Fees are ultimately determined by investment performance and capital market returns, creating serious challenges for hedge fund managers and other active investors that aren’t delivering alpha on a sustainable basis.There is a greater belief that long-term returns are structurally lower than they were ten and twenty years ago. So if you have an expected long-term return of, let’s say 6%, which many people think that might be high when you look at a balanced portfolio. Fees take up a lot of that return. And as long as we believe the world is going to be in a low-return environment, our clients are under a lot of pressure….and so when we talk about fee pressure, fee pressure comes from the real issue of lower expected returns. And I think this is one of the big issues around hedge funds and why we’re constantly reading about some hedge funds closing, some hedge funds are lowering their fees, because the fee structures are just too large versus the returns on a risk-adjusted basis that they’re achieving. – Larry Fink, BlackRock CEO and ChairmanI think fee rates going down are – I think is a reality of what’s happening. Some of that is mix shift. Some of that is changing regulation in terms of distribution. Some of that will ultimately – will accrue to the benefit, obviously, of the end client. I think ultimately, this comes down to our ability to generate sustainable alpha. I think if we can generate sustainable alpha in a way that, in some ways, kind of captures 3x to 4x the fee over time, I think we’ll be fine. If we’re in a period of significantly lower returns and lower sustainable alpha, then obviously, I think fee rates are going to have to come down accordingly. – Gary Shedling, BlackRock CFO and Senior Managing DirectorTheme 2: Active managers continue to justify their fees with investment performance on certain products and [the perception of] lower correlation among certain asset classes.I think performance wins in the end. There’s no question about that. And as we’ve said before, I mean it’s when you have a good quarter or a good year, it may slow redemptions a bit, but it takes a while to build back onto the shelf space. And we’ve seen, I think the number of 4 and 5-star funds for us has quadrupled here in the last quarter. So those are the things that really drive sales and shelf space…And that most of the industry that has more brokerage assets, it, as we all know, creates challenges in the transition to more of the advisory mode. But at the end of the day, if you have performance and you have reasonable fees, you’ll get distribution in that model as well. – Greg Johnson, Franklin Resources CEO and ChairmanOutside of the U.S. market, in lesser developed markets, less-efficient markets, more dispersion, less correlation, I think we still feel very strongly in places like Europe and Asia and certain emerging markets, that frankly, the ability to generate sustainable alpha can support higher fees. And I think our performance has certainly showed that over time. – Gary ShedlinTheme 3: RIAs are still bracing for the DOL’s implementation of the Fiduciary Rule and the Pension Protection Act, which is expected to accelerate assets into passive products.On April 7, the Department of Labor published a 60-day delay of its Fiduciary Rule until June 9. Following that announcement we evaluated the delay in relation to existing projects and the pre-established contingency plans developed in anticipation of the delay. We are continuing our efforts to complete projects established for full compliance on January 1, 2019…Our efforts associated with the new rule have touched nearly every business unit and required significant lift from our employees and business leaders whose commitment remains strong as we continue to work towards full implementation by early 2018. – Phillip Sanders, Waddell & Reed CEOIt’s something that we continue to be very engaged on…So we are very active on that, on the lobbying front. And we’ve been asking that questions, well, what does it mean? What kind of dollar number are we looking at? And I think it’s probably too early to say, because it depends just how clients react to the disclosure…But again, when you have that transparency and the questions, we don’t know how far it extends. And I wouldn’t want to try to extrapolate because we don’t know what that would mean. I think you’re right in saying there’s still quite a bit of uncertainty on it. – Greg JohnsonThe real headwind is in the DOL Pension Protection Act rule. They created a QDI, or a default option, which is primarily proprietary target date funds. Our view is that was going to open up and be more open architecture, customized solutions that would include more outside asset managers such as Artisan. Unfortunately, the litigations have increased the perceived diversification of an all-indexed oriented target date fund, and fee pressure has spurred more and more assets going to the proprietary target date funds, especially if it’s 100% passive. That has lowered our expectations in the short run of the DC assets turning around. We still think over the next couple of years you’ll see more and more customized solutions. But for right now, it just seems the passive solution is the safe approach right now. – Eric Colson, Artisan Partners CEO, Chairman, and PresidentMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
E&P: What We Learned from 1st Quarter Earnings
The first quarter of 2017 was productive and active for upstream E&P but the change in market capitalizations of many oil and gas companies does not match the reported increase in earnings and production estimates. Looking at our universe of energy companies in the E&P space, over 70% beat earnings estimates. This statistic held true no matter if the energy company was a global integrated operator or a pure upstream producer. To provide a flavor of the attitude, we selected two larger publicly traded energy companies involved in E&P (STO and XOM) as well as six companies with primary operations in the Permian Basin (PXD, CXO, NBL, XEC, FANG, and RSPP) and reviewed the highlights of their latest earnings releases. As summarized below, each of these companies exceeded analyst expectations.
STO – StatOil ASA
Over the first quarter StatOil’s market cap fell from $60.2 billion to $55.7 billion. But, Eldar Saetre, President and CEO of Statoil ASA had only good things to say about first quarter earnings.
Our solid financial result and strong cash flow across all segments was driven by higher prices, good operational performance and an organic production growth of 5%.We delivered seven discoveries from nine exploration wells drilled during first quarter. Many of these can be quickly put into profitable production.We are also about to start our exploration programme in the Barents Sea, testing several new opportunities over the next six months. In the quarter, we received approval for three plans for development and submitted additional two projects for approval by Norwegian authorities, showing commitment to industrial development on the NCS.XOM – Exxon Mobil Corporation
Exxon’s market cap fell over the first quarter from $373 to $340 billion but overall the company reported positive results. Darren W. Woods, Chairman and CEO, said,
Our results reflect an increase in commodity prices and highlight our continued focus on controlling costs and operating efficiently.We continue to make strategic acquisitions, advance key initiatives and fund long-term growth projects across the value chain.Upstream volumes were 4.2 million oil-equivalent barrels per day, a decline of 4 percent compared with the prior year, primarily due to the impact of lower entitlements due to increasing prices, and higher maintenance.Upstream earnings of $2.3 billion improved on higher liquids and gas realizations.The following six companies’ operations are focused in the Permian Basin. The bulleted information below is summarized from each of their earnings releases.PXD – Pioneer Natural Resource Company
Pioneer’s market cap remained relatively stable over the first quarter of 2017 at $31.3 billion in January and $31.6 billion at quarter end.
Production for the first quarter increased by 3% from 4Q16 and was above the top end of Pioneer’s guidance rangeProduction growth was driven by Spraberry/ Wolfcamp horizontal drilling programThe company reduced production costs compared to 4Q16.CXO – Concho Resources, Inc.
Over the first quarter Concho’s market cap fell somewhat from $19.6 billion to $18.6 billion but overall, the company reported positive earnings and activity results.
Concho delivered quarterly production of 181.4 Mboepd, exceeding the high end of the company’s guidance range and raised full-year 2017 production outlook to a range of 21% – 25% annual growth while maintaining their capital expenditures outlook.They increased crude oil production to 113.6 Mbpd, up 28% year-over-year.The company achieved record well performance in their Delaware Basin and New Mexico Shelf assets.The shift to manufacturing mode was made with large-scale development projects in the Delaware Basin and in the Midland Basin.The company reduced per-unit production expense and interest expense by 27% and 42%, respectively, year-over-year.Concho lowered full-year 2017 guidance for per-unit production and depreciation, depletion and amortization expenses.NBL - Noble Energy, Inc.
Nobel Energy’s market cap fell from $16.4 billion to $14.84 billion over the first quarter of 2017 even as President and CEO David L. Stover said, “Noble Energy is off to a great start in 2017, with strong operational and financial performance and importantly, numerous recent strategic accomplishments.”
The company delivered quarterly sales volumes at or exceeding the top end of guidance. And total oil volumes were at the high end of guidance, led by Delaware and DJ Basin performance.The company saw continued strong well performance in the Delaware Basin.Three new Wolfcamp A wells commenced production.Noble Energy's leading position in the Southern Delaware Basin was solidified through the acquisition of Clayton Williams Energy, increasing the company's position to 118,000 net acres.Full year sales volumes trended toward the upper half of original expectations, driven primarily from increased crude oil and NGL sales.XEC – Cimarex Energy Co.
Cimarex’s market cap decreased over the first quarter from $13.2 billion to $11.4 billion.
Total production was up 11% sequentially.Oil production was up 15% sequentially.Total company production, which increased 9% over the first quarter, came in above the high end of our guidance.Commodity prices improved significantly from a year ago and had a positive impact on Cimarex's financial results for the quarter.Realized oil prices increased 70% from the first quarter of 2016.Realized natural gas prices were up 57% from the first quarter 2016.NGL prices were up 107% from the same period one year ago.FANG - Diamondback Energy, Inc.
Over the first quarter Diamondback’s market cap increased from $9.3 billion to $10.1 billion.
1Q17 production was up 19% over 4Q16 with 13% quarterly organic growth.Estimated 1Q17 Midland Basin drill, complete and equip cost per completed lateral foot was down 5% quarter-over-quarter.Closed Brigham Resources acquisition, which increased Diamondback's total leasehold to approximately 189,000 net surface acres in the Permian Basin.Diamondback continues to decrease drilling times, lower costs, and achieve new company records.RSPP - RSP Permian, Inc.
RSP’s market cap decreased from $6.5 billion to $5.9 billion over the first quarter of 2017.
Production increased 84% compared to 1Q16 and increased 26% compared to 4Q16.Adjusted EBITDAX increased by 249% from 1Q16 and 37% compared to 4Q16.On March 1, 2017, RSP Permian closed their previously announced SHEP II acquisition for approximately $646 million of cash and 16.0 million shares of RSP common stock.
As the above earnings excerpts explain, the first quarter brought (1) higher oil and gas prices; (2) higher production rates; (3) lower production costs; (4) investment in new wells; and (5) an active environment for asset purchase and divestures. However, the stock price performance does not reflect the positive quarter performance. Of the 64 energy companies we track, 49 had lower market capitalizations as of May 11, 2017 compared to December 31, 2016.Why Is This?One significant reason for this mismatch is the outlook for crude oil has declined approximately 14% from the end of Q4 to the middle of May 2017. The following is a comparison of the 12 months futures contracts for WTI at the end of 4Q16 and middle of May 2017:
The fear of too much oil supply is dampening the pricing outlook for oil. Although 1Q17 resulted in slightly higher prices for oil, the successful increase in production from new drilling techniques and stacked reserve play wells is boosting production and moving prices lower. The industry now looks to OPEC and Russia for production cuts to assist in increasing the price.
In a volatile oil and gas market, the market capitalization of companies is more of a representation of the future earning potential of companies rather than the past. While the first quarter of 2017 showed hopeful results, the change in the market pricing of these companies puts a damper on the increase in earnings and makes us question if these companies’ successes are short lived.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Focus Financial’s Quest for an Unfair Advantage
A Long Journey to an Uncertain Destination
Starting later this week, the roads throughout Italy will be filled with more than the usual complement of exotic sports cars as the annual endurance race known as the Mille Miglia kicks off on May 18. The 1000 mile (or so) race was a major event between 1927 and 1957 in which major European auto manufacturers competed to show off not just the speed but the durability of their cars. Ferrari and Alfa Romeo typically dominated the event, although BMW won the only race held during World War 2 (go figure). For the past 30 years, the Mille Miglia has been a classic car tribute race in which wealthy collectors extravagantly thrash their pricey antique sports cars over vast stretches of Tuscan countryside and their livers with oceans of prosecco. If Mille Miglia was ever about the destination, today it is certainly all about the journey.Focus Finds Another Way Point on the Journey to IPOAs part of the analyst community that closely follows developments in the investment management industry, we were disappointed (but not surprised) that Focus Financial Partners pulled their S-1, again, and found a private equity recap partner instead of going public. Picking up on last week’s blog theme, Focus likes to tout their strategy of building an international network of efficiently connected wealth management firms as an “unfair advantage”, but it appears that their real capability is finding capital when necessary to avoid a public offering. Stone Point Capital and KKR bought 70% of the company, enabling prior private equity partners, affiliates who had sold their firms to Focus in exchange for stock, and employees with equity compensation to monetize their positions while Focus remains private.Stone Point / KKR’s investment thesis probably works something like this: wealth management is idiosyncratic, but also a relatively stable source of fees over time. Less threatened by robo-advisors and passive investing than the press would like to think, Focus Financial offers the opportunity to standardize back-of-the-house issues with a scaled up wealth advisory firm while keeping the storefront identity of advisors in place. That gives pricing power on the front end and efficiency on the back end to ultimately build a better sustainable margin. If this is successful, margin widens by five or ten percentage points relative to a stand-alone RIA. Focus can add more scale and some multiple arbitrage by buying smaller practices at single digit multiples. Once AUM tops $100 billion, you might pick up a turn on the EBITDA multiple. If markets don’t experience a prolonged decline during the holding period, Focus will pay Stone Point / KKR a high single-digit coupon on an unleveraged basis and/or will support some leverage to enhance ROE. With motivated advisors seeking new business and a market tailwind, private equity returns of 20% or more are available over the usual holding period of five to seven years, which has been getting longer because of a persistently weak IPO environment.At present, private equity has the “unfair advantage” of tremendous access to capital and freedom from regulatory oversight. Focus has a significant head-start in creating a national platform for wealth advisory firms, and is positioned to take advantage of an increasing need for exits by the aging population of wealth advisors. Put Stone Point / KKR’s unfair advantage together with that of Focus, and suddenly there’s no need for an IPO.Focus FundamentalsThere is plenty we don’t know about the recap, but we can infer a few things which explain the value of the transaction to the buyers. The ADVs of the 45 or so affiliate firms of Focus Financial reveal aggregate discretionary AUM at year end 2016 of approximately $60 billion, plus nondiscretionary AUM of another $15 billion for total AUM of over $75 billion. Per these ADVs, it also appears that almost all of the firms are wholly owned by Focus, so their AUM is wholly attributable to Focus Financial as well.Revenue is a function of AUM and Focus’s realized (or actual) fee schedule. Focus Financial’s affiliate wealth management firms generally serve the upper end of the mass affluent market, such that we estimate realized fees of a little less than 100 basis points. Realized fees of 90 to 95 basis points on total AUM would suggest that Focus generates revenue of $700 million to $725 million annually.We are curious about what sort of margin Focus has been able to demonstrate. The theory behind a roll-up (Focus executives insist the firm is not a roll-up) is economies of scale through common platforms, bundled research and technology, centralized marketing support, and other back office necessities. The question is how much are these efficiencies mitigated by the need for executive infrastructure, corporate development staff, integration costs, and the like. One final complication is what compensation levels have to be to motivate revenue producers at Focus’s affiliate firms. The RIA community is famous for mixing equity returns and compensation, but once equity is sold to Focus, the line of demarcation becomes clear, and compensation is a charge to margin. Our guess is that Focus’s profitability isn’t very different than we might expect from the affiliate firms on a stand?alone basis, or somewhere between 25% and 35%. If their EBITDA margin is around 30%, then Focus should be generating annual cash flow a bit north of $200 million.Focus Valuation MetricsReports suggest that the Stone Point / KKR recap valued Focus at around $2.0 billion. Given the performance metrics we’ve estimated above, that pricing implies an EBITDA multiple of between 9x and 10x, which makes sense to us and is more or less consistent with public market pricing, minus a modest discount.Two weeks prior to the recap, firms like Legg Mason were trading at 12x EBITDA, with AMG at 14x. It is possible that Focus’s performance was a bit less than we estimate, and if fees realized were a bit shy of 90 basis points and/or if Focus’s EBITDA margin was closer to 25%, then a $2.0 billion valuation would require an EBITDA multiple of closer to 12x. However, we think it is unlikely that Stone Point and KKR paid a top-tic multiple for Focus; doing so would leave them with less upside at exit.Selling to private equity is a lower risk transaction, which no doubt pressured the valuation. Accepting some discount enabled sellers to get out clean rather than sell some through an IPO and the rest over an SEC regulated timeline. Selling to private equity also allowed the parties to keep the ultimate terms and conditions of sale private. We think it is also unlikely, however, that the discount to public market pricing was much greater than 20% or so for Focus, because a bigger haircut would have induced Focus to consummate their IPO.Are We There Yet?Plenty has been written over the past two years about holding periods lengthening because ample private equity funding has diminished the liquidity advantage of public markets. The expense of being public and the disclosure requirements are off putting to many, and the flow of capital into the private equity community makes it much easier to keep companies like Focus out of the public markets. We watched enthusiasm for going public wane fifteen years ago with the dotcom bust and the advent of Sarbanes-Oxley. We would still suggest that no matter how long the private equity journey, the destination hasn’t changed. The PE community can only recycle investment ideas and investment dollars so many times – eventually Focus and other companies like it will have to go public. Even the Mille Miglia has a finish line.
Building Value in Your Investment Management Firm
The Unfair Advantage
One recurring question we hear from clients is what business model builds the most value for an investment management firm. It’s a reasonable question to ask these days, given the irony of simultaneously strong financial markets and the degree of negativity surrounding the RIA community. In the past month alone, Focus Financial dropped plans for a public offering, Morningstar reported that passive mutual funds pulled in over $500 billion in 2016 while active funds lost nearly $350 billion, and the parent of AllianceBernstein fired most of AB’s senior leadership. All of this happened at the same time that the Nasdaq hit new all-time highs.Looked at from this perspective, building value in an investment management firm appears to be fairly challenging, but from our perspective the challenges are uneven. Further, we don’t know that the secret to building value in an investment management firm is so much about choice of model as it is developing and executing a strategy which no one else can match. We like to refer to this as finding a firm’s “unfair advantage.”Unfair AdvantageWe didn’t coin the term “unfair advantage”, but we get it from the title of a book about racecar driving by Mark Donohue. In the late 1960s and early 1970s there were many great race car drivers, but few were as highly regarded at the time as Donohue. He was important not just because of his success across a variety of racing platforms – everything from sports car racing to Indy cars to NASCAR to Can-Am – but because he approached auto racing more as an engineer than a daredevil.Mark Donohue studied mechanical engineering at Brown and was known on racecar circuits for his skill at reading the handling and performance characteristics of his cars. Donohue’s most noteworthy success was taming the Porsche 917K. Porsche had spent so much time developing a twelve cylinder boxer motor that developed over 1,000 horsepower that they neglected attention to the aerodynamics and suspension work that would actually keep the car on the road. The 917 was ferociously powerful, but it was also nearly uncontrollable. Donohue took the body off of the car and drove it to check out the drivetrain and suspension first, and then started working on the aerodynamics. Once he was done, the car was unbeatable, and Donohue’s legend was cast.After several successful seasons in the Porsche, Donohue retired from racing to write Unfair Advantage. The advantage he sought in a race was not his own talent – Donohue did not think he was a particularly skilled driver – but to have the very best car in the race. In truth, the unfair advantage that Donohue’s team, Penske, enjoyed during this time was to have an Ivy-League educated driver who could fine tune a car to fit a particular race on a particular track under particular conditions. Donohue returned to racing in 1974, and died in a crash on a practice lap in 1975. Were it not for his book, he might have been forgotten.Finding Your Firm’s Unfair AdvantageAfter years of working with investment management firms of all shapes and sizes, it is our opinion that building the most value in an RIA comes down to the same thing: developing and capitalizing on some unfair advantage. That may sound unnecessarily mysterious or metaphorical, but it really boils down to examining the basic building blocks of firm architecture and finding out where your firm can excel like none other. We’ll break this down for you over the next few weeks.
Why Aren’t We Talking About the Gulf of Mexico?
Artem Abramov, of Rystad Energy, recently published an article in the Oil and Gas Financial Journal comparing shale and offshore drilling. He claims, the “Gulf of Mexico [is] as important as [the] Permian Basin for U.S. oil production” but it has been overlooked since the advancement of shale gas. The EIA reports that offshore drilling accounts for 17% of total domestic crude oil production. So, why aren’t we talking more about oil and gas production from the Gulf of Mexico (GoM)?Unlike shale plays, where production varies with oil prices, production in the Gulf of Mexico has been resilient to fluctuations in prices because projects in the Gulf of Mexico have longer time horizons. After the downturn in oil prices drilling activity remained relatively flat at 25-35 wellbores per quarter. The relative price insensitivity over the short term meant that the Gulf of Mexico did not see substantial production drops like many other oil producing regions of the U.S. when prices fell in mid-2014. However, this also means that as oil prices have recently increased, the Gulf has not seen substantial increases in production.The Oil and Gas Financial Journal article stated:Only two sources of oil supply in the U.S. remained exceptionally resilient throughout the downturn: The Permian Basin and the Gulf of Mexico. The Permian Basin’s output was growing every quarter, adding 300 Mbbl/d from the first quarter of 2015 through the fourth quarter of 2016. While exposed to seasonal disruptions, GoM’s production was able to deliver a 240 Mbbl/d growth over the same period, contributing almost equally with the Permian Basin to the limited decline pace of the total U.S. oil production.Right before the 2014 downturn in oil prices, many deepwater drilling projects were approved. This led to increased start-up activity in the Gulf in the second half of 2016 which increased crude and condensate production by 400 Mbbl/d from 2014 to 2016. In 2016, eight projects came online in the GoM and another seven projects are expected to come online by the end of 2018. In 2016, crude oil production in the Gulf of Mexico reached an annual high of 1.6 Mmbbl/d which surpassed the previous high which was set in 2009. Oil production is expected to reach 1.7 Mmbbl/d in 2017 and 1.8 Mmbbl/d in 2018 in the Gulf of Mexico.Recently, most oil and gas news has been centered on the Permian Basin. As we explained in a recent post, the Permian Basin has had recent success due to its locational advantage, vast amount of untapped reserves, and low breakeven prices. Most of the major M&A deals in the upstream sector were in the Permian Basin in 2016. According to James Scarlett of RS Energy Group, approximately 25% of the U.S.’ lower 48 production came from the Permian Basin and 38% of the rigs in the U.S. are in the Permian. The reason for so much concentration is that about 80% of currently economic (economic meaning under $50 breakeven oil) oil is in the Permian, particularly the Delaware Basin. Secondly, due to the numerous potential production zones (Wolfcamp, Bone Spring, Leonard Shale, Delaware Sands, etc.), there is a huge amount of oil in place for potential recovery (3,000 feet of pay zones). Couple this with an area (West Texas) that has ample existing infrastructure from decades of development, and this has led to what some people are calling a land grab in the area.The Gulf of Mexico’s success can be similarly explained. The EAI reports that 45% of total petroleum refining capital and 51% of U.S. natural gas processing plant capacity is located along the Gulf Coast, giving the Gulf easy access to its downstream market. Additionally, much of the midstream infrastructure is already in place, which allows companies to save money by utilizing already developed pipelines. Further, the Gulf of Mexico had 4.8 billion barrels of crude oil proved reserves at year end 2015, according to the most recent information published by the EIA. In comparison, RRC Districts 7C, 8, and 8A, which includes the majority of the Permian Basin, combined proved reserves at year end 2015 of 7.3 billion barrels, and North Dakota, home to the Bakken shale play, had 5.2 billion barrels of proved reserves (2015 reserve estimates do not include some recent significant discoveries, including the discovery of an estimated 20 billion barrels in the Wolfcamp shale play in the Permian Basin). In addition, the Gulf of Mexico has been able to realize increased drilling efficiency for many years. Average drilling speed in shale increased by 100% from 2011 to 2016, but the Gulf of Mexico was not far behind, averaging an increase in drilling speeds by 60-75% from 2015 to 2016. As shown in the chart below sourced from the Oil and Gas Financial Journal, drilling efficiency improvement in the GoM is greater than in shale oil.
While the energy sector as a whole is expected to benefit from President Trump’s pro-energy policy, offshore drilling has recently been at the center of political talks. Interior Department Secretary Ryan Zinke signed two secretarial orders last week which are expected to increase America’s offshore energy potential. The first order, directed by the Bureau of Ocean Energy Management (BOEM), is to develop a new five-year plan for offshore oil and gas exploration and to reconsider the regulations surrounding these activities. Secretary Zinke said that regulations which were created with good intentions, but that have been harmful to America’s energy industry, will be reviewed. While some regulations have been removed, such as the Offshore Air Quality Control, Reporting, and Compliance Rule, Offshore Petroleum Industry Training Organization (OPITO) officials are encouraging the U.S. to follow their common industry standards, which have been adopted by 45 other oil producing regions internationally.
The second order established a new position to coordinate the Interior Departments energy portfolio. Zinke noted that in 2008 federal leasing revenue for the Outer Continental Shelf (OCS) was approximately $18 billion, but it was only $2.8 billion in 2016. Focused on increasing leasing revenue, President Trump is likely to experience some legal obstacles. In 2006, Congress placed a moratorium on drilling within 125 miles of the Florida Coast until 2022. However, this area is estimated to contain up to 2.35 billion barrels of oil. President Obama in November 2016 permitted 10 lease sales in areas of the Gulf of Mexico in moratorium, but this plan only covered a small portion of the eastern gulf coast. President Trump wants to expand leasing rights but will likely have to battle much of this argument in court because it requires a public comment period.1
One impact of the recent downturn in oil prices was the need for shorter term capital projects. As we talked about in a recent post, "The Wild Goose Chase Is Over", companies have been looking to invest in quick ventures that have short payback periods. The Gulf of Mexico is known to have longer payback periods but has been working to shorten investment time horizons. Companies are focusing on “Subsea completions and tiebacks where you already have the infrastructure – the platform in place, the pipeline to the market place – so those require significantly less capital and faster lead times than the big spars that people think of in offshore projects” as Deloitte’s Andrew Slaughter said in a recent interview with the Oil and Gas Financial Journal.2
While the Permian Basin has been the center of most oil and gas discussion recently, there are notable investments being made in other oil rich areas of the U.S. In February, Shell invested in the Kaikias oil and gas project in the Gulf of Mexico. It will start production in 2019 and will be able to generate profits even with oil prices lower than $40 /bbl. Last December BP made a similar announcement of a $9 billion investment, called “Mad Dog Phase 2” in the Gulf of Mexico that is expected to be profitable at $40/ bbl oil. With uncertainty surrounding the future price of oil due to the unpredictability of OPEC’s production cuts, it is important for oil and gas producers to find economically efficient plays. While the Permian is currently one of the most economical plays, we cannot rule out all others such as those in the Gulf of Mexico. Although the market is not rallying around the Gulf of Mexico like it is around the Permian, we can expect continued growth in the region over the next few years.
Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
End Notes1 Dlouhy, Jennifer. “Trump to Expand Offshore Drilling, Review Deepwater Horizon Regs. Bloomberg News.
2 Tiebacks are subsea lines that connect new wells to existing projects.
Is Cash Always King?
Travis Harms, CFA, CPA/ ABV, Senior Vice President at Mercer Capital, recently published a blog post on Mercer Capital’s Financial Reporting Blogcontemplating the appropriate amount of cash for a company to hold. This topic is especially pertinent to the oil and gas industry, in which 70 companies went bankrupt last year. Now as companies have started to increase capital expenditures again, they must consider how much cash they should keep as a cushion while considering the effect of this low-yielding asset on value.
When it comes to money, “enough” is the hardest word to define in the English language. The challenge of defining “enough” extends to corporate managers deciding what cash balance is appropriate.Cash balances can provide a cushion against unanticipated adverse events in the business. The moment companies need cash is usually the worst time to try to raise capital. Having sufficient cash on hand to weather an unexpected downturn in the business can help shareholders avoid dilutive capital raises at inopportune times.On the other hand, cash is a very low-yielding asset. Large allocations to cash weigh down the returns to invested capital. If capital providers recognize the risk-reducing attributes of cash and reduce their return expectations accordingly, the effect of a large cash balance on value is probably negligible. If, instead, investors view the cash investment no differently than any other capital allocation, and fail to reduce their return expectations, then a large cash balance will be detrimental to value.
As shown in Table 1 above, investors provide debt and equity capital (the right side of the balance sheet), which the company then allocates to a portfolio of assets (the left side of the balance sheet). The enterprise value of the business represents the “engine” that generates operating cash flow (of which EBITDA is often considered a proxy). Since cash balances do not generate EBITDA, cash and other short-term investments are excluded from enterprise value.
In the current yield environment, the investment return on cash balances is nil. As a result, cash balances represent a drag on the weighted average return on the company’s assets. In both private and public companies, minority investors do not have any direct control regarding the allocation of the capital they provide. Corporate managers and directors need to evaluate the effect of large cash holdings on both the returns provided to capital providers and the required returns demanded by capital providers. In the balance of this post, we examine data from public markets to assess shareholder preferences with regard to cash holdings.
Summary of the DataWe examined data pertinent to this question for non-financial companies in the S&P 1000 at the end of 2016. The S&P 1000 index is a combination of the S&P MidCap 400 and the S&P SmallCap 600. At December 31, 2016, the companies in the S&P 1000 index had market capitalizations ranging from about $200 million on the small end up to approximately $10 billion.Table 2 summarizes pertinent data by industry.
Measured as a percentage of market value of invested capital (MVIC, or the sum of equity market capitalization and total debt), median cash balances for the various industry groups range from a low of 0.4% for utilities, to a high of 11.1% for information technology.
We considered a number of characteristics that may contribute to industries allocating more or less of their capital to cash. The relationships between cash balances, capital expenditure intensity and expected revenue growth are not very compelling. In contrast, as shown in Table 3, there does appear to be a degree of correlation between cash balances and beta. Correlation is not causation, of course. However, what the data does begin to suggest is that higher-risk companies tend to hold more cash than lower-risk companies (if risk is measured using beta).
This observation is consistent with the risk-reducing properties of cash mentioned above. Companies in riskier industries may hold more cash as a buffer against unexpected adverse changes. While this is intuitive from the perspective of corporate managers, the question remains as to whether shareholders perceive value in the allocation of capital to cash.
What is Cash Worth?Analysts typically calculate valuation multiples relative to enterprise value – in other words, on a “cash-neutral” basis. The principal merit of this approach is the recognition that, all else equal, a company with greater cash reserves should be worth more than a company with lesser cash reserves. This approach also recognizes that cash balances do not contribute to the generation of operating cash flow. Implicit in this approach, however, is the assumption that shareholders give full dollar-for-dollar credit for cash held on the balance sheet.This is undoubtedly true at the time of a transaction for a private company, as purchase agreements inevitably include target working capital levels with dollar-for-dollar adjustments to the negotiated purchase price for excess or deficit working capital relative to the target.However, it is not necessarily the case that minority investors facing a potentially lengthy holding period have the same perspective. Such investors may view large cash balances as no more than negative net present value capital projects that diminish value.
Table 4 below summarizes the two potential extreme positions.In the scenario on the left, investors assign the same enterprise value multiple to the high and low cash companies. This behavior is consistent with the notion that allocating resources to cash results in a corresponding reduction to the cash-hoarding company’s weighted average cost of capital. In other words, investors value the risk-mitigating properties of cash.In the scenario on the right, investors are unimpressed by management’s ability to hold onto cash. Since return expectations are not modified by the large cash balance and the cash balances do not generate any material cash flow, the ratios of MVIC to EBITDA are identical for the two companies.
In an effort to screen out potential noise associated with industry factors, we examined the data summarized in Table 2 further by industry to discern which of the two possibilities more closely reflects investor attitudes toward corporate cash balances. In order to avoid unduly small sample sizes, we examined the four most populous industries (consumer discretionary, healthcare, industrials, and information technology). We sorted the companies within each industry by cash balance (measured as a percentage of MVIC), dividing each industry into cohorts of equal thirds. Table 5 summarizes key results for each industry.
Consideration of the data summarized in Table 5 yields a number of observations.
Within the more mature consumer discretionary and industrials segments, cash balances are unrelated to company size, as the revenue for companies in Cohort 3 (least cash) is comparable to that of the companies in Cohort 1 (most cash). In contrast, cash balances in the faster-growing healthcare and information technology segments are inversely related to company size. The cash-rich healthcare and IT companies are approximately one-half the size of the low-cash companies in the respective industries.While differences in beta within the industry segments are modest, the observed data points are generally consistent with the relationship between risk and cash holdings noted with respect to Table 2. Perhaps cash balances are viewed as a counter-weight to greater operating risk.Projected revenue growth is inversely related to cash balances for companies in the consumer discretionary and industrials segments. For companies in the healthcare and IT industries, however, the companies with the highest cash balances have the highest growth expectations. Perhaps in these industries, cash balances are perceived by investors as “dry powder” for future positive-NPV projects.While differences in expected growth obscure direct observations regarding the impact of cash balances on WACC, data for the consumer discretionary and industrials segments more closely approximate the right side of Table 4, suggesting that investors in mature companies are unimpressed with large cash balances. For healthcare and IT, the data is more closely aligned with the left side of Table 4, suggesting that investors view cash accumulation as a reasonable strategy in industries in which positive-NPV projects are presumably abundant.ConclusionOne of the primary tasks of corporate managers and directors is capital allocation. While cash balances can provide a safety net that allows corporate managers to sleep better at night, for shareholders, the risk-mitigating benefit of corporate cash balances is balanced by the corresponding drag on returns. Based on the market data summarized in this post, the perceived availability of positive-NPV projects seems to influence investor preferences regarding cash stockpiles.Positive-NPV projects are presumably abundant in higher-growth industries such as healthcare and IT. For firms in those industries, investors appear more likely to view cash as “dry powder” for future value-enhancing investments, and are more willing to bear the cost of lowered returns until such investments are identified and made.In more mature segments such as consumer discretionary and industrials, positive-NPV projects are presumably scarcer. The value of large cash holdings among firms in these industries seems to be discounted by investors.For corporate managers and directors, cash balances should not be treated simply as a residual, but rather actively evaluated in conjunction with the firm’s capital budgeting and distribution policies. Cash may be king, but shareholders aren’t necessarily monarchists.
Q1 Shows Glimmer of Hope for Active Managers and Continued Gains for Trust Banks
This quarter’s newsletter focuses on the mutual fund sector, which has been plagued by asset outflows into ETFs and other passive strategies for most of the last decade. The first two months of this year do, however, offer a ray of hope as 45% of U.S. based active managers beat their relevant benchmark, resulting in February being the first month of inflows into active products since April 2015.The newsletter also reviews RIA performance over the last year by size and type of asset manager. Unsurprisingly, trust banks have outperformed their peers with the prospect of higher interest rates and reinvestment income. On the size front, publicly traded asset managers with less than $10 billion in AUM were bested by their larger counterparts, but this is primarily attributable to the undiversified nature of this index (two components, both of which are thinly traded) and in no way suggestive of some broader trend of client preferences for larger RIAs.The M&A outlook remains fairly robust as owner demographics and the maturation of the mutual fund industry spur consolidation and buying opportunities for those looking to add scale. Standard Life’s $4.6 billion purchase of Aberdeen Asset Management last month is a perfect example of this and may be indicative of future deal-making in the sector.You can read the newsletter below or download it here. If you would like to receive the emailed newsletter each quarter, subscribe here.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
How to Invest in PUDs in the Permian Basin without Paying for the Well
In previous posts, we have discussed the existence of royalty trusts & partnerships and their market pricing implications to royalty owners. Many of those trusts have a set number of wells generating royalty income at declining rates for multiple years to come. Viper Energy Partners LP (VNOM) is not a trust, but a partnership, solely focused on the Permian Basin with royalty interests in producing wells as well as proven undeveloped (PUD), probable and possible wells. Per their latest 10K filing:Viper Energy Partners LP owns, acquires, and exploits oil and natural gas properties in North America. VNOM holds mineral interests covering an area of approximately 30,442 net acres in the Permian Basin, West Texas. As of December 31, 2015, its estimated proved oil and natural gas reserves consisted of 31,435 thousand barrels of crude oil equivalent. Viper Energy Partners GP LLC operates as the general partner of VNOM. VNOM was founded in 2013 and is based in Midland, Texas and is a subsidiary of Diamondback Energy, Inc (FANG).VNOM filed the initial public offering in June of 2014. Below is the entire trading history of VNOM:
The following summarizes VNOM’s oil and gas assets in more detail per their latest 10K:
VNOM’s primarily owns mineral interests located in the Permian Basin. As of December 31, 2016, VNOM owned mineral interests consisting of 107,568 gross acres in the Permian Basin. In total, Diamondback operates approximately 41% of this acreage. Details of VNOM’s acreage, as of December 31, 2016, are summarized below:
Total Producing Wells: 545 vertical wells and 190 horizontal wellsNet Production during 4Q2016: 7,919 Boe/dEstimated Proved Reserves per Independent Petroleum Engineer: 31,435 Mboe
58% classified as PDP reservesIncludes 23 horizontal wells in various stages of completion68% Oil / 18% NGL / 14% Natural GasPUD Reserves from 86 gross horizontal well locationsRevenue generated from these mineral interests has increased from $77.8 million in 2014 to $78.8 million in 2016
VNOM, on average (on an acreage weighted basis), receives a 5.95% royalty interest from their 107,568 gross acres and they do not have to pay for any additional capital or operating expenses. The actual royalty percentages vary from 1% to 25% depending on the relative amount of production from the various leases. For example, in the Spanish trail area of Midland County, VNOM receives an average (on acreage weighted basis) of 20.4% for the 16,551 gross acres they own.
Because Diamondback operates 41% of VNOM’s acreage, the performance of VNOM is closely tied to the activity of Diamondback Energy, Inc. (FANG). Below is the price history of VNOM and FANG:
Market ObservationsThere are approximately 21 oil and gas focused royalty trusts and partnerships publicly traded, as of the date of this article. As demonstrated below, VNOM is unique from the other 20 similar entities.
While many of these entities have assets located in the Permian Basin, the areas that make VNOM unique may include but are not limited to the following:
Asset mix is primarily focused in the Permian Basin;Royalties are from producing wells;Future royalties are possible from PUD, probable and possible locations; andFANG is the operator of a significant portion of the VNOM’s acreage.
As a result, VNOM has the second largest market capitalization, the 4th highest price to revenue multiple, the lowest yield (of the entities that have a yield) and has the longest implied payback period at 21.2 years. Each of these data points indicates VNOM’s popularity in the market place among investors, FANG being the largest owning approximately 74% of the total shares outstanding of VNOM. For many of the above entities, opportunity to participate in PUD, Probable and Possible wells does not exist. Based upon our knowledge of the exploration and production industry, opportunities to participate in new wells, without having to pay for the capital expenditure of drilling the well, casing the well and fracking the well, appears to be an exciting and valuable option. The market appears to agree.Implications for Royalty OwnersIn many respects, royalty owners can utilize publicly traded royalty trusts and partnerships to observe changes in investor behavior and get a feel for how much their royalty interests may be worth. Here are a few areas to consider for your specific situation to compare and contrast with royalty trusts and partnerships.Set Number of Assets. Royalty trusts and partnerships typically have a set number of wells and producing assets after they are formed. Does your property have a fixed number of assets or will it grow? If new oil and gas wells are not being added to the property, then the oil and natural gas reserves will deplete as they age and produce.Location. The royalty trusts and partnerships above have assets all over North America. Some are located in hot spots while others are not. Location drives investor appetite as operating costs and production levels, which vary by location, drive profitability in an industry that has zero control over the price of their product. This is a significant reason for the high transaction activity in the Permian Basin. Operators know they are able to make a profit through high production rates and low operating costs in Permian Basin even at $40 oil. Consider the investor activity, or lack there-of, in your area.Price and Production. Now that the U.S. has significant recoverable oil and gas reserves and the ability to export unrefined crude world-wide, the U.S. can be considered a swing producer, a power which historically characterized OPEC. As a swing producer, price dictates the level of production the market will consume and production will increase or decrease relatively quickly to meet demand. In response to price changes, operators will increase or decrease production levels at will. Consider how your operator has behaved in various pricing environments and the operators of the Royalty Trusts.
In addition to the differences between your royalty assets and the royalty trusts and partnerships, consider the level of value indication provided by the royalty trusts and partnerships. The level of value is the publicly traded level of value verses the privately held royalty assets held by many land owners. Consider the following chart.
Chris Mercer explains,
The benchmark level is the marketable minority level of value, or the middle level in the chart above. Conceptually, it represents the pricing of the equity of a public company with an active and freely trading market for its shares. For a private company, it represents that same price as if there were a free and active market for its shares.
The lowest level on the traditional levels of value chart is called the nonmarketable minority level of value. This level represents the conceptual value of illiquid (i.e., nonmarketable) minority interests of private companies, or entities that lack active markets for their shares.Publicly traded royalty trusts and partnership provide an indication of value at the marketable minority value level for minority interests in an entity with royalties as the primary asset. For royalty owners the value level can be a mixed bag. Many own the asset directly while others own equity interests in entities with royalties as their main assets. It is important to understand the value level comparability difference for your situation.To move from the marketable minority value to the nonmarketable minority value level, simply apply a marketability discount. Stated a different way, apply a discount for not having the ability to quickly sell your asset and receive cash. Fully marketable assets, like those publicly traded, have the ability to exchange the asset for cash in approximately three days. All other assets which do not have this access lack marketability. Therefore, in order to build and find a market for the assets, a discount is typically required by potential investors.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
Active Management Down But Not Out
Fresh off a 111-82 KO from the San Antonio Spurs on Saturday, our hometown Memphis Grizzlies are certainly battered but not totally eliminated from this year’s NBA title race. As this post goes to press, we still don’t know the outcome of Game 2, but it will undoubtedly be an uphill climb for the Grizz as it usually is against their divisional foes in Central Texas. Still, the Spurs/Grizz rivalry over the last ten years has not been nearly as one-sided as the battle for fund flows between active and passive investors in the ETF era.
These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are down while the market is up about 15% over the last year.
Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies, but also sector-wide underperformance against their applicable benchmarks. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability.
Another potential headwind is the GOP’s current proposal to treat all 401(k) deferrals as after-tax contributions, which could disincentive employers from offering defined contribution plans that often invest in mutual funds and other active managers. Republican lawmakers still have a lot of work to do in getting this passed, but it is being seriously considered as one way to help finance the new administration’s proposed tax cuts.
Despite these headwinds, 45% of domestic active managers were beating their benchmarks for the first two months of this year, after just 31% in 2016, according to Morningstar and The Wall Street Journal. To put this in perspective, the last year that even half of all active funds outperformed their index was 2009. Higher volatility, asset decoupling, and rising market conditions has been beneficial to most stock and bond pickers over the last few months. As a result, actively managed mutual funds posted their first month of positive new inflows in February since April 2015, according to Morningstar.
The recent outperformance of some active managers means they may be gaining the upper hand on ETF’s value added proposition, which is all about alpha net of fees. ETFs and other passive strategies gained substantial inflows from active managers since their performance net of (lower) fees has been stronger than most active managers over the last decade, resulting in higher and higher allocations to index products. Active managers are now poised to reverse this trend, but it is going to take more than just two months of alpha to put much of a dent in this trend. We’ve all read that consistently beating the market is nearly impossible, even for the savviest of stock pickers, but none of that research was compiled when passive strategies dominated the investment landscape.
We don’t foresee a huge shift back to active management any time soon, but we realize that we were probably overdue for some mean reversion. It is conceivable that the current market environment could be more conducive to stock picking, but we’ll need more time to judge whether this is truly the case. Regardless, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. This is why we say that active management, much like the Grizz, is down but not out as the series currently stands.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
What Would You Do with $1 Billion?
Less than one month ago investors bet $1 billion on James Hackett, former President and CEO of Anadarko Petroleum Corp. Silver Run Acquisition Corp. II is a blank check company that will leverage James Hackett’s knowledge of the Eagle Ford Shale and Permian Basin to fund an opportunistic acquisition. Silver Run II was created by the Riverstone Holdings LLC, the bank that successfully started the blank check company over a year ago now known as Centennial Resource Production LLC. The original stock sale for Silver Run Acquisition Corp I, which raised $900 million is expected to exceed $1 billion. If the banks managing the deal exercise their options to buy shares, which they generally do, the Company would be tied for the record largest blank-check offering. Before we review the recent uptick in investment in oil and gas blank check companies, we will review the basics of blank check companies and special purpose acquisition companies (SPACs).What Is a Blank Check Company?A blank check company, as defined by the SEC, is a “development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person.” Because the acquisition opportunity has yet to be identified, investors do not know how their funds will be spent, so they write a blank check to the company. One kind of blank check company is a special purpose acquisition company (SPAC).What Is a SPAC?Alice Hsu, Partner at Akin Gump Strauss Hauer & Feld LLP, explained “SPACs are newly formed shell companies, without any revenue or operating history, that raise proceeds in an IPO” in order to finance a merger or acquisition in a specific timeframe. The money raised goes into a separate trust that can only be used for an eventual merger or acquisition. At least 80% of the assets held in the trust account must be used to fund the acquisition of the target business or businesses. If a SPAC does not meet certain goals within a specified time frame, generally 18 to 24 months, then the company will liquidate and return the pro-rata share of funds to investors.SPACs raise capital through IPOs, in which one unit and its attached warrant is typically priced at $10, making them “penny stocks.” A short period after the IPO, the common stock and the warrants comprising one unit will begin separate trading at which point holders have the option to continue to hold their units or separate them. SPACs are usually sponsored by an industry guru whose experience and knowledge of the industry gives them a unique position in to pursue acquisitions. In 2007, there were 58 SPACs that completed IPOs. But until 2016, oil and gas SPACs were uncommon.Oil and Gas SPACsSince the crash in oil prices in 2014, many oil and gas companies found themselves in dire need of capital. Many distressed companies sold off non-core assets for heavy discounts in order to quickly generate cash to pay off debt and avoid bankruptcy. This gave investors a unique opportunity to pick up assets at low prices and SPAC’s provide a source of private capital to do this.The first oil and gas SPAC, Avondale Acquisition (AACOU) founded in April 2015, never completed an IPO as its original sponsor former CEO of Chesapeake Energy & founder of American Energy Partners, LP, Aubrey McClendon, died in a car crash in March 2016. The Company formally withdrew its plans for an IPO to raise $200 million in November 2016.In early-2016 two oil and gas special purpose acquisition companies (SPACs) successfully completed IPOs. This included 2016’s largest U.S. IPO as of February 23, 2016: Silver Run Acquisition Corp. Corrie Driebusch and Ryan Dezember of the WSJ said the size of the deal in “an otherwise frozen market for initial public offering” […] “reaffirms investors’ appetite for bottom-feeding in the oil and gas business.” The timing the deal shows that investors believed in early 2016 that the oil and gas market had bottomed out and would rebound within the next two years when its term to make a deal would expire.Where Are Oil and Gas SPACs Investing?Silver Run Acquisition Corp (SRAQU) was sponsored by Mark Papa, former CEO of EOG Resources. Silver Run Acquisition Corp raised $500 million when it began trading on the NASDAQ. In July 2016, Silver Run acquired a controlling interest in Centennial Resource Production LLC, an independent natural gas company located in the core of the Delaware Basin. Centennial has acreage in Reeves, Ward, and Pecos Counties. The transaction was financed by Riverstone Holdings LLC, an energy investment banking firm. After the transaction Silver Run was renamed Centennial Resource Development Corp (CDEV).KLR Energy Acquisition Corp. (KLRE) raised approximately $85.1 million in its IPO. It is sponsored by Gary Hanna, former CEO of EPL Oil and Gas Inc. The Company announced a meeting date for stockholders to vote on the business combination with Tema Oil and Gas Company. The meeting is scheduled for April 26, 2017. Tema Oil and Gas Company is a privately held company operating in Texas and New Mexico and holds acreage in the core of the Deleware Basin in Loving County. After the Closing of the transaction the Company will change its name to Rosehill Resources Inc. and will trade on the NASDAQ under the tickers ROSE, ROSEU, and ROSEW.Kayne Anderson Acquisition Corp. started by a Los Angeles private equity firm which focuses on pipelines, raised $350 million in an IPO on March 30, 2017. This SPAC is different than most others in the oil and gas space as they do not have one industry guru as a sponsor but rather are sponsored by Kayne Anderson Sponsor, LLC which is most likely run by a team of investors at Kayne Anderson Capital Advisors, LLC.After listing on the NASDAQ just last week, Vantage Energy Acquisition Corp. (VEACU), a blank check special purpose acquisition company, raised $480 million. Vantage Energy Acquisition Corp. is sponsored by Roger Biemans who was the CEO of Vantage Energy until it sold to Rice Energy last October. It is likely that Vantage Energy will pursue investment opportunities in the Marcellus Shale, as Roger Bieman’s former experience was centered there.Additionally, it is rumored that Occidental Petroleum is in the talks to launch a SPAC sponsored by former CEO Stephen Chazen.ConclusionWhile the majority of M&A has been focused in the Permian Basin over the last year, the varying investments of oil and gas SPACs demonstrate that the knowledge of the industry experts is what investors find valuable. Investment by SPACs has been higher of course in the Delaware Basin, but some of the SPACs are focusing on natural gas in the Marcellus and Utica as well.The continuation of investment in oil and gas SPACs shows that investors still believe that there are opportunities to find bargain investments in the oil and gas space throughout many basins. The emergence of oil and gas SPACs however is still recent and there is little history to understand the success of such companies.Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Strategic Benefits of Stress Testing
“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”– Warren Buffett, Berkshire 2017 Annual Shareholder Letter
While the potential regulatory benefits are notable, stress testing should be viewed as more than just a regulatory check-the-box exercise. The process of stress testing can help bankers find silver (or gold in Warren’s case) linings during the next downturn.What Stress Testing Can Do For Your BankAs we have noted before, a bank stress test can be seen as analogous to stress tests performed by cardiologists to determine the health of a patient’s heart. Bank stress tests provide a variety of benefits that could serve to ultimately improve the health of the bank and avoid fatal consequences. Strategic benefits of a robust stress test are not confined merely to the results and structure of the test. A robust stress test can help bank management make better decisions in order to enhance performance during downturns. A bank that has a sound understanding of its potential risks in different market environments can improve its decision making, manage risk appropriately, and have a plan of action ready for when economic winds shift from tailwinds to headwinds.By improving risk management and capital planning through more robust stress testing, management can enhance performance of the bank, improve valuation, and provide better returns to shareholders. For example, a stronger bank may determine that it has sufficient capital to withstand extremely stressed scenarios and thus can have a game plan for taking market share and pursuing acquisitions or buybacks during dips in the economic, valuation, and credit cycle. Alternatively, a weaker bank may determine that considering a sale or capital raise during a peak in the cycle is the optimal path forward. If the weaker bank elects to raise capital, a stress test will help to assess how much capital may be needed to survive and thrive during a severe economic environment. Beyond the strategic benefits, estimating loan losses embedded within a sound stress test can also provide a bank with a head start on the pending shift in loan loss reserve accounting from the current “incurred loss” model to the more forward-looking approach proposed in FASB’s CECL (Current Expected Credit Loss) model.Top Down Stress TestingIn order to have a better understanding of the stress testing process, consider a hypothetical “top-down” portfolio-level stress test. While not prescriptive in regards to the particular stress testing methods, OCC Supervisory Guidance noted, “For most community banks, a simple, stressed loss-rate analysis based on call report categories may provide an acceptable foundation to determine if additional analysis is necessary.” The basic steps of a top-down stress test include determining the appropriate economic scenarios, segmenting the loan portfolio and estimating losses, estimating the impact of stress on earnings, and estimating the stress on capital.While the first step of determining a stressed scenario to consider varies depending upon a variety of factors, one way to determine your bank’s stressed economic scenario could be to consider the supervisory scenarios announced by the Federal Reserve in February 2017. While the more global economic conditions detailed in the supervisory scenarios may not be applicable to community banks, certain detail related to domestic variables within the scenarios could be useful when determining the economic scenarios to model at your bank. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices.The 2017 severely adverse scenario includes a severe global recession, accompanied by heightened corporate financial stress (real GDP contraction, rising unemployment, and declining asset values). Some have characterized the 2017 “severe” scenario as less severe than the 2016 scenario (given a relatively higher disposable income growth forecast and a lack of negative short-term yields, which were included in the 2016 economic scenarios). However, CRE prices were forecast to decline more in the 2017 scenario, and those banks more focused on CRE or corporate lending may find the 2017 scenarios more negatively impact their capital and earnings forecasts.For community banks facing more unique risks that are under greater regulatory scrutiny, such as those with significant concentrations in commercial real estate lending or a business model concentrated in particular niche segments, a top-down stress test can serve as a starting point to build their stress testing process. The current environment may be an opportune time for these banks to plan ahead.While credit concerns in recent quarters have been minimal and provisions and non-performing asset levels have trended lower for the banking sector as a whole, certain loan segments have shown some signs that the credit pendulum may have reached its apex and reversed course by swinging back in the other direction. REITs were net sellers of property in 2016 for the first time since 2009, and a rising rate environment could pressure capitalization rates higher and underlying commercial real estate asset values lower. Furthermore, banks with longer duration fixed rate loans could face a combination of margin pressure and credit quality concerns as rates rise.ConclusionRegulatory guidance suggests a wide range of effective stress testing methods depending on the bank’s complexity and portfolio risk–ranging from “top-down” to “bottom-up” stress testing. The guidance also notes that stress testing can be applied at various levels of the organization including transactional level stress testing, portfolio level stress testing, enterprise-wide level stress testing, and reverse stress testing.We acknowledge that community bank stress testing can be a complex exercise as it requires the bank to essentially perform the role of both doctor and patient. For example, the bank must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios for a bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank management begin building their stress testing expertise sooner rather than later.In order to assist community bankers with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests or reviewing ones prepared by banks internally, to make the process as efficient and valuable for the bank as possible.To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.This article originally appeared in Mercer Capital's Bank Watch, March 2017.
How to Value Overriding Royalty Interests
What is a Royalty Interest?Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing or any other expense associated with drilling and producing an oil and gas well.What is an Overriding Royalty Interest (ORRI)?A percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.ORRI’s typically do not own a perpetual interest in the mineral rights. Typically they are structured to have rights to royalties for the term of the lease period. Royalty interests, on the other hand, generally have mineral ownership into perpetuity, even after a lease expires. Thus the main difference between royalty interests and ORRI’s is that royalty interests are tied to the ownership of the mineral rights below the surface, and ORRI’s are tied to the lease agreement and ceases to exist once the lease expires.Some may find it surprising that the popular publicly traded Permian Basin Royalty Trust (PBT) only owns ORRI’s, not royalties, in various oil and gas properties in the United States. PBT owns a 75% net ORRI in the Waddell Ranch properties comprising Dune, Judkins, McKnight, Tubb, University-Waddell, and Waddell fields located in Crane County, Texas. As of December 31, 2016, its Waddell Ranch properties contained 349 net productive oil wells, 64 net productive gas wells, and 102 net injection wells.The company also holds a 95% net overriding royalty in the Texas Royalty properties that consist of various producing oil fields, such as Yates, Wasson, Sand Hills, East Texas, Kelly-Snyder, Panhandle Regular, N. Cowden, Todd, Keystone, Kermit, McElroy, Howard-Glasscock, Seminole, and others located in 33 counties in Texas. Its Texas Royalty properties consist of approximately 125 separate ORRI’s containing approximately 51,000 net producing acres.Over the past four years, crude oil and gas prices have fluctuated significantly. While this is creating significant volatility on the E&P side of the industry on both an operational and investment decision level, many look at royalty trusts as a way to bypass the complexities of an operating E&P and attempt to “pure play” the price of oil and gas. Based upon this assumption, we will analyze the changes PBT has endured over the past four years.Production
PBT derives revenue from ORRI’s which cover approximately 382,000 gross acres (85,205 net acres) in west Texas. Since the ORRI’s that PBT owns were not derived from a 100% working interest, their gross acreage differs from their net acreage. Net acreage is calculated as the company’s percentage interest multiplied by its gross acreage. Over the past four years, the amount of acreage has not changed. Production, on the other hand, has changed significantly as shown in the table below.
Comparing the production levels to the price levels of oil and gas indicates that even after the decline in oil and gas prices during 2014, production increased during 2015. Oil production increased 3% while gas production increased 44%. The increased production was in part due to the 3 new wells drilled during 2014, 3 workovers completed during 2014 and 29 wells completed during 2014 and 2015.
During 2016, investment activity was significantly different which resulted in a 28% decline in oil production and 33% decline in gas production. No wells were drilled and completed during 2016. Only 1 workover was performed. Clearly the operators were holding back capital as they waited for more price certainty in the future.
Reserves
The change in reserves tells the same story. After investing in the drilling and completion of new wells, and workover wells, the proved reserves increased from 2014 to 2015 for both oil and gas. The increase is significant as reserves are impacted by (1) investment in new/existing wells and (2) future prices of oil and gas. The price utilized in the 2015 reserves was significantly lower than what was used in the 2014 reserves. Therefore, the increase in reserves is significant as the additional proved reserves more than countered the reduction in the commodity prices in the reserve model.
For 2016, the reserves declined due to the lack of investment in current and future wells. And while pricing stayed relatively the same from 2015 to 2016, the loss in proved reserves was directly attributed to the lack of investment in new and existing wells.
Distributions
PBT is at its lowest yield in the last four years. While the price was lower at the end of 2015, the dividend as a percentage of price was higher in 2015 relative to 2016. The above chart shows the impact of (1) changes in oil and gas prices; as well as (2) changes in production levels. These two areas are directly related to the dividend per share. The price, however, is directly related to the movement of buyers and sellers of PBT securities. While the dividend is “trailing” information, because it is the result of the previous 12 months of activity, the price factors in forward looking information. For example, as of 2013, buyers and sellers of PBT were expecting higher dividends in 2014 due to the high price of oil and gas, PBT’s investment in wells and increasing proved reserves1. When commodity prices declined during 2014, the price quickly reflected the new pricing environment, the impact on reserves, and the shift in management’s investment attitude for new and existing wells. All of these factors pressured prices downward while the trailing dividends showed strength, resulting in a higher than normal yield. During 2015 and 2016, the price, dividend and yield settled to relatively tempered levels. All data points above have had enough time to reflect the current environment and as such, are communicating a similar story.
Finishing ThoughtWhen valuing a royalty interest or ORRI, here are a few items to keep in mind:Understand the rights and restrictions of the subject royalty interest:
Royalty interests may have value into perpetuity as it is a direct ownership in the minerals;ORRI’s typically only have value for the life of the lease;Understand the differences between the subject ORRI and a publicly traded security that owns ORRI’s and make adjustments for the differences;Understand the historical, current and future outlook for commodity prices relating to the subject ORRI;Understand the historical, current and future outlook for reserves;Utilize publicly traded yields to assess the markets attitude for investments in similar securities; andAdjust for the differences between a publicly traded security and a non-marketable security.
When comparing a royalty interest to an ORRI, it is critical to understand the subtle nuances of the rights and restrictions between the two. Owners of royalty interests utilizing PBT as a valuation gauge should adjust for such differences as well as other differences between publicly traded and non-marketable securities. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
End Note1 Although not shown in the above chart, proved reserves increased 32% between 2012 and 2013 for PBT
Excuse Me, Flo?
Inflows and Outflows Drive Disparity in Performance between Different Classes of Asset Managers
Immediately before ordering the Soup Du Jour and duping Sea Bass into picking up his lunch tab, Jim Carrey’s character in Dumb and Dumber, Lloyd Christmas, rudely accosts his waitress at the Truk-Stop Diner with this inexplicable reference to the early 1980s sitcom starring Polly Holliday as Florence Jean “Flo” Castleberry. Decades after the movie’s release in 1994, the market seems to be postulating the same question in pricing RIAs.
Breaking out the recent performance of various classes of asset managers, we see those sectors that are least dependent on active management (trust banks and traditional managers) as clearly outperforming those more reliant on investment returns (alternative asset managers and mutual funds). While there are other factors at work (a steepening yield curve and hedge fund scandals to name a few), this disparity is largely attributable to investment performance and the impact it has on asset flows.
We touched upon this topic in last week’s post, and basically AUM gains (the primary driver of revenue and profitability for an RIA) are attributable to one or two sources – market gains or client inflows (net of outflows). Since one can’t rely on stocks to always go up, asset flows are a more reliable gauge of an RIA’s sustainable performance regardless of market conditions. As shown above, there is a strong correlation between publicly traded RIAs and the market, so the disparity in performance between the various classes of asset managers is largely attributable to net asset flows. Subpar investment performance and the recent flight to passive products have plagued alternative asset managers and mutual funds, but benefited index providers with more competitive fees.
The market has taken notice and continues to bid up the valuations of passive managers with positive inflows. Part of this outperformance may also be due to the anticipation of more favorable regulation (e.g. the Fiduciary Rule) surrounding passive investors over active management. Stephen Tu, Senior Analyst at Moody’s Investor Service, says, “Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interest and minimize fiduciary risk.” In response, many traditional active managers like Janus Capital, Legg Mason, and Franklin Resources have begun offering passive products to take advantage of the prevailing trend.
Despite the high fees and underperformance, we’re not characterizing mutual fund and alternative asset investing as dumb and dumber. The reality is that many active managers do outperform their benchmarks and justify their fees. A proven track record of alpha generation will likely continue to attract assets from institutional clients even if fees aren’t competitive to an ETF that tracks a given benchmark or asset class.
It’s just that beating the market on a consistent basis is a near impossible feat, so most active managers are struggling to keep pace with the rise of passive products that offer a cheaper and more reliable alternative. Much like Harry and Lloyd’s rapid accumulation and subsequent squandering of other people’s money, active managers must improve their performance or lower their fees to avoid a similar fate.
The Wild Goose Chase Is Over
The Great Y2K scare led to approximately $134 billion in preparation for the world-altering event. The belief that computers would malfunction and the world as we then knew it would end at midnight of December 31, 1999, led all major companies and many families to seek out help in preparation for the event, no matter the cost. When the clocks struck midnight and everything but a few slot machines in Deleware continued running, we moved on to planning the next apocalyptic event – what if oil runs out?From 2000 to 2005, “concerns that supply could run out and soaring oil prices sent energy companies on a grand, often wildly expensive, chase for new production.” They were investing in multi-billion-dollar projects in the Arctic waters and Kazakhstan’s Captain Sea. A WSJ article titled, “Oil Companies Take Thrifty Bets,” explained that when oil was worth $100 per barrel oil companies had much higher risk tolerance and were able to invest heavily in the exploration of undeveloped land and ocean. But as the price of oil declined and has settled around $50 per barrel, the wild goose chase for oil has come to an end.Declining Capital ExpendituresWe are facing a different kind of supply crisis than previously imagined. Bloomberg analysts forecast that if OPEC cannot come to an agreement to extend cuts, it is forecasted that oil prices will fall to $40 per barrel. And if oil falls to $40 per barrel then much of the drilling activity that surged in the Permian Basin is expected come to a halt. Oil companies today can only focus on decreasing costs and reducing risks in order to stay afloat in an oversupplied market. From 2014 to 2016, capital expenditures of the E&P companies, shown below, declined, on average, by 64%.
In mid-2014 when the price of oil fell, exploration and production companies struggled to continue pumping oil from current wells. In order to fund day-to-day operations, companies had to pull the plug on most of their capital projects. Now that the price of oil has settled around $50 per barrel, exploration and production companies have begun to allocate small portions of their budget to research for new reserves and the exploration of new wells. Even as exploration and production companies’ revenues declined dramatically, capital expenditures shrunk from an average of 71% of revenues in 2011 to 43% of revenues in 2016. However, as capex budgets are shrinking, the cost to explore and drill new wells is increasing.
The price of fracking sand has increased recently as companies drill wells deeper in order to find efficiencies of scale. Deeper drilling, however, requires larger amounts of sand. As fracking has become more common, drilling in shale fields requires approximately 30% more sand every year. Although the price of fracking sand is still below $60 to $70 per ton, where it was before crude prices fell, Mr. O’Leary, director of oil-field services research at Tudor Pickering thinks that the price of sand will rise to $50 a ton this year. Last fall the cost of sand accounted for between 5% and 7% of the cost of a well but Mr. O’Leary expects that percentage to rise as exploration and production companies increase their usage of fracking sand this year. Further he said, “The millions of pounds of sand being poured down wells is pushing up sand prices, eroding some of the profits that energy companies have managed to regain since the oil bust ended.” In order to protect themselves from higher costs and shortages in fracking sand, some companies such as Pioneer Natural Resources have purchased their own sand mines.
In order to reduce costs and minimize risk, companies are looking for investments with shorter payback periods. Exxon, BP, Shell, and Chevron are investing in quick ventures in Texas and in existing projects in the Middle East and Brazil. Companies are looking back at old basins to see if new technologies can be used to extract any remaining resources. This is a big shift for companies who used to believe that the large upfront costs that would be paid off over 20 to 30 years generated the best return.
But what does the decline in capital expenditures today mean for supply and prices tomorrow? Due to the advancement of technology and the speed at which companies can bring new projects online, it is not likely that we will see a supply shortage any time soon. Rather low oil prices seem to be the new normal. When oil prices hit $60 then certain DUCS will be economical and will be brought online. And when oil hits $70… there will be more DUCs ready to be completed.
Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
RIA Performance Metrics: Keep an Eye on Your Dashboard
A persistent truth about investment management is that no analyst ever saw a piece of information he or she didn’t want. Professional investors are, by their very nature, research hounds – digging deep into a prospective investment’s operating model, financials, competitive landscape, management biographies, and whatever else might be relevant to try to evaluate the relative merit of buying into one idea instead of another. This same diligence doesn’t always extend to practice management, though, and we are not infrequently surprised at how little attention management teams at RIAs devote to studying their own companies.I was pondering this vexing irony recently during a long family road trip. My older daughter is sixteen and wanted to do her part of the driving, which her mom and I were happy to oblige. That said, sitting in the passenger seat is somewhat unnatural for me, and I couldn’t stop nervously looking over at the speedometer as it crept five, seven, ten, twelve miles per hour over the speed limit. It didn’t help knowing that my daughter is related to me.When I was sixteen, a friend of my parents came over for dinner in his new Jaguar XJ6. It was British Racing Green, with biscuit leather seats and wool carpet that smelled like the countryside west of London where Wilton sheep still graze among stone-circles built by Druids. This was the 1980s, and there weren’t many fast cars made at the time – especially sedans. The Jaguar had four doors, but it also had the same motor derived from the XK series of the 1950s and 60s, a low center of gravity, and a set of Pirelli racing tires. I was enthralled. “Wanna drive?” He didn’t have to ask twice.Off we went into the Georgia summer evening, looking for uninhabited roads with long straight-ways. “You can wind her out some if you want to; she stays pretty stable at speed.” She did, and before long we were approaching triple digits. I couldn’t stop staring at the speedometer, pondering my good fortune at knowing an enabling adult with a new Jaguar – my dream (or at least one of them). The XJ6 could do about 135 mph, but we topped out just shy of 120 before a reasonably sharp curve and a bridge appeared in front of us, and I had to back off the right pedal. “We’ll do this again sometime when you can really open her up,” I was told. Good thing that never happened, and also good that another friend of my parents, who drove a Ferrari, never offered the same.Looking back on my first experience with speed I’m struck by two things: 1) my parents’ friend was remarkably calm given the circumstance, and, 2) I was far too fixated on the dashboard instead of the road. Most XJ6 owners are well served to keep an eye on the engine temperature gauge, but anyone traveling north of 100 mph only needs to be looking at one thing: the road ahead.RIA teams, by contrast, seem inclined to the opposite. If the “road ahead” for an RIA is the financial markets, and the dashboard offers a read on the firm’s internal performance, it seems like many investment managers never look down.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies. But even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior. So we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA. Over a five year period, this RIA boasted aggregate revenue growth of more than 50%, increasing from $3.7 million to $5.7 million. AUM growth was even more substantial, nearly doubling from $600 million to over $1.1 billion.
Looking deeper, though, we notice a couple of unsettling trends. The five year period of measurement, 2012 through 2016, represent a bull market from which this RIA likely benefited substantially. Cumulative gains from market value were over $700 million, more than the total growth in AUM and masking the loss of clients over the period examined. Markets cannot always be counted on for RIA growth, so client terminations, totaling $285 million over the five year period or nearly half that of beginning AUM in 2012, is cause for concern. This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients.
Further, there appears to be loss in value of the firm to the marketplace. Realized fees declined four basis points over five years. Had the fee scheduled been sustained, this RIA would have booked another $372 thousand in revenue in 2016, all of which would have dropped to the bottom line. Pre-tax margins would have been almost seven percentage points higher. Small changes in model dynamics have an outsized impact on profitability in asset management firms, thanks to the inherent operating leverage of the model. But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue.
So, we would ask, what’s going on? Did this RIA simply ride a rising market while neglecting marketing? Are clients concerned about something that is causing them to leave? Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM? If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance? Is their realized fee schedule actually declining, or is it not? Is the firm negotiating fees with new or existing clients to get the business? Did a particularly lucrative client leave? What is happening to the fee mix going forward?
Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM. Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data. All should. Some teenage drivers pay too much attention to the dashboard, some RIA managers not enough. The risk to both is the same: ending up in the ditch.
How to Perform a Purchase Price Allocation for an Exploration and Production Company
This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016.
When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.
Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.
Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
A Bright Spot at the Bottom of the Barrel
How has the Asphalt Industry been Affected by Depressed Oil Prices?Asphalt and road oil are used primarily by the construction industry for roofing and waterproofing and for road construction. Asphalt is a byproduct of petroleum refining. During the distillation process of crude oil, asphalt does not boil off and is left as a heavy residue. Generally around 90% of crude is turned into high margin products such as gasoline, diesel, jet fuel, and petrochemicals while the other 10% is converted into asphalt and other low margin products. Petroleum refiners sell asphalt to asphalt product manufacturers who produce retail products such as asphalt paving mixtures and blocks; asphalt emulsions; prepared asphalt and tar roofing and siding products; and roofing asphalts and pitches, coating, and cement.
Demand for asphalt products is determined by the health of the construction industry and the level of infrastructure funding.
How has the Construction Industry Impacted Demand for Asphalt?Spending on construction in December 2016 increased 0.2% from November 2016 and 4.2% from December 2015 to $1.18 trillion. After several years of steady growth followed by decelerating growth in 2016, Dodge Data & Analytics forecasts total construction starts will increase by 5% in 2017 reaching $713 billion. AIA believes that factors such as job growth, consumer confidence and low interest rates have propelled construction spending.How has Funding for Infrastructure Impacted Demand for Asphalt?About 93% of the 2.2 million miles of paved roads and highways in the U.S. are paved with asphalt. Most road construction is funded by states, counties, or other federal programs. Thus demand for asphalt and road oils are largely dependent on the level of funding available. During the recession most local governments collected less revenue and could not afford investment in infrastructure. Both federal and state level taxes designed to generate revenue for transportation use a per-gallon fuel tax. Due to increasing fuel efficiency and lower gas prices, fuel taxes have generated less money. Further, the 18.4 cent-per-gallon federal gas tax has not been increased in more than twenty years and has not kept up with inflation or increasing costs. Some states have increased their state gas tax in order to fund these programs, but funding of infrastructure over the last decade has generally been insufficient.For the past decade, the federal government has been funding transportation for short periods of time using extensions of previous plans. In August 2005, the Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU) was signed into law. In July 2012, after multiple extensions of the SAFETEA-LU, the Moving Ahead for Progress in the 21st Century Act (MAP-21) was passed by Congress. MAP-21 extended SAFETEA-LU for the remainder of 2012, with new provisions for FY 2013 and beyond. Funding levels were maintained at FY 2012 levels with minor adjustments for inflation.President Obama signed the FAST (Fixing America’s Surface Transportation) Act in December of 2015. The FAST Act provided $305 billion from 2016 to 2022 for programs to improve highways, highway and motor vehicle safety, and other critical transportation projects. Included in this legislation is a new National Highway Freight Program which will focus most of its funding on highways. The legislation also aims to reduce administrative and bureaucratic obstacles allowing the DOT to delegate project oversight to states on a project and programmatic basis.While investment did modestly increase in 2016, it is likely that demand will pick up more in 2017 as projects funded by the FAST Act start being implemented. Mike Acott, president of the National Asphalt Pavement Association (NAPA) said that the most significant change since the FAST Act was passed has been a pickup in resurfacing activity. Resurfacing roads is a much cheaper alternative to repaving and many local governments were able to work the resurfacing of roads into the limits of their tight budgets. Increased demand for repaving materials led to industry innovation and new product developments to meet this demand.How did the Asphalt Industry Perform in 2016?As the price of crude oil fell so did the price of asphalt sold by petroleum refineries. Crude oil prices fell by 50% from June 2014 to January 2017 (the most recent PPI data available for asphalt) while asphalt prices fell 55% over this same time period.
Refiner’s margins generally increased in 2015 and fell over the last year. As shown in the chart above, the movement of refined product prices lags changes in crude prices. Thus in 2015, refiners purchased crude for cheaper prices than before but sold their products at the same prices. In 2016 however, asphalt prices began to fall and margins narrowed. Marathon reported that their asphalt operations were weaker than their “exceptionally strong” year of operations in 2015. Analysts expect the price of asphalt to increase over the next few years. As refining technology improves refiners are able to produce more gasoline out of a barrel of oil leaving less to be made into paving grade asphalt. This reduction in supply will likely increase asphalt prices.
As the price of crude fell, refiners margins narrowed, which led to a decrease in cost of goods sold for asphalt manufacturers resulting in a pickup in earnings. Because of the impact of transportation costs on the industry and the quick hardening time of ready mix asphalt, competition is based primarily on location and price.
In general asphalt manufacturers’ margins increased in 2016 as their cost of goods fell. Vulcan Materials, Inc. (VMC) produces aggregates and ready mix asphalt in Birmingham, Alabama. Its asphalt mix segment’s gross profit increased 25% in 2016. While sales volume and sales price declined by 3% and 2%, respectively the cost of goods sold decreased and expanded the Company’s gross profit margin by 4.3 percentage points. Martin Marietta (MLM), which produces aggregate and asphalt products in North Carolina, realized a 15.7% gross profit margin in its asphalt and paving segment in 2016 compared to a 12.6% margin in 2015.
How will the Asphalt Industry Perform in 2017?Going forward investment in infrastructure is expected to increase. After many states cut infrastructure funding, there is currently much work that needs to be done to improve the conditions of roads and highways. As state and local government budgets have improved since the recession, it is anticipated that tax revenue available for investment in road infrastructure will expand. Additionally, President Trump, during his campaign, pledged to invest $1 trillion in infrastructure in order to spur economic growth. Finally, prices for cement, which is a substitute for asphalt, are expected to rise which will increase the demand for asphalt. Overall, industry revenue is expected to increase by 2.3% over the next five years.1Mercer Capital has significant experience valuing assets and companies in the energy and construction industries. Our valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.End Note1 IBIS World Report 32412: Asphalt Manufacturing in the US: October 2016
An All-Terrain Clause for your RIA’s Buy-Sell Agreement
Clients writing new buy-sell agreements or re-writing existing ones frequently ask us how often they should have their RIA valued. Like most things in life, it depends. We usually recommend having a firm valued annually, and most of our clients usually do just that. “Usually,” though, is subject to many specific considerations.How many shareholders are there in the RIA? The more owners you have, the more transactions will occur and the more useful a semi-annual or quarterly valuation might be. Small firms with only a couple of owners typically don’t need to know their value on an annual basis, but checking in on some scheduled basis – such as every two or three years – is helpful to keep track of firm performance, update any life insurance coverage, and to plan for succession issues or sale of the firm.Is your firm growing rapidly? If so, an annual valuation might become stale very quickly. Mature firms probably only need to look at their valuation metrics once per year to see how their performance and outlook compares with the greater market for investment management firms.Even annual valuations can be inadequate, however, when an RIA experiences big increases or decreases in assets under management. Since we have been operating in a low volatility market (at least for U.S. equities) for some time, it’s easy to forget that normal, but nonetheless major, market swings can have a material impact on profitability and valuation. In the case of a market swoon, even a mature RIA with healthy margins can lose ground rapidly, and a valuation that looked reasonable six months earlier may no longer be practical. Consider an equity manager with $2 billion of AUM, realized fees of 60 basis points, and a 40% EBITDA margin. If the regular annual valuation is prepared at an effective EBITDA multiple of 9x, then enterprise value would come in at around $43 million.One might expect that a valuation such as that would satisfy the needs of an investment management firm over the course of a year, until the time came for the next update. Markets are fickle, though. Imagine the same RIA endures a significant market downturn late in the summer, and then an event happens which triggers the buy-sell. AUM drops 20% versus the start of the year, nothing changes in the expense base, and the valuation multiple is steady. Because of the inherent operating leverage in the asset management business, the profit margin drops from 40% to 25% on 20% lower revenue, and because of that compounding effect value declines by half.
This example has more simplifying assumptions than not, and most firm valuations would not move so dramatically just because of a 20% downturn in AUM. That said, market events and client whims can have an outsized impact on RIA profits and, consequently, valuation, such that an annual valuation may not hold up over the course of a year.
So what’s a firm to do? One option, of course, is to accept the vagaries of the market – any unusual events during the course of the year may be just as temporary as conditions at the annual valuation date. One of the functions of the buy-sell agreement is to get the parties to agree to what they are willing to live with, and what they are willing to live without. Many firms do just that.
This brings me to the subject of the photo above. European rally car races have always fascinated me, although I’ve never been brave enough to actually attend one. During the 1980s Audi ruled the rally scene with the Ur-quattro. The Ur-quattro was a hatchback that Audi developed after the racing rules were changed in the late 1970s to allow four-wheel drive. The Audi could handle anything, and to underscore that point the manufacturer used both Italian (“quattro” for four wheel drive) and German (“Ur” for primordial or original) to name it. Regardless of snow, mud, gravel, flat curves or deep hills, the Ur-quattro couldn’t be beat. Audi’s rally reputation was such that they started to offer the quattro system in all of their passenger cars, and all-wheel drive has become commonplace today – from Subaru to Lamborghini.
A client of ours that is drafting a new buy-sell agreement recently brought us an idea which we think offers a similar level of preparation for any circumstance. In their agreement, they’ve added a provision which would call for an interim update to their otherwise annual valuation if 1) the prospect of a transaction arises and 2) AUM is more than 10% higher or lower than at the time of the previous valuation. The annual valuation is important to set a pattern of expectations for parties to the buy-sell of how they’ll be treated in a transaction, and most of the time will suffice when a transaction occurs. Adding the update provision is a simple way to prepare for the possibility of substantial changes in the financial performance of the RIA. Even if they never use the provision, having it offers peace of mind for parties to the agreement that they’ll be treated fairly if the company’s performance changes radically over the course of the year.
In the decades since the Ur-quattro was introduced, Audi has sold cars with quattro to millions of people whose morning commute is nothing like a rally race. Most people buy all-wheel drive cars for that “just-in-case” moment that will make the added expense worth it. Like all-wheel drive, you may never need an event-based update provision in your buy-sell agreement. It’s nice to know, though, that your buy-sell is all-terrain ready, no matter how rough the ride gets.
Looking through the Buffett Brouhaha
The Oracle Still Believes in Human Innovation
Since I gave up politics for Lent this year, I’ve had more time to keep up with the deeper recesses of the financial press, which led me to Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway. Buffett’s prose is a literary genre unto itself; a remarkably plain-spoken approach to making even the most complex and dull aspects of investment management simple and entertaining. If all “management letters” were penned as well, shareholders might actually read them. Perhaps that’s why they aren’t.Press coverage of Buffett’s letter this year focused almost exclusively on the sections extolling the virtues of passive investing. Buffett updates us on his million dollar bet that a selected group of hedge funds won’t beat the S&P 500, after fees, over a ten year period; nine years in he’s winning handily. He nominates Jack Bogle for sainthood, and bemoans that wealthy people have squandered an estimated $100 billion (his estimate) on elaborate investment strategies that haven’t been as effective as index funds. In one of the more colorful passages in the letter, Buffett tells a family story that, while not directly addressing investment performance reporting standards, could be interpreted that way:Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other?
Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.”Buffett’s story could be the forward to the next edition of GIPS Standards; all you need is the right benchmark.All of this is, of course, a little hard to take from Warren Buffett. Not only has he made a (very successful) career out of asset management, he has previously been emphatically against spreading investment bets across too many assets – as one would in an index. Buffett and his longtime partner, Charlie Munger, have more than once characterized such breadth as “di-worse-ification.” Munger’s famous quote about bad mergers - “If you mix raisins with turds, they are still turds” – could equally apply to index investing, where the algorithm is to overweight Blockbuster and underweight Netflix. Despite a lengthy and successful career focusing on a few investments, Buffett appeared to have changed his mind.Predictably, there has been plenty of umbrage taken by the investment management community over the past week because of this. It doesn’t help that Moody’s latest quarterly Investors Service report tallied continued outflows from active managers in the fourth quarter of 2016. However, I’m not sure that this is the right time for portfolio managers to beat their chest and defend their alpha. For all of Buffett’s broadsides, this year’s letter is practically an apologia for active management.By my count, Berkshire Hathaway has beaten the S&P 500 in 34 of its 52 years, but more impressive than winning two thirds of the time is the order of magnitude. While the S&P 500 has produced a total compound annual return of 9.7% since 1965, Berkshire Hathaway has produced more than double that return, at 20.8%. Thanks to compounding, the aggregate return of Berkshire is 155 times that of the index. That’s a lot of alpha, and it isn’t just restricted to the early years. Berkshire has beaten the S&P 500 in seven of the last ten years, producing an average return 2.1% better than the index, and doubling the index return last year.The bulk of Buffett’s letter endorses active management. Berkshire Hathaway morphed over time from a stock-picking firm to one that also wholly owns businesses (the extreme end of active management). Consequently, when Buffett is particularly proud of one of Berkshire’s investments, he takes great pains to praise the humans who run those businesses. In particular, Buffett notes the accomplishments of his insurance company management teams who make profits out of managing underwriting risk and superior investment performance off of those companies’ float. And, as usual, Buffett gloats on Munger, noting that regardless of the future developments of artificial intelligence: “I will confidently wager that no computer will ever replicate Charlie.”The bulk of Buffett’s criticism of the hedge fund industry focuses on fees. He estimates that approximately 60% of the gains produced by the five hedge funds be measured against the S&P 500 were allocated to the fund managers. The issue seems not so much the value of humans in investment management, but the cost.
Are S&P Energy Stock Valuations Really Crazy Right Now?
A few days ago the Wall Street Journal published an article discussing what the author described as “crazy” stock valuations, and in particular the inflated valuations of oil and gas stocks from the perspective of operating earnings ratios.“The energy sector stands at more than 30 times Thomson Reuters IBES’s estimate of operating earnings over the next 12 months, higher than any time from when the sector data started in 1995 up to last year – when it briefly reached an extreme of almost 60 times.”The article also mentions that the S&P 500 as a whole is trading at almost 18 times estimated future operating margins. This got us to thinking - In light of what has transpired over the past two plus years in the energy sector, could it really be that stocks are overvalued? That certainly hasn’t been the sentiment that we hear from our clients. Maybe we’re all wrong? If so, what could be driving this?While we certainly are believers that value is driven by future operating earnings, and that earnings in the energy sector have fallen precipitously since 2014, is this all that determines the market’s pricing of the S&P 500 energy sector? As we reflect on this for a moment, a few additional considerations came to mind that may explain these “crazy” valuations more fully.Anticipated Tax ReliefOne consideration not captured in an operating earnings ratio that markets are using to impact values is expectations for future tax reform. Since the new administration has been inaugurated the stock market has risen significantly. Clearly, one of the sources of this market optimism is the platform of tax reform – including corporate taxes. There are a number of sources describing what this new structure may look like. One particularly insightful article was written by Jason B. Freeman in the January/February issue of Today’s CPA titled "Tax Reform Under a Trump Administration".President Trump’s plan would drop the corporate tax rate from 35% (among the highest in the world) to 15% or 20%. This would immediately bring tax relief at a corporate level and boost earnings. Judging by the equity market’s early reaction this morning to Mr. Trump’s State of the Union address, in which he highlighted this issue, anticipation of this action is fueling higher stock prices.Anticipated Regulation ReformThe market may also be considering the future impact President Trump’s regulation reform. While there is much uncertainty surrounding the future regulation of the oil and gas industry, President Trump ran as a friend to the oil and gas sector and promised to reduce regulations on the industry in order to boost the U.S. economy. Additionally, Oklahoma Attorney General Scott Pruitt was confirmed as the Environmental Protection Agency administrator. Pruitt has openly opposed the EPA, which is one of the main regulators of the oil and gas industry. Looser regulations on the oil and gas industry could reduce operating expenses associated with meeting current regulation and could provide new opportunities for the industry.Growth UnderpinningsThe energy sector has been hit hard, but a less visible aspect of the WSJ article’s premise is that there are signs that the energy sector’s depression in earnings may be short lived and the market is forecasting a rebound. Consider this, the price of oil is at or near decade lows and earnings are sensitive to commodity prices, particularly when the price of oil hovers close to breakeven costs for producers (which it is currently). Slight upward changes in oil and gas prices could have significant upward impacts on profits. In addition, due to the drop in commodity prices, the industry has responded by innovating and pushing costs downward for drilling shale wells.Reserves Reserves Reserves!Another aspect that can’t be detected by an operating earnings ratio is how awash in reserves we currently are. U.S. crude oil inventories have hit all-time highs, and demonstrate how poised the energy sector is to respond to manufacturing and consumer growth.
Reserves are the foundation of value for E&P companies which is why this metric is oftentimes much more important than mere earnings. It shows the potential for earnings 5 to 10 years or even 20 years down the road, which is something one year earnings estimates do not consider. Better ratios to consider here are equity values relative to daily or annual production or total proved reserves.
The Big PictureAt any given moment it can be hard to say if equities, sectors or companies are “overvalued”. Valuation is relative to begin with and ultimately at a point in time the “value” is what market participants will pay. As it pertains to oil and gas companies, it appears clear that earnings are low as the sector better copes with $50-55 oil and $3 gas. However, the market appears to see brighter days ahead, beyond 2017 and that confidence along with optimism for tax reform, operating efficiencies, and positioning for future growth are buoying prices. Perhaps investors aren’t crazy after all. Of course that’s just my opinion….I could be wrong.
Q4 Call Reports
Despite gaining 8% last quarter, publicly traded RIAs are still feeling the pressure from the regulatory overhang on the Fiduciary Rule and continued fee compression on most investment products. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Continued fee pressure and chronic underperformance have caused many traditional RIAs to consider expense caps or variable fee structures that toggle with performance.There is no doubt that investors have felt more comfortable with what is perceived to be low cost and safe passive investing versus choosing active managers at higher fees and suffering on average, because that’s what the average numbers show, underperformance net of a fee. – Alliance Bernstein’s Peter KrausI would say, in general, that we are trying to do something different and say to clients, if we don’t perform, we don’t expect to be paid more than five basis points, and if we do perform, subject to all the limitations in those documents, we would expect that clients would be happy to pay us, and that is a pretty competitive offering to the passive world. – ibidThat’s something we think can be very useful answer to some of these high pressures around just fees and rationalizing versus passive is only paying on the alpha. And that’s something that we certainly are looking at. I don’t think we have the same kind of pressure on the retail side, nor do we think it makes a lot of sense certainly on the institutional side. We think that could be very additive to our overall line-up. – Franklin Resources’s Greg JohnsonTheme 2: The shift from active to passive management is a major headwind for many alpha hunters, but the best in class performers see opportunity for increased market share when the dust settles.Disruption was also a major theme in our industry. Asset flows into passive products continue to accelerate. The availability of these products and the perception that they are low cost, and in many cases lower risk is impacting all aspects of the investment management industry. As a high value-added investment manager, we welcome disruption in the industry. That causes investors to scrutinize their managers and advisors to determine whether value is being added, fees are transparent and rational, and the client’s experience comes first. We believe we are well positioned to benefit from the ongoing shake-up of the traditional active industry, as well as the increasing frustration of hedge fund investors. –Artisan Partners's Eric ColsonFirst and foremost, an oversupply of traditional active strategies resulted in too many products hugging indexes and not delivering value. As less expensive passive products came on-line, offering the same exposure at a substantially lower price, a large migration of assets was inevitable… Not all of those investors will go passive. Our experience over the last several years supports our belief that many of those investors will select managers who offer differentiated strategies with high degrees of investment freedom and strong investment track records. - ibidI think that the headwinds for active management, both long-only and hedged, frankly, remain significant. Relative returns have been largely poor, and fee structures have been high. We firmly believe for ourselves the way to grow is to focus on delivering top quartile or better performance…I think active managers who operate in alternative strategies like we do, and as well as multi-strategy implementations, and can deliver that performance efficiently can be big winners. –Cohen & Steers’s Joe HarveyTheme 3: There remains a great deal of uncertainty around the implementation and impact of the new Fiduciary Rule, but many believe larger fee-based advisors are better positioned to adapt to any large scale changes ahead.I don’t think there’s one consistent view. I think you have a trend that was already in place pre-fiduciary rule of going to more of a planning model against the advisor picking individual funds. That’s going to continue. I think the fiduciary rule accelerated that. I think some larger firms favor that rule because it helps them move towards that platform even faster. And that’s where you get a little bit, I think, some mixed opinions on what to do next. – Franklin Resources’s Ken LewisOur sense is that in some cases – and it depends on the type of assets you have and the average size of account and what product it is. It’s possible the total cost of revenue sharing could go up a bit, it could go down a bit. But the trend towards standardization is I think being well embraced throughout the industry. - Cohen & Steers’s Bob SteersWe believe that success in the post-DOL world will require a more institutionalized product approach to asset management in sales and marketing. Consistent with this approach, we continue to shake the culture and organization of our firm by enhancing our risk management capabilities, sharpening our investment philosophies and processes, evolving toward more team-managed portfolios, investing in our research capabilities, and emphasizing tighter integration between our investment in sales and marketing personnel. - Waddell & Reed’s Phil SandersMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
2016 and 2017: Buy the Rumor and Sell the News?
Last year was a volatile year for credit and equity markets that saw price moves that more typically play out over a couple of years. The year began with a broad-based sell-off in risk assets that got underway in late 2015 due to concerns about the impact of the then Fed intention to raise short-term rates up to four times, widening credit spreads, and a collapse in oil prices. Credit (i.e., leverage loans and high yield debt) and equities rebounded in March and through the second quarter after market participants concluded that media headlines about potentially sub $20 oil were ridiculous and that the Fed probably would not raise rates four times; or, stated differently—the U.S. economy was not headed for recession. Markets staged the second strong rally of the year immediately following the national elections on November 8th with the surprise election of Donald Trump as the next POTUS, and Republicans holding Congress.Not surprisingly, the heavily regulated financial sector outperformed the broader market, with bank stocks (as represented by the SNL U.S. Bank Index) gaining 23% versus 5% for the S&P from November 8th through the end of the year. Most of the return for the bank index was realized after the election given the full year total return of 26%. Banks in the $1 to $5 billion and $5 to $10 billion groups led the way in 2016 with total returns on the order of 44% for the year.The magnitude of the rally in bank stocks was notable because the U.S. economy was not emerging from recession – when bank earnings are near a cyclical trough, poised to turn sharply higher as credit costs fall and loan demand improves.
Last year was a great year for most bank stock investors. Bank returns averaged around 40% in 2016, with 30% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realizing total returns greater than 50%. The returns reflected three factors: earnings growth, dividends (or share repurchases that were accretive to EPS), and multiple expansion.
As shown in Figure 4, the median P/E for publicly-traded banks expanded about 30% to 20.6x trailing 12-month earnings at year-end from 15.9x at year-end 2015. Likewise, the median P/TBV multiple expanded to 181% from 140%. While bank stocks closed the year at the highest P/E level seen this century, P/TBV multiples remain below the pre-crisis peak given lower ROEs (ROTCEs), which in turn are attributable to higher capital and lower NIMs.
Figure 5 summarizes profitability by asset size. Banks with assets between $5 and $10 billion were the most profitable on an ROA basis and realized the highest total returns for the year. This group stands to benefit the most from regulatory reform if the Dodd-Frank $10 billion threshold (and $50 billion for SIFIs) is raised. In the most optimistic scenario, the market appears to be discounting that banks’ profitability will materially improve with lower tax rates, higher rates, and less regulation. The corollary to this is that the stocks are not as expensive as they appear because forward earnings will be higher provided credit costs remain modest. Based upon our review, most analysts have incorporated lower tax rates into their 2018 estimates, which accounts for much more modest P/Es based upon 2018 consensus estimates compared to 2017 consensus estimates.
2016 M&A TrendsOn the surface, 2016 M&A activity eased modestly from 2014 and 2015 levels based upon fewer transactions announced; however, when measured relative to the number of banks and thrifts at the beginning of the year, 2016 was consistent with the long-running trend of 2-4% of institutions being acquired each year. The 246 announced transactions represented 3.8% of the 6,122 chartered institutions at the beginning of the year compared to 4.5% for 2014 and 4.2% for 2015.
As for pricing, median multiples softened a little bit, but we do not read much into that. Last year, the median P/TBV multiple for transactions in which deal pricing was disclosed eased to 136% compared to 142% in 2015; the median P/E based upon trailing 12 month earnings as reported declined to 21.2x versus 24.4x in 2015.
Elevated public market multiples since the national election have set the stage for higher M&A multiples in 2017 as publicly-traded buyers can “pay” a higher price with elevated share prices (Figure 8). The impact of this was seen among some larger transactions announced after the national election compared to when LOIs were announced earlier in the Fall. Activity may not necessarily pick-up with higher nominal prices, however, if would be sellers decide to wait for higher earnings as a result of anticipated increases in rates and lower taxes and regulations. In effect, some may wait for even better values or decide not to sell because ROEs improve sufficiently to justify remaining independent. Time will tell.
Figure 9 shows the change in deal multiples from announcement to closing and compares the change between deals announced and closed pre-election to those closed post-election. With the run-up in pricing, P/E and P/TBV multiples increased 12% and 9% from announcement to close compared to 4% and a decline of 1% pre-election.
2017 OutlookNo one knows what the future holds, although one can assess probabilities. An old market saw states “buy the rumor; sell the news” which means stocks move before the expected news comes to pass. As of the date of the drafting of this note (February 7), bank stocks are roughly flat in 2017. The stocks have priced in the likelihood of some roll-back in Dodd-Frank, higher short-term and long-term rates, lower tax rates, and a generally more favorable economic backdrop that supports loan growth and asset quality. The magnitude of these likely – but not preordained – outcomes and the timing are unknown. Following a big rally in 2016, returns for bank stocks may be muted in 2017 even if events in Washington and the Fed prove to be favorable for banks.That said, higher stock prices and investor demand for reasonable yielding sub-debt from quality issuers implies the M&A market for banks should be solid. The one caveat is that there are fewer banks, so a healthy M&A market for banks could still entail fewer transactions than were recorded in 2016.Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.This article originally appeared in Mercer Capital's Bank Watch, February 2017.
RIA Matchmaking
Before World War 2, Alfa Romeo developed a successful brand building limited numbers of large, powerful cars for wealthy Italian buyers. That business model didn’t survive the war, however. By the 1950s the company realized that, in order to survive, it needed to create smaller and more practical vehicles that could be produced and sold in large volume to the mass-affluent. The second iteration of the new Alfa Romeo was the 750-series, which included not only a sedan and coupe but also a beautiful Pininfarina-designed convertible that Alfa Romeo romantically dubbed the Giulietta (as in Romeo and Juliette). The Giulietta was light, mechanically robust, and very sophisticated. Orders poured in, and Alfa Romeo’s future was assured.As the wealth management industry matures, we are sensing a similar shift to mass-produced wealth management services, building extensive technology platforms and centralized investment management to support broad networks of client service representatives. What was once the wild-west of commissioned brokers living off the “5% rule” is transitioning to salaried staff and ETFs. The transition is slow, but industry trends like fee pressure, regulatory upheaval, and partner demographics are persistent motivators. Ultimately, these industry trends can only lead to one thing for the wealth management community: more M&A.For now, the investment management industry is highly fragmented both in number and in business model. Even though the 12,000 or so individual RIAs operating in the U.S. mostly derive their revenues from a percentage of assets under management and have expense streams characterized mostly by personnel, office space, and strong coffee, we rarely see two business models that we think are similar to each other. Investment management firms are reflections of their people - from the approach to investing to the types of clients they attract. Consequently, putting two firms together is more difficult than a lot of people imagine.Hardly a week goes by that we don’t get asked what we think are optimal qualities of an RIA merger partner. Answering that always feels a little like giving dating advice: different partners suit different partners. No one disputes that the industry is ripe for consolidation, but there’s no easy way to “swipe-right” on a target company’s ADV, and it’s pretty unlikely that sec.gov is going to have its own version of Tinder anytime soon.Nevertheless, in honor of today's holiday, here are a few thoughts on what to think about when considering a merger partner.TrustNo amount of committee meetings, reporting metrics, or other disciplined management feedback mechanisms can guarantee how your new co-workers will behave when you aren’t around. If your trust of their actions is conditional, or grounded in things like incentive compensation, the relationship won’t work for you or for them. People do not even change for their spouses – certainly not for their business partners. Walk away.Shared ValuesDoes your prospective merger partner see the industry the same way you do? Is their approach to investing, staff development, and going after new business the same? Assuming that you and your merger partner have both been around long enough to develop your own way of working, you might learn a thing or two from each other, and you might have some influence over each other – but mostly you will be you, and they will be they. Make sure you’re okay with that.Similar FriendsI think an underrated due diligence metric on a merger partner is their client demographics. The type of client served by a merger partner is very telling as to what kind of firm they really are. If you and your prospective merger partner have similar clients, then you’ll probably have a lot in common after the merger.Common InterestsVegans don’t like seeing bacon in the refrigerator, even if they’re not forced to eat it. In our experience, firms that favor passive investing do not mix well with avid stock-pickers. On the front end, it might look like such a merger expands product offerings and investment approaches to the clients of both firms, but in the end your portfolio managers won’t understand each other and will confuse the message for your clients.Compatible GoalsIf you want four kids but your fiancé doesn’t want any, having two kids will not constitute a workable compromise. If you want to grow your RIA into a large business and sell it, but your merger partner wants to operate his as a practice until he’s too old to work, you’ll have conflict from day two. Life can change certain individual and business goals, but it helps to have a common baseline at the start.A Good Pre-nupIn our experience, the only thing more contentious than a marital dissolution is a “business divorce.” Your buy-sell agreement needs to offer a valid “out” that enables the parties to the merger to preserve at least some of their economic substance while maintaining the core business of providing investment management services to clients. Not only do the partners depend on a good buy-sell agreement, but your employees and your clients do as well. Granted, the best agreement doesn’t supplant the need to build a mutually beneficial relationship every day, but offering some certainty as to how to wind-down the relationship won’t hurt either.Notice I didn’t say anything about money. Fee schedules, compensation plans, commitment to IT spending, and all of the numbers matter, of course; but that’s the easiest part of a merger to make work. The real currency of work is people – so focus on that and the numbers will be what the numbers will be.The best RIA mergers aren’t necessarily composed of “like” firms so much as “like-minded” firms that have different strengths to supplement different weaknesses. If you can see genuine opportunities with a potential target or acquirer that you cannot see alone or with another firm, then you might have a mutually beneficial relationship.Oh, and if by some chance your merger partner drives an old Alfa Romeo, skip the roses today and give him or her a dozen quarts of motor oil. It won’t go to waste.
Refining Overview
There are four main components to refined product prices: (1) Input Prices (i.e. crude oil), (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. Thus, in order to understand refined product prices we consider the macroeconomic trends in the global oil and gas market which drive input prices.Oil and Gas Market OverviewGlobal oil production outpaced global crude demand for almost a year which led to a plummet in oil prices in mid-2014. Oil prices have remained depressed since then and an oversupply of crude caused downward pressure on the price of crude oil which for months benefitted refiners as their product costs fell. A shortage of crude storage forced producers to sell crude at increasingly low prices to refiners, who then could earn substantial profits.In a move that surprised many markets, OPEC instituted production cuts for the first time in eight years following a November 30, 2016 meeting. OPEC planned to reduce output by 1.2 million barrels a day by January 2017. In addition, Russia, who is not a member of OPEC, agreed to cut oil production. The reduction in output is designed to reduce high inventory levels around the globe. The cuts are expected to be effective through May 25, 2017, at which time OPEC may opt to extend the cuts an additional six months.Oil prices may have found a new home around $50-$60 per barrel, which remains below normal levels, but exploration and production activities have recovered partially. The Baker Hughes North American (U.S.) total oil rig count increased by 32% over the year ended February 3, 2016. Crude oil prices (“WTI”) ended 2016 nearly 45% higher than year-end 2015. The WTI gain is the first annual price increase in two years, and is the largest annual gain in seven years.The oil and gas industry is heavily regulated. The future impact of many regulations surrounding the oil and gas industry however is uncertain as President Trump ran as a friend to the oil and gas sector and promised to reduce regulations on the industry in order to boost the U.S. economy. Additionally, Oklahoma Attorney General Scott Pruitt is on his way to becoming the next Environmental Protection Agency administrator. Pruitt has openly opposed the EPA, which is one of the main regulators of the refining industry. As we work to understand the current position of refiners, it is key to analyze the impact of legislation and regulation surrounding the industry.Refining RegulationIn early 2016 the crude oil export ban that had been in place since 1975 was lifted. Industry experts thought that the lifting of the export ban would better align the production capabilities of U.S. refineries. Refiners, on the other hand, feared that the exportation of crude oil would increase crude prices, as the pressure on price in an oversupplied U.S. market gave way. However, due to the state of the global oil market there is not much incentive to buy crude oil from the U.S. in the current market. Currently, it is estimated that less than 400,000 barrels per day (bpd) is being exported form the U.S. Once the Brent-WTI spread widens, and it is cheaper for other countries to buy WTI and pay transportation costs than to buy Brent, we may better understand the effect of the lifting of the ban.Although the price of crude oil remains low in comparison to historical levels, refined product prices fell to a similar extent as crude prices. As shown below, the price of gasoline fell to a low of $1.05/gallon in February 2016, which was almost one-third of the price of gasoline in July 2014. Since February the price of gasoline has increased 36%. In general, refined product prices have fallen over the last two years but have seen some recovery over the last 10 months.
Additionally, operating expenses have increased with the cost of Renewable Identification Numbers (RINS). The Renewable Fuels Standards (RFS) Program has had a significant impact on the refining sector over the last year. The RFS were signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. RINs (Renewable Identification Numbers) are used to implement the Renewable Fuel Standards. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. While large integrated refiners have the capability to blend their petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price. A common theme across refiners’ earnings calls last quarter was the effect of the rising cost of RINs on already squeezed margins. President Trump promised to help small and medium sized merchant refiners who were disadvantaged by RFS, but he also spoke fondly of the program during his campaign. It appears that many Republican lawmakers hope to repeal or reform the Standards, but the future of the Standards and the RIN system is still unclear.
Other regulations that might affect refiners’ margins going forward include the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS). Last December the RTR & NSPS rule was passed in in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations range from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The rule was expected to be fully implemented in 2018 however the expected new head of the EPA makes us to question the future implementation of the rules.
We can understand refiner’s current earning power through the refiner maker margin. The refiner marker margin (RMM) is a general indicator, calculated quarterly by British Petroleum, which shows the estimated profit refiners earn from refining one barrel of crude.
Refiners’ margins increased dramatically in the second and third quarters of 2015 as the price of crude fell and the price of refined petroleum products lagged behind. Refiners in the U.S. North West were making between $27 and $28 per barrel of oil, while global margins barely reached $20 per barrel. However, in the fourth quarter of 2015 refined product prices fell, refiners’ margins tightened, and the geographic gap in margins narrowed. After some relief in margin pressure in the second quarter of 2016, margins tightened to the lowest seen in three years.
M&AM&A activity in the refining sector was sluggish in the first half of 2016, partially due to the uncertainty which surrounded the refining industry and future regulation. However, M&A activity picked up in the third and fourth quarter of 2016. The chart below shows key valuation metrics associated with refining transactions which were announced in 2016.
Overall, valuation multiples are inflated, demonstrating that companies are buying the future earnings potentials of refiners and are not too discouraged by currently low earnings.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
There Was Blood
Warren Buffett’s guidance is salt in the wound for those in the oil and gas industry: “You pay a very high price in the stock market for a cheery consensus.” That was the title of his article published in Forbes Magazine in November of 2008. Energy companies, investors and royalty owners all paid a very high price to invest in the oil and gas industry prior to July 2014. But, those who invested when there was a “Cheery Consensus” have now endured more than 20 months since the crash of oil started. Fear and uncertainty were so rampant that many anticipated oil prices to fall to $10 per barrel. Yet during this turmoil did you remember another famous investing principle from Baron Rothschild: “Buy when there's blood in the streets, even if the blood is your own." Okay, I’m sure you remembered it at some point during the fall, but did you have the moxy to act on it?There was blood in the street, lots of it, over the last two years. Many operators and oil and gas service companies didn’t survive the last 20 months and most of the news headlines focused on their story. For royalty owners, who might depend upon royalty checks for steady income, it was equally scary as their payments shrunk due to low oil prices which were magnified by lower production rates. Operators went belly up or were acquired, each of which leads to administrative complications and disruptions in check disbursements to royalty owners. Some unlucky royalty owners received demand letters indicating they received royalty payments for interests they didn’t own and therefore must pay back multiple years’ worth of royalty receipts to the operators. How does that happen? It appears, when there is a cheery consensus, details get overlooked until the environment turns dire.However, the last 12 months have provided some relief. Oil prices have increased more than 65%, acquisition activity in the Permian Basin is high, and the oil and gas equity markets have shown positive growth. Additionally, investors seeking income generating investments have been interested in royalty trusts which have had significant returns over the last 12 months. If you had the moxy to grab the “falling knife” back in early 2016, it appears you grabbed the handle and not the blade. Returns over the last 12 months have been in the double digits and perhaps triple digits depending on the investment vehicle. Sadly, the fall in oil price was so significant that investments made more than 18 months ago are largely still under water, while those made less than 12 months ago are sitting pretty. This is true for royalty owners as well.Market indications are available in the form of publicly traded oil & gas royalty trusts. There are approximately 20 oil and gas focused royalty trusts publicly traded, as of the date of this article. In the last two months, the implied payback period increased 1.1 years, on average, from 11.1 years to 12.2 years. This occurred from declining yields as equity prices increased.Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard over the previous 24 months. Before the bottom fell out, oil traded as high as $107.95 in June of 2014 and plunged to a low of $29.05 in February of 2016. Since February, the price of oil appears to have found a new home between $50-$60 / barrel. That said the last two years have been a trying time to hold investments in oil and gas, especially in Royalty Trusts. Below is a chart of the market price performance for each royalty trust over the last two years. Only one is showing a positive price performance, Black Stone Minerals, LP, but this is slightly misleading as it’s only been publicly traded for the prior 42 months (just shy of two years).
The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner.
Yes, if you invested in the energy sector approximately two years ago, there is a good chance your investment is still underwater. However, if you invested one year ago, the results are dramatically different. We are approximately 12 months from the days oil prices hit the “bottom of the barrel” and since February 2016, WTI has increased more than 65%. Below is the same chart adjusted to show the performance over the last 12 months.
Only three of the twenty royalty trusts have negative price performance over the last year, compared to 19 when observing performance over the last two years. Of the three that are negative, two were discussed in earlier posts. Sandridge Mississippian Trust I and II’s operator was going through bankruptcy and the location of their wells was not as desirable as other plays. The other royalty trust with negative performance is Chesapeake Granite Wash Trust.
For the above 20 Royalty Trusts, we compared various pricing metrics between today and one year ago:
Observations and Disclaimers1Price to revenue and price to distributable income indicate, on average, the trusts are more expensive now than a year ago. This trend has continued from our discussion in December 2016.Yields were higher last year as they did not reflect the quickly falling market price. Increase in pricing over the last 12 months is the primary cause of the lower yields. Some Trusts have cut their distributions in response to falling royalties. The combination of the two results in lower yields.As of today, market prices have leveled off and annual distributions are comprised of a full year of lower royalty payments, resulting in lower yields compared to a year ago.Price to PV-10 is significantly higher this year compared to last. The market is now willing to pay 2.5x more than the present value of future cash flows for the operating wells as opposed to 0.6x a year ago. However, PV 10 data is only disclosed annually, typically during the first quarter of the year. We are monitoring disclosures to update our models as the data becomes available. Stay tuned.A year ago, many expected oil prices to reach $43/ barrel, or increase by 44%, over the year. This turned out to be directionally correct, but understated the actual performance. The current spot price is $53.88/ barrel which was an increase of 80%. Natural gas prices performed much the same way, increasing 34%. However, for the next 12 months oil prices are expected to increase by only 4% while natural gas prices are anticipated to jump by 15%.Implications for Royalty OwnersIn many respects, royalty owners can utilize publicly traded royalty trusts to observe changes in investor behavior and get a feel for how much their royalty interests may be worth. Here are a few areas to consider for your specific situation to compare and contrast with Royalty Trusts:Set Number of Assets. Royalty trusts typically have a set number of wells and producing assets after they are formed. Does your property have a fixed number of assets or will it grow? If new oil and gas wells are not being added to the property, then the oil and natural-gas reserves will be depleted as they age and produce.Location. The Royalty Trusts above have assets all over North America. Some are located in hot spots while others are not. Location drives investor appetite as operating costs and production levels, which vary by location, drive profitability in an industry that has zero control over the price of their product. This is a significant reason for the high transaction activity in the Permian Basin. Operators know they are able to make a profit through high production rates and low operating costs in Permian Basin even at $40 oil. Consider the investor activity, or lack there-of, in your area.Price and Production. Now that the U.S. has significant recoverable oil and gas reserves and the ability to export unrefined crude world-wide, the U.S. can be considered a swing producer, a power which historically characterized OPEC. As a swing producer, price dictates the level of production the market will consume and production will increase or decrease relatively quickly to meet demand. In response to price changes, operators will increase or decrease production levels at will. Consider how your operator has behaved in various pricing environments and the operators of the Royalty Trusts.
In addition to the differences between your royalty assets and the Royalty Trusts, consider the level of value indication provided by the Royalty Trusts. The level of value is the publicly traded level of value verses the privately held royalty assets held by many land owners. Consider the following chart.
Chris Mercer explains,
The benchmark level is the marketable minority level of value, or the middle level in the chart above. Conceptually, it represents the pricing of the equity of a public company with an active and freely trading market for its shares. For a private company, it represents that same price as if there were a free and active market for its shares.
The lowest level on the traditional levels of value chart is called the nonmarketable minority level of value. This level represents the conceptual value of illiquid (i.e., nonmarketable) minority interests of private companies, or entities that lack active markets for their shares.Royalty trusts provide an indication of value at the Marketable Minority Value level for minority interests in an entity with royalties as the primary asset. For royalty owners the value level can be a mixed bag. Many own the asset directly while others own equity interests in entities with royalties as their main assets. It is important to understand the value level comparability difference for your situation.To move from the Marketable Minority Value to the Nonmarketable Minority Value level, simply apply a marketability discount. Stated a different way, apply a discount for not having the ability to quickly sell your asset and receive cash. Fully marketable assets, like those publicly traded, have the ability to exchange the asset for cash in approximately three days. All other assets which do not have this access lack marketability. Therefore in order to build and find a market for the assets, a discount is typically required by potential investors.We have assisted many clients with various valuation and cash flow issues regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.1 Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness.
Master Limited Partnerships
Master Limited Partnerships (MLPs) are publicly traded partnerships, which reap the tax benefits of a partnership and the liquidity benefits of a public company. There are many tax benefits to an MLP. Unlike public companies, MLPs are taxed only at the unitholder level. Distributions to unitholders are tax deferred, if the Partnership distribution is greater than Partnership income. And, units can be passed down to successors at a basis of fair market value, which means that the capital gains tax is not passed down along with the unit. There are also some serious tax implications of the MLP structure. For example, when an MLP’s debt is forgiven, the amount cancelled is treated as income and is taxed at the unitholder level. However, there is generally not a cash distribution which accompanies this tax payment.History of MLPsApache Oil established the first MLP in 1981 and had such great success with the structure that real estate investors, restaurants, hotels, and NBA teams restructured to become MLPs. In 1987, Congress revamped the tax code specifying that in order to be an MLP at least 90% of a company’s income must be generated from “qualified sources”. Qualified sources include, “the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber).” In 2008, Congress expanded this to include carbon dioxide, biofuels, and other alternative fuels.E&P companies are sensitive to swings in commodity prices and do not have stable enough cash flows to sustain the distribution requirement of MLPs. Often times E&P companies spun off their midstream assets into MLPs because midstream operations provide stable cash flows and have the ability to reliably make distributions. Thus the majority of MLPs are involved in the midstream oil and gas sector. Recently, however, the stability of midstream cash flows has been called into question.Midstream companies have long term contracts called take-or-pay contracts which require producers to pay midstream companies even if they are not currently using their gathering assets. It was always assumed that these contracts were inviolate; however, the recent turmoil in the oil and gas market, which led to a multitude of bankruptcies in the E&P sector, caused these contracts to be called into question in bankruptcy court proceedings. During the bankruptcy process, producers can request that certain contracts be rejected. If the midstream contracts are thought to be vastly different from market value then the producer can request the judge consider the rejection of midstream contracts. We saw this in March of 2015 when a New York judge ruled that Sabine Oil and Gas Corp., which was going through bankruptcy proceedings, could reject contracts it was in with midstream companies. This uncertainty caused the price of MLPs to fall as investors began to question the immunity of their cash flows. From December 2014 to December 2015 the price of MLPs on average fell by 25%.MLPs have two classes of Partners: General Partners, who are responsible for managing day to day operations and receive compensation for doing so, and Limited Partners (called unitholders) who are investors in the Partnership and receive periodic distributions. Unlike a public company which is governed by a board, a MLP is generally managed by a general partner. Legally, the general partner has no fiduciary duty to the unitholders, but mostly their interests align.MLPs payout a large portion of cash flows (generally 80% to 100%) to their unitholders. Distributions are based on each MLP’s partnership agreement and usually minimum quarterly distributions are written into the MLP’s partnership agreements. The General Partner typically owns a 2% equity interest along with incentive distribution rights (IDRs). Incentive distribution rights give a general partner an increasing share in the incremental distributable cash flow of the Partnership. IDRs are meant to incentivize the GP to increase distributions for the limited partners.Valuing an MLPThere are approximately 140 MLPs and in 2013 over 50% of MLPs operated in the midstream and downstream oil and gas sector. While each Company is unique the guideline approach can commonly be used to value MLPs in the oil and gas sector. A price to earnings multiple however is uninformative when valuing an MLP. MLPs generally have a lot of fixed assets on the balance sheet that result in high depreciation expenses charged to earnings. Thus earnings are not a good indicator of value. Instead we turn to companies’ distribution history.Several MLPs and their key financials are summarized in the chart below. MLPs generally pique the interest of investors looking for income generating investments, demonstrated by the dividend yield. But there are three other measures that should be used to understand the value and inherent risk of an MLP: (1) Distribution Coverage Ratio (DCR), (2) Price / Distributable Cash Flow (P / DCF), and (3) Debt / EBITDA.A MLP’s distribution coverage ratio (DCR) measures the sustainability of current distributions. A DCR of 1.0 indicates that an MLP is distributing all available cash flow and a DCR of greater than 1.0 indicates that a Partnership is retaining some cash. A DCR of less than 1.0 is not sustainable. All of the MLPs above have sustainable levels of distributions but Magellan Midstream’s (MMP) DCR of 1.0 does beg for further analysis as they are paying out all available cash flow.Instead of evaluating Price / Earnings multiples, we analyze Price / Distributable Cash Flow for MLPs. Generally a P / DCR of more than 15x or 16x is considered high. However, if the MLP has consistently grown distributions then the partnership may be worth the premium. Magellan Midstream was trading at 17.4x distributable cash flow, which is on the higher end of the range shown above. However, MMP has increased its quarterly distribution 59 times since it IPO-ed in 2001. This trend of an increasing yield merits a higher P / DCF multiple.The Debt to EBITDA multiple can give us further insight into the company’s risk position. Since MLPs must pay out the majority of their cash flows as distributions to unitholders, in order to fund capital expenditures and acquisitions an MLP must take on debt. Magellan has a debt to EBITDA ration of 3.9x. Generally a debt to EBIDTA multiple above 5x would be cause for concern, but Debt / EBITDA multiples for MLPs have trended upwards over the last four years. In 2013 the median Debt / EBITDA multiple was 3.8x but increased to 5.4x by 2015. Over the past three years the median EBITDA of our group increased by a compound annual rate of 8% while debt increased at a rate of 16% showing that the industry as a whole has become more leveraged.Mercer Capital’s oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
EBITDA Single-Period Income Capitalization for Business Valuation
[Fall 2016] This article begins with a discussion of EBITDA, or earnings before interest, taxes, depreciation, and amortization. The focus on the EBITDA of private companies is almost ubiquitous among business appraisers, business owners, and other market participants. The article then addresses the relationship between depreciation (and amortization) and EBIT, or earnings before interest and taxes, as one measure of relative capital intensity. This relationship, which is termed the EBITDA Depreciation Factor, is then used to convert debt-free pretax (i.e., EBIT) multiples into corresponding multiples of EBITDA. The article presents analysis that illustrates why, in valuation terms (i.e., expected risk, growth, and capital intensity), the so-called pervasive rules of thumb suggesting that many companies are worth 4.03to 6.03EBITDA, plus or minus, exhibit such stickiness. The article suggests a technique based on the adjusted capital asset pricing model whereby business appraisers and market participants can independently develop EBITDA multiples under the income approach to valuation. Finally, the article presents private and public company market evidence regarding the EBITDA Depreciation Factor, which should facilitate further investigation and analysis.[Reprinted from the American Society of AppraisersBusiness Valuation Review, Volume 35, Issue 3, Fall 2016]Download the article in pdf format here.
Noble Energy Buys Clayton Williams: A Closer Look at the Acquisition
Deal Details 1On January 16, 2017, Noble Energy, Inc. (NBL) announced the acquisition of all Clayton Williams Energy (CWEI) equity for approximately $2.7 billion in NBL stock and cash. Noble Energy is a global independent oil and gas exploration and production company. Over 50% of their sales volume is generated from domestic onshore production. The Company focuses onshore domestic operations in the DJ, Delaware, and Eagle Ford Basins and the Marcellus Shale. The Company’s acquisition of CWEI demonstrates their effort to accelerate high margin growth by focusing capital in productive regions such as the Permian Basin.Shareholders of CWEI will receive approximately $34.75/share in cash and 2.7874 NBL common shares for each share of CWEI stock. Based on CWEI disclosures, NBL will assume control of 330,000 net acres in the Permian Basin and Giddings area of the Eagle Ford which include 13.6 MBOE of net daily production. The 170,000 net acres in the Permian are located in Ward and Reeves County. Approximately 72% of the current production is crude oil. The transaction indicated a 48% premium to the publicly traded equity value for CWEI. Noble Energy was willing to pay a premium for the CWEI because the CWEI’s acreage was continuous to Noble’s which provides Noble with potentially cost saving synergies.Based upon the consideration given by NBL, here is the implied market value of invested capital (MVIC) for CWEI:
A summary of CWEI’s book value balance sheet is shown below.2
Before venturing into our approach to the allocation, we have compared pricing multiples of the CWEI acquisition and other oil and gas public companies. At the time of the transaction, CWEI owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for CWEI versus selected transactions involving companies with a significant presence in the Permian Basin. Noble Energy’s pricing multiples are also presented to show size comparisons.
Observations:
Noble Energy’s purchase of CWEI was one of the largest acquisitions in the Permian basin over the last few years.Based on BOE per day production, CWEI was priced higher than Yates and SHE, as both companies were producing more than CWEI.Based upon net acres acquired, the CWEI transaction was priced in the middle of Yates and SHE and slightly above its’ suitor NBL.While this acquisition appears to be priced high on the BOEPD metric, the significant amount of acreage acquired by NBL indicates a net acre multiple that is consistent with other transactions.Assets PurchasedThe following maps, disclosed by CWEI, shows the acreage positions within each of the core resource plays, the Permian Basin and the Eagle Ford. The highlighted acquired assets include:65,000 net acres in Reeves County, Texas (Permian Basin map below) with over 100 wells producing or soon to be producing. A target pay zone of 3,500 feet wide (between the depths of 8,000 ft to 11,500 ft,) and 1 rig actively drilling in the area.Eagle Ford shale property includes 160,000 net acreage positions, 40 completed wells, a demonstrated and repeatable drilling program and new well costs of $4m per well.
Chairman, President and CEO of NBL David Stover had the following comments on their acquisition:
"This transaction brings all the key elements we value: excellent rock quality, a large contiguous acreage position adjacent to our own and robust midstream opportunities, reinforcing the Delaware Basin as a long-term value and growth driver for Noble Energy.""This combination creates the industry's second-largest Southern Delaware Basin acreage position and provides more than 4,200 drilling locations on approximately 120,000 net acres, with over 2 billion barrels of oil equivalent in net unrisked resource."Earlier, we displayed the high level categories for an allocation of purchase price. Two of these categories are oil and gas related assets: (1) the fixed assets on the balance sheet; and (2) the implied goodwill value. Each of these is inter-related as a majority of the fixed assets are related to the exploration and production of oil and gas resources. Based upon our experience, much of the “implied goodwill” is related to the present value of future benefits of the production of oil and gas. The valuation for current production and proved developed reserves can be straight forward. CWEI more than likely prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, it is important to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Drilling plan and synergistic efficiencies. Rarely are specific drilling plans disclosed publicly, but they can be observed at a high level in the reserve report, as well as certain expense assumptions that provide company specific expense profiles for operating and capital expenditures for new wells.
NBL’s acquisition of CWEI ranks as a top E&P transactions of 2017, not only because it is one of the first transactions of the year, but compared to 2016, it ranks in the top five in size. Based upon our experience involving public and private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that historical transactions may have little comparability to transactions today and any comparison depends upon the details and assumptions of each transaction.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
End Notes1 Clayton Williams Energy, September 22, 2016 Johnson Rice Energy Conference Presentation
2 As of September 30, 2016 per S&P Capital IQ
2016 M&A Overview
When oil prices collapsed in mid-2014, the M&A market soon came to a standstill as investors waited for clarity regarding the future of the domestic oil and gas market. The low price environment led to a disconnect between the value of oil and gas reserves and the price that buyers and sellers negotiated in a distressed market. As prices remained low, deal volume picked up in the beginning of 2016 as companies were forced to sell assets in order to quickly generate cash to pay off debt and avoid bankruptcy. As the year continued, M&A activity increased and total deal value at the end of 2016 doubled that of 2015.Factors Leading to Increased M&A activity in 2016Price stabilization of crude in the range of $45 to $54 played a role in the increase in M&A activity as investors regained confidence in the sector.Cost reduction in certain plays from new technology has allowed more cost-efficient drilling.The low price environment made distressed companies’ assets acquisition targets as these companies were willing to sell them for heavy discounts.In order to decrease break-even costs, companies merged to realize potential synergies.Recent discoveries and low break-even costs in the Permian Basin attracted investors and producers to the play and increased overall M&A deal volume.Price StabilizationCrude oil price volatility declined over the last year as excess supply began to decline. Since mid-April of 2016, US crude oil inventories have declined by approximately 6%. Additionally, OPEC production declined in the second quarter of 2016 and had slower-than-normal growth in the fourth quarter, which helped to reduce excess supply 1.Cost ReductionIn a stacked play, multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs, a multilateral well eliminates the cost of drilling the total depth twice. In some plays such as the Permian, the reservoir is deep enough at some points that operators can drill multiple horizontal wells from one main wellbore. This advancement of drilling technology has allowed producers in certain plays to reduce costs so that drilling in lower price environment is economically feasible.Only the Strong SurviveIn early 2016, banks decreased lending to oil and gas companies. In a low price environment, the value of a company’s reserves falls when valued using a traditional PV-10 calculation. Lower valuations have led to decreased borrowing capacity, which in turn has caused cash flow pressure for many companies. Thus many companies have had to sell non-core assets in order to ease cash flow pressures. But in order to generate liquidity quickly, they often were forced to accept heavily discounted prices. This increased deal volume in 2016 as many companies tried to avoid bankruptcy and buyers moved quickly to get their hands on cheap assets.Mergers for SynergiesAs companies worked to reduce break-even prices, many looked for strategic acquisition targets in hopes of realizing operational efficiencies which could reduce costs and give them a competitive advantage in the market. This increased the number of mergers in 2016 in the E&P industry and also in the midstream sector which benefits from the network effect.The Permian BasinApproximately $69 billion dollars of North American E&P assets and companies changed ownership during 2016 with the Permian Basin resource accounting for nearly 40% of the deal dollar volume.
The most significant trend in E&P this year was production companies’ move to the Permian Basin. Out of the 15 deals that were valued at over $1 billion, 8 were in the Permian Basin. The Permian became the center of the M&A stage due to its low drilling costs, resource diversity, and large remaining reserves. Although the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells.
Because the crude in the shale layers has only recently been explored, there are still tremendous reserves left. Just this year the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. Additionally, the Permian is a stacked play—which means that companies can drill multi-lateral horizontal wells to reduce costs. And, companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations.
Last week, we briefly looked at the six largest transactions in 2016. Recent asset deals in the US are summarized below. Due to the factors discussed above, average deals in Permian transacted at higher dollar per-acre multiples than other plays such as the Williston Basin.
When prices declined, production in the Permian continued increasing while production in other domestic plays such as the Bakken and the Eagle Ford declined significantly. Unlike the Eagle Ford and the Bakken, which are mostly drilled for oil, the Permian holds a more diverse combination of oil, gas, and NGLs, making it more economical to produce at low prices.
The Bakken was center stage in the early 2000s during the onset of hydraulic fracturing. The Eagle Ford, which was once the most active shale plays in the world, was the center of the M&A market in 2013 and 2014 when drilling activities increased there. M&A in the Eagle Ford and Bakken was sluggish in 2016, and the transactions that did occur there were largely motivated by distressed companies looking for liquidity or an exit.
M&A OverviewM&A activity is expected to remain strong in 2017. It is expected that OPEC will follow through on production cuts and excess inventory should be absorbed in early 2017. This will cause the price of oil to continue increasing. As the price of oil continues to rise, drilling in other plays besides the Permian Basin will begin to become more economical and M&A activity should increase in other plays. However, it is expected that oil and gas companies will have to turn to private equity in order to gain liquidity as banks remain cautious in lending to the energy sector.End Note1 Data from Bloomberg
WHITEPAPER | Dividend Policy in 30 Minutes
From the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. Dividend policy addresses both how much cash flow should be distributed to shareholders and the ideal form of such distributions. In the context of a family business’s life cycle, directors can use dividend policy to manage the company’s capital structure and tailor the form of returns to better match family shareholder preferences. Diverse shareholder preferences and characteristics can enhance the attractiveness of share repurchases relative to dividends; however, executing share repurchases for family businesses bring its own set of considerations and challenges. The purpose of this whitepaper is to help family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction. This whitepaper is the fourth in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.
Are Robo-Advisors on Any Banker’s Wish List?
Christmas appears to have come early for some bankers and their investors with the SNL Bank index up over 30% from the November 8, 2016 election to mid-December. While optimism abounds, one inconvenient truth remains for the time being: ROEs for the banking industry as a whole remain below pre-financial crisis levels despite credit costs that are below most historical standards. The factors challenging ROEs for the sector are numerous but include: compressed net interest margins from a historically low rate environment, enhanced competition from non-banks, a challenging regulatory and compliance environment, and evolving consumer preferences regarding the delivery of financial services.These factors are particularly acute for most community banks that depend heavily on spread income and do not have the scale to absorb expense pressures as easily as their larger brethren. Further, many community banks are at a crossroad because their ROE consistently has fallen below the cost of capital, which in turn is forcing boards to consider strategic options like outright sales or potentially risky acquisition strategies to obtain scale.In an ideal world, community banks could easily add fee businesses that are capital-light, such as wealth management and trust operations, to boost returns. By pairing traditional banking services with other financial services like wealth management, banks can obtain more touch points for customer relationships, enhance revenue, and potentially improve the bank’s valuation. While we have previously spoken about the potential benefits to community banks of acquiring or building out a traditional wealth management operation, we have not addressed emerging FinTech companies, like robo-advisors, that are focused on the wealth management space.While there has been a race to partner and/or acquire robo-advisors by many of the larger asset managers and banks, there have also been some interesting partnerships with community banks. One such partnership struck is among Cambridge Savings Bank, a $3.5 billion bank located near Boston, and SigFig, a robo-advisor founded in 2007. While SigFig has relationships with UBS and Wells Fargo, its partnership with Cambridge Savings is notable because the two built a service called “ConnectInvest.“ When announced in the spring of 2016, the partnership was described as the “first automated investment service integrated and bundled directly into a retail bank’s product offerings in the U.S.” ConnectInvest, which is available to Cambridge’s customers digitally (mobile and website), “allows customers to easily open, fund, and manage an automated investment account tailored to their goals.” Cambridge’s customers are interested in the offering and have started using it. The goal is get up to 10% of its customer base using ConnectInvest.With this example in mind, the remainder of this article offers an overview of the robo-advisory space for our community bank readers so that they may gain a better understanding of the key players and their service offerings and assess whether their bank could benefit from leveraging opportunities in this area.An Overview of Robo-AdvisorsRobo-advisors were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years). Robo-advisory has gained traction in the past several years as a niche within the FinTech industry by offering online wealth management tools powered by sophisticated algorithms that can help investors manage their portfolios at very low costs and with minimal need for human contact or advice. Technological advances that make the business model possible, coupled with a loss of consumer trust in the wealth management industry in the wake of the financial crisis, have created a favorable environment for robo-advisory startups to disrupt financial advisories, RIAs, and wealth managers. This growth is forcing traditional incumbents to confront the new entrants by adding the service via acquisition or partnership rather than dismiss it as a passing fad.Robo-advisors have been successful for a number of reasons, though like many digital products low-cost, convenience, and transparency are common attributes.Low Cost. Automated, algorithm-driven decision-making greatly lowers the cost of financial advice and portfolio management.Accessible. As a result of the lowered cost of financial advice, advanced investment strategies are more accessible to a wider customer base.Personalized Strategies. Sophisticated algorithms and computer systems create personalized investment strategies that are highly tailored to the specific needs of individual investors.Transparent. Through online platforms and mobile apps, clients are able to view information about their portfolios and enjoy visibility in regard to the way their money is being managed.Convenient. Portfolio information and management becomes available on-demand through online platforms and mobile apps.
Consistent with the rise in consumer demand for robo-advisory, investor interest has grown steadily. While robo-advisory has not drawn the levels of investment seen in other niches (such as online lending platforms), venture capital funding of robo-advisories has skyrocketed from almost non-existent levels ten years ago to hundreds of millions of dollars invested annually the last few years. 2016 saw several notable rounds of investment into not only some of the industry’s largest and most mature players (including rounds of $100 million for Betterment and $75 million for Personal Capital), but also for innovative startups just getting off the ground (such as SigFig and Vestmark).
The table below provides an overview of the fee schedules, assets under management and account opening minimums for several of the larger robo-advisors. The robo-advisors are separated into three tiers. Tier I consists of early robo-advisory firms who have positioned themselves at the top of the industry. Tier II consists of more recent robo-advisory startups that are experiencing rapid growth and are ripe for partnership. Tier III consists of robo-advisory services of traditional players who have decided to build and run their own technology in-house.
As shown, account opening sizes and fee schedules are lower than many traditional wealth management firms. The strategic challenge for a number of the FinTech startups in Tiers I and II is generating enough AUM and scale to produce revenue sufficient to maintain the significantly lower fee schedules. This can be challenging since the cost to acquire a new customer can be significant and each of these startups has required significant venture capital funding to develop. For example, each of these companies has raised over $100 million of venture capital funding since inception.
Key Potential Effects of Robo-AdvisoryWe see five potential effects of robo-advisors entering the financial services landscape.Fee pressure. Robo-advisors may be a niche area for the time being, but the emergence and success of a technology-driven solution that challenges an age-old business (wealth management) epitomizes what has long been associated with internet (and digital) delivery of services: faster, better, and cheaper.The Democratization of Wealth Management. As a result of the low costs of robo-advisory services, new investors have been able to gain access to sophisticated investment strategies that, in the past, have only been available to high net worth, accredited investors.Holistic Financial Life Management. As more people have access to financial advice through robo-advisors, traditional financial advisors are being forced to move away from return-driven goals for clients and pivot towards offering a more complete picture of a client’s financial well-being as clients save for milestones such as retirement, a child’s education, and a new house. This phenomenon has increased the differentiation pressure on traditional financial advisors and RIAs, as robo-advisors can offer a holistic snapshot in a manner that is comprehensive and easy to understandDrivers of the Changing Role of the Traditional Financial Advisor. The potential shift away from return-driven goals could leave the role of the traditional financial advisor in limbo. This raises the question of what traditional wealth managers will look like going forward. One potential answer is traditional financial advisors will tackle more complex issues, such as tax and estate planning, and leave the more programmed decision-making to robo-advisors.Build, Buy, Partner, or Wait and See. As the role of the financial advisor changes, traditional incumbents like community banks are faced with determining what they want their relationship with robo-advisory to look like. In short, incumbents are left with four options: build their own robo-advisory in-house, buy a startup and adopt its technology, create a strategic partnership with a startup, or stay in a holding pattern in regard to robo-advisory and continue business as usual.
Robo-advisory is an exciting development for wealth managers and offers opportunities potentially for bankers to expand or develop their offerings in this area. Similar to any other growth strategy, the goal will ultimately be for the bank to enhance profitability and shareholder value by adding desired customer services.
For those bankers who may want to add a robo-advisor to their wish list, the key question of whether to build, buy, or partner is a challenging one. We will be speaking at the annual Acquire or Be Acquired (AOBA) conference in January on the topic of how to develop a framework to better assess this question. Additionally, for those who may go the investment route via a minority investment or outright acquisition, we offer some perspective on how to value and structure investments in FinTech companies like robo-advisors. Given the vast array of FinTech companies emerging in different areas of financial services, it will be important for bankers to develop a framework for both assessing potential opportunities and focusing in on those that provide the greatest potential to enhance profitability and shareholder value. We will post our slide deck from our AOBA session and make it accessible to BankWatch readers in the first quarter of 2017, so stay tuned.
Additionally, we have a new book coming in the spring of 2017 – Creating Strategic Value Through Financial Technology. In this book, we illustrate the potential benefits of FinTech to banks, both large and small, so that they can gain a better understanding of FinTech and how it can create value for their shareholders and enhance the health and profitability of their institutions.
As always, please do not hesitate to contact us if we can help in any way.
This article originally appeared in Mercer Capital's Bank Watch, January 2017.
Trust Banks Thrive in 2016 on Steepening Yield Curve
All three publicly traded trust banks (BNY Mellon, State Street, and Northern Trust) outperformed the market in 2016, continuing their upward trajectory over the last few years but still lagging the broader indices since the financial crisis of 2008 and 2009. Placing this recent comeback in its historical context reveals the headwinds these businesses have been facing in a low interest rate environment that has significantly compressed their money market fees and yields on fixed income investments. Their recent success may therefore be more indicative of a reversion to mean valuation levels following years of depressed performance rather than a sudden surge of investor optimism regarding future prospects. Further, pricing improvements for this group appear to be more relative to an improved banking environment than a change in circumstances for trust services.
Still, in recent quarters, most trust bank stocks outperformed other classes of asset managers like mutual funds and alternative investors that endured a rocky 2016 as passive products and indexing strategies continued to gain ground on active management. The steepening yield curve portends higher NIM spreads and reinvestment income, and the market has responded accordingly – our trust bank index gained 20% for the year, besting the broader indices and all other classes of asset managers.
So have these securities gone from oversold to overbought? A quick glance at year-end pricing shows the group valued at 15x (forward and trailing) earnings with the rest of the market closer to 25x, so that alone would certainly suggest they aren’t yet too aggressively priced. Still, the three companies are all trading within 5% of their 52 week high (and all-time high for that matter), so it’s hard to say they’re really all that cheap either.
So if you’re looking for mean reversion within the sector then alternative asset managers might be your best bet, though we’d be remiss not to point out the inherent risks associated with some of these businesses.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
2016 Oil and Gas: A Year in Review
2016 was a year to remember and a year to forget for many in the oil and gas industry. On the positive side, energy commodity prices curbed their downward, volatile nature by finishing the year at higher prices than where they started. If this wasn’t enough good news, prices achieved this growth with relatively minimal volatility along the way. International and domestic supply are of particular importance as OPEC’s supply cuts and declining domestic supply helped bring a steady increase in the commodity prices. On the downside, many E&P companies were forced to restructure, through selling off assets or filing for bankruptcy, as a much need rebound in oil prices did not occur. The most popular area to snatch up assets was in the Permian Basin where approximately 40% of the North American deal volume occurred. This did not go unnoticed by many industry observers like Mercer Capital. Of our 31 Energy Valuation Insights posts from 2016, over 30% were related to the Permian Basin.Oil and Gas Commodity PricesAfter a volatile 2014 and shaky 2015, this past year brought about the feeling of stability in both natural gas and oil prices. For the year, WTI increased 43% and Henry Hub natural gas increased 58%. This was the first year-over-year increase in both WTI and Henry Hub since 2013, and prior to that 2007.
The WTI to Brent crude spread averaged 3% during 2016, the lowest overall annual average since 2010 when the average was 0%. Factors related to the lower spread include a strong U.S. Dollar, and a full year of U.S. crude oil exports since the 40-year ban was lifted in December 2015.
International Supply NewsInternational production decisions, especially those of OPEC, will continue to drive much of the change in oil price going forward. The primary supply factor for 2016 was the actions of OPEC and agreements to cut supply in an effort to stabilize the oil markets. Compounding the issues were OPEC members Iran and Libya which returned to production levels not seen in years due to the lifting of economic sanctions and stabilization of governments. Most recently, OPEC’s latest production cut agreements led to changes in trade. For example, Middle Eastern suppliers are working to keep their market share in Asia by keeping America and Africa’s trade confined to the Atlantic. OPEC in the past has been able to maintain market share by increasing production, driving prices down, and outlasting the competition. In the commodities market, the flow of trade dictates supplier’s ability to take advantage of price gaps in certain areas.Domestic Supply NewsDomestically, production was mixed based upon reserve location and financial wellbeing of producers. Because drilling costs in the Permian are lower than many other plays in the U.S., when oil prices began to show signs of recovery, rig counts in the Permian picked up faster than in any other domestic play. Producers were eager to begin operating after two years of an uneconomical drilling environment, and for many producers, the Permian was the first play in which the cost of oil rose above breakeven costs. Additionally, the Export Ban lifted at the beginning of the year provided more avenues for producers to sell crude.Domestic reserve estimates increased significantly this year as the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. This discovery alone is 3x larger than the entire Bakken play in North Dakota, and equates an estimated $900 billion of oil.BankruptciesAs anticipated, many E&P operators and servicers needed a sharp increase in oil prices to avoid restructuring or filing for bankruptcy during 2016. As the sharp increase in oil prices did not occur, tough decisions were made during the year. As mentioned in our July 2016 post, there were four types of energy companies operating in 2016:The “I need to restructure yesterday” company;The “In denial about restructuring” company;The “Racing to restructure” company (to be healthier when oil prices recover); andThe “Low leverage / healthy” company (looking for opportunities);
Three of the above types are characterized as being in a motivated seller position.
Midway through the year, industry analysts noted over 100 oil and gas companies have filed for bankruptcy with an estimate that we may only be half way done. By the end of the year, “more than 220 upstream and oilfield service companies have declared bankruptcy since the start of the downturn in 2014.” While this is a significant number of bankrupt companies, the higher oil price may give reason to have a positive outlook for 2017. Additionally, 2016 provided significant acquisition opportunities for those companies looking for strategic purchases.TransactionsCrude oil price stability and financially weak E&P companies resulted in an increase in sellers, voluntary or involuntary, which created a relatively robust merger and acquisition market. In comparison to the last ten years, 2016 was the 4th highest year for number of deals. Approximately $69 billion dollars of North American E&P assets and companies changed ownership during 2016 with the Permian Basin resource accounting for nearly 40% of the deal dollar volume. The Marcellus/Utica and Scoop/Stack were a distant 2nd and 3rd, respectively accounting for $6.7 billion and $5.1 billion in deal value.
The top six deals during 2016 in terms of dollar value are listed in the chart below. While the top three transactions were scattered throughout North America, the next three involved companies with core assets in the Permian Basin.
The largest deals in 2016 are summarized below.
Largest North American Deal in 2016: Suncor Energy purchases Canadian Oil Sands2nd Largest North American Deal In 2016: Range Resources purchases Memorial Resources3rd Largest North American Deal In 2016: Rice Energy purchases Vantage Energy4th Largest North American Deal In 2016: Diamondback purchases Brigham Resources5th Largest North American Deal In 2016: RSP Permian purchases Silver-Hill Energy. We explored an allocation of purchase price for this transaction in an earlier post.6th Largest North American Deal In 2016: EOG purchases Yates Petroleum: Refer Here for more information. We explored an allocation of purchase price for this transaction in an earlier post.Outlook for 2017The impacts of the oil and gas downturn will continue into 2017 and likely past that. While OPECs decision to cut production should help supply and demand rebalance and prices to continue recovering, the path to recovery is likely to be slow. There are reasons to expect improvement in the oil and gas market in 2017, but many producers are hesitant to be too optimist.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
RIA Valuation Insights: Best of 2016
Happy New Year 2017! Here are this past year’s 5 most popular posts from the RIA Valuation Insights Blog.1. The Valuation of Asset Management FirmsThis posts introduced a whitepaper summarizing thoughts on the valuation of RIAs. Understanding the value of an asset management business requires some appreciation for what is simple and what is complex. On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, asset management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the particular risks and opportunities of a given asset management firm is fundamental to developing a valuation.2. What Does the Market Think About RIA Aggregators? Focus Financial is About to Find Out.Focus Financial Partners started preparing documents to file an initial public offering. While it may seem like a good idea on paper, we have many questions about the Focus IPO including: why now, how much, and how is this not a roll-up?3. Portfolio Valuation: How to Value Venture Capital Portfolio InvestmentsIn this guest post from Mercer Capital’s Financial Reporting Blog, our process when providing periodic fair value marks for venture capital fund investments in pre-public companies is described. This process includes examining the most recent financing round economics, adjusting valuation inputs the measurement date, measuring fair value, and reconciling and testing for reasonableness.4. What is Normal Compensation at an Asset Management Firm?Investment management is a talent business, and that talent commands a substantial portion of firm revenue which often exceeds the allocation to equity holders. While there is no perfect answer as to what an individual or group of individuals should be compensated in an RIA, we can look to market data and compensation analysis, measured against the particular characteristics of a given investment management firm’s business model, to make reasonable assumptions about what compensation is appropriate and, by extension, what level of profitability can be expected.5. Updated: Valuation Best Practices for Venture Capital and Private Equity FundsThe International Private Equity and Venture Capital Valuation (IPEV) Guidelines were developed in 2005 to set out recommendations on best practices in the valuation of private equity investments. The IPEV Board is made up of leading industry associations from around the world, including the National Venture Capital Association (NVCA) and the Private Equity Growth Capital Council (PEGCC) in the United States. In October 2015, the IPEV Board published draft amendments to the existing guidelines that, if approved, will go into effect at the beginning of 2016.
Quick Facts: Bakken
Each quarter, Mercer Capital’s Exploration & Production Industry newsletter provides an overview of the E&P sector, including world demand and supply, public market performance, valuation multiples for public companies, and a region focus. Mercer Capital closely follows oil and gas trends in the Permian Basin, Eagle Ford Shale, Bakken Shale, and Marcellus and Utica Shale. Last quarter our E&P newsletter, focused on the Bakken Shale. Today, we take a step back and review the broad characteristics of the Bakken Shale. Download this information in a convenient PDF at the bottom of this post.Bakken at a GlanceFirst Discovered1951Discovery as Viable Play2000Primary ProductionOilOil TypeSweet, Light CrudePlayUnconventional ShaleDrillingHorizontal, Multi-Stage Hydraulic FracturingTop 3 Production CompaniesContinental, Whiting, HessBreakeven$29 – $77 per barrel 1Abnormal DUCs526 2Production Since 20072,517 MMBOE 3IssuesCost of Extraction & Cost of TransportationPotentialImproving Technology, Dakota Access Pipeline Project, and Large, Undiscovered Quantities of Oil & Gas1 North Dakota Dept. of Mineral Reserves Sept. 2015 county-level estimates
2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence)
3 EIA as of June 2016OverviewAt 14,700 sq. miles, the Bakken and associated Three Forks formation is the largest continuous crude oil source in the U.S. Discovered in 1951, it remained largely unproductive until 2000 when technological advances such as hydraulic fracturing and horizontal drilling enabled economically viable production of its sizable reserves.The region has struggled recently due to falling oil prices.Geography & DrillingThe Bakken is primarily an oil producing region. It is made up of three layers: top and bottom shale layers, and a siltstone and sandstone middle member. The two shale layers function as source rock that traps oil in the middle member. Even this middle member, however, has low permeability and low porosity, making this a tight, unconventional play. Multi-stage hydraulic fracturing and horizontal drilling are used to extract oil, and pad drilling is commonly used to enhance efficiency. Underlying the Bakken shale layers is a more extensive, thicker shale play called the Three Forks. This layer is accessed using the same unconventional techniques, and is estimated to hold a little over half the undiscovered, recoverable resources of the total Bakken/Three Forks petroleum system.Issues & Future PotentialLimited shipping options from the Upper Midwest create high transportation costs in the play. In combination with the low price of oil and the use of advanced drilling techniques, this lack of transportation pushes the cost of production above the realized wellhead price for most wells in the play. Looking to the future, the Bakken will benefit from new pipelines, continued technological improvements, the likelihood of eventual increases in oil prices, and the formation’s large remaining quantities of oil and gas.Bakken ProductionUndiscovered, Recoverable Resources in BakkenResource Estimate*Oil7,383 MMBNatural Gas6,726 BCFLiquid Natural Gas527 MMB*Mean estimates in the 2013 USGS report.AVAILABLE RESOURCEQuick Facts: BakkenDownload this information in a convenient, one-page PDF. Download
Mercer Capital’s Value Matters® 2017-01
Differing Expert Witness Valuation Conclusions
Renewable Fuel Standards and Refiners
The Renewable Fuel Standards (RFS) program, which originated from the Energy Policy act of 2005, set a goal to use 36 billion gallons of renewable fuels by 2022. RFS was signed into law by President George W. Bush in order to reduce greenhouse gas emissions and boost rural farm economies. Each November, the EPA issues rules increasing Renewable Fuel Volume Targets for the next year. The following table shows the Renewable Fuel Volume requirements for the past three years and the targets for 2017.
Separate quotas and blending requirements are determined for cellulosic biofuels, biomass-based diesel, advanced biofuels, and total renewable fuel. The individual obligations for producers are called Renewable Volume Obligations (RVO). Refiners and importers of gasoline and diesel fuel must meet Renewable Volume Obligations (RVOs) by blending ethanol and biodiesel into gasoline and diesel fuel. An RVO is determined by multiplying the output of the producer by the EPA's announced blending ratios for each of the four standards described above.
RINs (Renewable Identification Numbers) are 38-digit numbers used to implement the Renewable Fuel Standards. RBN Energy describes RINs as the “Currency of the […] RFS program”. The EPA explains that when a producer makes one gallon of renewable fuel, RINs are generated. At the end of the year, producers and importers use RINs to demonstrate their compliance with the RFS. Refiners and producers without blending capabilities can either purchase renewable fuels with RINs attached or they can purchase RINs through the EPA's Moderated Transaction System. RINs can be carried over from one compliance year to another, if unused. On the other hand, a RIN deficit can be carried over into the next year but must be made up for during the following year.
While integrated refiners blend their petroleum products with renewable fuels, merchant refiners do not have the capability to blend their own petroleum products.
Tesoro Corp., an integrated refiner, is not affected by RIN costs. Steven Sterin, EVP & CFO explained in their third quarter earnings call, “in a quarter where RIN costs rise, we reflect the higher obligation in refining and the benefit from blending in our marketing segment. It's important to know that we run our business in the integrated manner. This does not have a material impact on total Company results.” But he did acknowledge that gasoline blending is where the true benefit of integration is realized. Even Tesoro faces challenges acquiring cellulosic and biodiesel RINs.
Merchant refiners are required to obtain RINs for RFS compliance purposes. A common theme across refiners’ earnings calls last quarter was the effect of the rising cost of RINs on already squeezed margins. Holly Frontier, a merchant refiner, spent $63 million on RINs, in the third quarter alone. Holly Frontier’s President and CEO, George Damiris, said in their third quarter earnings call that they have considered expanding into fuel marketing because of the current RINs environment.
The increase in RIN costs is at the simplest, an issue of supply and demand. Production targets that are greater than equilibrium supply and demand cause price increases to correct the shortage of goods. As Renewable Fuel Volume targets have increased year over year, the price of RINs continue increasing. Reuters quoted that on average Renewable fuel credits saw a 25% increase in price from 2Q 2015 to 2Q 2016.
What’s Next?President-elect Trump voiced a pro-ethanol platform when visiting America’s farm states implying that he would keep increasing RFS targets. However, he is also known to be pro-oil and many oil groups have called for changes or the repeal of the RFS program which is known to hurt independent refiners.President-elect Trump has nominated Exxon CEO, Rex Tillerson, as Secretary of State and former Texas Governor, Rick Perry, for Secretary of Energy. Additionally, many more cabinet positions are stacked with oil and gas supporters such as Montana Republican Ryan Zinke, who was nominated to the Department of the Interior, and Oklahoma Attorney General and EPA critic Scott Pruit, who was nominated to head the EPA.Trump’s nominations suggest that the upcoming presidential term will provide a friendly oil and gas environment. While it is unclear what the President-elect’s plan is for the RFS program, it is likely that he will face challenges balancing farm and oil interests.
The Rise of Robo-Advisors
Part 2
As the second part to last week’s blogpost, the following section from Jay Wilson’s forthcoming book on FinTech describes ways to think about the valuation of robo-advisors, including some real world examples of technology based investment management platforms that transacted.Build, Buy, Partner, or Wait and SeePerhaps even more so than other FinTech industry niches, robo-advisory is well positioned for mergers, acquisitions, and partnerships. As mentioned earlier, traditional incumbents are being forced to determine what they want their future relationship with robo-advisors to look like as the role of the financial advisor changes. This quandary leaves incumbents with four options: attempt to build their own robo-advisory platform in-house; buy out a startup and incorporate its technology into their investment strategies; create a business-to-business partnership with a startup; or sit out the robo-advisory wave and continue to operate as usual.Of these options, we are seeing a rise in incumbents acquiring robo-advisory expertise. Large firms that have followed this strategy include Invesco’s acquisition of Jemstep, Goldman Sachs’ acquisition of Honest Dollar, BlackRock’s Acquisition of Future Advisor, and Ally’s acquisition of TradeKing.Other incumbents have elected to be more direct and build their own robo-advisory services in-house. Schwab’s Intelligent Portfolio service launched in March 2015 and was on the leading edge of traditional players building and offering their own robo-advisory services. Two months later, Vanguard launched its internally built robo-advisor, named Personal Advisor, which has already become quite large and manages $31 billion in assets. Furthermore, Morgan Stanley, TD Ameritrade, and Fidelity have all announced plans to release their own homegrown robo-advisories in the future.The partnership strategy has also popped up among traditional incumbents. Partnerships allow traditional incumbents to gain access to a broader array of products to offer their customers without acquiring a robo-advisor. In May 2016, UBS’ Wealth Management Americas group announced a major partnership with startup SigFig in which SigFig will design and customize digital tools for UBS advisors to offer their clients. In exchange, UBS made an equity investment in SigFig, showing the confidence UBS has in SigFig’s ability to create an innovative platform. Also, FutureAdvisor, operating under the auspices of Blackrock, announced partnerships with RBC, BBVA Compass, and LPL in 2016 to offer these institutions’ clients more affordable and automated investment advice, as the institutions continue to explore the idea of building their own robo-advisory service. Personal Capital, a robo-advisor started in 2009, announced a partnership with AlliancePartners to offer its digital wealth management platform to approximately 200 community banks. As seen in the actions of these incumbents, partnering with a startup is becoming an increasingly attractive option, as it allows the incumbent to give robo-advisory a test drive without wholly committing to the idea yet.Lastly, we have also seen traditional incumbents elect to ignore the robo-advisory trend altogether. Raymond James indicated that they would not be offering or launching a robo-advisory platform to compete with its advisors. Raymond James noted that their core business is serving financial advisors and a robo-advisory solution that offers wealth management solutions directly to consumers does not fit their business model. They did indicate that they are looking to expand technology and other services to help their investment advisors but noted that robo-advisory is not a solution that they plan to launch presently.Thus, there are a number of strategic options with varying degrees of commitment by which traditional incumbents can either enter the robo-advisory field, or elect to stay on the sideline near-term. The question of whether to build, buy, partner, or wait and see will become increasingly asked and may extend from large incumbents to smaller RIAs, banks, and wealth managers as robo-advisories continue to pop up across the financial landscape and consumers increasingly desire these products.For those financial institutions considering strategic options as it relates to robo-advisory, we take a closer look at two of the announced robo-advisory transactions–BlackRock/Future Advisor and Ally/TradeKing–in greater detail.BlackRock’s Acquisition of Future Advisor1Blackrock’s acquisition of robo-advisory startup FutureAdvisor for an undisclosed amount in August 2015 is perhaps the most notable example of a robo-advisor acquisition strategy. The acquisition showed the increased staying power of robo-advisors, as Blackrock is the world’s largest asset manager. FutureAdvisor provides investors with a low cost index investing service that diversifies their portfolio in a personalized and holistic manner based on the individual investor’s age, needs, and risk tolerance. A series of algorithms automatically rebalance investors’ accounts, constantly look for tax savings and manage multiple accounts for investors. Assets are held by Fidelity or TD Ameritrade in the investor’s name, to assuage investors’ fears concerning safety and accessibility of funds.FutureAdvisor was founded by Jon Xu and Bo Lu, former Microsoft employees, in early 2010. Significant funding rounds included a first round of seed funding ($1M in early 2010), another seed funding round and a $5 million Series A issue in 2012 and a Series B issue of $15.5 million in 2014. As previously noted, following Blackrock’s acquisition announcement in August 2015, FutureAdvisor announced several significant partnerships (BBVA Compass, RBC, and LPL) to offer low cost investment advice to each entities clients.Bo-Lu, a co-founder of Future Advisor, referred to the acquisition as a “watershed moment, not just as an entity but for the broader financial services industry as a whole.” To better understand the mindset of Blackrock, consider two quotes from members of Blackrock.“Over the next several years, no matter what you think about digital advice, you would be pressed to argue that it won’t be more popular versus less popular five to ten years from now” – Rob Goldstein, Head of Blackrock’s Tech Division2
“More Americans are responsible for investing for the important life goals, whether that is retirement, education, etc. We think that a broad cross section of that market may be slightly under-served. We believe that is the mass-affluent or those who don’t want to seek out a traditional advice model.” - Frank Porcelli, head of BlackRock’s U.S. Wealth Advisory business3The acquisition confirmed the increased staying power of automated investment advice. Blackrock is the world’s largest asset manager and the acquisition of FutureAdvisor signaled Blackrock’s intent to stay ahead of the robo-advisory curve. In addition, FutureAdvisor’s partnership with LPL, BBVA Compass, and RBC prompted other banks to follow suit, including UBS’ partnership with FinTech startup SigFig and Morgan Stanley’s effort to build its own robo-advisor.After the acquisition, FutureAdvisor was able to evolve into a “startup within a huge company,” according to founder Jon Xu. The company still held on to the creative culture and environment of a tech startup, but now has the resources and tools of asset management giant Blackrock at its disposal.The acquisition also reinforced the trend towards a model based on convenience for the consumer rooted in the automated processes. The evolution of financial advising and wealth management will hinge on whether or not the knowledge and personal attention of a human can add enough value to outweigh the benefits of convenience fostered by automation.Ally’s Acquisition of TradeKing4In April 2016, Ally Financial Inc., a bank holding company that provides a variety of financial services including auto financing, corporate financing, and insurance, announced an acquisition of TradeKing for a total purchase price of $275 million. TradeKing is a discount online brokerage firm that provides trading tools to self-directed investors. TradeKing initially offered some of the lowest cost stock trade commissions (at ~$5 share on equity trades) and was also one of the earlier online brokers to integrate social networking and an online community where customers could discuss trading analysis and strategies. Interestingly, Ally noted that it was not interested in offering traditional advisor led investment services but it was interested in digital offerings such as robo-advisors and robo-advisory was cited as a primary consideration for Ally’s interest in TradeKing. In 2014, TradeKing formed TradeKing Advisors, which offers robo-advisory services for a minimum investment of $500.The acquisition reflected creative thinking in the banking industry as bank M&A is typically primarily about cost savings and secondarily about expansion into new markets. Revenue synergies are touted periodically in bank acquisitions but they tend to be secondary considerations for investors and bank managers/directors. The TradeKing acquisition represents a shift in this mindset as the potential benefits from the transaction will largely be in the form of revenue synergies as Ally leverages TradeKing’s brokerage platform and attempts to achieve greater revenues by offering trading and wealth management services to its existing customer base. Convenience for Ally’s customers was clearly top of mind as evidenced by the following quotes from the CEO of both TradeKing and Ally around the time of announcement:“Banking and brokerage should be together so you can save and invest—and easily move money between the two.” Don Montonaro, CEO TradeKing5
“We have a good composition of customers across all demographic segments, from affluent boomers to millennials… Our customers have been happy with our deposit products, but are asking for more from the online bank.”– Diane Morais, Ally Bank, CEO6End Notes1Sources: Financialadvising.com, “Jon Xu Interview”; Forbes.com, “BlackRock To Buy FutureAdvisor, Signaling Robo-Advice Is Here To Stay.”; Financial-planning.com, “FutureAdvisor co-founder: Risk, robos and 'hyperpersonalization.”
2Samantha Sharf, “BlackRock To Buy FutureAdvisor, Signaling Robo-Advice Is Here To Stay,” Forbes, August 26 2015.
3Ibid.
4Sources for Case Study: Techcrunch; S&P Global Market Intelligence; Various articles including: “Ally, Fidelity to Launch Robo-Advisory Services by Theresa W. Carey on Digital Investor; TradeKing Website; and Bloomberg Business.
5Theresa W. Carey, “Ally, Fidelity to Launch Robo-Advisory Services,” Barron’s, April 23, 2016.
6Ibid.
The Rise of Robo-Advisors
Part 1
Despite the potential for FinTech innovation within wealth management, significant uncertainty still exists regarding whether these innovations will displace traditional wealth management business models. In this two part blogpost, excerpted from colleague, Jay Wilson's, new book on FinTech forthcoming from Wiley in early 2017, we look at the potential of Robo-Advisors and offer some thoughts on valuation.
Robo-advisory has the potential to significantly impact traditional wealth management. It represents a FinTech niche that is similar to the transition from full-service traditional brokers to discount online brokers. Robo-advisors were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years). Robo-advisory has gained traction in the past several years as a niche within the FinTech industry offering online wealth management tools powered by sophisticated algorithms that can help investors manage their portfolios at low costs and with minimal need for human contact or advice. Technological advances making this business model possible, coupled with a loss of consumer trust in the wealth management industry in the wake of the financial crisis, have created a favorable environment for the growth of robo-advisory startups meant to disrupt financial advisories, RIAs, and wealth managers. This growth is forcing traditional incumbents to explore their treatment of the robo-advisory model in an effort to determine their response to the disruption of the industry.
While there are a number of reasons for the success of robo-advisors attracting and retaining clients thus far, we highlight a few primary reasons.Low Cost. Automated, algorithm-driven decision-making greatly lowers the cost of financial advice and portfolio management.Accessible. As a result of the lowered cost of financial advice, advanced investment strategies are more accessible to a wider customer base.Personalized Strategies. Sophisticated algorithms and computer systems create personalized investment strategies that are highly tailored to the specific needs of individual investors.Transparent. Through online platforms and mobile apps, clients are able to view information about their portfolios and enjoy visibility in regard to the way their money in being managed.Convenient. Portfolio information and management becomes available on-demand through online platforms and mobile apps.
Consistent with the rise in consumer demand for robo-advisory, investor interest has grown steadily. While robo-advisory has not drawn the levels of investment seen in other niches (such as online lending platforms), venture capital funding of robo-advisories has skyrocketed from almost non-existent levels ten years ago to hundreds of millions of dollars invested annually the last few years. 2016 saw several notable rounds of investment into not only some of the industry’s largest and most mature players (including rounds of $100 million for Betterment and $75 million for Personal Capital), but also for innovative startups just getting off the ground (such as SigFig and Vestmark).
The exhibit below provides an overview of the fee schedules, assets under management and account opening minimums for several of the larger robo-advisors. The robo-advisors are separated into three tiers. Tier I consists of early robo-advisory firms who have positioned themselves at the top of the industry. Tier II consists of more recent robo-advisory startups that are experiencing rapid growth and are ripe for partnership. Tier III consists of robo-advisory services of traditional players who have decided to build and run their own technology in-house. As shown, account opening sizes and fee schedules are lower than many traditional wealth management firms. The strategic challenge for a number of the FinTech startups in Tiers 1 and II is generating enough AUM and scale to produce revenue sufficient to maintain the significantly lower fee schedules. This can be challenging since the cost to acquire a new customer can be significant and each of these startups has required significant venture capital funding to develop. For example, each of these companies has raised over $100 million of venture capital funding since inception.
Key Potential Effects of Robo-AdvisoryWe see four potential effects of robo-advisors entering the financial services landscape.The Democratization of Wealth Management. As a result of the low costs of robo-advisory services, new investors have been able to gain access to sophisticated investment strategies that, in the past, have only been available to high net worth, accredited investors.Holistic Financial Life Management. As more people have access to financial advice through robo-advisors, traditional financial advisors are being forced to move away from return-driven goals for clients and pivot towards offering a more complete picture of a client’s financial well-being as clients save for milestones such as retirement, a child’s education, and a new house. This phenomenon has increased the differentiation pressure on traditional financial advisors and RIAs, as robo-advisors can offer a holistic snapshot in a manner that is comprehensive and easy to understandDrivers of the Changing Role of the Traditional Financial Advisor. The potential shift away from return-driven goals could leave the role of the traditional financial advisor in limbo. This raises the question of what traditional wealth managers will look like going forward. One potential answer is traditional financial advisors will tackle more complex issues, such as tax and estate planning, and leave the more programmed decision-making to robo-advisors.Build, Buy, Partner, or Wait and See. As the role of the financial advisor changes, traditional incumbents are faced with determining what they want their relationship with robo-advisory to look like. In short, incumbents are left with four options: build their own robo-advisory in-house, buy a startup and adopt its technology, create a strategic partnership with a startup, or stay in a holding pattern in regard to robo-advisory and continue business as usual. We discuss each option in more depth in the following section.
The debate about the impact of technology on wealth management has moved on to considerations about how best to respond. In the second part of this post, we pick up on this last thought about strategies to capitalize on FinTech in the investment management industry, and include a couple of case studies for how it has been done.
Use the Interim Time Between Now and the Future Sale of a Business to Wisely Prepare
Is business ownership a binary thing? Do we either own our businesses or not? The binary notion leads business owners to think either in terms of either the status quo or of an eventual sale of the business.The truth is that between the two bookends of status quo and an eventual third-party sale are many possibilities for creating shareholder liquidity and diversification and facilitating both ownership and management transitions. We call this time "interim time." The literal translation of “interim” from the original Latin means, “the time between.” Interim time, then, is the time between now, or the current status quo of a business, and an ultimate sale of that business. Let’s look at the bookends:Status Quo. First, let’s talk about the either. The status quo may be an excellent strategy. If sales and earnings are rising, existing owners can benefit from the growth and expected appreciation in value and maintain control of the business. However, the status quo, in many instances, does not provide liquidity and diversification opportunities for owners and places all execution risk on them. A decision to maintain the status quo for your business may not do much to advance necessary ownership and management transitions, as well. A decision to maintain the status quo should be based on conscious decision making and not on procrastination. And the status quo has an insidious side to it – unless you and the other owners do something, you will stay in the status quo for a long, long time; therefore, you have to question the status quo on an ongoing basis.Ultimate Third-Party Sale. Now, let’s talk about the or. If your business is continuing in a status quo mode, chances are you are not preparing it for an eventual sale. After all, it will happen someday, but not in the foreseeable future. Chances are also that you and the other owners may not be preparing yourselves for an eventual sale. And if you are maintaining a status quo status, you may not be able to influence the timing of an eventual sale. The ideal time to sell a business is when the markets are hot, when financing is readily available, when your business is tracking upward and has a good outlook, and when the owners are ready. In reality, what you can hope to achieve in a sale of your business is the best pricing available in the market at the time of the sale. If you remain in the status quo, you may not get to choose the timing of the eventual sale.If it seems like we are painting an eventual third party sale as an unfavorable outcome, we are not. It can result in an unfavorable outcome, however, if your business is not ready for sale at the given time and if you and your other owners are not ready, personally, for that eventual sale.What to Do in the Interim TimeManaging illiquid, private wealth in private businesses is far more than running the businesses themselves. We all have to manage our businesses. Managing the wealth in our businesses requires a much more active role for business owners and often a different level of attention on the business itself.The status quo and an eventual third-party sale are, indeed, bookends. Consider the table.
If we are managing the wealth in our closely held and family businesses, we will be focused on creating liquidity opportunities over time and on achieving reasonable returns from our companies on a risk-adjusted basis. We will be using our companies as vehicles to generate liquid wealth and diversification opportunities over time.
The table shows the bookends of status quo and third-party sale options. In between are a number of options that owners of successful private companies can use to manage the wealth tied up in them and to create ongoing opportunities for liquidity and diversification.
At the far right, after the sale of a business, its owners must, in many cases, be prepared for the rest of their lives. So it is important to run a business in such a way that its owners develop liquidity and diversification to create options for the rest of their lives.
The table is certainly not all inclusive, but it does include some easily implementable options like establishing a dividend/distribution policy or making occasional share repurchases as owners need some liquidity or, for example, when an owner leaves the company. This purchase might be pursuant to the terms of a buy-sell agreement.
If your company has significant excess assets, it is probably a good idea to clean up your balance sheet and declare a special dividend. And it may be appropriate to have one or more key managers acquire small stakes in the company to facilitate alignment and future management transitions.
I call these options “easily implementable,” but they won’t happen unless someone does something.
The next category of options in the table above are termed “significant and realistic minority options.” They include relatively small leveraged dividend recapitalizations or share repurchases. The options also might include the creation of a 30% or less ESOP in appropriate circumstances. These transactions certainly won’t happen without someone doing something. They will likely require the assistance of outside expertise, and there will be certain transaction costs. Transaction costs should be considered in the context of investments.
The third category after the status quo is called “control level options.” For some successful private companies, it may be appropriate to engage in substantial transactions to create liquidity opportunities and to retain ownership in expected future growth and appreciation. Options here include:
Leveraged share repurchasesLeveraged dividend recapitalizationsEmployee Stock Ownership Plans
The final category is the bookend of third-party sale transactions. It should now be clear that there are options other than selling a business today, or simply maintaining the status quo, for managing the illiquid wealth in your private company.Benefits of Focusing on Interim TimeThe shareholder benefits of employing one or more of the above strategies over time include the following:Acceleration of cash returns, liquidity opportunities, and opportunities for diversification and creating liquidity independent of your companyAbility for your owners to diversify their portfoliosOptimization of your company’s capital structure with reasonable leverageEnhanced return on equity with reasonable leverageEnhanced earnings per share for some optionsPlanned changes in ownership structure with shareholder redemptions, with remaining owners achieving pickups in their relative ownership of the companyEnhanced performance and reduced business risk with focus on the business
Employing one or more of the above The One Percent Solution strategies is tantamount to using modern investment theory concepts and basic corporate finance tools in the management of illiquid private company wealth.
For more information or to discuss a valuation and transaction issue in confidence, please do not hesitate to contact us.
Exploration & Production 3Q16 Newsletter | Region Focus: Bakken
Each quarter, Mercer Capital’s Exploration & Production Industry newsletter provides an overview of the E&P sector, including world demand and supply, public market performance, valuation multiples for public companies, and a region focus. This quarter we focus on the Bakken Shale.Excerpting from the third quarter newsletter:Oil prices trended up for the beginning of the third quarter but ended the quarter about where they started. For the last two years companies have postponed exploration activities and cut capital projects to drill new wells. Now that oil prices show signs of recovery, production has increased across the U.S.
Although oil prices have increased slightly, oil and gas bankruptcies continued in the third quarter as 52 companies filed for bankruptcy. The majority filed for Chapter 11 protection in hopes to reorganize. Many of the firms that went bankrupt were smaller companies who had less flexibility to exchange debt or draw a second-lien.
The price of crude oil is determined by market forces: supply and demand. In order to understand the current pricing environment, we analyze these metrics on pages 1 and 2 of the newsletter.View the newsletter below or download the PDF.
WHITEPAPER | Capital Budgeting in 30 Minutes
Switching costs for capital investment are high and do-overs are expensive. A capital project is simply any use of the family business’s capital resources in the present with a view toward earning a return on that investment over time, and may take the form of acquisitions, capital expenditures, research & development, or other investments. Net present value and internal rate of return are the two primary tools used to determine whether the forecasted marginal cash flows are sufficient to justify the proposed project. However, a healthy capital budgeting process goes beyond mere financial feasibility to address the proposed project’s “fit” within the overall corporate strategy. The purpose of this whitepaper is to assist directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.This whitepaper is the third in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.
Royalty Interests Discover the Permian
In August 2016, we discussed bankruptcy and valuation issues related to royalty interest owners. We mentioned using the publicly traded market as one method to value royalty interests, specifically observing royalty trusts. As a primer for O&G royalty trusts, these trusts hold various royalty and net profit interests in wells operated by large exploration & production companies. These trusts have little in the way of operating expenses, have defined termination dates and can serve as an investment opportunity that provides exposure to oil and gas prices. This Motley Fool article, from 2014, explains the pros and cons of investing in this sort of vehicle.Market indications are available in the form of publicly traded oil & gas (“O&G”) royalty trusts. There are approximately 20 oil and gas focused royalty trusts publicly traded, as of the date of this article.1Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard over the previous 29 months. Before the bottom fell out, oil traded as high as $106.86 in June of 2014 and plunged to a low of $29.05 in February of 2016. Since February, the price of oil appears to have found a new home around $50 / barrel. Here is a comparison of the 20 publicly traded royalty trusts’ metrics today versus one year ago.Observations and Disclaimers:Price to revenue and price to distributable income indicate, on average, the trusts are more expensive now than a year ago. This is a flip from our August 2016 blog post when multiples were lower in July 2016 than July 2015.Yields were higher last year as trailing yields did not reflect the quickly falling market price.As of today, market prices have leveled off and annual distributions are comprised of a full year of lower royalty payments, resulting in lower yields compared to a year ago.Price to PV 10 is higher this year compared to last. The remaining observations are for commodity prices, both current and futures price for the 12 month contract.Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness.
Below is a chart of the market price performance for each royalty trust over the last two years.
The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner, and possibly have not experienced the small rebound during 2016.
Uncertainty is high as some operators have been forced to file bankruptcy after commodity prices have remained low for too long for them to survive. Three of the above 20 royalty trusts are tied to SandRidge Energy. In May 2016, SandRidge Filed for Bankruptcy Reorganization and Emerged from Bankruptcy in October 2016. During this time, the three royalty trusts: (1) SandRidge Mississippian Trust 12, (2) SandRidge Mississippian Trust II3 and (3) SandRidge Permian Trust4 experienced the following performance:
The popularity of the Permian Basin is nothing new this year. In oil and gas, location is key when trying to generate returns on invested capital. Even as the price of oil is near three year lows, transaction activity is high in this area of the country. Royalty Trusts appear to support the trend to try to get a piece of the very hot Permian Basin. Add on the reserve discovery in the Wolfcamp formation by the United States Geological Survey last month and it is clear that there is no other place to be drilling for oil right now. This attention appears to have spread into the royalty trusts. As the publicly traded price indicates, after SandRidge Energy files for bankruptcy, albeit “pre-arranged reorganization,” each of the three related royalty trusts decline. The price of the two trusts which do not own properties in the Permian Basin decline more than 20% initially after the bankruptcy filing while the SandRidge Permian Trust’s price declines only 6%. Upon emergence from bankruptcy, the trust with Permian related assets was up 11% while the two non-Permian related trusts were down more than 35%.
Depending on your situation, the current pricing environment may provide excellent planning opportunities as market prices are relatively low. With the Treasury Department attempting to change the way gift and estate planning can be performed, it is even more timely to execute a transfer plan. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
End Notes1 Data for charts and tables for this post are from Capital IQ
2 The Trust holds Royalty Interests in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Garfield, Grant and Woods counties in Oklahoma. (respective 10-K, March 2016)
3 The Trust holds Royalty Interests in specified oil and natural gas properties located in the Mississippian formation in Alfalfa, Grant, Kay, Noble and Woods counties in northern Oklahoma and Barber, Comanche, Harper and Sumner counties in southern Kansas. (respective 10-K, March 2016)
4 The Trust holds Royalty Interests in specified oil and natural gas properties in the Permian Basin located in Andrews County, Texas. (respective 10-K, March 2016)
Sterling National Regifts Trust Department to Midland
Last Christmas, a gift grab almost ripped my entire family apart. If you have never participated in a gift grab and all of its associated horrors, the rules are simple enough. Each participant is tasked with finding a gift under a specific price point that (hopefully) everyone would enjoy. On the day of the gift exchange, numbers are drawn by random to determine the order, with the first player choosing a gift to open, and the second player choosing whether to steal the opened gift or open a new one, and so on. If a player has a gift stolen from them, they get to open a new gift.What was supposed to be a “fun” game soon devolved into a sort of passive-aggressive warfare, the likes of which I have never seen. By the time every gift had been allotted, factions had been made, treaties broken, and at least three of us were on the verge of tears. I, meanwhile, was happy as a clam with my punny bag of “hand soap” – quite literally, soap shaped into little hands that was once lovingly described as looking like a “bag of amputated baby hands.” No one else wanted them, but what can I say; I’m a sucker for word play.As inspiration for fair deals and perfect swaps, we looked into Midland State Bancorp’s recent acquisition of Sterling National Bank’s trust department. From what we’ve read about the deal, it appears both parties walked away with what they wanted.In November of 2014, Sterling National Bank announced the acquisition of Hudson Valley Bank (“HVB”) in order to expand Sterling’s loan and deposit market into the greater New York City metropolitan area. The deal was a lucrative one in terms of both market expansion and balance sheet growth. As of the closing in June of 2015, Sterling acquired 28 new branches across five counties, with $288 million in assets, $1.8 billion in loans, and $3.2 billion in deposits. Along with the deal, however, Sterling also happened to acquire HVB’s small, but not immaterial, trust department with over $423 million in managed assets. The only problem was that Sterling had opened an additive gift that they did not have the structure for and was too small to stand on its own, but too large to ignore.Midland States Bank announced its acquisition of Sterling’s wealth management assets in February of this year, the majority if which happened to be in Special Needs and Settlement Trusts. Midland’s structure was well suited for the deal, with a specialty in trusts that had developed through a prior acquisition in 2013. The deal closed for $4.8 million, retaining all 12 members of Sterling’s trust department, and bringing its wealth management AUM up to $1.6 billion. The EBITDA margin was not disclosed in the announcement of the deal (the fact that the price alone was reported, is unusual), but following a typical EBITDA margin of 20% to 30% for a trust department, the deal falls within a range of EBITDA multiples from 5.7x to 8.6x. The midpoint of the range, 6.8x, depicts a strategic sale that was neither a fire sale nor a purse buster.
This appears to be a gift exchange done well – greater manpower and AUM for Midland’s trust department, and a cleaner balance sheet and some cash to boot for Sterling’s bank practice - a strategic deal for both buyer and seller. My family should take note.
With another holiday season upon us, we hope that if you get dragged into a gift grab, your gift be perfect for you. And if you’re in need of some creepy soap, I know a guy…
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
An Introduction to Dividends and Dividend Policy for Private Companies
As the calendar year draws to a close, many private companies consider the issue of dividends and dividend policy. Originally published in Unlocking Private Company Wealth, Z. Christopher Mercer, ASA, CFA, ABAR provides an introduction to dividends and dividend policy. He begins with the obvious observation that no matter how informal, your company has a dividend policy. Reprinted with permission.
The issue of dividends and dividend policy is of great significance to owners of closely held and family businesses and deserves considered attention.
Fortunately, I had an early introduction to dividend policy beginning with a call from a client back in the 1980s.
I had been valuing a family business, Plumley Rubber Company, founded by Mr. Harold Plumley, for a number of years. One day in the latter 1980s, Mr. Plumley called me and asked me to help him establish a formal dividend policy for his company, which was owned by himself and his four sons, all of whom worked in the business.
Normally I do not divulge the names of clients, but my association with the Plumley family and Plumley Companies (its later name) was made public in 1996 when Michael Plumley, oldest son of the founder and then President of the company, spoke at the 1996 International Business Valuation Conference of the American Society of Appraisers held in Memphis, Tennessee. He told the story of Plumley Companies and was kind enough to share a portion of my involvement with them over nearly 20 years at that point.
Let’s put dividends into perspective, beginning with a discussion of (net) earnings and (net) cash flow. These are two very important concepts for any discussion about dividends and dividend policy for closely held and family businesses. To simplify, I’ll often drop the (net) when discussion earnings and cash flow, but you will see that this little word is important.(Net) Earnings of a BusinessThe earnings of a business can be expressed by the simple equation:Earnings = Total Revenue – Total CostCosts include all the operating costs of a business, including taxes.C Corporations. If your corporation is a C corporation, it will pay taxes on its earnings and earnings will be net of taxes. The line on the income statement is that of net income, or the income remaining after all expenses, including taxes, both state and federal, have been paid. By the way, if your company is a C corporation, feel free to give me a call to start a conversation about this decision.S Corporations and LLCs. If your corporation is an S corporation or an LLC (limited liability company), the company will make a distribution so that its owners can pay their pass-through taxes on the income. To get to the equivalent point of net income on a C corporation’s income statement, it is necessary to go to the line called net income (but it is not) and to subtract the total amount of distributions paid to owners for them to pay the state and federal income taxes they owe on the company’s (i.e., their pass through) earnings. This amount would come from the cash flow statement or the statement of changes in retained earnings.
Ignoring any differences in tax rates, the net income, after taxes (corporate or personal) should be about the same for C corporations and pass-through entities.(Net) Cash FlowCompanies have non-cash charges like depreciation and amortization related to fixed assets and intangible assets. They also have cash charges for things that don’t flow through the income statement. Capital expenditures for plant and equipment, buildings, computers and other fixed assets are netted against depreciation and amortization, and the result is either positive or negative in a given year. Capital expenditures tend to be "lumpy" while the related depreciation expenses are amortized over a period of years, often causing swings in the net of the two.There are other "expenses" and "income" of businesses that do not flow through the income statement. These investments, either positive or negative, relate to the working capital of a business. Working capital assets include inventories and accounts receivable, and working capital liabilities include accounts payable and other short-term obligations. Changes in working capital can lead to a range of outcomes for a business. Consider these two extremes that could occur regarding cash in a given year:Make lots of money but have no cash. Rapidly growing companies may find that while they have positive earnings, they have no cash left at the end of the month or year. They have to finance their rapid growth by leaving all or more than all of earnings in the business in the form of working capital to finance investments in accounts receivable and/or inventories and in the purchase of fixed assets to support that growth.Make little money, even have losses, and generate cash. Companies that experience sales declines may earn little, or even lose money on the income statement, and still generate lots of cash because they collect prior receivables or convert previously accumulated inventories into cash during the slowdown.
Working capital on the balance sheet is the difference between current assets and current liabilities. Many companies have short-term lines of credit with which they finance working capital investments. The concept of working capital, then, may include changes in short-term debt.
In addition, companies generate cash by borrowing funds on a longer-term basis, for example, to finance lumpy capital expenditures. In the course of a year, a company may be a net borrower of long-term debt or be in a position of paying down its long-term debt. So we’ll need to consider the net change in long-term debt if we want to understand what happens to cash in a business during a given year.
We are developing a concept of (net) cash flow, which can be defined as follows in Figure 11.Most financial analysts and bankers will agree that this is a pretty good definition of Net Cash Flow.Net Cash Flow is the Source of Good ThingsWe focus on cash flow because it is the source of all good things that come from a business. The current year’s cash flow for a business is, for example, the source of:Long-term debt repayment. Paying debt is good. Bankers are extremely focused on cash flow, because they only want to lend long-term funds to businesses that have the expectation of sufficient cash flow to repay the debt, including principal and interest on the scheduled basis. Interest expense has already been paid when we look at net cash flow. Companies borrow on a long-term basis to finance a number of things like land, buildings and equipment, software and hardware, and many other productive assets that may be difficult to finance currently. They may also borrow on a long term basis to finance stock repurchases or special dividends.Reinvestment for future growth. Investment in a business is good if adequate returns are available. If a company generates positive cash flow in a given year, it is available to reinvest in the business to finance its future growth. Reinvested earnings are a critical source of investment capital for closely held and private companies Reinvesting with the expectation of future growth (in dividends and capital gains) is an important source of shareholder returns, but the return is deferred, at least in the form of cash, until a future date.Dividends or distributions. Corporate dividends are also good, particularly if you are a recipient. Cash flow is also the normal source for dividends (for C corporation owners) or what we call “economic distributions,” or distributions net of shareholder pass-through taxes (for S corporation and LLC owners).What is a Dividend?At its simplest, a dividend (or economic distribution) reflects the portion of earnings not reinvested in a business in a given year, but paid out to owners in the form of current returns.For some or many closely held and family businesses, effective dividends can include another component, and that is the amount of any discretionary expenses that likely would be “normalized” if they were to be sold. Discretionary expenses include:Above-market compensation for owner-managers. Owners of some private businesses who compensate themselves and/or family members at above-market rates should realize that the above-market portion of such compensation is an effective dividend.Mystery employees on the payroll. Some companies place non-working spouses, children or other relatives on the payroll when no work is required of them.Expenses associated with non-operating assets used for owners’ personal benefit. Non-operating assets can include company-owned vacation homes, aircraft not necessary for the operation of the business, vehicles operated by non-working family members, and others.
It is essential to analyze above-market compensation and other discretionary expenses from owners’ viewpoints to ascertain the real rate of return that is obtained from investments in private businesses. In an earlier chapter, we touched on the concept of the rate of return on investment for a closely held business. Assuming that there were no realized capital gains from a business during a given year, the annual return (AR) is measured as follows:Now, we add to this any discretionary expenses that are above market or not normal operating expenses of the business that are taken out by owners:We now know what dividends are, and they include discretionary benefits that will likely be ceased and normalized into earnings in the event of a sale.We won’t focus on discretionary benefits in the continuing discussion of dividends and dividend policy. However, it is important for business owners to understand that, to the extent discretionary benefits exist, they reflect portions of their returns on investments in their businesses.In summary, dividends are current returns to the owners of a business. Dividends are normally residual payments to owners after all other necessary debt obligations have been paid and all desirable reinvestments in the business have been made.Dividends and Dividend Policy for Private CompaniesWith the above introduction to dividends for private companies, we can now talk about dividend policy. The remainder of this chapter focuses on seven critical things for consideration as you think about your company’s dividend policy.Every company has a dividend policy.Dividend policy influences return on business investment.Dividend policy is a starting point for portfolio diversification.Special dividends enhance personal liquidity and diversification.Dividend policy does matter for private companies.Dividend policy focuses management attention on financial performance.Boards of directors need to establish thoughtful dividend policies.
We now focus on each of these seven factors you need to know about your company’s dividend policy.Every Company Has a Dividend PolicyLet’s begin with the obvious observation that your company has a dividend policy. It may not be a formal policy, but you have one. Every year, every company earns money (or not) and generates cash flow (or not). Assume for the moment that a company generates positive earnings as we defined the term above. If you think about it, there are only three things that can be done with the earnings of a business:Reinvest the earnings in the business, either in the form of working capital, plant and equipment, software and computers, and the like, or even excess or surplus assets.Pay down debt.Pay dividends to owners (or economic distributions – after pass-through taxes – for S corporations and LLCs) or repurchase stock (another form of returns to shareholders).
That’s it. Those are all the choices. Every business will do one or more of these things with its earnings each year. If a business generates excess cash and reinvests in CDs, or accumulates other non-operating assets, it is reinvesting in the business, although likely not at an optimal rate of return on the reinvestment. Even if your business does not pay a dividend to you and your fellow owners, you have a dividend policy and your dividend payout ratio is 0% of earnings.
On the other hand, if your business generates substantial cash flow and does not require significant reinvestment to grow, it may be possible to have a dividend policy of paying out 90% or even up to 100% of earnings in most years. This is often the case in non capital intensive service businesses.
Recall that if a business pays discretionary benefits to its owners that are above market rates of compensation, or if it pays significant expenses that are personal to the owners, it is the economic equivalent of paying a dividend to owners. So when talking to business owners where such expenses are significant, we remind them that they are, indeed, paying dividends and should be aware of that fact.
Some may think that discretionary expenses are the provenance of only small businesses; however, they exist in many businesses of substantial size, even into the hundreds of millions in value.
Discretionary expenses are not necessarily bad, but they can create issues. In companies with more than one shareholder, discretionary expenses create the potential for (un)fairness issues. However, discretionary expenses are paid for the benefit of one shareholder or group of shareholders and not for others, they are still a return to some shareholders.
Every company, including yours, has a dividend policy. Is it the right policy for your company and its owners?Dividend Policy Influences Return on Business InvestmentTo see the relationship between dividend policy and return on investment we can examine a couple of equations. This brief discussion is based on a lengthier discussion in my book, Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2007). There is a basic valuation equation, referred to as the Gordon Model. This model states that the price (P0) of a security is its expected dividend (D1) capitalized at its discount rate (R) minus its expected long term growth rate in the dividend (Gd). This model is expressed as follows:D1 is equal to Earnings times the portion of earnings paid out, or the dividend payout ratio (DPO), so we can rewrite the basic equation as follows:What this equation says is that the more that a company pays out in dividends, the less rapidly it will be able to grow, because Gd, or the growth rate in the dividend, is actually the expected growth rate of earnings based on the relevant dividend policy.We can look at this simplistically in word equations as follows:Dividend Income + Capital Gains = Total ReturnDividend Yield + Growth (Appreciation) = Cost of Equity (or the discount rate, R)These equations reflect basic corporate finance principles that pertain, not only to public companies, but to private businesses as well. There is an important assumption in all of the above equations – cash flow not paid out in dividends is reinvested in the business at its discount rate, R.There are many examples of successful private companies that do not pay dividends, even in the face of unfavorable reinvestment opportunities. To the extent that dividends are not paid and earnings are reinvested in low-yielding assets, the accumulation of excess assets will tend to dampen the return on equity and investment returns for all shareholders.Further, the accumulation of excess assets dampens the relative valuation of companies, because return on equity (ROE) is an important driver of value. For example, consider the following relationship without proof:ROE x Price/Earnings Multiple = Price/Book ValueAt a given multiple of (net) earnings available in the marketplace, a company’s ROE will determine its price/book value multiple. The price/book value multiple tells how valuable a company is in relationship to its book value, or the depreciated cost value of its shareholders’ investments in the business.Let’s consider a simple example. Assume that a company generates an ROE of 10% and that the relevant market price/earnings multiple (P/E) is 10x. Using the formula above:In this example, the company would be valued at its book value and the shareholders would not benefit from any “goodwill,” or value in excess of book value. Consider, however, that a similar company earns an ROE of 15%.Assuming the same P/E of 10x, it would be valued at 150% of its book value.Suppose the second company, because of its superior returns, received a P/E of 11x. In that case the price/book multiple would be 165%.
To the extent that a company’s dividend policy influences its ongoing ROE, it influences its relative value in the marketplace and the ongoing returns its shareholders receive.
In short, your dividend policy influences your return on investment in your business, as well as your current returns from that investment.Dividend Policy is a Starting Point for Portfolio DiversificationRecall the story of my being asked to help develop a dividend policy for a private company. The company had grown rapidly for a number of years and its growth and diversification opportunities in the auto parts supply business were not as attractive as they had been. The CEO, who was the majority shareholder, realized this and also that his sons (his fellow shareholders) could benefit from a current return on their investments in the company, which, collectively, were significant.We reviewed the dividend policies of all of the public companies that we believed to be reasonably comparable to the company. I don’t recall the exact numbers now, but I believe that the average dividend yield for the public companies was in the range of 3%. As I analyzed the private company, it was clear that it was still growing somewhat faster than the publics, so the ultimate recommendation for a dividend was about 1.5% of value.The value that the 1.5% dividend yield was compared to was the independent appraisal that we prepared each year. Based on the value at the time, I recall that the annual dividend began at something on the order of $300,000 per year. But, for the father and the sons, it was a beginning point for diversification of their portfolios away from total concentration in their successful private business.Your dividend policy can be the starting point for wealth diversification, or it can enhance the diversification process if it is already underway.Special Dividends Enhance Personal Liquidity and DiversificationA number of years ago, I was an adviser to a publicly traded bank holding company. Because of past anemic dividends, this bank had accumulated several million dollars of excess capital. The stock was very thinly traded and the market price was quite low, reflecting a very low ROE (remember the discussion above).Because of the very thin market for shares, a stock repurchase program was not considered workable. After some analysis, I recommended that the board of directors approve a large, one-time special dividend. At the same time I suggested they approve a small increase in the ongoing quarterly dividend. Both of these recommendations provided shareholders with liquidity and the opportunity to diversify their holdings.Since the board of directors collectively held a large portion of the stock, the discussion of liquidity and diversification opportunities while maintaining their relative ownership position in the bank was attractive.At the final board meeting before the transaction, one of the directors did a little bit of math. He noted that if they paid out a large special dividend, the bank would lose earnings on those millions and earnings would decline. I agreed with his math, but pointed out (calculations already in the board package) that the assets being liquidated were very low in yield and that earnings (and earnings per share) would not decline much. With equity being reduced by a larger percentage, the bank’s ROE should increase. So that increase in ROE, given a steady P/E multiple in the marketplace, should increase the bank’s Price/Book Value multiple.The director put me on the spot. He asked point blank: "What will happen to the stock price?" I told him that I didn’t know for sure (does one ever?) but that it should increase somewhat and, if the markets believed that they would operate similarly in the future, it could increase a good bit. The stock price increased more than 20% following the special dividend.Special dividends, to the extent that your company has excess assets, can enhance personal liquidity and diversification. They can also help increase ongoing shareholder returns. I have always been against retaining significant excess assets on company balance sheets because of their negative effect on shareholder returns and their adverse psychological impact. It is too easy for management to get "comfortable" with a bloated balance sheet.If your business has excess assets, consider paying a special dividend. Your shareholders will appreciate it.Dividend Policy Does Matter for Private CompaniesSomeone once said that earnings are a matter of opinion, but dividends are a matter of fact. What we know is that when dividends are paid, the owners of companies enjoy their benefit, pay their taxes, and make individual choices regarding their reinvestment or consumption.The total return from an investment in a business equals its dividend yield plus appreciation (assuming no capital gains), relative to beginning value. However, unlike unrealized appreciation, returns from dividends are current and bankable. They reduce the uncertainty of achieving returns. Further, if a company’s growth has slowed because of relatively few good reinvestment opportunities, a healthy dividend policy can help assure continuing favorable returns overall.Based on many years of working with closely held businesses, we have observed that companies that do not pay dividends and, instead, accumulate excess assets, tend to have lower returns over time. There is, however, a more insidious issue. The management of companies that maintain lots of excess assets may tend to get lazy-minded. Worse, however, is the opposite tendency. With lots of cash on hand, it is too easy to feel pressure to make a large and perhaps unwise investment, e.g., an acquisition, that will not only consume the excess cash but detract from returns in the remainder of the business.Dividend policy is the throttle by which well-run companies gauge their speed of reinvestment. If investment opportunities abound, then a no- or low-dividend payout may be appropriate. However, if reinvestment opportunities are slim, then a heavy dividend payout may be entirely appropriate.Any way you cut it, dividend policy does matter for private companies.Dividend Policy Focuses Management Attention on Financial PerformanceBoards of directors are generally cautious with dividends and once regular dividends are being paid, are reluctant to cut them. The need, based on declared policy, to pay out, say, 35% of earnings in the form of shareholder dividends (example only) will focus management’s attention on generating sufficient earnings and cash flow each year to pay the dividend and to make necessary reinvestments in the business to keep it growing.No management (even if it is you) wants to have to tell a board of directors (even if you are on it) or shareholder group that the dividend may need to be reduced or eliminated because of poor financial performance.Boards of Directors Need to Establish Thoughtful Dividend PoliciesIf dividend policy is the throttle with which to manage cash flow not needed for reinvestment in a business, it makes sense to handle that throttle carefully and thoughtfully. Returns to shareholders can come in the form of dividends or in the form of share repurchases.While a share repurchase is not a cash dividend, it does provide cash to selling shareholders and offsetting benefits to remaining shareholders. Chapter 10 of the book (Leveraged Share Repurchase: An Illustrative Example) provides an example of a substantial leveraged share repurchase from a controlling shareholder to provide liquidity and diversification.From a theoretical and practical standpoint, the primary reason to withhold available dividends today is to reinvest to be able to provide larger future dividends – and larger in present value terms today. It is not a good dividend policy to withhold dividends for reasons like the following:A patriarch withholds dividends to prevent the second (or third or more) generations from being able to have access to funds.A control group chooses to defer dividends to avoid making distributions to certain minority shareholders.Dividends are not paid because management (and the board) want to build a large nest egg against possible future
adversities.Dividends are not paid to accumulate excess or non-operating assets on the balance sheet for personal or vanity
reasons.Dividend policy is important and your board of directors needs to establish a thoughtful dividend policy for your business.ConclusionDividends and dividend policies are important for the owners of closely held and family businesses. Dividends can provide a source of liquidity and diversification for owners of private companies. Dividend policy can also have an impact on the way that management focuses on financial performance.To discuss corporate valuation or transaction advisory issues in confidence, please contact us.
Buy-Sell Agreements for Investment Management Firms
An Ounce of Prevention is Worth a Pound of Cure
The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. One of the most famous is pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely-held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five figure settlement in some industries is a seven figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well”, we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties:Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules-Of-Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule-of-thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value”, does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level” of value, as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely-held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression. By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts”.Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience:Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper
The Permian Basin: Loaves and Fishes
One of the most commonly taught Bible stories is the miracle of Jesus feeding five thousand people with only five loaves of bread and two fish. Last week we learned of a new miracle story of never ending sustenance. The Permian Basin, which has been drilled since the 1920s and produced billions of barrels of oil, was discovered to hold the largest unconventional crude accumulation in the US.Less than 10 years ago, the United States Geological Survey (USGS) estimated that the Permian Basin held just 1.0 billion barrels of conventional oil and 1.3 billion barrels of unconventional oil classified as technically recoverable reserves.1 The advancement of horizontal drilling techniques, however, increased the amount of recoverable reserves. Now, according to the Texas Rail Road commission, over 29 billion barrels of oil and 75 trillion cubic feet of gas have been produced from the Permian over the last 90 years. Further, last Tuesday, the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation. This discovery alone is 3x larger than the entire Bakken play in North Dakota, and equates an estimated $900 billion of oil.
The Wolfcamp Shale has been a recent target of E&P companies in the face of two years of low oil prices. The Wolfcamp is an oil and gas zone located below the Spraberry oil play in the Midland Basin. The Spraberry oil play has been developed since 1943 but the Wolfcamp was not developed until the onset of horizontal drilling. Companies saw opportunity in the Wolfcamp shale because of its depth and geological makeup. The Permian Basin is a stacked play which means that multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs like the Permian, a multilateral well eliminates the cost of drilling the total depth twice. The Wolfcamp is as much as a mile deep at some points which means that operators can drill multiple horizontal wells from one main wellbore.
M&A activity in the E&P sector has picked up this year due to the opportunity seen in the Permian. There have been 132 deals in the Permian this year so far, totaling $20.8 billion in deal value, which is more than 40% of total E&P deal value generated throughout the US. Much of this activity has been focused in the Midland Basin. Because drilling costs in the Permian are lower than many other plays in the US, when oil prices began to show signs of recovery, rig counts in the Permian picked up faster than in any other domestic play. Producers were eager to begin operating after two years of an uneconomical drilling environment, and for many producers the Permian was the first play in which the cost of oil rose above breakeven costs. The chart below shows the combined rig counts of oil and gas rigs in various domestic plays.
What Does This Mean?Business Insider associates some of the collapse of oil prices in 2014 to be driven by the increase in production in the Permian. The oversupply of oil pushed prices down worldwide. Just as oil prices have started recovering, this new discovery makes producers seriously consider if $50 per barrel oil is a thing of the past. Walter Guidroz, program coordinator for the USGS Energy Resources Program said, “The fact that this is the largest assessment of continuous oil we have ever done just goes to show that, even in areas that have produced billions of barrels of oil, there is still the potential to find billions more.”From a valuation perspective, acreage values in the Permian are likely to continue increasing as more producers try to get their hands on valuable Permian acreage and available land becomes scarcer. However, there is one problem with talking about technically recoverable resources: cost is not considered. Many headlines recently boasted that the discovery in the Wolfcamp is worth $900 billion in revenue at today’s prices… but what about cost? When using the income approach to value oil and gas assets, earnings estimates, not revenue, are capitalized. Art Berman, a petroleum geologist, described this best: “if the oil magically leaped out of the ground without the cost of drilling and completing wells; if there were no operating costs to produce it; if there were no taxes and no royalties” then the Wolfcamp discovery would be worth $900 billion.This is not to say that the Wolfcamp discovery is inconsequential, but to simply highlight the affect the pricing environment has on oil and gas valuations. The oil and gas industry is constantly changing. Each location in the Permian is different and costs vary by region. As a result, the valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.End Note1 The USGS defines recoverable resources as those that can be produced using currently available technology and industry practices. Whether or not it is profitable to produce these resources has not been evaluated.
U.K. Based Henderson Group Acquires Janus Capital for $2.6 Billion
Coming to America
Though probably not as historic as Plymouth landing or even the Eddie Murphy comedy, Henderson’s purchase of Denver RIA Janus Capital last month is a rare sign of confidence in active managers that have been losing ground to passive investors for quite some time. The era of ETFs and indexing has dominated asset flows for quite some time, so this transaction seems to counter the recent trend.Last week, we touched on the recent election’s possible impact on active management, and the gist of it is that potentially heightened volatility and lower asset correlations under a Trump presidency could bode well for stock and bond pickers (though most fixed income investors would not agree with that position at the moment). Indeed, a quick look at active manager pricing over the last two weeks shows several industry leaders (Pzena, Diamond Hill, Hennessy, GAMCO, etc.) up 10% to 20% since the election. Investor sentiment seems to be shifting, or is at least less bearish on the sector than just a few months ago.As for whether JNS or HGG will be more likely to give thanks this Thursday, both sides are up modestly since the deal was announced in early October, though it has been a rocky seven weeks. Janus-Henderson should benefit from the ability to cross-sell each other’s products, though it is often harder to capitalize on this potential in practice. They’ve also both been adversely affected by asset flows out of active strategies, but are now poised to benefit from any semblance of mean reversion. With Janus serving primarily U.S. investors with domestic funds and Henderson having more of a European and global focus, there doesn’t appear to be much product overlap either. Janus CEO Dick Weil recently told analysts that the two companies are “almost mirror images of each other on opposite sides of the Atlantic,” and they certainly do seem to complement one another. Since Janus shareholders will now benefit from a lower (UK) corporate tax rate (and Thanksgiving is not celebrated in England), we suspect they’ll be more inclined to give thanks on turkey day.Looking strictly at the economics of the deal in the context of other recent transactions that we’ve analyzed, it doesn’t appear that Henderson overpaid for Janus with earnings and activity (revenue and AUM) metrics reasonably in line with precedent multiples. Given the size of Janus and expected synergies ($110 million in annual net costs savings) of the deal, one might have expected a higher valuation, but recent share price volatility and client outflows likely precluded much of a premium. Putting it all together, the transaction price appears appropriate to both sides from a financial perspective.
One potential wrinkle in the deal is how famed 72 year-old bond investor, Bill Gross, and his new total return fund will be managed by the merged entity. There is also the question of his succession planning and client retention once he finally retires, since there’s certainly the possibility that all those (non-Gross) assets could flow back to PIMCO or another actively managed bond fund. Since Gross’ former co-manager, Kumar Palghat, recently left for another bond fund at Janus and his former boss, Dick Weil, just moved to Henderson’s offices in London (while Gross remains in Newport Beach), investors may hold some concern over the former bond king’s further alienation from the rest of the company.
At this point, we don’t yet know if the Janus-Henderson marriage will end up as happily as Prince Joffer’s, but since Janus is named after the ancient Roman god of change and new beginnings, we’re hopeful for a smooth transition.
WHITEPAPER | Capital Structure in 30 Minutes
Capital structure decisions have long-term consequences for shareholders. Family business directors evaluate capital structure with an eye toward identifying the financing mix that minimizes the weighted average cost of capital. This decision is complicated by the iterative nature of capital costs: the financing mix influences the cost of the different financing sources. While the nominal cost of debt is always less than the nominal cost of equity, the relevant consideration for directors is the marginal cost of debt and equity, which measures the impact of a given financing decision on the overall cost of capital. The purpose of this whitepaper is to equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business. This whitepaper is the second in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.
Quick Facts: Permian Basin
Over the past few weeks, we have discussed the increase in M&A activity in the Permian and looked at specific characteristics that make the Permian attractive in a low price environment. Today, we take a step back and review the broad characteristics of the Permian Basin. Download this information in a convenient PDF at the bottom of this post.Permian at a GlanceFirst Discovered1920Discovery as Viable PlayBegan in 1923, declined post 1970s, increased again after 2007Primary ProductionOilOil TypeSweet, Light CrudePlayConventional & Unconventional PlaysDrillingVertical (traditionally), Horizontal (81% of recent drilling) and Multi-Stage Hydraulic FracturingTop 3 Production CompaniesOccidental, Pioneer, ApacheBreakeven$25 – $63 per barrel 1Abnormal DUCs433 2Production Since 20077,156 MMBOE 3IssuesCheapest Oil Has Already Been ProducedPotentialImproving Technology, Easy Entry, Stacked Play Efficiency, Low Service & Transport Costs, & Under-Explored Layers1 Bloomberg Intelligence county-level estimates
2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence)
3 EIA as of June 2016Overview of Permian BasinStretching over 86,000 sq. miles in western Texas and New Mexico, the Permian Basin is the most productive formation in the U.S. Since 2007, new technologies have created a boom in the region by increasing the production of old wells and enabling drilling in previously underdeveloped geological layers. In the current low price environment, Permian production has been affected less than other large U.S. reserves.Geography & DrillingThe Permian Basin produces from a variety of geological formations. These formations are layered on top of each other, creating stacked reservoirs of limestone, sandstone, and shale. For decades, wells have targeted conventional, permeable reservoir layers that trap oil and gas produced primarily in the shale layers. Recently developed enhanced extraction techniques have maintained these reservoirs’ outputs. However, since 2007, hydraulic fracturing targeting the less permeable tight sand and shale layers has driven over 60% of new production growth. Many of these new wells are “stacked plays” that capitalize on the region’s layered geography by exploiting multiple producing zones (conventional and unconventional) from one surface drill point. The Permian is divided into basins such as the Delaware Basin and Midland Basin which are further divided into zones, or stacks, such as the Wolfcamp, Spraberry, Clearfork, Avalon, and Bone Springs.Issues & Future PotentialThe easiest, cheapest oil and gas to extract from the Permian Basin was produced long ago making many areas uneconomical to produce at low oil prices. However, Permian wells tend to be more efficient than pure shale plays because they drill through many productive layers. For example, Wolfcamp wells are estimated by Bloomberg Intelligence to have the lowest break-even point of any U.S. shale oil play. The Permian will benefit from continued technological advances, development of less-known, potentially productive layers, and an abundance of low cost support services and pipelines.Permian Production
Baker Hughes collects and publishes information regarding active drilling rigs in the United States and internationally. The number of active rigs is used as a key indicator of demand for oilfield services & equipment. However, rig counts can be misleading if not considered along with production. Rig counts in the Permian drastically decreased in late 2014 and throughout 2015. However, production did not experience the same decline. This demonstrates that producers with average or poor locations, higher costs, and inefficiencies were forced out of the market, while those with good locations and lower costs continued to drill for oil and gas in the Permian.
AVAILABLE RESOURCEQuick Facts: Permian BasinDownload this information in a convenient, one-page PDF. Download
3Q16 Call Reports
The Times They are A-Changin’
After a rough start to the year, the asset management industry is facing a new reality dominated by passive managers and rising regulation. Although most publicly traded active managers have benefited from a relatively stable third quarter, management comments suggest fee pressure is on the rise and margins have compressed as pricier offerings from hedge funds and PE firms continue to underperform the market. However, the greatest concern this past quarter has been the impending Department of Labor’s Fiduciary Rule. The ruling prohibits compensation models that conflict with the client’s best interests, and is expected to create pressure on active managers to provide lower-cost, passive products and to complete the shift from commission-based to fee-based accounts.1 With the final implementation date less than six months away, we expect the ruling and its consequences will be the topic of discussion for several quarters to come.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: With a better understanding of the various requirements of the DOL’s Fiduciary Rule, asset managers are focused on reassuring investors of their compliance and anticipating costs of implementation.Well, the rule is slightly less onerous than was originally proposed, so compliance with it will be more manageable than it might have otherwise been. We don’t anticipate any significant issues in complying with it. […] But I do think the DOL changes are going to have – and we’ve all talked about this, all meaning all people in the industry have talked about it – are going to have significant adjustments to how financial advisors engage with their clients all over the country. And it’s going to have a significant effect on what those clients actually populate their accounts with, meaning active versus passive. It will have a significant effect on the fees that managers charge, the manner in which those fees are charged and the manner in which the advice is given. It will have an effect on how services are arranged, how services are modelled, how risk controls are actually reviewed, how firms actually create consistency around their risk management and around the advice they give in that channel. […] None of it is particularly clear, meaning specifically clear. Generally, it’s absolutely clear, meaning that as transparency goes up, there is more fee pressure, the character of the assets in the funds are going to be subject to greater scrutiny from a firm-wide point of view. – Alliance Bernstein’s Peter KrausIf clients believe they have a fair opportunity to be in the market to build a better financial future for themselves, if they believe the Department of Labor rules gives them that security that people are working on their behalves, and they put more money to work and keep and keep getting, moving money out of all this cash into bank deposits into the financial markets, we will be the best-positioned firm for that. So we welcome these changes. – BlackRock’s Laurence FinkFee pressure is not new, and so, this is sort of a grinding long-term pressure on the industry. I don’t think we’re going through a fork in the road right now, specifically. I think the DOL legislation creates additional pressure, more grinding. – Janus Capital’s Richard MaccoyWe believe success under the new DOL construct will require a more institutionalized process for both investment management and the sales and marketing parts of our organization. By institutionalize, I mean the ability to clearly articulate a product’s investment philosophy and process with all relevant data analytics related to portfolio construction, risk parameters, attribution analysis, sources of alpha generation, etc. – Waddell & Reed’s Philip James SandersTheme 2: Despite slightly improved market conditions, the plight of the active manager remains challenged as both regulation and consumer sentiment continue to favor passive management.For the market, the past quarter was a solid performance period across most asset classes and a generally better environment for the performance of active management. And while one quarter does not make a trend, we are encouraged by this, as we benefited across a number of our portfolios. 2016 investment performance has gradually improved across the complex as the year has progressed, but we understand that this is a process and will take some time to get back to our historical levels of success. I will note, however, that the improved investment performance of active managers industry-wide did not translate into active management flows regaining traction versus passive. – Waddell & Reed’s Philip James SandersI don’t think there’s anybody that I’ve spoken to in the active world that doesn’t see the DOL as a challenge in the active to passive debate. […] And so yes, I think the early on reaction is going to be to keep it simple, passive is going to be easier, it’s low cost. How do you argue with low cost? But over time that low cost solution is going to have a cost. Unless you assume that there’s just no alpha in the world, and that’s a pretty tough assumption, because we know there is alpha in the world. The question is what do you pay for it. – Alliance Bernstein’s Peter KrausAs we’ve been reading almost every day in the press and as we discussed in our 2015 Letter to Shareholders, most active managers are battling significant headwinds. Disruptive innovation, waves of new regulations and unprecedented market interventions are adversely affecting broad swaths of active only, active long only and alternative managers. This has manifested itself in persistent organic decay and fee pressures for a majority of these managers, but especially for those that are focused on core style boxes. We are anticipating that going forward these trends will intensify rather than abate. – Cohen & Steers’s Bob SteersTheme 3: In light of continued fee pressure and shrinking margins, most companies within the RIA industry are pausing to take a hard look at their expense structures. As we discussed a few weeks ago, the industry is in need of consolidation as the current market has exposed a number of weak performers.Well, I think that the lower growth environment is clearly going to make companies think hard about how do they expand their income, if not their margins. On a standalone basis that becomes more and more challenging. And so that does lead people to think about consolidation. The interesting question is how much expense can you take out when you put these organizations together? And that, I think, that remains a challenging transaction or a challenging process for the industry. - Alliance Bernstein’s Peter KrausLooking ahead and taking into account current industry trends, we are planning to closely manage expenses while also selectively investing in people and new products to compete globally for a share of asset allocations. This will mean adding select investment vehicles and fund share classes, both here and intentionally, selectively adding depth to our existing investment teams, and being competitive and forward-looking with regard to investment management fees and expenses. – Cohen & Steers’s Bob SteersWe have viewed this as an opportunity to rethink our internal structure within this changing, converging industry context. And as a result, we are bringing together many elements of retail, unaffiliated and institutional efforts, including relationship management, marketing and product, and in addition, restructuring some aspects of wholesale sales management. We believe this will make us more efficient and responsive to industry trends and also create meaningful expense savings. – Waddell & Reed’s Thomas W. ButchEnd Note1 “Implications of the Final DOL Fiduciary Rule for Asset Managers.” DST Kasina. April 2016.
The Fair Market Value of Oil and Gas Reserves
A couple of weeks ago we looked at Exon Mobil Corp.’s lack of asset write-downs to understand different values placed on oil and gas reserves in a GAAP, Non-GAAP, and IFRS context. This week we explain how to find the fair market value of oil and gas reserves.
Oil and gas assets represent the majority of value of an E&P company. The oil and gas financial journal describes reserves as “a measurable value of a company's worth and a basic measure of its life span.” Thus understanding the fair market value of a company’s PDP, PDNP, and PUDs is key to understanding the fair market value of the Company. As we discussed last time, the FASB and SEC offer reporting guidelines regarding the disclosure of proved reserves. But none of these represent the actual market price. It is especially important to understand the price one can receive for reserves as many companies have recently sold “non-core” assets to generate cash to pay off debt and fund operations.
The American Society of Appraisers defines the Fair market value as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.1The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach. The IRS provides guidance in determining the fair market value of an oil and gas producing property. Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF). When valuing acreage rights comparable transactions do provide the best indication of value. However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.Cost ApproachThe cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.Market ApproachThe market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices. A comparable sale should be for a property that is located within the same play and within a field of similar maturity. Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors. Thus the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.Income ApproachThe income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount. Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.In practice, this method requires that:
The appraiser project income, expense, and net income on an annual basisEach year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basisThe total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income.
Although the income approach is the least preferred method of the IRS, these techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves, and most closely resembles the financial statement reporting requirements discussed in our previous post. This method is the best indication of value when a seismic survey has been performed and reliable reserve estimates are available. In order to properly account for risk, we divide the reserves by PDP, PDNP, PUD, Probable, and Possible reserves. We will review the key inputs in a DCF analysis of oil and gas reserves below.Cash InflowsIn order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price. Estimates of production are collected from Reserve reports which are produced by geological engineers.The forward price curve provides monthly price estimates for 84 months from the current date. Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example a company may sell raw crude to the distributor at 65% of Brent.Cash OutflowsMany E&P companies do not own the land on which they produce. Instead they pay royalty payments to the land owner as a form of a lease payment. Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property. Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.DiscountOil and gas reserves can be based on pre-tax or after-tax cash flows. Pre-tax cash flows make reserve values more comparable as tax rates vary by location. When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.Risk Adjustment FactorsWhile DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of the Probable and Possible reserve categories. A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC). You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below.
The low oil price environment forced many companies to sell acreage and proved reserves in order to generate cash to pay off debt. In order to create a new business models in the face of low oil prices, it is critical for companies to understand the value of their assets. The valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
End Note1 American Society of Appraisers, ASA Business Valuation Standards© (Revision published November 2009), “Definitions,” p. 27.
RSP Permian / Silver Hill Energy: A Closer Look at the Acquisition
On October 13, 2016 RSP Permian (RSPP) announced the acquisition of Silver Hill Energy (SHE) for approximately $2.4 billion dollars. SHE will receive approximately $1.182 billion in RSPP common stock and $1.25 billion in cash. Based on RSPP disclosures, the assets received include (1) wells currently producing 15,000 barrels of oil equivalent per day (BOEPD); and (2) 41,000 in net acreage throughout Loving and Winkler County Texas. Approximately 69% of the current production is crude oil. Based upon the consideration given by RSPP, here is the implied market value of invested capital (MVIC) for SHE:
The other side of the transaction ledger is the value of the individual assets acquired. Since SHE is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value. 1
Before venturing into our approach to the allocation, we have compared pricing multiples of the SHE acquisition and other oil and gas public companies. At the time of the transaction, SHE owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for SHE versus the market pricing multiples for publicly traded operators in the Delaware Basin.
Valuation Metrics
Based upon these ratios2, we have the following observations:
RSPP is approximately 2x larger than SHE;Of the seven public companies, SHE is very close in size to Matador Resources Company (MTDR). SHE has acreage adjacent to acreage operated by MTDR;Based on per day production, the SHE transaction was priced at the highest indicated value;Based upon net acres acquired, the SHE transaction was priced at the higher end of the indicated value of all the publicly traded companies. Note that approximately 95% of the acreage acquired is considered developed;
Based upon these observations, we have the following commentary on SHE:It appears the majority of SHE’s asset values are in the producing 58 wells:
95% of the 41,000 net acreage is considered producing;49 of the 58 producing wells are horizontal;Less than 5% of the net acres are undeveloped;58 wells over 39,050 acres equates to well spacing of one per 673 acres. While 49 are horizontal wells, it appears they may be opportunities to add additional wells;Additionally, with less than 5% of the net acres to be explored, a higher than average BOEPD multiple may be explainable.Lastly, based on the data reviewed to date and the location of SHE’s acreage, RSPP may have identified opportunities to recomplete existing wells, with longer lateral and horizontal wells which may produce from other resource plays within the area.
The following map, disclosed by RSPP, shows the acreage position within the resource play as well as the depths of the highly sought after Wolfcamp resource. According to this map, SHE’s acreage is centered in the deepest portions of the Wolfcamp, approximately 7,500 to 8,500+ feet. This location allows for penetration into multiple zones. RSPP has thus far identified seven zones they would target. Additionally RSPP has identified other wells around the acquired acreage (shown below) that have seen success from multi-zone production. Some of these wells are that of SHE, others from competing operators. 3
Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) 58 wells currently producing 15,000 barrels of oil equivalent per day; (2) proved developed reserves; and (3) 41,000 net acres, of which 5% are considered undeveloped. The valuation for current production and proved developed reserves is fairly straight forward. No doubt SHE prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Financial Statements. It would also be helpful to understand more about SHE’s decision to sell and perhaps the financial situation immediately prior to the sale. If SHE was backed by private equity investors rather than a typical oil and gas operator, management could have had different reasons to exit their investments. Timing may also have played a part as Permian dominated assets currently appear to be selling for a Premium compared to other domestic plays.Synergistic efficiencies. Drilling efficiencies have been disclosed by RSPP, but we don’t know how many are new well locations verses recompletion of existing into multiple resource plays.
Much of the acquisition details have not been disclosed, and we’ll wait for additional filings from RSPP to learn more. Regardless, RSPP’s acquisition of SHE ranks as a top five E&P related transactions of 2016 based on size and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
End Notes1 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information.
2 BOEPD = Barrels of Oil Equivalent Produced Per Day
PD Reserves = Proved Developed Reserves
3 RSP Investor Presentation Acquisition of Silver Hill on October 13, 2016
TriState Buys Aberdeen’s Domestic Fixed Income Business
A Pleasant October Surprise
In the late 1960s, BMW introduced a simple product that made the company what it is today. The 2002 was a straightforward, useful, two door coupe with a small but powerful motor, light weight, four seats, and a decent trunk. It was economical, easy to work on, and fun. It sold like crazy, and morphed over time into what is now known as their 3-series, the mainstay of their global automotive line. One lesson from this trajectory is that strategy doesn’t have to be complicated to be successful – a lesson that has broad applications, including the topic of this blog post.It’s no secret that banks are facing tough times, with lousy spreads, exponential increases in regulation, indifferent customers, and cunning competition. There are many fancy ways to navigate this, but one simple one is deploying capital in attractive financial businesses that generate strong margins – such as asset management.Banks looking to diversify their revenue stream with investment management fee income would be well advised to study TriState Capital’s acquisition-fueled buildout of its RIA, Chartwell. The Pittsburgh depository started with an internal wealth management arm, bought $7.5 billion wealth manager Chartwell Investment Partners in early 2014, picked up the $2.5 billion Killen Group in late 2015, and last week announced the acquisition of a $4.0 billion domestic fixed income platform strategy from Aberdeen Asset Management.The Aberdeen acquisition represents about $4.0 billion in domestic fixed income over four strategies. Realized fees appear to be just shy of 20 basis points. Six portfolio managers from Aberdeen are coming with the acquisition, and the operation looks fairly profitable on a pro forma basis, with TSC expecting EBITDA on the order of $3.5 million (annualized on a run rate basis), for a margin of approximately 45%.A few things stand out about the TriState/Aberdeen acquisition.Consistent acquisition criteria. TSC has a well-defined acquisition criterion for growing the RIA that has remained consistent from the original Chartwell acquisition. Appropriate and well-defined criteria are significant for any bank looking to augment asset management products through acquisition, because in many cases there are too many, often dissimilar, RIAs from which to choose. TSC seeks out asset management capabilities with compatible product structures, competent management teams, and consistent profitability that will grow and enhance their existing business. They also have consistently shopped within their existing geographic markets.Attractive Pricing. TriState’s acquisitions are consistently well-bought. Aberdeen had a strategic motivation to sell these fixed income products, which were a small enough part of their overall business to let go of fairly cheaply. As a consequence, TSC is paying 1.5x run-rate revenue, and more importantly, a little less than 4.0x EBITDA – a very compelling valuation that sets up TriState Chartwell for an attractive internal rate of return.Embracing the RIA Strategy. TSC appears to have gotten past the usual cultural angst that depository institutions have developing an RIA. The TriState investment management business has a separate identity, and it doesn’t seem to bother bank management that these acquisitions are dilutive to the bank’s tangible book value – in fact, they don’t even mention it. The RIA does what it is supposed to do – deploy the bank’s excess capital to produce discretionary cash flow. The bank’s earnings grow, and so does the bank’s valuation.
With the latest acquisition, TSC has nearly doubled run-rate assets under management since 2014, putting excess capital at the bank to work in attractively priced acquisitions which have been individually and collectively accretive to earnings. The strategy has worked well for TriState, and investors have taken notice. Over the past two years, TSC’s share price is up nearly 80%, while SNL Securities’ Small Cap U.S. Bank Index is up less than half that much. Asset managers in general have fared much worse, with the broad U.S. Asset Manager Index constructed by SNL showing a modest decline over the same period.
Many banks are understandably wary of trying their hand at investment management. RIAs are a different kind of financial institution in every way, cross-selling is often more myth than reality, and it can be difficult to explain to bank investors how to reconcile the differences in investment management performance characteristics and more traditional bank measures. Still, in a world where banks are caught in the gravitational pull of low NIMs and Basel III, and the asset management industry is in need of consolidation, there is ample reason to consider the possibilities of pairing up for mutual success.
Oil and Gas Reserve Values
This is the first of two posts in which we will investigate the different values placed on oil and gas reserves in a GAAP, Non-GAAP, IFRS, and fair market value context. As an example we will consider Exxon Mobil Corp., the nation’s largest energy company, which is under investigation for its lack of asset write-downs amid falling oil and gas prices.
The Exploration and Production sector focuses on finding and using oil and gas reserves; thus the value of an E&P company exists in the value of its reserves. For many companies, such as professional service firms and tech start-ups, book value is meaningless from a valuation perspective because the true value of the company is not reflected on the balance sheet. But, because E&P companies’ value lies in the value of their reserves, investors often look to book value in order gauge future performance. In order to protect investors from misleading information, the SEC, FASB, and IFRS have specific rules for reporting and accounting for proved reserves.
When we talk about reserve values there is a difference between the fair market value of reserves, the value of reserves as shown on a company’s 10-K, and the GAAP standard measure for oil and gas reserves. The SEC uses a reported value known as PV-10 in order to make proved reserves comparable across companies. PV-10 is the value of reserves calculated as the present value of estimated future revenues less direct expenses discounted at an annual rate of 10%. But, PV-10 is a non-GAAP accepted measure. The FASB’s ASC 932 requires a similar standardized measure for the value of proved reserves called SMOG (standardized measure of oil and gas). SMOG is calculated with the same methodology as PV-10 but deducts income taxes whereas PV-10 does not.
Both PV-10 and SMOG require (1): reserve estimates (2): a sales price and (3): an estimate of cost.All reserve estimates involve some degree of uncertainty, which can be minimized with dependable geological and engineering data and proper interpretation of the data. There are two methods of reserve estimates. While both are based on geological, engineering, and economic data, a deterministic estimate is single estimated value while a probabilistic estimate is a range of values given with their associated probabilities.The price of oil/natural gas used to calculate future income must be the twelve-month average price not the year end spot price.While the SEC and FASB provide guidelines for what should be included as a direct expense, costs, realistically, are estimated differently by every company leading to some inconsistency in these standardized values across firms.
The SEC’s Modernization of Oil and Gas Reporting requires that PUDs only include wells that are “economically producible” within five years. As the price of oil dropped in 2014, companies had to revise revenue estimates for many of their wells and some wells were no longer considered economically viable during the SEC’s five year time period. Thus many companies had to reclassify certain proved reserves as probable or possible reserves.
Bradley Olson, of the Wall Street Journal, reported:With low crude oil and natural gas prices, billions of barrels of fuel in the ground cannot be tapped cost effectively, making reserves revisions and write-downs staples of oil-patch earnings in recent years, and helping push energy company losses to record levels.Competitors of Exxon have booked over $200 billion of write downs since oil prices collapsed in 2014, but Exxon has not recorded losses associated with reserve write downs. Exxon says that they have not written down the value of their reserves because they use conservative accounting techniques when they initially book the value of new fields and wells. Unlike its competitors, Exxon’s proved reserves only consist of fields in which “management has made significant funding commitments toward the development of the reserves.” Exxon’s CEO challenges management to make sure that capital expenditure projects will be viable even in a low price environment. Thus, when the price of oil fell Exxon claimed that they still had the necessary funding to develop its PUDs and did not have to write down the value of its reserves. However, if a 60% drop in oil prices did not impair reserve values, then maybe Exxon’s reserves were undervalued before.The SEC recently broadened the definition of proved reserves as:those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible—from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations[… ]The SEC elaborates on many details such as what is a reasonable time frame, what part of the reservoir is included as proved, and when can improved recovery techniques be used to estimate future production. But there is still room for interpretation. Although Exxon executive, Alan Jeffers said that Exxon is confident that its financial reporting is legal, it is clear that Exxon has used the somewhat ambiguous definition of proved reserves to do something different than many of its peers. Additionally, this investigation overlaps with another investigation into Exxon’s asset values in consideration of the future cost of environmental regulations and the global response to climate change.Just as there are differences in reporting standards when determining the value of proved reserves, there are differences in the way companies determine if reserves are impaired. Companies that have overseas operations often keep two sets of books because they must also follow International Financial Reporting Standards (IFRS). Both GAAP and IFRS have the same goal of making sure that assets are not reported above the value that could be recovered from liquidating the asset, but they have different methodologies to determine if an asset is impaired. Under IFRS, future discounted cash flows are compared to the book value of the asset, while under GAAP, undiscounted future cash flows are compared to book value. Although the threshold of impairment is higher under GAAP, GAAP write downs cannot be reversed when economic conditions recover, unlike IFRS write downs which are reversible. In order to write down assets, discounted cash flows are used by both IFRS and GAAP.It is important to remember, especially, in a low oil price environment that the reserve values presented on company’s 10-Ks may not be an accurate representation of fair market value. Fair market value represents the price at which property would change hands between a hypothetical buyer and seller. Next time we will discuss how to determine the fair market value of oil and gas reserves.Contact Mercer Capital to discuss your valuation needs in confidence and learn more about how we can help you succeed.
M&A in the Permian: The Trend Continues
Last week, we looked at the recent transition of E&P companies out of the Bakken and the Eagle Ford to the Permian. We concluded that E&P companies are moving to the Permian for its (1) upside potential, (2) low break even prices, and (3) diversity of resources. This week M&A activity reinforced this idea. In the last week, there were 18 E&P deals in the U.S.1 Seven of those transactions were in the Permian and over half of the total deal value generated ($768 million in total) from September 30 to October 6 was in the Permian. Today we focus on two transactions: Resolute Energy’s acquisition of Delaware Basin Acreage and Apollo and Post Oak Energy’s merger to form Double Eagle Energy Permian. Before we drill down the details of these transactions, here’s a breakdown of total announced deal value generated in the U.S. this year.Resolute Energy / Firewheel Energy TransactionResolute Energy, a Denver based company, received notice twice in 2015 that it was at risk of being delisted from the NYSE and its EBITDA fell so low that the Company considered a Chapter 11 restructuring in late 2015. The Company sold its Powder River and Midland Basin assets for $275 million which allowed it to reduce its debt and increase its drilling activity in the Delaware Basin. Since then they have more than tripled their Delaware Basin output. They estimated third quarter output for 2016 to be between 16,000 and 16,500 Boe/d, which is a 37% increase from the second quarter of 2015.On October 4 Resolute announced its acquisition of 3,293 acres in the Delaware Basin from Firewheel Energy, a portfolio Company of EnCap Investments. The acquired acreage will increase Resolute’s position in Reeves County in the Delaware Basin by 25%, according to their press release. The acquired acreage includes thirteen horizontal and fifteen vertical wells, which produce approximately 1,200 Boe/d.Resolute’s purchase price consisted of $90 million payable in cash and $45 million payable in common stock. Although Resolute’s stock had been at risk of being delisted just 9 months prior, the Company was able to increase the value of its stock by refocusing operations in the Permian, which investors have lately placed a premium on, and by participating in a one-for-five reverse stock split. This allowed the Company to fund this transaction with common stock and generate cash to fund the acquisition with an offering of a new class of preferred shares.Resolute reported the value of the Proved reserves as $45.8 million and Undeveloped Acreage as $79.8 million.Double Eagle Lone Star LLC / Veritas Energy Partners Holdings LLC MergerTwo private-equity backed E&P companies recently merged their Permian focused operations. Double Eagle Lone Star LLC, an affiliate of Apollo Global Management, assembled a portfolio of assets in the Powder River Basin, the DJ Basin, Mid-Continent, Eagle Ford and Permian. The Company sold its SCOOP (South Central Oklahoma Oil Province) and STACK (Sooner Trend Anadarko Basin Canadian and Kingfisher Counties) assets for $250 million in order to transition its focus away from Anadarko Basin in Oklahoma to the Permian in west Texas. Veritas Energy acquired acreage mainly in the Midland Basin and Fort Worth Area and formed a partnership with Post Oak Energy Capital to focus on increasing acreage in the Midland Basin. The two announced their merger on October 3rd. The new Company will have more than 63,000 net acres in the Permian’s Midland Basin. The deal values were not disclosed.Analysts with 1Derrick predict that the Company was formed in order to prepare for an IPO in order to take advantage of the high equity valuations of pure play Permian producers. Industry averages of EV/ Boe of proved reserves are estimated to be $13.45, while Permian producers multiples are often higher than $25 / Boe.2In order to prepare for an IPO, however, Double Eagle Permian will have to focus on developing its assets as only 70% of the assets are currently operated. The Texas Railroad commission reports that the combined Texas production of both Double Eagle and Veritas is about 3,000 Boe/d. The appeal of the Permian to market participants is the low cost of drilling. Thus in order to reach its full potential, the Company must be able to achieve the double-digit production growth that many of its peers have.These two transactions demonstrate that market is currently placing high value on the equity of companies located in the Permian and E&P companies are doing what they can to take advantage of this. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs.End Notes1Only includes packages valued at greater than $100 million.
21Derrick
Recent Bribery Scandal, Another Blow to Alternative Asset Managers
Just a few days ago, the largest publicly traded hedge fund, Och-Ziff Capital Management Group, agreed to pay $413 million to settle federal charges that it disbursed more than $100 million in bribes to African government officials. Even before this announcement, the hedge fund industry was in quite the slump. Since June of last year, publicly traded hedgees and PE firms have lost 40% of their market cap. We’ve discussed the many headwinds facing this industry in prior posts but generally speaking, investors are simply fed up with the low return, high fee combination that has recently characterized the industry, particularly over the last year and a half. The Fed’s anti-volatility campaign hasn’t helped matters, and isn’t likely to abate any time soon.
The Och-Ziff scandal reveals another potential headwind that isn’t necessarily company-specific. While difficult to measure, reputational risk is very real for these businesses that rely heavily on investor trust, transparency, and overall status within the financial community to raise capital. FIFA-like scandals are unacceptable to institutional investors already wary of high fees and sub-par performance.
With this as a backdrop, it is hard to envision much of a silver lining. Still, as we’ve noted in a prior post, asset bubbles are relative. With a third of the developed world selling bonds at negative yields, and the U.S. stock market trending up after six straight quarters of earnings declines, bidding for any return at all in the private company space looks, at least on a relative basis, attractive. Fund raising is still alive and well in alt assets, and should be for some time to come.
The old 2 and 20 management fee / carry model, however, is on life support and probably not going to make it - at least not as the industry standard. The few PE firms and hedge funds still capable of charging such high rates are consistently in the top 5% of investment performance, and sustaining that level of alpha over the long term is nearly impossible. One and ten over a predetermined hurdle is the new normal, and even that could come under pressure if performance continues to suffer while fees tighten for other classes of asset managers.
A glance at current multiples doesn’t reveal much except that Blackstone’s earnings are likely depressed, and analysts are expecting some recovery next year as LTM multiples exceed forward P/E ratios for most of these businesses. In an era of fee compression and passive investing, this seems optimistic, though some mean reversion is entirely possible. AUM multiples, on the other hand, have always been high for this sector and are likely to remain that way due to performance fees and non-asset-based sources of income for PE firms. Still, with most of the group trading close to their 52 week high, any significant upside seems unlikely, and OZM shares may never recover.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
M&A Overview: Race to the Permian
M&A activity in the exploration and production industry has recovered from the standstill experienced one year ago as oil and gas companies waited to see what the market would throw at them next. When crude oil prices dropped, companies reduced their exploration budgets and stopped drilling new wells. When prices remained low, many companies began to sell off non-core assets in order to generate cash to pay off debt. Companies, who cut drilling activity when prices collapsed, are now looking to replace their reserves through acquisitions. Bloomberg analysts predict that the majority of M&A activity going forward will be asset purchases as E&P companies look to acquire more than 50% of their reserve replacement.The majority of these transactions have occurred in the Permian. This year, 38% of total E&P deal value was generated from deals in the Permian, and 24% of the number of total deals occurred in the Permian.1 This demonstrates that more deals and larger deals are happening in the Permian than in other plays in the U.S.
Last week we looked in depth at EOG’s acquisition of Yates Petroleum for $2.5 billion. The acquisition helped EOG shift from the Eagle Ford into the Permian. EOG’s CEO Bill Thomas told investors, “We’ll be able to grow oil (production) with less capital and more efficiently than we do now.” EOG’s share price rose by more than 6% the day after the transaction.
E&P companies are flocking to the Permian for many reasons, including its (1) upside potential, (2) low break even prices, and (3) diversity of resources.
Upside PotentialAlthough the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells. Because the crude in the shale layers have only recently been explored, there are still tremendous reserves left.Low Breakeven PricesThe Permian has low break even prices compared to other reserves in the U.S. Although production costs may not be as low as Pioneer Natural Resources CEO, Scott Sheffield, boasted ($2.25 per barrel excluding taxes), costs are lower than other plays due to the geological makeup of the shale.The Permian is a stacked play which means that multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs like the Permian, a multilateral well eliminates the cost of drilling the total depth twice.2In many plays, the low price of crude oil has made drilling uneconomical. Many companies are trying to acquire acreage in the Permian, where production is cheaper, because it is unclear when crude prices will rise and if they will ever rise to the same levels as before.Diversity of ResourcesThe Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus. Even as gas prices collapsed, production in the Permian increased. Companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations. The market for commodities is inherently risky because producers are price takers. Although related, the price of natural gas and crude oil are not perfectly correlated. Thus when the price of natural gas fell six years ago, producers in the Marcellus and Utica were entirely exposed to the natural gas market, while producers in the Permian were able to rely on their profits from crude oil to fund operations.
Exploration and Production companies are trying to get their hands on acreage in the Permian now before the next swing in crude oil prices. OPEC agreed on Wednesday to cut its production of crude oil. IEA analysts believe that the proposed cuts to between 32.5 million and 33 million barrels per day would bring production back in line with demand until the second half of 2017. Definitive policies are expected to be set in November, but there still remains doubt that the deal will be able to relieve supply due to OPEC’s inability to enforce these quotas.
This uncertainty about the future price of crude oil has caused producers to leave other plays and increase their acreage in the Permian. Consequently, this has increased acreage prices in the Permian compared to other plays, such as the Bakken and Eagle Ford. A summary of some transactions in the Permian this year is shown below.
Callon Petroleum increased its position in the Permian the same day as the EOG / Yates transaction. Callon was traditionally an offshore driller in the Gulf of Mexico. They began shifting out of the Gulf in 2010 due to the high costs of offshore drilling and sold their last offshore asset in 2013. Since then the company has steadily been increasing its stake in the Permian. Since the second quarter of last year the Company has increased production by 56%, while at the same time reducing capital expenditures by 48%.3 The company has recently been using its highly valued stock to fund acquisitions in the Permian. The price of Callon’s stock price has tripled since January even though they have increased their shares outstanding by 50% over the same time period. This demonstrates investor’s confidence in the Permian.
The valuation implications of reserves and acreage can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs.
End Notes1 1Derrick
2 New Aspects of Multilateral Well Construction. Fraija, José; Ohmer, Hervé; and Pulick, Tom. Online Available at http://www.slb.com/~/media/Files/resources/oilfield_review/ors02/aut02/p52_69.ashx.
3 1Derrick
Performance Fees are Dead! Long Live Performance Fees!
Earlier this month, Mercer Capital had the pleasure of helping sponsor the Southern Capital Conference, an annual gathering of venture capital and private equity GPs, as well as the LPs who invest with them. Many of the firms and investors were from the Southeast, but there was some representation from the New York-Boston corridor and even a few from Palo Alto. If you believe everything you read about this segment of the investment community, you might expect a fair amount of groaning from the General Partners, with private equity managers under pressure to improve performance, negotiate fees, and increase transparency. The reality was very different.This particular conference started meeting annually over 30 years ago, when alternative asset funds like PE and VC were a cottage industry that appealed to a small niche of investors. Now this conference is just one of hundreds of alt asset conferences held in the U.S. every year. With all that growth and development there has inevitably been some change in the space, and no doubt there is more to come. I was reflecting on this at the conference when a friend emailed me an article about the 1954 introduction by Mercedes-Benz of the 300SL, best known for distinctive gull wing doors which other car companies have tried to emulate, including Tesla in their Model X.Today we would call a 300SL an “exotic” car, but in the mid-1950s there was no such thing. One of Mercedes’s distributors, Max Hoffman, suggested the development of a mildly toned-down Grand Prix racer into a fast but comfortable road car. The 300SL was a technological marvel at the time, with a focus on aerodynamics and a tubular space frame that necessitated the famous doors. It was also the first car to feature direct fuel injection, which has only recently become common in passenger vehicles. The Gullwing was the fastest production car at the time. It was also very expensive, similar in price to a contemporary Ferrari and well above the rest of the Mercedes line. In exchange for paying an exorbitant price and tolerating difficult ingress and egress, the 300SL buyer got quite a conversation piece and leading performance. It worked; and in the process Mercedes discovered a whole new product category.The enduring appeal of private equity and hedge funds seems to mimic the success of the Gullwing. Pay managers more for the hope of better returns, and in exchange accept less transparency and liquidity than one could achieve allocated to registered securities. This sentiment was echoed by the closing speaker at the conference, head of a wealth management firm serving ultra-high net worth families. After giving us what has become a fairly common forecast of much lower returns from equities and bonds, he explained that he’s commonly suggesting private equity to his clients - not just for diversification but also to boost returns. Fees are high, yes, but at least this one wealth manager thought you get what you pay for.So there was little lament about fee compression or LP demands at the conference. If anything, the concerns voiced by the GP community were that there was too much money chasing too few opportunities. It’s tough to “make your money on the buy” when you get locked in a bidding war with four other firms for the same portfolio company – as the price bids up, the prospective return on investment bids down. The entry prices paid with recent vintage year PE funds portend lower returns going forward – even if a fund avoids unicorn rounds and IPO downrounds.That said, asset bubbles are relative. With a third of the developed world selling bonds at negative yields, and the U.S. stock market trending up after six straight quarters of earnings declines, bidding for any return at all in the private company space looks, at least on a relative basis, attractive. So fund raising is still alive and well in alt assets, and should be for some time to come.This isn’t to say, though, that change isn’t on the way. We all know that the tremendous growth of the PE space hasn’t come strictly from wealthy families who can stomach huge return volatility and illiquidity. Much of the growth has been sovereign wealth funds, pensions, endowments, and other institutional class investors that ultimately have to serve the public good. The SEC has gotten interested in the industry, and that only leads to one outcome: more uniformity, more transparency, and more competitive pricing.So what’s next for performance fees? We have some clues to this mystery in Mercedes’s development of its successor to the Gullwing: the 230SL. Introduced nine years after the original SL, the model was upgraded twice over its nine year product life, and provided a more conventional sports car than the Gullwing. The 230SL wasn’t the fastest production car when it was introduced in 1963; it was powered by a stock inline-six cylinder motor that Mercedes used in other vehicles (the 300SL had a unique engine derived from the German Messerschmitt ME109 fighter aircraft). Nor did the 230SL have as much distinctive bodywork, although the large greenhouse of the hardtop was affectionately nicknamed the “Pagoda-Top.” But despite being a more conventional product, the 230SL was every bit a performance sport car, was cost effective to produce, and was profitable to sell at about two-thirds the sticker price of the original 300SL. Mercedes sold fifteen-times as many Pagoda-Tops as they had Gullwings, in the same number of model years.So, despite the fact that alternative investment vehicles are inevitably going to endure some homogenization, increased regulation, and some fee compression, there remains a need for the product category. And we think performance fees will endure – at least as long as there is still some performance to fee.1964 230SL. Photo Credit: Wikipedia
EOG/Yates Merger
A Closer Look at the Acquisition
On September 6, 2016 EOG Resources (EOG) announced the acquisition of Yates Petroleum (Yates) for approximately $2.4 billion dollars, by our calculations. Yates will receive approximately $2.2 billion in EOG common stock and $37 million in cash. In addition, EOG assumed $114 million (net) in Yates debt.1 Based on EOG’s disclosures, the assets received by EOG include (1) Wells currently producing 29,600 barrels of oil equivalent per day (BOEPD); (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage throughout New Mexico, Wyoming, Colorado, Montana, North Dakota and Utah. Approximately 48% of the current production and proved developed reserves are crude oil. Based upon the consideration given by EOG, here is the implied market value of invested capital (MVIC) for Yates:
The other side of the transaction ledger is the value of the individual assets acquired. Since Yates is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value and their key information items.2
Before venturing into our approach to the allocation, we have compared pricing multiples of the Yates acquisition and other oil and gas public companies. At the time of the transaction, Yates owned acreage rights in several domestic resource plays with the most popular resource play of 186,000 net acres in the Delaware Basin. The below chart shows the implied pricing metrics for Yates versus the market pricing multiples for publicly traded operators in the Delaware Basin.
Valuation MetricsBased upon these ratios, we have the following observations:3EOG is approximately 25x larger than Yates;Of the six public companies, Yates is very close in size to Matador Resources Company (MTDR);Based on per day production, the Yates transaction was priced at the lowest indicated value except for Apache Corp (APA);Based upon net acres acquired, the Yates transaction was priced at the lowest indicated value of all the publicly traded companies;Based on proved developed reserves, the Yates transaction was priced at the highest indicated value of the group.
Based upon these observations, we have the following commentary on Yates:The attractive upside for Yates is not in the current production, but in the undeveloped acreage, possibly adjacent to EOG acreage (explains the low MVIC to BOEPD metric);Of the acreage that Yates owned, a large majority of it is not highly coveted by Yates and EOG (explains the low MVIC to net acre metric);Of the proved developed reserves known by Yates, EOG believes they can develop significantly more reserves in the future (explains the high MVIC to proved developed reserves metric);As the interest for EOG does not appear to be in vast amounts of acreage that Yates owns, the current production nor the developed reserve, this leads us to believe the highly coveted Delaware Basin positions were the primary drivers for the acquisition.Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) Wells currently producing 29,600 barrels of oil equivalent per day; (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage. The valuation for current production and proved developed reserves is fairly straight forward. No doubt Yates prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.Acreage Owned by Yates
The highly publicized acreage includes: (1) 186,000 net acres in the Delaware Basin; (2) 138,000 net acres in the Northwest Shelf; (3) 200,000 net acres in the Powder River Basin and (4) other western basins which add up to 1.1 million net acres. The following maps, disclosed by EOG, show the resource plays Yates owned acreage within. These resource plays range from Texas to Canada. Of the eight resource plays named in the map, EOG classifies two as the “best plays”. These are the Delaware Basin and the Powder River Basin.
Delaware Basin
EOG then allows us a closer look at the location of Yates acreage in the Delaware Basin in comparison to EOG’s acreage. Many instances exist where Yates acreage is right next to EOG’s acreage, this could allow for longer and more cost effective lateral wells. Market transactions for acreage in this area vary significantly based on seller motivation, buyer synergies and commodity price timing. Our experience indicates acreage rights historically transact from $50 per acre to $14,000 per acre and above, depending on location.
Northwest Shelf
Another map comparing Yates and EOG’s acreage location in the Northwest Shelf shows less instances where the two companies acreage is connected but clearly demonstrates Yates is seemingly centered in the most desired areas of the Northwest Shelf. In addition to these two plays, the map shows Yates acreage located in northern Chaves and Lea counties. EOG does not show any acreage in these areas. Our historical transaction data indicates acreage rights transact for $50 to $350 per acre in northern Chaves, Lea, and Roosevelt counties. Compare this to the Delaware Basin and Northwest Shelf areas which have spots that historically transact for $5,000 per acre and above.
Powder River Basin
EOG also discusses their interest in the Powder River Basin. As the map shows, EOG has significant acreage positions in the middle of the play. Similarly, Yates has large clumps of acreage rights in the same general area and in some cases, right next to EOG. This tends to indicate efficient drilling benefits may exist in the Powder River Basin too. Similar to the resource plays in New Mexico, acreage rights pricing varies widely by location.
Drilling DeeperMore information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions.Financial Statements. It would also be helpful to understand more about Yate’s decision to sell, and perhaps, the financial situation immediately prior to the sale. What we know is approximately 48% of the current production is oil which leaves 52% of the production as either natural gas or natural gas liquids. This leads us to ask: is Yates an example of oil prices exposing a struggling natural gas company? Yates had $245 million in debt, and $114 million in net debt. Based upon our calculated $2.3 billion MVIC indication, debt is approximately 4.85% of the capital structure. While this is just a guess on our part, this doesn’t indicate a financially stressed company. It does make us question their ability to obtain additional financing for new wells.Synergistic efficiencies. Drilling efficiencies have been disclosed by EOG, but we don’t know how many new well locations EOG created by having access to Yates acreage. Yates may not have been able to release on their own for many reasons.
Much of the acquisition details have not been disclosed and we’ll wait for additional filings from EOG to learn more. Regardless, EOG’s acquisition of Yates was one of the largest E&P related transactions of 2016 and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
End Notes1 $245 million in Yates debt less $131 million in Yates cash
2 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information.
3 BOEPD = Barrels of Oil Equivalent Produced Per Day, PD Reserves = Proved Developed Reserves
5 Trends to Watch in the Medical Device Industry in 2016
Medical Device OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons 65 and above) totaled 48 million in 2015 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 98 million, representing 24% of the total U.S. population.The elderly account for nearly one third of total healthcare consumption. Personal healthcare spendingfor the 65 and above population segment was $19,000 per person in 2012, five times the spending per child ($3,600) and almost triple the spending per working-age person ($6,600).According to United Nations projections, the global elderly population will rise from 608 million (8.3% of world population) in 2015 to 1.8 billion (18.1% of world population) in 2060. Europe’s elderly are projected to reach 28% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to experience drastic transformations over the next several decades, with the over 65 population segments expected to expand from 8% in 2015 to more than 23% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.2 trillion in 2015 to $5.6 trillion in 2025. Healthcare spending as a percentage of GDP is also expected to expand from 17% in 2015 to over 20% by 2025.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 57 million elderly and disabled Americans, constituting approximately 15% of the federal budget in 2015. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2014. Medicare also accounts for 26% of hospital spending, 29% of retail prescription drugs sales, and 23% of physician services.
Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Netoutlays to the four parts of Medicare totaled $540 billion in 2015, and spending is expected to reach $709 billion by 2020. Between 2000 and 2010, growth in Medicare spending per capita was comparable or lower than private health insurance spending.
The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades by curtailing increases in Medicare payments to healthcare providers, and establishing several new policies and programs designed to reduce costs. On a per person basis, Medicare spending is projected to grow at 4.3% annually from 2015 and 2025, compared to 5.7% average annualized growth realized from 2000 to 2014.
As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The 2.3% levy was expected to net nearly $30 billion over a decade into the early 2020s. The tax became effective on December 31, 2012, but met resistance from industry participants and policy makers. In July of 2015, the U.S. House of Representatives voted to repeal the medical device tax. In late 2015, Congress passed legislation promulgatinga two-year moratorium on the tax beginning January 2016.
3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (the patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers typically receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.
The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models by the end of 2016 and 2018, respectively. In March 2016, the HHS estimated 30% of Medicare payments were tied to alternative, value-based models, nearly one yearahead of schedule. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.
The medical device industry faces similar reimbursement issues globally. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down industry product prices. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.
4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth re- view, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete.
Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval, as well as establishment registration. The current iteration of the act, MDUFA III, was enacted in 2012 and expected to collect approximately $400 million in user fees over five years. The FDA and the medical device industry have reached a broad agreement on the outlines of the next iteration. The FDA is expected to collect nearly $1 billion in user fees over five years pursuant to MDUFA IV, which would go into effect in in October 2017.
Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the U.S. FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU, the Company’s second largest end market behind the U.S. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold on the market. This CE marking verifies that a device meets all regulatory requirements for the EU, and that they meet EU safety standards. A set of different directives apply to different types of devices, and the device must be compliant with the directive that purviews it.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa) have seen an increase in healthcare spending as a percentage of total output over the last two decades.
Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia and Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.
SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.
Quick Facts: Eagle Ford
Over the previous weeks, we have discussed specific factors in the Eagle Ford like DUCs (Drilled but Uncompleted Wells) and how certain operators behave in this resource play. Today, we take a step back and review the broad characteristics of the Eagle Ford Shale resource. Download this information in a convenient PDF at the bottom of this post.Eagle Ford at a GlanceFirst Discovered2008Discovery as Viable Play2008Primary ProductionOilOil TypeSweet, Light CrudePlayUnconventional ShaleDrillingHorizontal, Multi-Stage Hydraulic FracturingTop 3 Production CompaniesEOG Resources, BHP Billiton, Conoco PhillipsBreakeven$27 – $63 per barrel 1Abnormal DUCs416 2Production Since 20074,338 MMBOE 3IssuesLikely to have High Entry Cost & Low Oil PricesPotentialLow Breakeven Oil & Gas Prices due to High Productivity per Well & New Play so Large Amounts of Oil & Gas Remain1 Bloomberg Intelligence county-level estimates
2 Drilled Uncompleted Wells with > 3 months in inventory as of January 2016; also referred to as fraclog (Bloomberg Intelligence)
3 EIA as of June 2016Eagle Ford ShaleLocated in south Texas, the Eagle Ford is the most active shale play in the world. The shale’s potential was first recognized in 2008 when the first drillers, Petrohawk, found natural gas. Soon after that, other drillers began to enter the play and discovered not only significant natural gas reserves, but also large quantities of oil. Since then companies have invested heavily in Eagle Ford, with almost $30 billion spent on developing the play in 2013. In 2015, 57% of production was oil, and 43% of production was natural gas.As with other oil and gas formations, the current price environment hampers profitability. However, the region has some of the lowest natural gas breakeven prices in the U.S. (according to Barclays) and the lowest shale oil breakeven prices after the Permian (according to Bloomberg). Such low costs are likely to attract many large players to the region, particularly as other areas struggle. This in turn will raise the cost to enter the play.Undiscovered, Recoverable Resources in Eagle FordResource Estimate*Recoverable Oil994 MMBRecoverable Natural Gas52,428 BCFRecoverable Liquid N.G.2,059 MMB*Estimate calculated from the mean undiscovered, recoverable reserve estimates in the 2011 USGS report.The U.S. Geological Survey (USGS) completed a geology-based assessment of the undiscovered, technically recoverable oil and gas resources in Upper Cretaceous strata of the U.S. Gulf Coast region, which includes the Eagle Ford Group. The amount of undiscovered, recoverable natural gas in the Eagle Ford exceeds that in the Permian Basin.Eagle Ford Production
Baker Hughes collects and publishes information regarding active drilling rigs in the United States and internationally. The number of active rigs is used as a key indicator of demand for oilfield services & equipment. However, rig counts can be misleading if not considered along with production. Rig counts in the Eagle Ford drastically decreased in late 2014 and throughout 2015. However production did not experience the same scale of decline. This demonstrates that producers with average or poor locations, higher costs, and inefficiencies were forced out of the market, while those with good locations and lower costs continued to drill for oil and gas in the Eagle Ford.
AVAILABLE RESOURCEQuick Facts: Eagle FordDownload this information in a convenient, one-page PDF. Download
Characteristics of a Good Buy-Sell Agreement
The creation of buy-sell agreements involves a certain amount of future-thinking. The parties must think about what could, might, or will happen and write an agreement that will work for all sides in the event an agreement is triggered at some unknown time in the future. This article addresses the important characteristics of buy-sell agreements that are important for business owners and for attorneys advising them.What Do Buy-Sell Agreements Do?Buy-sell agreements are entered into between corporations and their shareholders to protect companies against disruptive, harmful, or nonproductive owners (including divorced spouses, competitors, disgruntled former employees and the like). They also provide protections for shareholders who may, for any number of reasons, depart the company. The estates of deceased owners need protection, as do shareholders who have been terminated, with or without cause.It is important that buy-sell agreements be entered into while the interests of the parties (the corporation and the shareholders) are aligned, or at least not sufficiently misaligned, that they cannot discuss the business and valuation aspects of their buy-sell agreements. To the extent possible, attorneys should encourage parties to enter into buy-sell agreements or to review their agreements and update them if they are out of date or circumstances have changed.What is known for certain is that once a trigger event has occurred, the interests of the parties (i.e., the buyer(s) and the seller(s)) diverge and agreement over the pricing and terms of necessary transactions can become difficult or impossible to achieve.Characteristics of a Good Buy-Sell AgreementFrom valuation and other business perspectives, buy-sell agreements generally incorporate several important aspects defining their operation. The list of characteristics of successful buy-sell agreements below is taken from my book, Buy-Sell Agreements for Closely Held and Family Business Owners.Require agreement at a point in time (before trigger events or other dissension) among shareholders of a company and/or between shareholders and the company. It may seem obvious, but if there is no agreement between the shareholders and the company, then there is no buy-sell agreement. Such agreements must be evidenced by a writing of the agreement and by the signatures of all parties who will be subject to the agreement. Agreement is not always easy to obtain. Shareholders have different backgrounds, financial positions, personal outlooks, and involvement with a business, so agreement is not automatic. However, it is important that attorneys continue to work with clients to encourage agreement and that business owners remain committed to reaching agreement and signing their buy-sell agreements.The point in time at which agreement is reached is the date of the signing of each particular buy-sell agreement.Relate to transactions that may or will occur at future points in time between the shareholders, or between the shareholders and the corporation.When the shareholders of a new venture come together to discuss a buy-sell agreement, it is foreseeable that many things can happen that will trigger the operation of a buy-sell agreement. Owners may quit, one may be fired, another may retire, one could die, still another could become divorced, and another could become bankrupt — to name a few.The owners can discuss these future potential trigger events and which ones they want to include specifically in their buy-sell agreements. It is important that all owners think seriously about these issues because, at the time a buy-sell agreement is being drafted, no one knows what might happen to him or to her or to any of the other owners. In other words, no one knows who will be a buyer and who will be a seller.When the owners of an existing enterprise come together to review their buy-sell agreement, they may know that some of the above-mentioned events have already happened in the lives of their fellow owners. They will know if the buy-sell agreement operated satisfactorily, or was triggered at all.For all owners of all enterprises, discussions about buy-sell agreements reflect a form of future thinking, which is sometimes (perhaps always) difficult. As Yogi Berra famously said: “The future’s hard to predict. It hasn’t happened yet.”Choices have to be made regarding buy-sell agreements. Ignoring the importance of these documents because it is difficult to future think about them is one choice. Based on over thirty years of working with businesses and business owners, ignoring the issue is not a good choice.Define the conditions that will cause the buy-sell provisions to be triggered. Most often, business owners think of death as the most likely trigger event for buy-sell agreements. It is actually the least frequent trigger event for most companies.Trigger events have to be defined specifically. Death is fairly obvious. However, firings can be with or without cause, and agreements may need to specify what happens in each circumstance. The parties to an agreement must future think a bit to anticipate what could happen and document the agreement appropriately. If this sounds like work, it is.Determine the price at which the identified future transactions will occur (as in price per share, per unit, or per member interest). Because of the diverging interests of parties following trigger events, this is one of the hardest parts of establishing effective buy-sell agreements. This is why many appraisers and other advisers to closely held businesses recommend appraisal with a pre-determined appraiser as a generally preferable pricing mechanism for substantial business enterprises.There are buy-sell agreements with fixed prices. Unfortunately, these agreements are seldom updated and are ticking time bombs. For a poster child example of what can happen with fixed price agreements, read here.Other buy-sell agreements contain formula pricing provisions. Unfortunately, we haven’t seen a formula yet that can reasonably value any company over time with changing conditions at the company, within its industry and markets, in the local, regional or national economies, and in all market conditions and interest rate environments.Then, there are what we call valuation process agreements, which provide for a valuation process to determine the price. Many agreements have an embedded multiple appraiser process which will not be exercised until the occurrence of a trigger event. These agreements, too, are fraught with potential pitfalls.We assert that the best pricing mechanism for most buy-sell agreements of successful closely held and family businesses is a single appraiser process where the appraiser is selected by the parties at the outset and provides an appraisal to determine an agreement’s initial pricing. The appraiser is then asked to provide reappraisals each year (or every other year at most) to reset the price for the buy-sell agreement.Determine the terms under which the price will be paid.Many buy-sell agreements call for the price determined under their terms to be paid by the issuance of a promissory note by the company. Quite often, the price determined by appraisal will be the fair market value of the interest. However, many notes defined in buy-sell agreements are not worth par, or their face amounts, so recipients end up getting less than fair market value for their interests.A promissory note might be worth less than par if it has a below market interest rate for notes of comparable risk. Often, there is no security for promissory notes issued in connection with buy-sell agreements, and no protection against future financings that are subordinated, leaving the promissory note less protected.Provide for funding so the contemplated transactions can occur on terms and conditions satisfactory to selling owners and the corporation (or other purchasing owners). This element is important and often overlooked.Life insurance is often considered as a funding mechanism for buy-sell agreements. One big problem is that the only time that life insurance is received is when an insured owner dies. However, death is the least likely trigger event for most companies. Firings, retirings, divorcings, disabilities, and other things happen with far greater frequency.Funding may come from a promissory note as discussed above. It can also come from outside financing if the company is able to obtain such financing. Sinking funds have their own issues, because a selling shareholder was present while any sinking fund was accumulated, and would likely desire to share in its value.Satisfy the business requirements of the parties. While buy-sell agreements have much in common, each business situation is different, and unique parties are involved. In the end, legal counsel must draft buy-sell agreements to address the business issues that are important to the parties. Clearly, establishing and agreeing on the key business issues and having them reflected in the agreement can be difficult. If the owners do not reach agreement on key business issues, no attorney can draft a reasonable document for the parties.All of the potential trigger events discussed above are business issues (and personal issues) for business owners. Other business issues could include the maintenance of relative ownership between groups of shareholders, the admission of additional shareholders, and other issues that may or not relate directly to potential future trigger events. Some family businesses add clauses in the event of a shareholder’s divorce to preclude the shares from being granted to a divorcing spouse who is not of direct lineal descent of the family.Provide support for estate tax planning for the shareholders, whether in family companies or in non-family situations.One client of many years has a buy-sell agreement and the family has engaged in significant gift and estate tax planning. Several years ago, the gift tax returns of the owners of a client company were audited. Agreement could not be reached with the Internal Revenue Service, and the matter proceeded on a path towards Tax Court. One of the key issues in dispute was whether the buy-sell agreement met the requirements of IRS Code Section 2703 (b). After much discussion and preparation for trial, agreement was reached that the buy-sell agreement withstood the exceptions (subparagraph (b)) to the general rule of Code Section 2703:(b) Exceptions
Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
(1) It is a bona fide business arrangement.
(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
(3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.As part of the preparations for trial, I was asked to render a supplemental report on behalf of Mercer Capital to assist the court in analyzing the relevant shareholder agreements from business and valuation perspectives. Fortunately, the case settled on the eve of trial with agreement that the relevant agreement satisfied the requirements, and with settlement at the conclusions of fair market value issued by Mercer Capital for the relevant years. The issues raised by the relationship of buy-sell agreements and estate planning are important.Satisfy legal requirements relating to the operation of the agreements. Buy-sell agreements must be drafted such that they are legally binding on the parties to them. In addition, agreements must be drafted to comply with laws and/or regulations that may be applicable to their operation. Business owners must rely on legal counsel regarding such matters.Business owners must agree on the business and valuation issues relevant to their buy-sell agreements. However, those agreements must be memorialized by competent legal counsel, who should be involved in the discussions to begin with, together with estate planning counsel, other financial advisers and a qualified business appraiser.ConclusionBuy-sell agreements are business and legal documents that are created in the context of business, valuation and legal requirements. We need to engage in future thinking in order that our agreements will withstand not only the tests of time, but also potential challenges from the Internal Revenue Service.
An Investor’s View of Major League Sports Franchises: Outsized Returns or a Risky Play?
This following article was originally published by The Texas Lawbook.
It has been often discussed, particularly in recent years, that the value of privately held professional sports franchises is a newsworthy item. Analysts, investors, and fans alike have an interest in observing team owners buy and sell teams and watch the prices at which they trade. However, are team owners doing as well as some may portray? How about their investments as compared to their investing peers in the stock markets.
We attempt to answer these questions based on some known data sources and return analytics over time. The answers are interesting but not entirely clear.
There are two components to an investor’s rate of return: (i) interim returns in the form of cash flows or dividends, and (ii) price appreciation. Many commentators and writers have noted that some major league sports franchises have incurred operating losses in past years. For example, at one point it appeared that the MLB franchises on average had operating losses as players’ salaries increased faster than revenues. This was a big factor underlying the NFL and NHL lockouts in 2011 and 2012. There is a silver lining, however, and that appears to be the price appreciation realized from the increased values of these major league franchises.
We traced over time the estimated appreciation (by league) of the values of sports teams, according to Forbes magazine. We also tracked the returns over the same time frames of several familiar equity market indices. The table below summarizes our findings.
We tracked this data going all the way back to 1991. We then sorted the returns over different decades – the 1990s, the 2000s, and our current decade. We aggregated it for the 25 total years of data.1
We observe that equity markets outperformed league appreciation in the 1990s, but the leagues caught up in the 2000s and 2010s. The biggest reason for the significant increase in the 2000s and the 2010s (among others) is television contracts – specifically, increases in national TV contracts for the NFL and NBA and regional and local contracts for MLB and NHL (and to a lesser degree the NBA as well).
Consider a few examples:
The NFL had its national TV contract increase dramatically in the last several renewals, most significantly, the most recent one. The 2014 season was the first year of the NFL’s nine-year deal with Fox, CBS, and NBC. The networks will pay about $3.1 billion in rights fees every season or 63% more than the previous TV deal.The NBA, which signed a nine-year deal with ESPN and Turner Broadcasting and other networks, had total fees worth $24 billion in 2014. This skyrocketed to $3.6 billion a year, up from about $930 million in the contracts reached in 2007. In addition, NBA teams have benefited from increased local TV rights that have usually doubled or even tripled in annual rights fees in the last 5 years.For MLB and NHL teams, the majority of the TV revenue comes from local TV contracts. These contracts have also appreciated substantially in the last five years increasing 3 to 5 times in comparison to the contracts signed 5 to 7 years ago.
This increased TV revenue has been the primary driver of the very strong price appreciation in the 2000s and particularly in last five years (2011-2016).
In the last five years (2011-2016), the MLB team values have increased on average 19.8% compounded according to Forbes. The NBA Forbes value estimates increased by 27.6% for the same period. The NFL increased 17.4% and the NHL 21.3%. This short 5-year period has seen the highest percentage increase in the last 25 years. The compounded increases are 10% to 13% for the four major sports leagues over a 25-year period (1991-2016). In comparison, the DOW increased 7.4% compounded, the NASDQ 10.1% the S&P 500 7.0% and the Russell 2000 8.2%.
Therefore, solely from an appreciation point of view, an investment in a major league sports franchise appears to have been a very good return in the last 25 years, especially in the last five years. Of course, these returns vary by team and nothing is guaranteed. It is also notable that some teams have incurred operating losses that will offset a significant amount of the total return. This can impact investments in the form of debt or even capital calls from investors. This gets even more complicated when considering the value of minority interests in teams whereby the ability to monetize their returns is more uncertain. In fact, minority interests typically trade (however infrequently) at lower value levels than what the pro-rata value of a franchise would otherwise be worth. Therefore, appreciation returns that appear positive can come with drawbacks as well. Critical analysis is important to investors to help them determine if their returns are worth the risks.
Mercer Capital has arguably the most expertise in sports valuation and related stadium advisory in the country. For more information, contact one of our professionals.End Note1 We would note that Forbes does not have access to many team financials as teams are closely held (with the notable exception of the Green Bay Packers).Forbes relies on limited data and educated estimates of actual revenues and profits in order to make their estimated values.This is a limiting factor to properly value a single franchise at a single point in time.That said, as part of Forbes’ analysis they have interview access to a number of team owners to test the reasonableness of their valuations and key assumptions.In addition, their estimated values are adjusted year-to-year to account for actual sale prices of teams that sell.This is helpful when observing estimated aggregate values over a long period of time.
Long Term Value Drivers in the Eagle Ford
Get Your DUCs in a Row
The Eagle Ford Shale is one of the largest economic developments in the state of Texas. Almost $30 billion was spent developing the play in 2013. However, that figure dropped off dramatically in 2015 and 2016. In the wake of that drop-off some of the key residuals of that investment remain and are still on the precipice of becoming more active. These residual investments exist in the form of drilled, but uncompleted horizontal wells – sometimes known as “DUCs” or “Fracklog”.Economically, these DUCs function as a form of storage for companies who do not want to complete and produce these wells at current pricing. Thus, they sit idle – waiting to be completed and graduate to a full-fledged producing PDP well. This is a phenomenon that exists in all the major shale plays in the U.S. and second only to the Bakken, the Eagle Ford has the largest inventory of DUCs (460) in the U.S.
Many of the big shale producers are jumping on board the fracklog bandwagon. The largest U.S. shale producer to fracklog is EOG Resources (EOG). It started 2015 with 200 DUCs and announced it would “intentionally delay” about 85 more wells this year (these are overall figures, not Eagle Ford specific). Anadarko Petroleum (APC) said it expects to have about 440 uncompleted wells by the year’s end.
As a point of comparison, last week there were only a total of 44 rigs in the Eagle Ford, as compared to 205 at year-end 2014.
As it pertains to the Eagle Ford specifically, Chesapeake leads the way with 86 DUCs with several other major Eagle Ford players with significant counts as well.
Producers have hoped this would bring value to their shareholders, by delaying capital expenditures and functioning as storage for future reserves. These companies can then wait for more favorable oil and gas prices that justify the capital investment to complete the wells. This brings a favorable ROI to the costs, which is the core metric that management teams are tracking. How much value that this creates (or preserves depending on point of view) is linked to how much capital it requires to complete the well as compared to production and price (production x price = revenue). The Eagle Ford shale has pockets of some of the best possible wells for this ROI potential. Bloomberg Intelligence has estimated that breakeven prices for oil in the Eagle Ford can be as low as $27 per barrel. This helps explain why DUCs in the Eagle ford actually decreased in 2015 while other plays had a marked increase; several groups of wells in the Eagle Ford still had positive ROI’s and were economical to be drilled.
However, there is a flip side to simply waiting until oil prices go up. Some estimates claim it will take only one to three months to get production from these now-uncompleted wells. Bloomberg Intelligence has projected the output from these wells to be as high as three million barrels per day. This onslaught of new oil could serve to cap any rally in the oil prices.
“The destruction of production potential that we've needed to see to complete the bust cycle in oil and completely rebalance markets, allowing for a long-term constructive rise in the prices of oil and natural gas, have yet to be seen.” – Daniel Dicker, Real MoneyIf Eagle Ford producers wish to capitalize on these undrilled wells, timing, resources and capital must be ready to go when the time becomes right.
If the Pathstone–Convergent Combo is the Shape of Things to Come
RIA Heads Need to Remember that MOEs are Tricky
Culture trumps everything. A big part of RIA consolidators’ pitch to target firms is that they can trade paper, give the sellers access to their administrative and marketing infrastructure, but keep their unique culture. We’ll hear more about this as Focus Financial gets closer to their IPO. MOEs (mergers of equals) are a different animal, and not just because “some of us are more equal than others” (ask Tom Hiddleston). When firms of similar size join forces to get a bigger footprint, solve leadership issues, stop advisors from competing with each other, etc. – realizing those benefits is the easy part. The hard work happens because different firms have different histories, and different histories create different cultures. Blending cultures can be awkward. My father was on a business trip in Asia at Christmastime 30 years ago. He walked into a large mainline department store in Tokyo and was stunned at the holiday display just inside the front door: Santa Claus on a cross (!).I don’t know that Pathstone Federal Street is going to have quite as difficult a time merging in Convergent Wealth Advisors, but no doubt there will be moments. If it works, others will want to follow suit. If it doesn’t, it will be a cautionary tale we’ll talk about for some time. For now, it might be helpful for RIA managers considering MOEs to read the following piece written by one of our colleagues, Jeff Davis. Jeff usually works with depository institutions, but no doubt his checklist of dos and don’ts for MOEs will ring true in the investment management community as well.– Matthew R. Crow, ASA, CFA
When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote.
What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures.
Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share.
Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.)
Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair.
The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share, (for non-banks) tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.
What Would Warren Buffet Do?
[caption id="attachment_12679" align="aligncenter" width="349"] Photo Credit: Gus's Fried Chicken[/caption]
One of my favorite pastimes is sampling the amazing food Memphis has to offer. Many of the best restaurants are located in buildings that are unassuming – or sometimes downright disconcerting. I am a little hesitant about walking down back streets and into old buildings to find my next meal, but I find comfort in the reviews of others. With its Styrofoam plates and 40 ounce bottles of beer, Gus’s World Famous Fried Chicken may not seem very promising, but the reviews are excellent … “lurking below that crunch is a subterranean flesh so moist and tender that it almost defies reality.” How could you not give it a try?
We often rely on the reviews of experts for decisions as trivial as where to eat lunch. When it comes to investing, we pay even more attention to what the experts say.
It caught investors’ attention when Warren Buffet further increased his stake in Phillips 66 from 78.782 million shares as of June 30, 2016 to 79.6 million as of August 30, 2016. He now has invested over $6 billion in Phillips 66 and owns almost 15% of Phillips’ available shares. His recent move has sparked a lot of questions regarding what Warren Buffet was thinking.
Does he think the delayed effect of the export ban won’t hurt refining margins?Does he think crack spreads are on the rise for good?Or does he know something that I don’t?
Uncertainty currently surrounds the refining industry. In early 2016 the crude oil export ban that had been in place since 1975 was lifted. Industry experts thought that lifting the export ban would better align the production capabilities of U.S. refineries. Refiners, on the other hand, feared that the exportation of crude would increase crude prices, as the pressure on price, in an oversupplied U.S. market, gives way. Nine months later, we do not know all the consequences as the Brent-WTI spread is still insignificant. Once the spread widens — and it is cheaper for other countries to buy WTI and pay transportation costs than to buy Brent — the true effect will be understood. Until then, refiners should enjoy currently low input prices.
Adding to the uncertainty, the refining industry is heavily regulated. One of the newest rules is the Petroleum Refinery Sector Risk and Technology Review (RTR) and the New Source Performance Standards (NSPS) rule. The RTR & NSPS was passed in December of 2015 in order to control air pollution from refineries and provide the public with information about refineries’ air pollution. These regulations range from fence line and storage tank monitoring to more complex requirements for key refinery processing units. The rule is expected to be fully implemented in 2018. However additional time has already been proposed by the EPA. The EIA estimates the rule will cost refineries a total of $40 million per year, while the American Petroleum Institute (API) argued that the annual cost would exceed $100 million.
This uncertainty has led to a standstill in M&A activity.
While M&A Activity in the exploration and production sector has picked up since the beginning of 2016, M&A in refining and marketing has remained sluggish. Over the last nine months, the majority of the transactions in refining and marketing were between chemical and lubricant refineries and renewable fuels refineries. Currently, investors are sticking with what they know – demand for renewable fuels will increase and chemical lubricants are still in high demand.
The few transactions that occurred with petroleum transportation product refineries had very little public information. Thus we look to the public market in order to understand valuation multiples.
Since the fall of crude prices in 2014, valuation multiples have been through multiple cycles of compression and expansion. For refiners, low oil prices initially signal higher profit margins as refined oil product prices are not perfectly correlated with input prices. This is especially true for non-transportation refined product prices (such as asphalt, butane, coke, sulfur, and propane) whose prices are even less likely to respond to changes in the price of crude oil. Thus, upon the initial fall of prices, earnings increased because the price of refined petroleum products did not fall as quickly as the price of crude. Additionally, the low prices of crude oil and natural gas decrease refiners’ own operating expenses. Refining is itself an energy intensive process and natural gas is used to power refineries. By the fourth quarter of 2015, refiners’ margins began to compress as the price of refined petroleum transportation products started falling. Refiners’ profits continued to fall through the first quarter of 2016, but have since recovered as the price of refined products saw slight increases.1
Buffet’s move gave downstream investors hope that refining profits won’t disappear altogether as the oil and gas market changes.
Refining and Marketing valuation multiples are somewhat inflated in the current market due to compressed profit margins. This tells us that the market views refiners’ decline in earnings as temporary. Phillips 66 profitability is in line with the group average, but has a higher EV/ EBITDA multiple of 11.3x whereas the average is 9.1x. This is due to their comparatively large size and depressed first quarter earnings. Additionally Phillips 66 operations are not entirely concentrated in the refining industry. Phillips has well developed midstream operations which they have expanded recently. Midstream operations are not as sensitive to changes in price and thus do not face the same risk of margin compression.
Warren Buffet is known for making long term investments. His position in Phillips 66 does not imply smooth sailing ahead for the refining sector. Refiners’ inputs and products are both commodities, which means that the price they pay for inputs and the prices they receive for their products are generally determined by the market and out of their control. However, demand for refined products increases with the strength of the economy, and Chairwoman Janet Yellen’s recent announcement that an interest rate hike is on the table predicts that a strong economy is in our future. The oil and gas industry is still surrounded with uncertainty, but refiners have generally proven to be resilient through the oil market downturn. Despite the uncertainty, we can find some comfort from Warren Buffets recent investment decision.
I know that I will find the best food on back streets, in shacks in the Lowes parking lot, and in basements downtown, but reassurance is comforting. When I ask myself what would Warren Buffet do … I think he would eat fried chicken.
End NoteThe refiner marker margin (RMM) is a general indicator, calculated quarterly by British Petroleum, which shows the estimated profit refiners earn from refining one barrel of crude.
Twilio and the Rise Of Debt Financing
Despite the inhospitable IPO climate, one tech company managed to brave the market with just the right mix of novelty and disruption to garner attention and reap rewards. Twilio, a cloud communications platform designed to help developers add messaging, voice and video to web and mobile applications, went public on June 23. Priced at $15 per share, Twilio’s share price closed at $28.79, the largest single-day increase of an IPO in over two years, which increased the company’s market cap by 95% to nearly $2.4 billion. The next day, on June 24, the UK voted to leave the European Union. Brexit effectively wiped out over $2 trillion in global equity, ushering in weeks of market volatility and a freefall of the pound. Despite the global volatility, Twilio’s share price as of June 30 was up to $36.50 per share. Optimistic investors lauded the IPO as an indication of a turnaround in the venture-backed IPO market, and for good reason. Over the 2010 to 2015 period, more than half of the 200 tech companies that went public were trading below their initial IPO price by mid-2016.The number of venture capital exits completed in the second quarter of 2016 (153) was the lowest total since the second quarter of 2010, with only 19 venture-backed IPOs in the first half of 2016 (well below the 52 IPOs completed in the first half of 2015). As discussed previously, unfavorable IPO market conditions have led many companies to alternative exits such as M&A. A growing number of venture capital firms have also turned towards another source for cheap cash: debt.Given the current interest rate environment, several unicorns, including Airbnb, Didi Chuxing and Uber, have capitalized on the cheap debt available in the market as an alternative to issuing more equity. The debt markets are proving unusually receptive to venture financing, for example giving Uber, a cash flow negative company with famously opaque financials, over $1.6 billion at 5.0%. Concerns over weaker credit standards in the banking industry have risen as competition for quality loans has driven down loan yields. Prolonged periods of low interest rates have compressed margins and impeded any profitability gained from an increase in loan growth alone. Since the Fed first announced progressive rate hikes in December, banks have positioned themselves as asset sensitive in order to benefit from an increase in rates that has yet to occur. In fact, thanks to Brexit and the wave of capital market uncertainty it created, the central bank has even discussed cutting short-term rates. In order to maintain profitability, banks need lending volume – which is where unicorns come in. Venture capital has taken advantage of the perfect storm that is the banking industry to acquire low-cost debt and build credit for future rate negotiations, should the need ever arise. In addition, private companies use debt financing to avoid breaching the 2,000 accredited investor threshold for remaining private. Crossing the 2,000 limit would require full disclosure of company financials, which could bring to light certain underperforming metrics these companies have been trying to overcome, as evidenced by their refusal to undergo an IPO. Whether more companies choose to go down the debt route is yet to be seen, but it is a financing vehicle that enables companies to avoid having to leave the sympathetic capital still available in private markets.
Three Reasons to Consider a Valuation of Your FinTech Company
“Nowadays people know the price of everything and the value of nothing.”– Oscar Wilde, The Picture of Dorian Gray
The above quote seems especially apt in the FinTech industry because the implied values of high-profile, private FinTech companies are often mistakenly reported by the media based on the share price paid by investors in a recently completed funding round. The problem with applying the pricing of the most recent raise to all shares is that the media rarely knows about investor preferences attributable to each funding. As a result, the value of the company is most likely overstated. Capital structures and shareholder preferences matter. Pari passu is not a given although it is often implicitly implied in media reports.
Consider the following example. Investors in a late-stage funding invest $100 million in return for 100,000 convertible preferred shares that represent 10% of the company’s post-raise fully diluted shares. The investors also get certain economic, control rights and other preferences with their preferred shares that earlier investors did not obtain. The headline notes that a new FinTech Unicorn has arrived because the implied value is $1 billion based upon the $100 million investment for the 10% interest; however, this simple calculation typically will overstate the Company’s value because the majority of the shares do not have the same rights and preferences as those purchased in the most recent financing round.
Valuing companies with limited if any operating history that involves a new technology is inherently difficult. The challenge increases when the subject has a complex capital structure. Nevertheless, valuations—whether reasonable or unreasonable—have very real economic consequences for investors, employees and other stakeholders, especially when new capital is injected into the equation. We are biased, but we believe private FinTech companies will be well served over the long-run to obtain periodic valuations from independent third parties. Reasons to do so include the following.1. To Measure Value Creation Over TimeOne of the best performance scorecard metrics to measure is value creation over extended time periods. For public companies, it is a simple process. Measure a company’s total return (percentage change in share price plus the return from reinvested dividends) and compare it to other benchmark measures such as the broader market, industry, and/or peers. For example, a publicly traded payments company whose shareholders have achieved a one-year total return of 10.0% can note on their scorecard that their performance has outpaced the returns from the S&P 500 and Mercer Capital’s FinTech Payments Index, which rose 4.0% and 4.6%, respectively, in the twelve months ended June 30, 2016.For private companies, annual or more frequent valuations have to be obtained to create a realistic scorecard. Rules-of-thumb exist in every industry, but they are at best approximations and often haphazard guesses that do not take into account the key value drivers of earning power (or cash flow generation), growth, and risk. Some privately held financial services companies like banks may be able to proxy value creation without annual valuations by tracking growth in book value, ROE, and dividend payments, but even for homogenous entities such as banks these metrics say nothing about an institution’s risk profile. FinTech companies with little homogeneity among business models are poorly suited to measure value based upon rules-of-thumbs that are applied to revenues or even EBITDA. Every company is unique, and markets in which companies are valued are not static.Also, there may be a tendency to overlook balance sheets beyond cash because FinTech balance sheets typically do not “drive” earning power as intangible assets, such as customer databases, intellectual property, patents, and the like, are not recorded unless there has been an acquisition. While understandable, ignoring the balance sheet can be a mistake because sometimes there are aspects to it that will impact value.Additionally, dividends (the other element of shareholder return) and dividend paying capacity should be an important value consideration, even though FinTech companies often do not or cannot pay dividends in order to reinvest internally generated capital to fund future growth. Another benefit of the valuation process might be insight that suggests the board should shift to distributions from reinvestment because incremental returns are too low to justify.It is advisable for private FinTech companies to measure value creation by having annual or more frequent valuations performed by an outside third-party. For example, consider Table 1 for Private FinTech Company that tracks returns to shareholders based upon changes in the appraised value of the shares and dividends paid over a three-year period. While the hypothetical 45% total return outwardly appears attractive, there is no context. Comparisons with publicly traded FinTech companies, broad industry indexes and realized returns following an acquisition for public and private companies will provide further relevance to the scorecard (Chart 1).2. For Planning PurposesProjections for an early-stage FinTech company are a given. In theory so too are rising valuations as important milestones, such as targeted market penetration, users, revenues, and EBITDA, are met. Unless the company does not require significant capital and/or internal capital generation is sufficient, the projections should incorporate additional capital raises and expected dilution based upon implicit valuations. On a go forward basis periodic valuations can be overlaid with the initial and any refreshed forecasts to measure how the company is progressing in terms of value creation relative to plan and to alternatives (e.g., a strategy pivot to a collaborative partnership from disruptor). The key is to measure and compare in order to have a contextual perspective to facilitate decision making.3. For Employee Ownership PlansFinTech companies usually attract talent by offering stock ownership so that employees share in the upside should the company’s valuation improve over time. Plus, stock-based compensation lessens a company’s cash needs all else equal. Complex capital structures with private equity investors that have preferences vis-a-vie employees create another potential valuation wrinkle. Returns to the two groups usually will differ. Well documented, periodic valuations are critical. There have been examples where employees have lost money by paying taxes based upon valuations higher than the company realized in a sale. While downside exposure to a company’s faltering performance and/or market conditions is the risk that comes with the potential upside of equity ownership, it is important to have a formalized valuation process to demonstrate compliance with tax and financial reporting regulations. Certainly, scrutiny from auditors, the SEC, and/or the IRS are likely at some point, but very real tax issues also can result from poorly structured or administered equity compensation plans for employees.ConclusionIf you are interested in discussing the valuation needs for your FinTech company, please contact us. Depending upon how it is defined FinTech is a relatively new industry “vertical.” Mercer Capital has been providing valuation and transaction advisory services to a wide swath of financial services companies for over 30 years that runs the gamut from banks to FinTech. Financials are our largest practice vertical. We have a deep bench and would be delighted to assist.This article originally appeared in the Second Quarter 2016 issue of Mercer Capital's Value Focus: FinTech newsletter.Learn More
Royalty Interests: First in Line, Last in Conversation
When the price of oil started its descent during 2014, the majority of media attention was, and still is, focused on exploration, production, and oil field services companies. While bankruptcy courts are busy deciphering reorganization plans and perhaps liquidations of companies, one group of oil and gas participants are getting little attention: royalty owners. While the last two years have been a rough ride, opportunities do exists for forward thinking royalty owners and investors.Although they are first to receive money from production, for the most part, royalty owners have been left to fend for themselves during this commodity price downturn. The lucky ones, holding their breath hoping their operator doesn’t go bankrupt, watched their monthly distributions fall to fractions of their 2014 payments. The unlucky ones haven’t seen a payment in months only to learn through media sources that their operator entered bankruptcy. When this situation occurs, many questions surface:What will happen to my royalty payments?What will happen to the lease contract?What legal action should I take?
While Mercer Capital does not provide legal advice we can provide guidance on valuing royalty interests in the current environment. For some guidance on the legal questions, refer to the the first end note.
Each of the questions above indicates uncertainty. As uncertainty increases, risk increases as well. As risk increases, the value of a given asset declines. But let us back up. When understanding the value of a royalty interest, it is important to understand its origin and its financial features.OriginRoyalties typically originate from an agreement between a land owner and an exploration and production (E&P) company. E&P companies that approach the owners of the property where they seek to drill wells, have two options: (1) purchase the land from the current owner; or (2) acquire the rights to drill and produce. Option two is typically cheaper, initially. The monetary components of a contract between the land owner and the E&P company is usually comprised of two components: (1) an up-front cash payment (commonly referred to as a lease bonus); and (2) a royalty interest in all future wells on the property.Financial FeaturesThe financial features of a royalty interest are best described in the definition of a royalty as follows: Ownership of a percentage of production or production revenues, produced from leased acreage. The owner of this share of production does not bear any of the cost of exploration, drilling, producing, operating, marketing, or any other expense associated with drilling and producing an oil and gas well.2Generally, royalty payments are made on a monthly basis for the production generated in the prior month. As the definition above indicates, royalty interests are not exposed to the costs of drilling, producing, or operating the well. In simplified terms, there are three main inputs driving the monthly royalty payment: (1) commodity price; (2) monthly production; and (3) royalty interest percentage. Royalty interest percentage typically will stay the same throughout the contract life, unless amendments are made. Therefore, any changes in the paystub come from changes in commodity price and production levels.Valuation of a Royalty InterestAs the financial features suggest, valuation of a royalty interest can be a straight forward exercise for an experienced professional with knowledge of the nuances. Typically there are two methods used to estimate the value of a royalty trust: (1) income approach and (2) market approach.Income ApproachA discounted cash flow analysis is based on the theory that the value of any investment is equal to the present value of its expected future economic benefit stream. In order to calculate the value one must project the future expected cash flows and discounts them back at an appropriate discount rate. Expected cash flows must project both anticipated production of the resource and anticipated prices for the resource. However, a discounted cash flow analysis is only as good as its inputs and as we discussed in our previous blog post, NYMEX future prices are no more than informed speculation. Thus the discount rate must appropriately compensate for the risk.Market ApproachAnother method used to calculate the value of a royalty interest utilizes market transactions of royalty interests in similar oil and gas resource plays. This can be done in two ways: (1) observing direct transactions of royalty interests; and (2) publicly traded royalty trusts.As a primer for O&G royalty trusts, these trusts hold various royalty and net profit interests in wells operated by large exploration & production companies. These trusts have little in the way of operating expenses, have defined termination dates, and can be an investment to provide exposure to oil and gas prices. This Motley Fool article, from 2014, explains the pros and cons of investing in this sort of vehicle.Market indications are available in the form of publicly traded oil & gas (“O&G”) royalty trusts. There are approximately 17 oil and gas focused royalty trusts publicly traded, as of the date of this article.Market ObservationsRoyalty trusts, like the rest of the oil and gas industry, have been hit hard as the price of oil fell. Here is a comparison of the 17 publicly traded royalty trusts’ metrics today versus one year ago.Observations and disclaimers:Price to revenue and price to distributable income indicate, on average, the trusts are cheaper now than a year ago.Yields were higher last year as trailing yields had not caught up to the quickly falling market price (from August 2014 to July 2015, the group was down 40% to 60%).Market prices have leveled off and yields have had a chance to catch up, resulting in lower yields compared to a year ago.Price to PV 10 is higher this year compared to last, primarily the result of timing differences between the releases of reserve reports (end of fiscal year, which for most is calendar year) the mid-year date we captured and the market price.The remaining observations are for commodity prices, both current and futures contract for the 12 month.Disclaimer: no two of the above royalty trusts are alike. Differences abound in asset mix, asset location, term, resource mix, just to name a few. In future blog posts, we will explore each trust individually and discuss their uniqueness.
Below is a chart of the market price performance for each royalty trust over the last two years.
The above chart looks very similar to the performance of the price of oil and gas over the same time period. Royalty interest owners have seen their monthly payments move in the same manner, and possibly have not experienced the small rebound over the first six months of 2016.
Uncertainty is high as operators have been forced to file bankruptcy after commodity prices have remained low for too long for them to survive. Depending on your situation, the current pricing environment may provide excellent planning opportunities as market prices are relatively low. With the Treasury Department attempting to change the way gift and estate planning can be performed, it is even more timely to execute a transfer plan. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.
End Note1 See the article, "Protecting Oil & Gas Royalties in the Event of Bankruptcy" from the Dallas Bar Association on the topic or the article, "Bankruptcy In The Oil Patch" by the Oil and Gas Financial Journal.
What Does the Market Think About RIA Aggregators? Focus Financial is About to Find Out.
My older daughter turns sixteen next month. Most parents dread giving their children vehicular independence, but I managed to repress that instinct by concentrating on the more delightful prospect of adding a new car to the family fleet: a Fiat 500. The original 500 (or Quattrocento) came out in 1957, and Fiat sold almost 4 million of them before they discontinued the model in 1975. Since Fiat announced they were returning to the U.S. market and bringing the Italian equivalent of Britain’s Mini or Germany’s Beetle, I wanted one. While I couldn’t make the Quattrocento work for me, I thought the size (big enough for four adults but easy to park), powertrain (peppy but economical), and unique features (like a folding fabric roof) made it perfect for a new driver who appreciates cars like her dad.Unfortunately, as my daughter’s sixteenth birthday approached, my fantasy of what she should drive had a head-on collision with reality. The Fiat’s small size is handy when you have to wedge your car down Italian city streets (I found one on vacation that was EXACTLY five inches wider than my rented Volvo wagon, with the side mirrors retracted), but not so pragmatic in our town, where every third vehicle is a giant SUV that probably wouldn’t even notice a collision with a 500. I think Fiat may have had the same realization, as their U.S. sales have been far lower than expected, and as a consequence has delayed the reintroduction of Alfa Romeo to the U.S. (a real tragedy). There are at least two lessons to be drawn from this: 1) sometimes bigger is unquestionably better, and 2) some ideas look a lot better on paper than in practice.I was reflecting on both of these themes last week after word got out that Focus Financial Partners had started preparing documents to file an initial public offering. Because Focus has less than $1 billion in revenue, it can keep details of the offering private until three weeks before the offering, so unfortunately we don’t have an S-1 to review. The Company itself hasn’t said anything about filing.Focus is another great idea, at least on paper, but has garnered success in a timeline littered with lots of bumps along the way. If they choose to go through with the public offering this time, their S-1 will be a treasure map of information about RIA consolidation, which is probably going to be as painful as it is inevitable.We have so many questions about the Focus IPO, it’s hard to know where to start. For example:Why Now?Focus is a ten year old company that has been headed for IPO since day one. Part of their pitch to prospective RIA targets is enabling them to ride the rise in Focus’s valuation at the offering. Focus previously started the filing process for an IPO last summer. So, in one regard, this isn’t unexpected.Further, Focus is backed by the VC/PE community, having picked up financing by Summit Partners in 2007 and Centerbridge Partners in 2013. Polaris is also still involved. The timing of those deals is noteworthy, because asset manager multiples were at peak levels in both 2007 and 2013 (so much for booking gains on the buy). We wonder if Centerbridge isn’t looking at the stakes Polaris and Summit have held – for longer than they wanted – and are seeking an exit while they can. We’ll probably never know why Focus didn’t go through with an offering last summer. Compared to a year ago, valuation multiples in the space aren’t any stronger, and the IPO market isn’t any more robust. One would think that Centerbridge, which has been in Focus for three years, would be getting impatient. However, if the stock market coughs and the IPO window closes, it could be some time before Focus is ready to go public again.About the only two compelling reasons we can come up with for a Focus IPO today is 1) the SEC’s proposed rules on transition planning and 2) scale. With regard to the former, the Focus IPO narrative will undoubtedly feature that it appears the SEC is going to require RIAs to document some kind of ownership exit strategy. Focus is all over this issue, and has the capacity and expertise to offer a pre-packaged solution to this aspect of SEC compliance. As for the matter of scale, Focus may be big enough now to garner a better valuation…How Much?Thinking about valuation may be a little premature, since we haven’t yet seen the S-1. Numbers on the order of $1 billion have been bandied about, but not whether that’s pre-money or post. Focus has plenty of debt and preferred stock (possibly north of $750 million), but since debt is cheap, one wonders if the company is in a hurry to pay it down. What we do know is that Focus currently has run rate revenue on the order of $400 million. If Focus is running an EBITDA margin between 25% and 35%, and the IPO prices at 9x to 12x EBITDA, Focus could deleverage and wind up with a balance sheet that looks a little more like a typical RIA, and/or get their VC and PE investors liquidity. The RIA managers who got stock by selling their shops to Focus will probably have to wait.Some have suggested that Focus is pulling a stronger EBITDA margin than my range, and could command a higher multiple. We admittedly don’t know enough to comment at length on margin expectations, but the infrastructure necessary to manage a consortium of small to medium size wealth management firms, some of whom are owned outright and some of whom are partially owned, is expensive. As for the multiple, I think it comes down to whether or not the market is ready to accept this business model.How is This Not a Roll-Up?More than anything, the Focus IPO will cast some light on what the market really thinks of RIA aggregators. Focus management has been, and will likely remain, defiant that their company is not a roll-up firm – probably because they don’t want to be compared to National Financial Partners. But I just did, and so will the market. A more favorable comparison might be to Affiliated Managers Group, but AMG’s valuation has also struggled recently, and is down by almost a quarter over the past year.That said, the notion of a national RIA focused on retail clients makes sense. What Focus and other firms like it are trying to assemble looks a lot like the retail side of the old wirehouse firms, absent all the conflicts of interest. But the RIA landscape may be fragmented for a reason, and re-assembling a diaspora of heterogeneous personalities and corporate cultures will undoubtedly prove challenging. I remember a client of mine in a different industry joining a roll-up in the mid-1990s, and being reassured that change would be “evolutionary, not revolutionary.”That sounds attractive, and Focus has made best efforts to create a platform that allowed acquired RIAs to maintain their individual sense of identity. Trouble is that the RIA industry is highly, and increasingly, regulated. The need for compliance and training and comparable pricing and marketing efficiency will create a gravitational force that will pull the dozens of individual RIAs acquired by Focus toward some regimented similarity.Nothing wrong with that; but it sounds a lot like a roll-up.
Does Fair Market Value (and its Associated Discounts) Avoid the Intent of 2704 and Thus “Undervalue” Certain Types of Transferred Interests?
[August 2016] The IRS released its long expected proposed regulations in regards to Section 2704 on August 2. The substance of this proposal, according to the IRS, is to regulate treatment of entities for estate and gift tax purposes. According to the summary the proposal is:“…concerning the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer (GST) tax purposes. Specifically, these proposed regulations concern the treatment of certain lapsing rights and restrictions on liquidation in determining the value of the transferred interests. These proposed regulations affect certain transferors of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests.”Before we delve any deeper on this article, let’s clarify a few things up front:We are appraisers, not lawyers and we are neither qualified nor particularly interested in dissecting the proposal from a legal perspective. Our friends in the legal community can address that.This is a proposal that, as of the writing of this article, is not in effect, could change, or might never go into effect. (Nonetheless we aim to comment from a valuation perspective as if it does).
With that said – what we hope to do in this post is to (i) give readers some context about the impetus of these proposed Section 2704 changes, (ii) share what these proposed changes are, and (iii) share what this might mean from a valuation standpoint.Background of the ProposalAccording to the IRS, treatment by taxpayers in regards to certain rights and transfers, as well as rulings of the Tax Court in regards to these rights and transfers have allowed taxpayers to avoid application of Section 2704. Representative of this sentiment, Page 6 of the proposal puts it this way when referencing Section 2704(b):“The Treasury Department and the IRS have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments.”The areas that the IRS cites as no longer ineffective fall into three primary areas:2704(a). Specifically the area covering so-called “Deathbed Transfers” – whereby liquidation rights lapse upon death. The IRS cites Estate of Harrison v. Commissioner as an example of this. The IRS claims that such transfers generally have minimal economic effects, but result in a transfer tax value that is based on less than the value of the interest.2704(b). Inter-family transfers and specifically restrictions on liquidation for family interest transfers. Reasons for this include that courts have concluded that Section 2704 applies to restrictions on the ability to liquidate an entire entity, and not on the ability to liquidate a transferred interest in that entity. Also the IRS says state laws and utilization of “assignees” have allowed taxpayers avoid 2704.2704(b). Granting of insubstantial interests to non-family members (such as a charity or employee) to avoid application of the statute. The IRS says this needs to be changed, because, in reality, such non-family interests generally do not constrain a family’s ability to remove a restriction on an individual interest.Proposed Changes and AmendmentsIn light of this perceived avoidance and ineffectiveness of certain provisions in 2704, the IRS has proposed a number of new regulations including:Change the definition of a “controlled entity” to be viewed through the lens of an entire family including lineal descendants as opposed to individual(s).Amend the regulations to address what constitutes control of an LLC or other entity that is not a corporation, partnership, or limited partnership.Amend the regulations to limit the use of eliminating or lapsing rights (voting or liquidation rights) and limit the exception to transfers occurring three (3) years or more before death.Ignore transfer restrictions for minority interests and thus assume that they would be marketable, regardless of governing documents and/or state laws.Ignore the presence of non-family members with less than 10% of the overall equity value.Valuation ImpactThe IRS is not proposing changing the definition of fair market value. However, when applying fair market value under the constructs as contemplated in the proposed 2704 changes, there would be a smaller (or perhaps no) value delineation for minority interests as compared to enterprise value of an entity. According to the IRS’s position, this would prevent taxpayers from “undervaluing” transferred interests among family members. This, of course, runs in stark contrast to the marketplace, of which fair market value is supposed to be a reflection. The marketplace’s long track record on this is abundantly clear - it differentiates for minority interests as compared to the value of entire enterprises. Thus the proposed regulations essentially circumvent the levels of value for family members as defined in a “controlled entity.”If the proposal is adopted as contemplated, there will be a powerful incentive for families with businesses and investment holding entities to initiate or complete transfers before these regulations take effect (which is thought to be December 2016). If Mercer Capital can be of any assistance in light of this development, please contact us.
The SEC’s Proposed “Transition Plan” Requirement is One More Reason to Think about your Firm’s Ownership
James Bond’s engineering mastermind, Q, makes his living out of planning for the unexpected. Over the years, the star of the franchise has been saved from nearly certain demise by a remarkable variety of devices – but none of them more preposterous than the one that saved Roger Moore’s character in The Spy Who Loved Me, in which Bond escapes a typical car chase in his Lotus Esprit by driving into the Mediterranean, only to have the car immediately transform into a submarine. The whole scene could have been a metaphor for Lotus Motors itself, which was very much underwater – financially – at the time.Lotus’s founder, Colin Chapman, was a genius at designing sports cars, but had a harder time making the business consistently successful. By the late 1970s, Lotus was gasping for air. Desperate for cash, Lotus got involved with John DeLorean to design his eponymous car, the DMC-12, and promptly got embroiled in the DeLorean scandal. The pressure built on Lotus and on Chapman, who died of a heart attack in 1982 at the age of 54. The untimely death of Chapman, coupled with poor sales and the ongoing investigation, almost bankrupted Lotus. Q may have planned ahead for the unexpected for James Bond, but Chapman unfortunately didn’t do a similar amount of planning for Lotus. As a consequence, the Bond franchise has been, all in all, more successful.Picking up on this, the SEC seems concerned about RIAs doing some planning for the unexpected, and hence they’ve unleashed 206(4)-7. By now you’ve probably read the SEC’s proposed rules on Adviser Business Continuity and Transition Plans. While there are two weeks left on the comment period, I’ve been a little surprised at how few comments have been posted, so far at least. Maybe that means the RIA community has decided this is inevitable, and they’re already looking forward to how to comply with the rules once they’re finalized.Most of the proposed rule simply codifies a reasonable standard for practice management at an RIA. Certain of the proposal’s requirements, such as IT management and being able to conduct business and communicate with staff and clients in the event of a natural disaster, are likely to be met with turn-key solutions from vendors. Mercer Capital has had some firsthand experience with these kinds of issues: we had to move to temporary quarters for a year after a fire in our office building fifteen years ago, and we provided an alternative location for a New Orleans-based valuation firm for a short time after Hurricane Katrina. It’s amazing what you can do with remote hosted data, laptops, and cell phones when you have to.Of more interest is how the requirement for a “transition plan” in the event of the death or incapacitation of an advisory firm owner will be implemented. The primary elements the SEC wants to see on business transition planning are:Policies and procedures that would safeguard, transfer and/or distribute client assets during transitionPlans for transitioning the corporate governance of the adviserIdentification of any material financial resources available to the adviserPolicies and procedures that would generate client-specific information needed to transition client accounts to a new adviserAssessing the applicable laws and contractual obligations governing an RIA and its clients that would be relevant given the adviser’s transition Again, much of this is check-the-box kind of stuff that will become fairly routine over time. The one sticky wicket, as we see it, is the requirement to have a plan to transition the corporate governance of the RIA. In other words, if a key owner becomes incapacitated, dies, or for whatever reason cannot fulfill his or her position on the organization chart, who will? Since corporate governance at an RIA is usually accompanied by ownership, what the SEC is really asking is “who is going to own and manage the advisory firm in the event that a key owner/manager cannot?” Most of the commentary on this topic has been directed at small RIAs with one owner, which essentially operate as sole proprietorships. For small firms, the options are many, but follow a similar theme: sell the firm immediately at a pre-arranged valuation to another RIA that is in a position to take over. The narrative included with the SEC’s proposal is careful not to define the parameters of any particular RIA’s transition plan too specifically. Every situation is going to be different, but eventually, the regulation is going to have to get fairly granular with regard to expectations of transition plans. Thinking ahead to that time, we would suggest the following might be a descriptive (as opposed to prescriptive) guide to what issues are going to be prominent for RIAs, depending on size. As has been suggested by several commentators on the proposed regulation, solo practitioners and smaller RIAs probably have no recourse for a transition plan that provides for corporate governance (and, thus, control ownership) than some version of a living will for their practice that sells it, immediately, to either a peer RIA or a consolidator like Focus Financial (who filed for an IPO over the weekend). One thing to keep in mind, at that size, is counterparty risk; will the contracted acquirer/operator of the RIA be in a position – financially and operationally – to purchase and run the selling firm if something happens to its owner, and will the acquirer be able to do it on a moment’s notice such that client service is not interrupted? Will the SEC require some kind of “fire-drill” to check if the transition plan works? And who will be held accountable (estate of the Seller, contracted buyer, or both) if the transition plan fails when it’s triggered? Transitions don’t always go smoothly even in a regular acquisition setting, when everyone has time to plan for them and when the seller is available to assist with the transition process. As the size of the firm increases, so typically does the number of owners. One awkward size might be the next one, a medium sized RIA with up to $1.0 billion under management, a few owners and a dozen or more employees. At that scale, it’s not uncommon for the founding partner to hold a majority stake or at least a substantial minority stake. An RIA of this size usually generates more value, per dollar of AUM, than a smaller firm. More value means, of course, a higher purchase price. So while it may be easier to manage the client service issue internally, not every RIA in this size range will be in a position to finance the purchase of the deceased or disabled partner. The largest RIAs have the internal resources to protect their clients in the event of an untimely death. At these sizes, the most significant issues are whether or not the ownership agreements providing for repurchase of a deceased or disabled partner are thorough and current, and whether or not the ownership group has some agreement as to the value of the business. We are involved in numerous matters each year where one or more of these factors is not present, and as a consequence there is a material disagreement as to the value of a buyout. We are also involved with many clients who substantially mitigate this risk by reviewing their buy-sell agreements regularly and have annual valuations prepared so the owners know what to expect in the event of the unexpected. Obviously, we recommend the latter. Regardless of how much planning you do, your RIA is unlikely to emerge from an unexpected calamity without a scratch, but at least you won’t be all wet.Photo Credit: Sun Motors
Fairness Considerations for Mergers of Equals
When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote.
What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures.
Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share.
Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.)
Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair.
The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share (for non-banks), tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.
The Market is Bearish on AUM Growth, but What if the Market is Wrong?
I just got back from a long vacation in Italy, and while I intended to work on the blog while I was there, Brooks and Madeleine were taking care of things so well I hardly had to look up from my Chianti. About the closest I got to working was spending some time in Modena at the Enzo Ferrari Museum, photographing cars to use in future blogposts.The GT pictured above is a very special Ferrari, the 500 Superfast. It was a limited edition car in 1964 that Ferrari based on a “standard” 330 GT – to which Ferrari then added some Pininfarina bodywork and a larger displacement twelve cylinder motor. A few were made with a five speed manual transmission – a rarity then. A Superfast boasted a top speed of nearly 170 miles per hour. They also cost twice as much as a Rolls Royce (there’s been more than a little multiple expansion since then). Ferrari sold three dozen of them. If you’re interested, I noticed one up for auction in Monterey later this month.Some people can rationalize a car like the Superfast as an alternative asset, but really it’s a 20-standard deviation discretionary expenditure. As in no one needs a collector car. Car collectors don’t need a 50 year old Ferrari. Ferrari collectors don’t need a Superfast. I don’t know how many asset managers will be at Monterey this year, but probably fewer than in the past few years, as it seems like there is a dark cloud hanging over the industry. While conventional wisdom always has value, I’d like to suggest that pessimism is not entirely warranted.Yyuuggeee Walls of WorryWe have written at length about bearish signs in the RIA space, and valuation metrics seem to generally reflect a reduced growth outlook. We wonder, though, if things are really that bad. Market prophets forecasting tough sledding ahead for asset management usually point to three things:Fee schedules are compressing because fees are more visible and clients are more interested in passive products.Demographics suggest the populations of developed countries are moving from the asset accumulation stage of their lives to the asset de-accumulation stage (retirement).The lower outlook for investment returns means RIAs won’t just be able to ride the market to grow revenues.
For this post, I’ll set aside the first of these. We suspect there is, over all, some phantom fee compression in the industry as assets are allocated to passive instruments and active managers who charge more don’t get the RFP they once would have. This has been written about extensively here and elsewhere. At present it is a trend, and all trends eventually break.
The other two common themes focus on demographics and market outlook which are not, necessarily, bearish for the investment management space.De-Accumulation is OverratedBroadly, there is a public policy assumption that people consume more than they produce, save, or invest in retirement and deplete their assets. This is true of the population as a whole, but the investment management community does not serve the population as a whole.In fact, most wealthy retirees actually accumulate investible assets in retirement, according to a recent article in the Journal of Financial Planning by Chris Browning, Ph.D., Tao Guo, Ph.D., Yuanshan Cheng, and Michael Finke, Ph.D., called “Spending in Retirement: Determining the Consumption Gap”. The paper studies the investment and spending habits of retired Americans in various wealth categories in an attempt to measure the typical “consumption gap” – or the amount that retirees under-consume relative to their potential consumption given certain levels of accumulated assets and investment performance.I won’t recite all of the detail in this study, but the gist of it is this: while most retirees do experience de-accumulation (spending down their investible assets in retirement), those in the top quintile (rank based on financial assets) do not. These relatively more wealthy retirees consume much less than they could in retirement, and in fact the average financial assets of this cohort increases during retirement. This top quintile is the only quintile served by the investment management community, and this habit of elderly clients actually growing investment assets during retirement is more reflective of what RIAs should experience.Even though the baby boomer generation is reaching retirement age and a majority are leaving the workforce, this isn’t likely to drain AUM balances in the investment management community as much as some might anticipate.Low Investment Returns Increase AUM BalancesIn theory, lower interest rates and lower expected investment returns should encourage consumption and discourage investment. This basic supply/demand concept is the theory by which the Federal Reserve attempts to manage growth, inflation, and unemployment. Based on this, lower expected investment returns should be negative for investment managers for at least two reasons: 1) clients have a lower opportunity cost of consumption, so they save less, and, 2) investment managers don’t get the benefit of increased revenue from market appreciation. All else equal, the latter is absolutely the case, but all else is not equal.By definition, saving and investing is deferred consumption. Funding that deferred consumption requires saving enough, with “enough” being a function of expected investment returns. Retirement saving is the biggest category of investment in the United States. If the cost of retiring is held constant – which it pretty much is – and the expected rate of return in a retirement account is reduced, the only way to make up the deficiency is to save more.You know the math: to produce $100 in consumption in twenty years requires an investment of about $21 if the expected investment return is 8%. Reduce that expected return to 5%, and the investment required to produce $100 in twenty years almost doubles to $38. For defined benefit plans and insurance companies, this equation is very real. Even for individuals with 401Ks or 529 plans or other designated savings accounts, lower expected returns implies higher levels of required investment for a given desired level of future consumption.We seem to be living in a time where common laws of economics don’t always hold. Low investment returns may spur more savings, as has been the case in Japan for decades.People are Living Longer, Which Should Delight Pension Fund ManagersTwo years ago, the Society of Actuaries officially recognized that Americans are living longer. The revisions to the life expectancy tables added 2.0 years to the life expectancy of an average 65 year old male and 2.4 years to the life expectancy of an average 65 year old female. The study has not been without controversy, but the likely impact on the asset management industry is very positive:Defined benefit plan contributions will have to increase, by law.Defined contribution plan investments will, similarly, have to increase.Many people will use some of their added life expectancy to work later into life, adding to their years of investment asset accumulationRetirees will be more cautious about spending retirement assets, which could exacerbate the phenomenon that Browning et al. wrote about in the Journal of Financial Planning.
Add to this further research which suggests wealthier Americans (again, the clients of the asset management community) live even longer than the life expectancy tables suggest, and the AUM required to fund retirement expands even further.See you in MontereyOnly the financial community could make a crisis out of strong markets and longer life spans. There’s no doubt that the RIA community has plenty to fret over, but there are also plenty of reasons to be optimistic as well. Robo-advisors won’t supplant a relationship business. Indexing won’t outsmart human ingenuity. And clients facing the prospects of longer lives and lower returns will need more help, not less, from their investment managers.
Will Marcellus E&P Companies Make a Comeback?
The Rio Olympics are underway, but the Road to Rio was more than a little rocky. Reports of disease, pollution, and protests left us wondering if they could pull it off. But a dazzling Opening Ceremony made us wonder, are the Rio Olympics the next comeback story?For the last two years we have been asking when will oil prices recover? But natural gas E&P companies have been asking this question for almost seven years. Analysts have worked to predict which companies will make a comeback once prices recover, but the road to recovery has been and will continue to be long and rocky.Natural gas consumption has steadily increased since prices fell in 2009, but consumption of natural gas has been unable to keep up with the increased production that resulted from the shale gas revolution. Over the last ten years, natural gas production increased by a compound annual growth rate of 4% while consumption growth lagged at less than 3% per year.Since 2012, the Marcellus and Utica provided 85% of the U.S.’ shale gas production growth as hydraulic fracturing techniques improved. But this fast growth led to excess supply. The American Oil and Gas Reporter commented, “Production in the Northeast is particularly abundant, with volumes increasing from 2 Bcf/d in 2008 to more than 18 Bcf/d in 2014. That astronomical growth rate is expected to continue, reaching 30 Bcf/d by 2020.” By November of 2015, the northeast was already producing 20.3 Bcf/d.E&P companies have increasingly used debt to finance capital expenditures in order to drive sales volume and maintain revenue in a falling price environment. While heavy debt financing allows companies to maintain revenue, it also threatens their liquidity when prices stay low. A prime example is the case of Rex Energy.
Until recently Rex Energy was picked by many analysts as one of the E&P companies expected to make a large rebound. Analysts calculated the implied upside potential as 146% and thirteen analysts gave Rex a buy rating. Rex’s stock price declined at the end of 2008 during the finanical crisis when natural gas prices fell. But, Rex quickly recovered by investing in the Marcellus right before the peak of the shale gas revolution.
Rex maintained a debt to equity ratio of less than 80% until mid-2013 when their stock price started to fall again. Since then, Rex’s debt to equity ratio has steadily risen, exceeding 1,320% by the end of the second quarter of 2016. Shares of Rex have been trading at sub $1 levels since early May of this year, placing the stock in danger of being delisted from the NYSE.
In an effort to improve short term liquidity, Rex announced two weeks ago that they would exchange debt for common shares. The deal will take some of the immediate pressure off of the company by reducing interest expense by approximately $11.1 million, but the long term solvency of the company is still in doubt barring a significant price rebound. For almost two years analysts have waited for a comeback of Rex Energy, but Shale Experts now predicts that Rex is on the verge of bankruptcy.
Rex Energy exemplifies why “cheap, abundant, and profitable” can’t last in the marketplace. As Art Berman explained, shale gas enthusiasts believe that shale is “cheap, abundant, and profitable thus defying all rules of business and economics. That is magical thinking.” Valuation multiples for E&P companies operating in the Marcellus fell over the last six years as natural gas prices declined and production increased.1 There have only been five reported transactions in the Marcellus this year compared with 28 in the Permian.
While no one can pinpoint when the price of oil and gas will recover, analyzing supply and demand indicators can be helpful for predicting future price movements. The supply of natural gas is not expected to ease in the near future, but a recent uptick in natural gas consumption may help ease the downward trend in prices by narrowing the gap between demand and supply. The EIA reported that in 2015 natural gas consumption increased more than any other source of power generation and that record consumption in July of 2016 led to an increase in net withdrawals from inventories. The chart below, shared by the EIA on August 8th inToday in Energy, demonstrates that demand is starting to catch up with production.
Rex Energy may not be making the comeback that analysts once forecasted, but that does not mean hope is lost for all E&P companies in the Marcellus. The current low price environment may squeeze out some of the highly levered companies, but less aggressively financed companies, such as Antero, have an opportunity to buy inexpensive acreage and expand operations in anticipation of a more favorable pricing environment in the future. A comeback may still be possible for the companies that can last until the price rebounds.
Have value questions in the oil and gas space, as an executive, investor, owner, creditor or other interested party? Utilizing an experienced oil and gas reserve appraiser can help in understanding valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
End Note1 EV/ Production multiples are based on the multiples of companies who primarily operate in the Marcellus and Utica Shale. For more information see Mercer Capital’s E&P Index by Mineral Reserve.
Captain Obvious: Location is Key in E&P
I was 14, playing a golf tournament in Austin, Texas. At the time, Hole 11 gave me fits and nightmares. My strength was accuracy and short game, and my weakness was driving distance. Unfortunately, Hole 11 required the participants to carry a rather large hazard, a distance which I could achieve about once every 82 attempts. To add to my frustration, there were no lay-up options, no bail outs, and no safe shots. This situation left me with one option to survive the drive, hit the perfect shot at the perfect time for each round of the tournament. This option had a very low probability of success. As any golfer can imagine, I felt exposed, angry and stuck in a bad situation. Clearly, I did not select a tournament where the course fit my strategy.In today’s energy climate, many exploration and production companies find themselves in a similar situation. Exposed with too much debt, angry with the oil price environment and stuck selling reserve assets at prices they are forced to take because their strategy did not fit their location. For me, I did not pay attention to the layout of the course before entering the tournament. For E&P Companies, the reserves location is playing a significant role on if they can succeed in the current economic environment. For some, their "core plays" continue to produce profitably and new well investment is economic. However, for others, the cost of production is too high and they find themselves stuck in a bad situation with few options, which include selling "non-core" assets before or during bankruptcy reorganization.According to our analysis of the major shale plays in the U.S. (Permian, Eagle Ford, Marcellus, Utica and Bakken), in general the breakeven costs to produce are highest in the Bakken and lowest in the Permian. The remaining plays range between the two. Due to its lower cost structure, the Permian is gaining significantly more attention from opportunistic market participants.Deal activity, while quiet in the first quarter of the year, has picked up significantly in the last four months. In the U.S., there were 103 transactions of oil and gas resource properties with a total disclosed value of $19.7 billion, according to Shale Experts. Approximately 27% of these deals were in the Permian Basin and accounted for 25% of the total dollar volume, or $5 billion dollars. However, activity in the Permian has increased. In the last two months, deals in the Permian accounted for 35% of the transaction volume and 43% of the total dollar volume, or $3.3 Billion for June and July. Therefore, 67% of the Permian’s year to date transaction dollar volume occurred in June and July.Pioneer (PXD) has been one of the more active companies making investments in the play. Although PXD had a large presence in the Permian already, two months ago Pioneer invested $435 million in an additional 28,000 net acres by purchasing the rights from Devon Energy (DVN). According to CEO, Scott Sheffield, PXD’s motivation was protection based:"Why we are acquiring 28,000 net acres in the Midland Basin from Devon…? It's simply because it's totally integrated among our acreage. We did not want somebody to come in… most of the competition couldn't bid on this because they couldn't get longer laterals. We have it, had it totally surrounded allocated $14,000 per acre. And what’s interesting right after we made the announcement on the acquisition, somebody is paying $58,000 per acre right next to this acreage."Clearly PXD has found itself in the right location at the right economic time and is using its recent strong performance and relatively low leverage levels to be aggressive when so many of its competitors are in the weaker position or changing strategies and "core assets", including their transaction counterpart, Devon.Additionally, PXD appears to benefit from successful placement of horizontal wells within their acreage rights, high production rates and operational efficiencies. This translates into favorable cost per BOE information. As CEO Sheffield explained in the 2Q16 earnings call:"What’s amazing to me is that the horizontal well operating costs, excluding taxes, are down to almost $2 per BOE. So definitely we can compete with anything that Saudi Arabia has."While that has the power to drive headlines in the media world (confession, I believe that is how I learned about it), it also appears to be a very selective disclosure. A Forbes article written by Art Berman sheds more light on the specifics of PXD’s cost per BOE. The short of it is, overall PXD has significantly higher cost per BOE company-wide, as in $19 per BOE. However, CEO Sheffield’s comments could be read as an indication that one or more of their wells is experiencing operating costs per BOE of approximately $2.00 (excluding taxes of course and perhaps a few other selective expenses). Regardless, the intimation from the comments is that the Permian is a productive and profitable play at current prices and some wells may produce so well that it can compete with the lowest cost producers in the world. This is also supported by the transaction activity of the stronger E&P companies buying up assets from the weaker entities and the existence of drilling activity in the Permian.However, each location in the Permian is different and the "sweet spots" are just that — spots. They are not everywhere in the Permian. As a result, the valuation implications of reserves and acreage rights can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
Q2 Management Calls Were More "Interesting" than Usual
Management calls are usually, for the most part, fairly mundane. It's usually not a good sign for a call to be "interesting", and this quarter we picked up on several "interesting" themes.In some regards, the second quarter of 2016 seems to be much of a continuation of the first for the asset management space. Most managers are continuing to enjoy handsome margins, but growth appears to be virtually nonexistent and stresses seem to be increasing, generally, across the industry. Although commodity prices have picked up some since the beginning of the year, equities have continued to struggle, favoring ETFs and a flight to other passive instruments, while global strategies have suffered from increased volatility in the aftermath of Brexit among other touchpoints of political unrest. Active managers seem to be struggling to distinguish and substantiate their offerings to retain clients after a period of extended relative underperformance. The DOL's Fiduciary Rule adds a twist to all of this. Although the ruling was intended to primarily impact financial advisors, the ruling expanded regulatory authority over financial advice for IRA holders and the "appropriateness" of fees. Otherwise known as the "Conflict of Interest" rule, the Fiduciary Rule prohibits compensation models that conflict with the client's best interest, and further scrutinizes the risk appropriateness of certain product offerings.As we did last quarter, we take a look at some of the pacemakers in the traditional asset management industry and how they have dealt with the myriad of challenges in the first half of the year.Theme 1: Although uncertainty remains about the timing and impact of the DOL's Fiduciary Rule, managers across the board are focused on the challenges and opportunities implicit in the ruling."As I have discussed in past calls, broadening access to NextShares to include major fund distributors is critical to near term commercial success. Significant progress continues toward that goal. Since the publication in March of the final Department of Labor rule adopting a fiduciary standard for advice to covered retirement accounts, our conversations with broker-dealers are increasingly highlighting the potential role of NextShares in helping advisors address their heightened responsibilities as fiduciaries under the DOL rule." – Eaton Vance's Tom Faust"The Department of Labor's recent fiduciary standard rule has elevated the scrutiny over the appropriateness of fees and product choices. Advisors are demanding solutions for their clients and better technology to support their practice. […] Our investment in Project E (a series of tech, product and brand initiatives) will bring new options to our clients in a more robust technology platform for the financial advisors associated with our broker-dealer, ultimately strengthening the competitiveness of this channel. We believe we will be able to fully address the DOL requirements while preserving our ability to grow advisor productivity and sales with the ongoing inclusion of our products." – Waddell & Reed's Philip James Sanders"We're hearing conversations about all kinds of things, relative to DOL. A couple of things that I think are relevant are – pricing was already decelerating. […] The other piece of DOL I think is that distributors will look intently at their investment offerings and the breadth of them. And in addition to pricing, I think risk, however defined, will be front and center in those discussions. And you've read publicly that one large broker dealer has announced a plan to dramatically prune its product offerings. Whether others follow suit remains less clear. But I think this amalgam of risk and expense will be very much a part of the DOL discussion." – Waddell & Reed's Thomas W. Butch"We're waiting for some more work done on the client side, frankly, to interpret what those new DOL rules will mean for their businesses. And then we'll follow along. We have, obviously, some concerns. We also see opportunities for us in the changing landscape. But it's really too early to have conviction." – Janus's Richard Weil"I think if the large firms move towards more SMA type accounts, we feel pretty well-positioned for that. As you know, in the tax-aware muni space, that's a huge incentive or a huge opportunity for us and has been growing persistently for almost 18 months. So that's an example of us being able to both pivot and take advantage of [the DOL ruling]." – AllianceBerstein's Peter KrausTheme 2: The volatility experienced in the aftermath of Brexit was immediate and acute, but not life-threatening. Many managers believe the impact will be short-term, and have continued to grow their international investments in both Europe and Asia."The Brexit vote in June was yet another episode of volatility and uncertainty. […] The absolute returns of our non-US and global strategies have been impacted in recent periods by poor market performance and overseas developed markets, particularly in Europe." – Artisan Partners's Eric Colson"I think that Brexit over the long-term will be good for the UK. It will result in some short-term pain, probably a brush with recession. But long term, I think it's good that they can control their own destiny apart from being tied to Europe. And in terms of commercial real estate in the UK, we are expecting prices to decline anywhere from 5% to 15% or 20% depending on the property type and the biggest declines are being expected in the office market. However, we think that for some other property type such as industrial where for example the decline in the pound could be good for trade interest and to the property markets in London." – Cohen & Steers's Joe Harvey"We are now investigating how best to service our growing Japanese business and may add additional resources to support that effort. And we have a search underway for a new head of non-US distribution. As our investment capabilities grow more global, it seems natural to focus more attention on serving clients in international markets. While it is unlikely that we'll do something dramatic, the changes afoot in the US market lend greater urgency to our desire to make Eaton Vance a more global company." – Eaton Vance's Tom Faust"We've made significant investments in building our businesses outside the United States. And in that perspective, our non-US businesses have and continued in this past quarter to deliver strong growth." – Janus's Richard Weil"I think the major effect has been a resurgence of sales in the Asia ex-Japan space. I think that is the major difference. Brexit clearly had a chilling effect on risk-taking in Europe and on trading activity, which was reflected in the Bernstein numbers. I don't think we've seen any material move of flow from Europe to the US" – AllianceBernstein's Peter KrausTheme 3: The persistent flight to passive has exposed a number of winners and losers in the active management space. Managers willing and able to adapt and respond to the changing climate by offering a greater mix of both active and passive funds have generally fared better than those trying to wait out the storm."During the quarter, we saw a slowdown in gross inflows which we believe is attributable to a number of factors including market uncertainty and the demand for high-capacity low fee products. In the short term, this is a difficult environment for high value-added active managers." – Artisan Partners's Eric Colson"The pace of change in our industry is accelerating with continued outflows from equity, market share gains by ETFs, investors looking for managers to deliver and distributors responding to the DOL fiduciary rule before it is finalized and while it is being challenged in the courts. […] We are focused on being a specialist manager and delivering more for less. We continue across all fronts to enhance our brand and capabilities and real assets." – Cohen & Steers's Joe Harvey"In this period of disruptive change in our industry, every investment manager is being forced to consider how to respond. […] We are not willing to concede that we can't grow our traditional active business. […] As we said before, we view traditional active management as now a game of winners and losers with Eaton Vance's performance and distribution strengths positioning us to be a winner. We continue to devote significant sales and marketing resources to growing our high performance active strategies." – Eaton Vance's Tom Faust"What we're doing is essentially competing against index funds and index ETFs where we're saying to the client or saying to the financial advisor, we can provide index like or benchmark like returns, but with customization to take into account other holdings that the investor might have, social objectives or social screens that the manager wants to impose, and the ability to achieve better tax treatment because in a separate account you can manage taxes down to the individual lot level and you can pass through losses." – Eaton Vance's Tom Faust"ETFs will absolutely continue to be an important part of the book of business of the financial advisors that we do business with, and looking to see how we can offer either some differentiated actively managed capabilities, either from our current affiliates or through other sub-advisory relationships, as well as are there those smart data types of opportunities, that we also think would be differentiated and work better in ETF than they would work in an open end mutual fund. […] This is an interesting environment for those types of non-correlated, non benchmark type of products because the indices just keep going up and up and up. Our view is that this is a time that people should be investing in those types of strategies, but it's really not as easy to get people to be compelling to buy those types of strategies where right now the indices seem to be doing well." – Virtus Investment Partners's George Aylward"This remains a very challenging environment for active managers. The current global macro-economic and geo-political backdrop has resulted in heightened investor demand for stability, safety, and yield, resulting, in our view, in valuation anomalies across various sectors and markets. We continue to believe that these anomalies will normalize over time, providing a much more favorable backdrop for active management. However, it is also clear that we have not been at our best in navigating the current environment and must do a better job as a whole. The recent performance challenges for active managers combined with an increased focus on fees has resulted in growing demand for passive products. We understand that the landscape has changed, but believe that there is a role for both passive and active strategies in client portfolios. […] We recognize that the industry is evolving and that in order to retain our position of excellence, we must remain open-minded to innovation and change." – Waddell & Reed's Philip Sanders"Given the very challenging global market dynamics and, in particular, how that affected active asset managers, we were particularly pleased to have slightly positive flows for the quarter and very encouraged by the strength of the flows in our U.S. mutual fund business where we gained market share in both fundamental equity and our fixed income business. […] We have a number of strategies which are particularly designed to help clients in period of market stress, in periods of high market volatility. […] Active managers in the first two quarters were experiencing an extremely challenging environment in 2016. Industry outflows for active mutual funds, equity, and fixed income are on pace to post one of the worst years in more than 25 years of history." – Janus's Richard Weil"We are doing as well as we are in such a volatile market because our value proposition has never been clearer. Not only can clients be confident of Bernstein's wealth forecasting, asset allocation, and risk management tools. They can now invest in a series of innovative targeted services that allow them to capitalize on specific market opportunities." – AllianceBernstein's Peter KrausMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.
WHITEPAPER | Corporate Finance in 30 Minutes
Corporate finance does not need to be a mystery.In this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Structured around the three key decisions of capital structure, capital budgeting, and dividend policy, the guide is designed to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Our goal with this whitepaper is to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion. This whitepaper is the first in the "Corporate Finance in 30 Minutes Series." Continue reading the whitepaper series below.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.
PV-X: WACCs for E&P Companies
In the oil and gas industry, standardized reporting and industry analysts typically use a 10% discount rate on projects’ future cash flows. In this post we explain how such a discount rate is calculated and its effects on valuation; and then discuss a model that provides the discount rates that exploration and production companies face in the current market.
Exploration and production companies often use a standardized 10% discount rate in discounted cash flow analysis. The rate appears in oil and gas companies’ reserve reports, where it is used to generate a PV-10 value (an estimate of the pre-tax discounted cash flow value of the company’s cash flows generated from its proved reserves). This standardized discount rate also appears in other calculations where a quick, rough estimate of the present value of a project’s cash flows is needed.
Having a sense of a company’s WACC, then, can lead to a more realistic assessment of the value of a company’s reserves. Despite the prevalence of the 10% value, it is unclear how closely this discount rate aligns with reality. Even if the rate is a general benchmark for the industry as a whole, it is unclear how it varies from company to company and region to region. Such information would help determine the oil and gas prices at which companies can justify raising funds for new drilling—at what point US drilling activity might start to recover. The information would give investors a better sense of whether the PV-10 value is a fairly reasonable statement, an overstatement, or an understatement of value. And for companies, it can help them in transactions to understand how they and another company might find very different value in the same reserves.
There are several factors in the current market that might push the current discount rate higher or lower than the standard rate of 10%. The first key factor is the low interest rate on government bonds. Interest rates on debt are found by adding a credit spread based on the perceived financial health of the company to the risk-free government bond rate. Thus when interest rates are low, the cost of borrowing is low. Since equity investors compare the returns of the equity market to the debt market, a lower return on debt leads them to require less return on equity. Therefore the low interest rate environment should be a strong force pushing the WACC below 10%. At the same time, the recent volatility in oil prices has increased uncertainty and volatility in the industry, causing investors to require higher returns on investments and creating a higher cost of capital.
AnalysisTo better understand the combined effect of these factors, and many others, on the cost of capital for oil and gas companies, we have analyzed WACC for seven groups of publicly traded oil and gas companies.1 We made one important assumption in our analysis—that the funding for the next project would not dramatically differ from a company’s current capital structure. The model does not find optimal company WACCs, but attempts to estimate companies’ WACCs with their current capital structure. With or without this assumption, finding the WACC for each company requires calculating the cost of equity and the cost of debt. The CAPM model (required return on equity=risk-free rate + beta*equity risk premium) was used to calculate cost of equity.2We created two models, using different methodologies to calculate the cost of debt, in order to calculate the WACC. The first method of calculating the cost of debt is fairly standard for a WACC calculation. The model multiplies the current effective interest rate (which is the interest expense divided by simple average of debt at the beginning of last twelve months and end of period) by one minus the company’s marginal corporate tax rate.The second method gives what we think of as a projected future cost of debt for long-term projects (such as oil and gas production). It uses S&P’s company credit ratings, and S&P’s 20 year corporate bond yield curve for bonds of different ratings to assign an interest rate on new loans for a company. The key advantage to this method is that it gives a pre-tax cost of debt based on what the debt market, or at least S&P, assumes it would cost to raise more debt, rather than generating a number based on historical rates. However, these companies have never actually had to pay that amount for debt in the past. Because of this trade-off, the WACCs for companies were calculated using both this method and the standard WACC calculation.The Results
The model’s outputs suggest that the standard 10% discount rate is a higher cost of capital than companies are actually facing in the current environment. The unusually low government interest rates have lowered required returns so that even with the recent volatility in the industry, the oil and gas WACC is below what was once considered a reasonable standard. However, how far off the 10% rate is depends on whether one looks at the WACC for these companies based on the standard cost of debt or the projected cost of debt using S&P ratings.
A standard WACC cannot always account for the rapid rise in leverage some companies have experienced. For companies producing primarily in North America or North American regions, the minimum standard WACC for each group is based on a company with debt representing over 80% of its capital structure. These companies have low WACCs because the calculation is based on interest rates they obtained in the past when they were less leveraged. Now, due to falling oil prices, their equity values have shrunk and many companies’ remaining capital is mostly composed of old debt. Therefore, that cost of capital appears quite low. However, if the company were to try to raise new funds for a project, their current leverage—and the risk of default associated with it—would force them to pay a very high cost for either debt or equity. Thus, using these numbers overstates the value of reserves, especially for struggling companies.
A more contemporary picture of the value of companies’ proved reserves is provided by the S&P ratings based WACC.3 In the case of the Bakken, the most levered company, Halcón Resources, which by the standard measure has the lowest WAAC in the group (6.23%), now has the highest (13.15%). This adjustment now appears particularly relevant as Halcón has filed for bankruptcy. In the Permian, the company with the minimum WACC went from one with over 85% debt to one with only 12% debt. At the same time, not all highly leveraged companies are automatically punished by this model and assigned the highest WACCs. For some, this capital structure may be optimal, and other factors may bolster their S&P credit rating.
The S&P rating based WACC model shows that right now a standard discount rate for North American E&P companies should be around 9.4%. Using this rate in the Bloomberg break-even model drops the break-even price 2-3.5% depending on the area. As for the PV-10 calculation: if it were instead a PV-9.4 calculation, those proved reserves included in the PV-10 calculation would be more valuable. Additionally, more reserves would be included in the PV- 10 calculation, as the engineers evaluating the reserves would include some reserves that were once not considered to be economically viable due to the PV-10 value. Therefore a current PV-10 understates the present value of reserves relative to a PV-10 in periods where 10% is the average discount rate.
For a more detailed discussion on the valuation process and how Mercer Capital can use its years of oil and gas valuation experience to help you, please contact a Mercer Capital professional.
End Notes1 The seven groups include four groups of companies that generate over 50% of production from the Eagle Ford Shale, the Permian Basin, the Bakken, or the Marcellus Shale and Utica Shale; a group of companies having over 90% of production in North America but who are not concentrated in the previously mentioned regions; a global integrated group; and a group of global E&P companies.
2 We used the yield on twenty-year treasuries as our risk free rate. A two year Beta was used, because we feel investors considering an oil and gas company investment would base their decisions largely on what has happened since the fall in prices that began two years ago. Mercer Capital regularly reviews a spectrum of studies on the equity risk premium, as well as conducting its own study. Most of these studies suggest that the appropriate large capitalization equity risk premium lies in the range of 4.0% to 7.0%. The chosen equity risk premium of 5.50% represents a composite assumption which is consistent with this range. The model does not, however, apply a country specific risk premium for global companies, and so global companies’ WACCs are likely understated by the model.
3 Not all of the companies in our sample had S&P credit ratings so some were excluded from our analysis. We ran a control group in order to test whether the exclusion of some companies would bias the model. We estimated the ratings of companies without a rating based on the ratings received by other companies in the group with similar debt to enterprise value ratios. The results suggested the reduction in the number of companies did not significantly affect the model.
Oil and Gas Market Discussion: Part 2
In May 2016, we attended a panel event discussing investment opportunities in the financially distressed oil and gas sector. The panel included a “who’s who” of oil and gas experts located in Texas. Two industry participants, two consultants, one analyst and one economist discussed the economic outlook for energy prices and then corporate strategy and investment opportunities given the economic outlook. This post, the second and last summarizing this panel discussion, will report opinions given on corporate strategy and investment opportunities. (To read more about the economic outlook please read here.)Corporate StrategyAfter discussing the price outlook, the panelists shifted the conversation to practical decision making based on our limited ability to forecast price changes. First, they looked at corporate strategy. Merger and acquisition activity has slowed. Once oil prices started to decline in mid-to-late 2014, the M&A market fell quiet for more than 12 months. This “silent period” is a normal reaction to high volatility periods. For corporations trying to make decisions for the long term, volatility creates an uncertain future, and thus an unfriendly environment for investment. However, the panelists believe the “silent period” is now reaching a breaking point as the amount of debt carried by some companies is beginning to force action. One panelist commented that while there are “no willing sellers in the market,” some transactions have occurred when a “forced seller” tries to avoid or prolong filing for bankruptcy protection.Those bankruptcies are happening more and more frequently, leading one participant to describe four types of energy companies in the market today:The “I need to restructure yesterday” company;The “In denial about restructuring” company;The “Racing to restructure” company (to be healthier when oil prices recover); andThe “Low leverage / healthy” company (looking for opportunities);
By categorizing each active company in the oil and gas market into one of these four buckets, it is easier to interpret some companies’ actions, and therefore to interpret the direction of the market. This in turn enables wiser investment strategies.Investing OpportunitiesTwo areas of opportunity discussed were reserves and oil field services. A panelist who actively invests in “low risk, existing producing properties with PUD (proved undeveloped wells) rights” described the potential value of investing in reserves. In recent transactions, this particular panelist was able to pay a purchase price based only on the value of the given property’s PDPs (proved developed producing reserves). The only properties for which he may make an exception and allocate “a little” value for the non-producing areas are those located in the Permian Basin. The time horizon for this investment is definitely long term as the strategy depends on the price of oil recovering so that the PUD opportunities—which the investor pays nothing for in this current market—become valuable again. Thus, this strategy works well for experienced investors with enough cash to pull it off, such as investment funds or other E&P companies.The second investing opportunity is more easily accessible to the average retail investor than purchasing reserves. This simpler opportunity focuses on investing in “higher quality oil field service companies that live in the operating expenses of exploration and production companies.” There are a couple positives to this strategy. Since existing wells must be maintained, this strategy enables one to invest in a high quality company that receives regular business from E&P companies, while also taking advantage of the fact that most companies operating in the oil and gas sector are trading at discounted prices. Furthermore, if prices recover, more wells will be drilled and completed, and these too will need to be maintained. Thus, high quality oilfield service companies may offer low risk returns in the current environment while also offering considerable upside if oil prices increase. A market data point to monitor for this investment strategy is the drilled but uncompleted well count and the well completion count data. As discussed in the previous post, this information is more directly tied to future production than the commonly referred to rig count data, and an increase in completions will mean an increase in business for oil field services companies.SummaryOverall, this panel was a helpful reminder to stay focused on the basics during times of turmoil. Basic supply and demand factors world-wide are still driving the price of oil and gas. The only change has been the behavior of certain suppliers (OPEC) and doubts about future demand (country specific). Because of the way those changes have affected oil prices, overleveraged E&P companies will be forced to restructure their debt or be forced out of the market. After an 18 month “silent period,” more action is either expected in the near term as these debts become due. Lastly, having available, investable cash is critical in order to take advantage of certain investing opportunities in the market today. Certain strategies favor professional and institutional investors, while others can be enjoyed by retail investors. Overall, it is a very volatile time in oil and gas. The perspectives of these six experts in their respective fields provide guidance for strategy and investing in the near and long term. If you want to move forward either as a company interested in M&A activity or as an investor, utilizing an experienced oil and gas reserve appraiser can help to further lift the fog on valuation issues in this current, hazy environment. Contact Mercer Capital to discuss your needs and learn more about how we can help you succeed.
BlackRock Sees Opportunity in Challenging Environment for Asset Managers
A Whole New World
Often branded as an industry bellwether for its size and breadth of services, BlackRock (ticker: BLK) has been as solid as the name would imply given the recent fallout in asset manager valuations. In last week’s earnings call, CEO Larry Fink attributes the company’s recent success to “the differentiating platform we have built at BlackRock over the past 28 years…, the diversity of our product offerings, the risk capabilities of Aladdin, [and] the market insights offered by the BlackRock Investment Institute.”
Specifically, BLK benefited from $126 billion in net inflows over the last year as many RIAs have leaked client assets to passive funds and robo-advisors. BlackRock is clearly gaining market share within the industry and currently manages $4.9 trillion in client assets. This scale has allowed it to make the necessary investments in technology and talent to continue the upward growth trajectory in a sideways market. In addition, BlackRock has also recently invested in ETF businesses to take advantage of the rising popularity of indexing strategies. In essence, BlackRock has used its size (and balance sheet) to evolve with the industry and gain market share in the process.
Still, the last twelve months have been anything but a magic carpet ride for most industry participants. A low yield environment dominated by ETFs and passive products has not been conducive to many RIAs, especially active managers like Pzena and Legg Mason, which are down 31% and 43%, respectively, over the six months ended June 30, 2016.
As we discussed last week, investors are growing increasingly intolerant of the high fee/low performance combination, so both traditional and alternate asset managers are feeling the heat. Mounting regulatory pressures are additional headwinds as the Financial Stability Oversight Council is currently reviewing six areas of the asset management business for potential enhancements to regulatory oversight – liquidity and redemption, leverage, securities lending, data and disclosure, operational risk of service provider concentrations, and resolvability and transition planning. The SEC is also assessing the sector’s systemic risk exposure and should finalize three proposals on mutual fund and ETF regulation at some point this quarter.
While the current trend toward passive investing hasn’t shown any signs of strain, we don’t foresee active management ever going away for good. In fact, best-in-class stock and bond pickers should build market share as enterprising investors seek the few diamonds in the rough (last Aladdin reference, I swear) that have actually outperformed their relevant benchmark. Depressed valuations may induce further consolidation, so this trend could ease the number of stand-alone active management firms as competitively priced passive strategies continue to collect AUM. With over 11,000 RIAs and aging owner demographics, such consolidation is probably long overdue.
Asset Managers of All Shapes and Sizes Continue to Underperform the Broader Indices
Nowhere to Hide
Piggybacking off our post from a couple of weeks back, the downward trend in asset manager pricing has persisted for another quarter, no matter how you slice it. Publicly traded trust banks, alt managers, mutual funds, and traditional RIAs are all down over the last year, with hedge funds and PE firms leading the plunge. Rising compliance costs, fee and margin compression, asset outflows on active strategies, and stalling growth prospects are all culprits for the overall decline, but alternative asset managers have definitely been hit the hardest over the last year.
As a matter of practicality, it shouldn't be surprising that the most expensive asset class with the worst overall performance would eventually be shunned by investors. This trend is really just a microcosm or more exaggerated example of what's going on across the entire asset manager landscape – individual and institutional investors no longer have to accept high fees and chronic underperformance, so they're turning their attention to passively managed products or indexing strategies to boost their effective return. John Oliver certainly didn't do the industry any favors with his 20 minute rant on advisor fees in his Last Week Tonight episode from a few weeks back.
There was also virtually no size effect. Most every asset manager from GROW (U.S. Global) to TROW (T. Rowe Price) has struggled to keep pace with the broader indices. No matter the asset base, a low-fee, passively biased environment is not conducive to most asset managers of any size, shape, or form. Add rising regulatory costs and a market that's not exactly undervalued, and you get multiple contraction and a bear market for RIAs.
So what's the market trying to tell us about the future of this business? Probably that fee compression, asset outflows, rising compliance costs, and heightened market volatility will likely have an adverse effect on future earnings for some time to come. For alternative asset managers, the market seems to be pricing in more pronounced cuts to their fee structure and/or continued outflows.
It might also signal a buying opportunity for industry participants looking to add scale since most RIAs have finally gotten cheaper after years of steady growth following the last financial crisis. AMG's recent acquisition seems to be at least partially motivated by recent declines in hedge fund valuations. Further consolidation seems inevitable and might be the most viable way to restore a depleted asset base and profit margin. We'll keep you apprised on deal-making trends in future posts.
Bankruptcy: An Overview Part 3
From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the last in a series of three aimed at helping those companies, and any others who may face bankruptcy in the future, to understand the valuation-related aspects of Chapter 11 restructuring. In the first post we highlighted two reorganization requirements tied to valuation. First, the plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding. Second, upon confirmation by the bankruptcy court, the plan must not be likely to result in liquidation or further reorganization. In the second post we explored in depth the consequences of the first requirement. Here we examine the importance of the second requirement.Cash-Flow TestFor a company that has followed the steps explained in the previous post, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Even if a company shows that the restructuring plan will benefit stakeholders more than liquidation will, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash-flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash-flow test can be broken into three parts.The first step in conducting the cash-flow test is to identify the cash-flows that the restructured company will generate. These cash-flows are available to service all the obligations of the emerging entity. Remember the discussion in the second post—a stream of cash-flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash-flows for the cash-flow test is often a straightforward matter of using these projected cash-flows in the new model.Once the fundamental cash-flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash-flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash-flows of the company will not be used only to pay debts, and so the third and final step in the cash-flow test is documenting the impact of the net cash-flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash-flows are invested in working capital and capital equipment; and modeling changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.ConclusionAlthough the Chapter 11 process can seem like no more than a burden, a rigorous assessment of cash-flows and a company’s capital structure can help the company as it tries to develop a plan for years of future success. We hope that these past three posts explaining the key valuation-related steps of a Chapter 11 restructuring help managers realize this potential.However, we also understand that executives of oil and gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success. With years of experience in both oil and gas, and in bankruptcy, at Mercer Capital, we are well positioned to help in both of these roles. For a confidential conversation about bankruptcy proceedings and how we can help, please contact a Mercer Capital professional.
AMG Sees Opportunity in Alt Asset Space
Value Play or Falling Knife?
Last week, Affiliated Managers Group (ticker: AMG) announced the completion of its investment in three alternative asset managers — Capula Investment Management LLP, Mount Lucas Management LP, and Capeview Capital LLP. These transactions are the cornerstone of AMG's 6/6/16 definitive agreement with Petershill Fund I, a group of investment vehicles managed by Goldman Sachs Asset Management, LP, to acquire all of Petershill's minority interests in the aforementioned firms as well as two other alternative investment managers, Partner Fund Management and Winton Capital Group, which haven't yet closed.Under the terms of the agreement, AMG will acquire these interests for approximately $800 million to be paid in cash at closing (roughly half of which was just paid for Capula, Mount Lucas, and Capeview with the balance expected to close by year-end). Given that RIA disclosures only present ownership percentages in range form and three of the entities are headquartered in London, the ADV is of little use to us in ascertaining the exact interest acquired in these businesses (though it's probably safe to assume something close to 50% given their typical investment structure discussed in a previous post).Perhaps more instructive is AMG's admission that management expects the transaction to increase economic earnings per share by $0.50 to $0.80 in 2017, availing some insight on deal pricing (though much of this accretion is likely due to synergies).
At first glance an effective multiple of 18-29x next year's earnings seems a bit rich, even in this market, but closer inspection reveals pricing more in line with industry peer measures. The high level of variance in the metrics is largely attributable to the uncertain and variable nature of performance fees and carried interest income.
Such ostensibly high valuations are more a function of depressed earnings from fee pressure and fund outflows than overly bullish sentiment on the sector’s prospects. In an investing landscape dominated by indexing strategies and passive products, investors are becoming increasingly weary of the high fees and recent underperformance associated with many hedge funds and private equity firms. Publicly traded alternative asset managers have clearly fared the worst over the last year relative to other classes of RIAs and trust banks.
AMG apparently sees this decline as a buying opportunity, since these businesses might be the cheapest they've been in quite some time. And although trying to catch a falling knife is typically ill-advised, AMG has partially hedged this risk by investing in established hedge fund managers with over $1 billion in client assets. At any rate, the market doesn't seem convinced — though only time will tell.
Oil and Gas Market Discussion: Part 1
Like the first few holes on an early morning golf round, the current oil and gas market is very foggy. In golf, hitting a shot into the unknown can be peaceful, enjoyable, and exciting. However, in the oil and gas market, blindly taking investment shots is downright frightening. Uncertainty on the direction of the price of oil, the cause of the historical decline, the future of demand, leverage levels of E&P companies, and the value of oil and gas assets will delay many investment decisions. In May 2016, we attended a panel event discussing investment opportunities in the financially distressed oil and gas sector. The panel included a "who’s who" of oil and gas experts located in Texas. Two industry participants, two consultants, one analyst and one economist discussed the economic outlook for energy prices; and then corporate strategy and investment opportunities given the economic outlook. This post, the first of two summarizing this panel discussion, will report on the economic discussion.Economic Outlook for Energy PricesTo no one’s surprise, the outlook for energy prices depends on forecasts of future supply and demand, and those forecasts in turn depend on predicting the timing and interaction of complex global events. On the demand side, economists do not anticipate significant change in the near term. Many economists are hesitant to project growth as others indicate a global pull back is due. Even looking only at the U.S. we can see how the way we use oil has changed in the last 40 years. Oil was used to power houses, offices, and factories in the 1970's and 1980's, but environmental pressure since then has reduced the use of oil in favor of cleaner energy. Combine the changes to the power grid with efforts to help both the environment and consumers by increasing the energy efficiency of automobiles, and it appears pressure to reduce U.S. demand for oil will continue into the future. Therefore, it is difficult to argue convincingly that an increase in foreign or domestic demand will drive near-term oil price growth.On the supply side, the world is still reacting to OPEC’s increased production, which has enabled those countries to maintain market share by driving down prices. North American production, for instance, is anticipated to continue its decline in the near term — the result of a slow-down in investment over the past year and a half as many resource plays are no longer economically viable. While wells are continuing to produce oil, completion and drilling of new wells has been delayed. As hydrocarbons are a depleting resource, anything produced must be replaced by discoveries elsewhere. Without investment to replenish reserves, depletion becomes a significant hindrance on growth as inventory and reserve levels drop. It is now a waiting game for current wells’ production to decline enough to impact inventory levels. When this happens to companies across an entire region, oil prices may rise.
One traditional market indicator frequently monitored by industry participants to determine investment levels is rig count. As rig counts fall, the indication is that new production will go down; as rig counts rise, the opposite is true. However, one panelist suggested, "Rig count is not as important to measure future production as the number of drilled but uncompleted wells." As the price of oil started to decline in 2014, many drillers chose to delay the completion of their wells, hoping for a rebound in price. This price rebound has yet to happen, but the number of uncompleted wells continues to increase. Since it takes less time to complete a well than it does to drill and then complete one, it seems reasonable to assume that companies might be more capable of quickly replenishing their depleted inventories than we would think from looking at the number of rigs. This will help U.S. companies to capitalize if prices start to rise, but also will keep in check any growth in oil prices as supply will increase faster than it normally would.
In a shift away from the U.S. market, the panel then emphasized that one should not develop a narrow focus on investment and that production in the U.S. International production decisions, especially those of OPEC, will continue to drive much of the change in oil price going forward. For this international sector, the economist on the panel communicated the theme: "History doesn’t repeat but it does rhyme." He explained his point by highlighting one particular period in the oil industry’s last 50 years that can help us to understand the decisions OPEC is making now.
From 1978-2003, the Saudi’s acted as the swing producer in OPEC to influence prices. At the end of this time period, they learned that the swing producer ultimately loses market share. They vowed never again to act in a manner that would shrink their market share. At the time, U.S. production was dropping consistently year over year, and so people paid little attention to the change in attitude. In the mid to late 2000s, however, fracking technology helped unlock significant U.S. inventory. This new technology made the U.S. energy independent, at least as long as oil prices remained above a certain price point needed for the main resource plays to be economical. Jump forward to 2014, and everyone was "shocked" when a significant drop in the price of oil was not met with an OPEC cut in production. From the perspective of Saudi Arabia and the rest of the OPEC nations, however, they simply kept their earlier vow. Deciding to produce at the same or increased levels would better enable them to fend off challenges to their market share from countries such as the U.S. who were starting to fulfill a larger share of the world’s oil needs.
Ultimately, however, the economist ended the discussion of future prices by emphasizing that while certain trends can seem clear, especially in hindsight, there are many factors that can influence oil and gas prices. While people have their opinions, no one can consistently and accurately forecast all these complex factors, and thus "no one knows where the prices of oil and gas will go." All we can really say with reasonable certainty is that the "drivers impacting the price will be similar to the past ones." Although this explanation was not "ground breaking"material, we find it helpful to be reminded of the basics during times of turmoil.
In the next blog post, we will look at how one can navigate this turmoil to find successful opportunities as either an investor or a business. If you want to discuss further how the current price outlook can shape asset valuations, and how one can project value when the future is so uncertain, please contact a Mercer Capital professional.
Bankruptcy: An Overview Part 2
From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the second of three aimed at helping those companies and any others who may face bankruptcy in the future to understand the valuation-related aspects of Chapter 11 restructuring. In the first post, we highlighted two reorganization requirements tied to valuation. Here we will explore the consequences of the first of those requirements:The plan should demonstrate that the economic outcomes for the consenting stakeholders (creditors or equity holders) are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.A Floor Value: Liquidation ValueIf a company can no longer pay its debts and does not restructure, it will undergo Chapter 7 liquidation. Thus, this law simply mandates that Chapter 11 restructuring only be approved if it is stakeholders’ best option. Given this understanding of the law, the first valuation step in successful Chapter 11 restructuring is assessing the alternative, liquidation value. This value will be a threshold that any reorganization plan must outperform in order to be accepted by the court.The value in liquidating a business is unfortunately not as simple as finding the fair market value, or even a book value for all the assets. The liquidation premise contemplates a sale of the company’s assets within a short period. Any valuation must account for the fact that inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents, while reserves, and especially PUD and unproven reserves, would likely incur significant discounts. The size of this discount can be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario. For instance, as mentioned in "Bridging Valuation Gaps: Part 1," the price Samson recently paid for properties in a distressed sale equaled the reserve report value of PDP and PDNPs. The discount was so steep that the company essentially received the PUD reserves for free.Reorganization ValueOnce an accurate liquidation value is established, the next step is determining whether the company can be reorganized in a way that provides more value to a company’s shareholders than discounted asset sales. ASC 852 defines1 reorganization value as:“The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”Typically the “value attributable to the reconstituted entity,” the new enterprise value for the restructured business, is the largest element of the total reorganization value. Unlike a liquidation, this enterprise value falls under what valuation professionals call a “going concern” value premise. This means that the business is not valued based on what one would be paid for selling individual assets, but rather the return that would be generated by the future operations of the emerging, restructured entity. To measure enterprise value in this way, reorganization plans primarily use a type of income approach, the discounted cash-flow (DCF) method. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:Forecast of Expected Future Cash-flows. Guidance from management can be critical in developing a supportable cash-flow forecast. Generally, valuation specialists develop cash-flow forecasts for discrete periods that may range from three to ten years. Conceptually, one would forecast discrete cash-flows for as many periods as necessary until a stabilized cash-flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash-flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash-flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. Historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business can provide reference points to evaluate each element of the cash-flow forecast.Terminal Value. The terminal value captures the value of all cash-flows after the discrete forecast period. Terminal value is determined by using assumptions about long-term cash-flow growth rate and the discount rate to capitalize cash-flow at the end of the forecast period. This means that the model takes the cash flow value for the last discrete year, and then grows it at a constant rate for perpetuity. In some cases the terminal value may be estimated by applying current or projected market multiples to the projected results in the last discrete year. An average EV/EBITDA of comparable companies, for instance, might be used to find a likely market value of the business at that date.Discount Rate. The discount rate is used to estimate the present value of the forecasted cash-flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity risk premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the business and financial risks associated with the expected cash-flows of the emerging entity.
The sum of the present values of all the forecasted cash-flows, including discrete period cash-flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of that expected business enterprise value of the emerging entity and proceeds from any sale or other disposal of assets during the reorganization. Since the DCF-determined part of this value relies on so many forecast assumptions, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigations. The eventual confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a range of reorganization values or a single point estimate.
In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders in the restructuring entity. From the perspective of the stakeholders, the reorganization value represents all of the resources available to meet the post-petition liabilities (liabilities from continued operations during restructuring) and allowed claims and interests called for in the confirmed reorganization plan. If this agreed upon reorganization value exceeds the value to the stakeholders of the liquidation, then there is only one more valuation hurdle to be cleared. This is an examination of whether the restructuring creates a company that will be viable for a long time—that isn’t likely to be back in bankruptcy court in a few years. We will address that process in our third and final blog post of this series.
If you want to learn more about the valuation side of the bankruptcy process, and how we at Mercer can use our years of experience in bankruptcy and in the oil and gas industry to help you emerge from Chapter 11 well-prepared for future success, contact one of our valuation analysts for a confidential discussion.
Footnote1ASC 852-10-20.
Brexit Just Accelerates Downward Trend in RIA Valuations
Gimme Shelter
Brexit’s full impact on the market is still to be determined, but a quick review of asset manager pricing reveals a valuation gap with the broader equity market that opened over the past twelve months, got much worse in June, and even accelerated over the past week.The headline performance comparison is striking. Over the past twelve months, while the S&P 500 rose modestly, the SNL U.S. Asset Manager index underperformed by over 24%.
This trend held for seven of the last twelve months, and accelerated in June with a big blow-out post Brexit. The same asset manager index dropped almost 10% last month, versus a decline of just over 1% for the S&P 500. You can see what last week was like: brutal.
Internally, at Mercer Capital, we’ve speculated as to whether or not publicly traded RIAs were essentially a synthetic futures contract on the financial markets. And if asset management firm valuations are falling, does that imply something about sentiment toward the ultimate direction of the capital markets?
There is, after all, a lot of other noise to consider. AUM is piling up in passive strategies while only treading water across the industry. Equity markets feel stuck - like a helium balloon on a ceiling – in a narrow trading range at uncomfortably high multiples. The market is awash with liquidity, but actual trading activity seems to be trending downward.
So if market valuations in the industry are getting a haircut, what does that mean? If you convert this market activity to some kind of discounted cash flow model, valuations would only drop if a) the cost of capital was rising, b) margins were declining, and/or c) profit growth expectations had dropped.
The Cost of Capital for Asset Managers is Probably StableIf you think back to your first or second finance class, you’ll remember that the weighted average cost of capital, or WACC, has two components: the cost of equity and the cost of debt. Most asset managers have very little if any debt in their capital structures, so we really only need to be concerned with the cost of equity. The cost of equity is usually considered to be some premium to the risk free rate, represented by the yield to maturity on government debt. Yields on longer dated Treasuries have collapsed over the past month and the past year, which all else equal would reduce the cost of equity. As for the equity risk premium, in theory this should encompass both systematic risk (volatility of returns relative to the market) and non-systematic risk (issues specific to the individual company). Non-systematic risk isn’t the issue here, and industry beta – which we think of as market neutral or a bit north of 1.0 – is always de-beta-ble. All in all, though, I think it’s safe to say the cost of capital for asset managers has not increased; if anything, it should have gone down a bit. In a yield starved world, the recurring revenue stream of asset management represents a coupon-clipping opportunity that should bid the cost of capital down, and the multiple up, unless something else is also at play.Profit Margins May Have PeakedSeems like we’ve been reading about job cuts and fund consolidations and position realignments every day for weeks now. No one is acknowledging this publicly, but it feels like Q1 board meetings must have been full of internal profit warnings at RIAs. We’ve been watching fee schedules for some time now – particularly at mutual funds – and with the equity markets more or less flat-lining, it’s easy for costs to creep up. Compliance costs are rising – especially at smaller RIAs. Add to this the risk of a market pull back – especially a sustained one – tugging the wrong way on the inherent operating leverage in investment houses, and you see the risk. Hopefully the Q2 management calls will cover this topic; we’ll be there when they do.Growth (or lack thereof) May Be the Big StoryWhere is the growth in the investment management industry? Major indices are not cheap. Indexing is grabbing market share. Clients are more and more fee conscious. Wealth management firms have the built-in relationship advantage, but need a good market tailwind to offset client spending. Client acquisition is always an opportunity, but industry-wide is a zero sum game. So maybe growth challenges (top line or bottom line – your choice) are what we’re seeing in public asset manager pricing. We’ve sounded this alarm before, but the tone of the alarm is getting louder.Moves like JaggerI once saw an interview with Mick Jagger in which he said that, growing up, his most likely career was to be a teacher. His dad taught, and Jagger figured that after he finished with the band-thing he would teach English. By the time he banged up his Aston Martin 50 years ago, Jagger probably knew he didn’t have a future in education. But even then I doubt he foresaw the five decade music career ahead. When ERISA came to be 42 years ago, no one would have expected the asset management industry to grow like it did. As a consequence of that growth, lots of managers got their satisfaction, but after the past eight years many others are probably facing their 19th nervous breakdown.
Minority Value Multiples Can Trade Higher Than Enterprise Value Multiples: Sometimes it’s Cheaper to Buy the Whole Company
Many investors, analysts and business appraiser’s believe1 that publicly traded price multiples / minority equity value multiples can be used to estimate enterprise value, control level value of a business, or by simply applying an incremental premium for control to a selected publicly traded minority multiple. Typically this method can be done by using a sample of comparable publicly traded companies, observing a range of P/E2 multiples and selecting a multiple within the range or typically by analyzing enterprise transaction multiples. At this point, a simple premium for control is applied and market value of debt is added to arrive at an enterprise value.For example, if a sample of comparable publicly traded companies has a P/E multiple range of 10x to 14x and the appraiser selects 12x, he would then apply a premium for control of 25% (historically observed average in studies), add the market value of debt and arrive at an enterprise value multiple north of 15x earnings.However, this mathematical calculation many times is not a supportable method to estimate a marketplace transaction for enterprise value.As business appraisers, our job is to “Mirror the Marketplace” when valuing businesses. In doing so, the above methodology and the implicit assumption made is that minority value serves as a reasonable baseline, or starting point, for enterprise value. Very few appraisers understand that the most accurate explanation of the relationship between minority value and enterprise value is that there is no functional relationship between minority multiples and enterprise value.Why is this explanation true?The reason is based on stock market dynamics and trading history, but primarily because: The economic and financial drivers that influence an enterprise buyer are fundamentally different than a minority buyer. List of drivers for the typical minority buyer:Has a contained and restricted insight into earnings and growth prospects;Has limited or nearly no insight into the long term business plan & its associated risks;May have controlled information into the competitive environment; andMay have narrow views into the future outlook for new products, pricing strategies and risk profile, etc.
The opposite is often true for the enterprise buyer. These factors have a significant and dramatic impact on enterprise value. As a result, there are times when a minority price pro-rata can significantly exceed what a prudent enterprise level buyer will pay, pro-rata, for a company. Vice versa, there are times when the enterprise value can be much more than the amount indicated by an application of an average premium for control percentages.Case StudyA publicly traded restaurant company operated 22 locations across the U.S. After a brief due diligence period, it was discovered that two of these locations generated 3x to 4x the profit of an average company store, 40% of the total company annual cash flow and had short-terms remaining on their leases (3 and 5 years). These two locations were also unique in they were located in a resort area, with a landlord who had a history of increasing rent dramatically, to “milk out” the excess profits, after the initial lease period. This piece of information was not known to the public as it was a trade secret of the landlord and lessor, but not shared with the public. Therefore, it was likely that the future profits of the restaurant company from current stores would go down significantly at the end of the current lease period. As a consequence, the value, and its associated multiples, to a prudent enterprise buyer would be substantially less than the minority multiples observed in the public market.In contrast to the above case study, there are other times when new products are coming online with risk and growth prospects that are not reflected in current or historical earnings. As a consequence, when the new products hit the market, the earnings may jump and significantly increase the enterprise value above and beyond the observed minority price.ConclusionAs a result of the above Case Study, it is clear that an appraiser must go through a proper due diligence process to understand of the impact of the cost, income, and market approach to truly understand the enterprise value of a company. It is also clear that assuming a publicly traded minority value as a reasonable basis to calculate enterprise value can lead to a significant error in due diligence and negatively impacts the credibility of an enterprise value opinion.This article was originally published in Valuation Viewpoint, July 2014.Footnotes1 Based on studies and articles
2 Price to Earnings Ratios
How to Choose the Best Business Appraiser
Are you considering buying or selling an operation, have a gift or estate tax issue, buying or selling a minority equity interest in an operation, or have fair value or fair market value-related financial reporting requirements for either GAAP or tax purposes?If so, a fundamental question exists: How much is your business and assets worth? To find out, you need the experience and expertise of a business valuation expert – a business appraiser.Small businesses and big corporations often don’t know what to expect when choosing a business appraiser. Two critical questions to ask are: (1) How do I know if they are qualified; and (2) What should an appraisal cost? Appraisers play a vital role in the market, and choosing one takes a little knowledge and lots of comparing to get comfortable with your selection.Look for Professional CertificationsMany business owners, attorneys and advisers aren’t sure what qualifications a trustworthy expert business appraiser should have. Just as accountants and doctors might use CPA and M.D., respectively, business appraisers often have a set of initials confirming they have received extensive training and/or have ample experience in their field. These certifications span a broad range, but they all indicate that the business appraiser knows what he or she is doing. Here’s an overview of common certifications:ASA (Accredited Senior Appraiser) – Issued by the American Society of Appraisers (ASA). To earn this prestigious certification, applicants must have a 4-year degree, 5 years of business appraisal experience; take 96 hours of ASA’s rigorous course sets and 12 hours of oral and written exams. They must also interview with their local ASA chapter, pass an ethics test, and submit two appraisal reports before their peers. In addition, active ASAs must complete additional courses on an ongoing basis to keep their designation.CBA (Certified Business Appraiser) – Issued by the Institute of Business Appraisers (IBA). Holders must be an active member of the IBA, have a 4-year business degree, complete 6 hours of various workshops and training programs, pass the CBA exam, have submitted two demonstration reports and have 5 years of appraisal experience or 90 hours of class time. Requirements may be lessened for those who hold other business appraisal certifications prior to application.CPA/ABV (Certified Public Accountant Accredited in Business Valuation) – Issued by the American Institute of Certified Public Accountants (AICPA). Holders must have a valid CPA, complete the ABV exam, work on ten engagements and meet business valuation experience and education requirements.CVA (Certified Valuation Analyst) – Issued by the National Association of Certified Valuation Analysts (NACVA). Holders must have a valid CPA or relevant business degree, at least three personal and business references, has passed a proctored exam and two years or ten engagements of business appraisal experience.
Obviously these certificates have vastly different levels of experience to satisfy the designation. Be sure and know the difference when selecting your appraiser. Of course, these certifications aren’t tell-all determinants of an appraiser’s skill or qualifications. Not all ASAs are equally experienced in the same industry. Consider their work experience, industry experience and client references. Review their website and publications made by the appraiser. While experience and expertise are really important, credentialing provides added support in litigation environment before the court, the IRS or when subjected to auditor review.Beware of Right-Hand AppraisersMake sure that your business appraiser exercises complete objectivity when appraising your firm. An appraiser’s job isn’t to promote you, but to give an unbiased assessment of your organization’s worth. Unruly “right-hand” appraisers may overstate the value of your business for personal gain. These tactics created quite the turmoil in the late 80s real estate market. Homes were frequently overvalued, encouraging banks to hand out heftier loans. When the decade turned, the market crashed.This is another area where certifications can help. Business appraisers with professional certifications are bound by a code of ethics that prohibits right-handing and other shady practices. Non-certified appraisers may also operate by these ethics, but it’s not guaranteed. Remember that appraisers aren’t on the side of buyers, sellers or loan officers; they work for the good of the free market. Before you sign anything, read the appraisal agreement and verify that there is an independence clause.Know the CostsDepending on who you hire, a business valuation can cost between a few thousand to well into the six figures, depending upon the scope of the project. The more services you require, especially those for litigation purposes, the more your appraiser will charge. Especially in “high-stake” situations, most often litigation, the credentials, experience and expertise of your valuation expert matter. Selecting a low-cost provider is often “penny wise and pound foolish” as the results may cost more in the end. Also, keep in mind that litigation services can run hundreds of dollars per hour and can easily skyrocket if proceedings drag on.Don’t sign a contract with the first appraiser you meet. Instead, compare estimates from a variety of sources, look at their qualifications, and evaluate what your situation requires. Projects that will receive a high level of scrutiny from auditors, the IRS, opposing council or judges will require significant documentation. However, if you’re a small business looking for an oral appraisal, fees should be lower as very little documentation (i.e. report writing) is required.This article originally appeared in Valuation Viewpoint, October 2014.
What to Consider During A Business Appraisal
Many situations warrant an business appraisal / valuation. Some of the most common occurrences in which a business will need to conduct a valuation include litigation matters, preparation for the sale of a business, tax purposes, buyouts of financial stakeholders, financial reporting of acquired businesses and the issuance of a business-related insurance policy.Furthermore, conducting a business valuation takes energy and time, and should be conducted by an independent valuation specialist. Selecting a valuation specialist / business appraiser can be complex, which we discussed in a another article, "How to Choose the Best Business Appraiser."When beginning the process of a business valuation, a clear understanding of the owner’s bundle of rights is critical before any investigative and analytical procedures are started. After a clear scope is outlined, the analysis is ready to commence. We conceptualize the value principles of most operating businesses into three components: (1) Risk, (2) Growth and (3) Earnings. We believe these are key components of value in a business. Using these as a guide, we seek to understand the nature, history and operations of a business through the perspective and intimacy of the team operating the assets every day, management. To do so, we find it helpful to discuss the operations in the same way as management thinks about its business. We strive to understand the risks that management wants to minimize the growth opportunities that management wants to obtain and the earnings that provide the scorecard for historical operations. The following details the factors which impact these three key components of value in a business.RiskRisk is the measurable possibility of something happening or not happening.1 For businesses, risk can be measured in numerous ways including benchmarking against similar businesses (“guideline”) or using a more theoretical approach such as a buildup method from market observation. None of this can be done, reasonably and supportably, without understanding the key economic drivers of the business. This prerequisite entails understanding the historical and current operations, the industry and competitive environment, operating assets, liabilities (booked and/or contingent), stakeholders, growth factors and the earnings profile of the business going forward. After understanding the drivers of risk for the subject business, the same drivers may be ascertained for the guideline businesses so that a supportable comparison can be made, ideally. However, lack of publicly available information does not make this comparison simple, and professional judgment is involved. Rarely is an exact "replica" of a business found in a guideline sample. With an appropriate understanding of the risk factors, and its comparison to similar businesses, the resulting value of a business begins to form. All other factors equal, low risk translates to higher valuation and vice versa.GrowthBusiness growth is primarily discussed in the context of revenues, profits, cash flows and assets. For some companies it also can include number of locations, products, contracts, square feet, customers and employees. In addition, growth on a larger, macro scale must also be considered as it applies to economies, industries, markets and populations. These areas are an example of the growth factors which can significantly impact a valuation and careful attention must be made to fully understand these factors in context. When we investigate the nature and history of the business, we find a relative context for future growth. Many times management and business owners make decisions to enhance shareholder value, which may include attaining the highest valuation possible. These decisions are most transparent in forecasts and projections. Risk is inter-related to future growth expectations. In short, considering growth in the context of risk is critical during a business appraisal. All other factors being equal, high growth translates into higher valuations and vice versa.EarningsEarnings are naturally a key component to analyze and arguably the most important of the three. Earnings, in this context, is a broad term to discuss operating performance of a business and is inclusive of such terms as EBITDA, net income, dividends, distributions and cash flow, to name a few. Earnings are the primary financial benefit of owning a business and are indications of performance. Careful consideration of these metrics, including industry specific earnings metrics, is very important. Changes in theses metrics over time can provide clarity on operational problems and successes. In addition, appraisers may also consider the earnings of other guideline businesses in the industry. Benchmarking may provide conclusive support regarding industry specific issues in the business but also macro issues across the economy. Earnings have significant impact on businesses strategy, future investment and capital decisions. Without investigating the earnings of a business, an appraiser cannot make an informed opinion on the value of a business.SummaryAll these components can vary substantially as time passes. An appraiser cannot simply assume that growth and earnings will continue uninterrupted into perpetuity. A marketplace is organic and can change quickly. When this occurs, growth over the long term can be difficult to achieve, and people may underestimate the risk associated with high long term growth projections. Careful analysis is necessary when estimating terminal values at the end of a long term growth forecast. When it comes down to valuing a business, understanding risk, growth and earnings are paramount.This article was originally published in Valuation Viewpoint, November 2014.Footnote1 Barron’s Dictionary of Finance and Investment Terms
8 Tips To Creating An Effective Business Plan
You’ve been a business executive for more than 10 years. During the last few years, you have essentially run a business as the manager of a division of a company. You have earned millions of dollars for your employer, while earning a modest salary for yourself."What if I started my own business?" you keep thinking to yourself. "Could I as a business owner become so successful that I can keep millions of dollars in profits for myself?"The answer "yes" might seem obvious, but it’s not. In fact, running a division of a company and running your own company are two completely different skill sets even if both enterprises have the same number of employees.If you want to run your own company, you are the individual who needs to raise the capital from investors to start, maintain and grow the business. That means you need an effective business plan. Here are eight tips that will help you create such a plan.1. Conduct a Market SurveyWhat is the market for the product and/or service you want to manufacture and/or sell? You might think that there is one because the division you are currently running is flourishing, but the market could be worse in the future. Facts from a market survey that shows your idea will succeed should be inserted into your business plan. A more pessimistic survey could convince you to work on a different product and/or service that will be marketable.2. Recruit Managers with ExpertiseAnd experience. You need to know when to create a business plan and when to present it to investors. Writing a business plan when you’re a lone wolf will not be effective. You need to find a few people whom you trust to work for you. Listing their skills and accomplishments in your business plan will make it more effective. Investors are more apt to be interested in a new business with five accomplished people than one.3. Be Specific and ModestA business plan that, for example, claims your company will be the Facebook of businesses sounds egomaniacal. Investors might think, “If the owners of this new business are that good, what do they need me for?” They also might think you’re immature and not especially professional. The business plan should be as specific as possible about the product and/or service and why it will flourish in the marketplace.4. Be Reader-FriendlyMost investors are in a hurry. They might seem more inclined to spend a considerable amount of time reading every word of your report because of the potential financial stakes, but they’re also human beings. Generally, investors want to read a well-written report with colorful (and informative) graphs and charts. That might mean you should hire a writer, editor, and graphics designer to help devise your business plan.5. Be Honest about the NumbersInvestors know a new business will take a while before it generates profits and revenues. An effective business plan will show investors that you expect losses at first. The plan should detail the extensive financial commitment you plan to make as the company is launched and realistically project when that investment will pay off. The figures are best presented in charts and graphs. “Graphs, charts, and images can help bring your concept to life,” reports “5 Tips for a Great Business Plan,” a Forbes magazine article. “Plus, it breaks up the text and helps a plan flow better.”6. Explain Why Investing Is CrucialThe business plan should detail how much money you and your partners are investing in the business and should detail how much more money you need from investors. It should also detail what the investors’ money will be spent on. Will it be on managerial salaries? Salaries for future employees? Product development? Product distribution? Investors are more apt to be willing to invest money if they know what it’s being spent on — and they might be more confident in your venture if they see that you’re willing to take financial risks.7. Summarize Your PlanYour business plan should include an extensive and detailed narrative, but it must also include a one- or two-page summary of the plan before the narrative. Prospective investors must be able to explain the plan to other prospective investors in one minute. An effective executive summary will help them do this, “Because bankers and professional investors receive so many business plans, they sometimes go right to the executive summary for an overall view of what your plan is all about,” reports Entrepreneur magazine in “How to Create a Business Plan Investors Will Love.”8. Make Sure an Attorney Reviews PlanYour attorney should help you decide the structure of your business. Should it be a corporation? A solo proprietorship? A general partnership? A limited liability company? A limited liability partnership? The attorney should help you present the advantages of the business structure you choose to the prospective investors in the business plan. And he or she should give you advice on whether any information presented in the business plan could pose a legal problem.These eight tips are just a start. You should also consult experts such as the U.S. Small Business Administration for more advice. Good luck.This article was originally published in Valuation Viewpoint, December 2014.
Hidden Tax Traps Commonly Unearthed During Business Due Diligence
There are number of aspects that always get immediate attention when a business is analyzed for an acquisition. These are standard elements that are practically on a default checklist of any decent due diligence team.A number of tax traps become apparent during the process for those professionals who knows how to look for these issues. This article seeks to identify a few that commonly show up during the due diligence process of acquiring the equity of a company.The Missing WithholdingAny business that has employees has a payroll has a tax withholding liability, and many business farm this accounting work out to third parties. It’s mundane work that has little to do with core functions of most businesses, so third party accounting firms and offices get a lot of the workload. Unfortunately, they also get lump sums of money to pay for the withholding requirements as well on a monthly basis. And those pots of cash can often be very attractive to a character who wants to shave off a few percentages of the total or “lose” a monthly payment altogether. Because the IRS and tax agencies get so much withholding on a regular basis, a shorted payment or a missing amount can be overlooked for a while. However, eventually the IRS and tax agencies reconcile amounts owed and eventually target a business for an audit. Should a business be acquired before that audit happens, the review can be a painful hit of withholding due, compounded tax interest, and tax penalties.Business Deductions Not Matching ExpensesSmall businesses are notorious for having very inflated tax-deductible expenses that tend to disappear when the real accounting books are reviewed. No surprise, the IRS often casts a very pessimistic eye on small businesses as a result. If a company has a history of inflated tax returns it’s not going to become apparent unless so those same returns are examined in direct comparison to the real accounting records. Any appraiser who is aware of this relationship knows to ask for both and looks to tie out specific expense numbers accordingly. A failure to look for this kind of baggage means the new owner could be stuck with tax penalties or worse, a tax investigation for tax evasion.Inflated Depreciation LandminesBusinesses are allowed to depreciate large equipment and asset purchases, but they need to be depreciated over time. Incorrect calculations on tax filings can trigger audits and corrections. However, like other tax issues, the tax agency correction can be years after the fact. These landmines often get missed unless someone actually looks at the depreciation figures filed and checks on their validity.In SummaryTax traps don’t have to be discovered the hard way. A targeted due diligence assignment will catch these issues, specifically looking for tax problems when examining liabilities. Don’t consider an acquisition of the equity of a business without knowing the tax records have been specifically reviewed.This article was originally published in Valuation Viewpoint, April 2015.
Brexit and Killen Underscore the Need for Buyer Protection in Asset Manager Transactions
Black swan events and the very nature of the asset management business illustrate the importance of contingent consideration in RIA acquisitions for prospective buyers. The volatility associated with equity managers means AUM and financial performance can swing widely with market conditions, so doubling down on a one-time payment for an RIA can be extremely risky, particularly at high valuations. Of course, the market can just as easily pivot in the buyer’s favor after the deal closes, but gaining Board approval for such gambles is an exercise in futility if insurance is available in the form of contingent consideration.Back in December, we blogged about Tri-State Capital’s recently announced acquisition of $2.6 billion manager, The Killen Group of Berwyn, PA. The deal terms included an initial $15 million payment and contingent consideration of 7x any incremental growth in Killen’s annual run rate EBITDA in excess of $3 million for the pending calendar year (2016). Upon announcement, the estimated total deal value was in the $30-$35 million range, but when the deal closed in April, this estimate dropped to $15-$20 million. The table below illustrates the implied valuation metrics and returns had this deal been structured as a one-time payment under the two value scenarios.
Fortunately for Tri-State, the bank elected to structure the deal as an earn-out whereby roughly half of the total potential consideration was guaranteed and the remaining half had to be “earned” by meeting certain earnings objectives following deal closure. The downward revision implies that the business is not likely to generate more than $3 million in EBITDA this year, and an ~11x purchase for a closely held RIA with compliance issues and a declining AUM balance (ADV disclosures indicate that Killen’s AUM fell 27% in 2015) would have been hard to justify had the total deal value been paid up front. Instead, Tri-State is still likely to boast a decent ROI on this deal without paying another dime for it if the business fails to perform in line with initial expectations. The following table shows the implied total deal value under four different scenarios of EBITDA for this year.
Under this structure, the seller is incentivized to ensure the business continues to perform after the initial payment. This assurance is critical in many RIAs that are often heavily dependent upon the selling shareholder(s) for client relationships or investing acumen. If key accounts are not transitioned to the prospective acquirer or the market corrects itself following the transaction, the buyer will likely be off the hook for further consideration.
Contingent consideration doesn’t always have to be based on future earnings. Perhaps the most acquisitive business in the RIA space is Affiliated Managers Group, whose investment model includes a revenue sharing agreement whereby the target’s fees are split (at a fixed percentage) into two segments: the operating allocation and the owners’ allocation. The operating allocation covers all operating expenses of the affiliate (target) at the discretion of the target’s management, while the owner’s allocation goes to the firm’s partners and AMG according to their respective ownership interest in the business.
[caption id="attachment_11668" align="aligncenter" width="500"]Source: AMG[/caption]
This structure allows the affiliate to retain operating autonomy while limiting AMG’s exposure to operating leverage because the owners’ allocation is set at a fixed percentage of revenue, not earnings. Since there’s usually some portion of an asset manager’s expense base that is predominantly fixed, earnings are typically more volatile than fee income, so the revenue sharing agreement is a partial hedge against earnings volatility during a Brexit or other black swan event.
Still, the best hedge against a market downturn is a solid profit margin, as we’ve discussed in a prior post. With Brexit coinciding with a quarterly billing cycle for many asset managers, earnings are likely to take a huge hit along with the market. Those RIAs with a robust EBITDA margin will likely stay in the black as opposed to their less profitable counterparts that may be under water until market conditions improve.
M&A Activity in the Bakken
Crude prices in North Dakota are even lower than the already depressed price of WTI and Brent. This is largely due to region’s insufficient pipeline network. This creates high transportation costs, and in turn decreases realized wellhead prices. As of June 15th crude oil prices in North Dakota were almost 20% lower than the price of WTI and 21% lower than the price of Brent. On top of lower revenue per barrel, the Bakken faces higher initial drilling costs than many other mineral reserves. Together these factors mean that production is not economically feasible in the current low price environment. As of June 17, even as oil prices rose to above $45 per barrel, Baker Hughes reported that there were only 24 rigs operating in North Dakota. In order to survive, when producing is no longer economically feasible, production companies are selling “non-core” assets to generate the cash.In October of 2015, Occidental Petroleum Corporation sold its Bakken Assets to Lime Rock Resources. This sale marked the first exit of the downturn by a major oil company from the Bakken Shale formation. So far, M&A activity of Bakken assets has slowed in 2016, but most Bakken assets are selling for heavy discounts making them attractive to buyers. Some other recent transactions in the Bakken are highlighted below.The sale of Emerald Oil’s Bakken assets can help us understand the current pricing environment. Emerald Oil, an independent producer in the Williston Basin, filed for Chapter 11 Bankruptcy on March 22 and was delisted from the NYSE on March 24. During this time, Emerald had entered into a deal with Latium Enterprises to sell acreage at $1,740 per acre, but the transaction fell through. Last month, Emerald Oil announced that CL Energy Opportunity fund would buy substantially all of their assets for $73 million which equates to less than $980 per acre. This represents a 44% haircut in just two months. What we see in this case is a continuing fall in the value of acreage as investors learn that assets in the Bakken can be bought at even lower discounts if they wait for the continuation of low oil prices to put more and more pressure on distressed buyers to make a sale. While this is a stalking horse offer, they are not likely to get much higher on the final deal. As Emerald oil became more desperate to reorganize in order to avoid Chapter 7 bankruptcy, they became more willing to sell at a lower price.Oil Prices are expected to remain low into the third quarter of this year and possibly into the second quarter of 2017. As the price of oil remains depressed, many companies avoiding bankruptcy or reorganizing through Chapter 11 will be forced to sell non-core assets in order to generate cash. In a distressed market, it is extremely important to push for the best offer possible. Mercer Capital can help you understand the true value of your assets and can help you through the Chapter 11 Process.
A Watched Pot Never Boils: Still Waiting on Margin Relief
As expected after lackluster job gains in May, the Federal Open Market Committee declined to raise the Fed Funds target at the latest policy meeting on June 15th. While the majority of policymakers still expect the Fed to boost rates twice before the end of this year, the number of officials who forecast just one rate hike increased from one to six from the previous forecasting round in March. In addition, Fed officials lowered their expectations for future years, now expecting the fed funds rate to rise to 1.6% by year-end 2017, down from the 1.9% estimate in March, and 2.4% in 2018, down from the previous estimate of 3.0%. During a press briefing on June 3rd, members of the Economic Advisory Committee of the American Bankers Association said they still expect the Fed to boost rates twice before the end of this year, but after years of speculation regarding timing of rate increases, when that will happen remains anyone’s best guess. The bond market never believed the forecasts.Rate increases are long awaited by community bankers as banks are facing profitability challenges. Net interest margins continue to compress and loan growth remains stymied by intense competition for high quality loans. Margin relief remains out of the grasp of most community banks, absent further rate hikes beyond the December 2015 hike. After rebounding modestly in the third and fourth quarter of 2015, the median net interest margin of community banks (defined as those with assets between $100 million and $5 billion), ticked down modestly in the first quarter of 2016 as intense competition for quality loans drove down loan yields and the decline in long-term rates put downward pressure on securities’ yields (Charts 1 and 2).
Overall, median net interest income continued to increase as growth in loans offset margin compression, but intense competition raises concerns over how much credit standards have been relaxed to drive loan growth.
Although the majority of banks’ balance sheets are poised to take advantage of rising rates, the lift to net interest margins is dependent on asset yields rising faster than the cost of funds (Chart 3).
While deposits costs essentially reached a floor several quarters ago, data suggests the threat of rising deposit rates may limit margin expansion in a rising rate environment. As shown in Chart 4, the percentage of banks reporting quarter-over-quarter increases in the cost of interest bearing deposits has been trending upward over the last eight quarters. In a higher rate environment, customers are more likely to shop around for higher rates. The increase observed in interest bearing accounts could reflect the fact that higher loan growth has compelled some banks to raise rates or perhaps an effort to build goodwill with customers in anticipation of rising rates and increased rate sensitivity. For banks with asset sensitive balance sheets, the benefit of rising interest rates will be greater the stickier low cost deposits are.
While net interest margin is a key metric for banks, focusing on other drivers of profitability is one way to combat margin compression in the face of further delays in interest rate hikes or upward pressure on deposit costs. Consider the following:
Look for opportunities to grow non-interest income. One strategic option may be to expand bank offerings into non-traditional bank business lines that are less capital intensive and offer prospects for non-interest income growth such as acquisitions or partnerships with insurance, wealth management, specialty finance, and/or financial technology companies. FinTech’s consumer-focused technology and ability to quickly adapt can pair well with community banks who can provide an established customer base and knowledge of the regulatory process and environment. For more information, we recently wrote an article on why current market conditions may be ripe for FinTech partnerships.Leverage technology to curb efficiency ratios. Compliance and regulatory costs continue to rise and represent a bigger burden to community banks who lack the scale to accommodate these expenses in comparison to their larger peers. A recent article from American Banker included data presented by Chris Nichols, chief strategy officer of CenterState Banks, at a recent fintech conference in Atlanta that shows why engaging customers digitally is more efficient. Furthermore, a recent article published on SNL highlights how, in some regards, community banks can be quicker to adopt new technology than larger peers. While size may limit what projects are feasible for community banks, agility has its benefits.Increase scale. Create economies of scale and improve profitability organically or by merging with a larger company. Organic loan growth is an obvious cure to the margin blues, but must be achieved while maintaining credit quality and holding adequate capital. M&A remains a classic solution to revenue headwinds in a mature industry, and bank acquirers can potentially have savings beyond expense synergies with some NIM relief resulting from potential accretion income on the acquired assets, which are marked to fair value at acquisition.
Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank’s unique situation in confidence, feel free to contact us.
10 Ideas for Experts When Preparing for Depositions
An expert deposition is a formal proceeding. I can only speak from my own experience in having my deposition taken and in attending a number of depositions of other experts or parties to various matters. There is one thing that is true in the majority of expert depositions I have seen. The opposing attorney prepares for the deposition. In one deposition, the opposing counsel had his outline of questions to ask me contained in a three-ring notebook. I couldn’t be sure, but it appeared to have more than 50 pages of typewritten questions.If opposing counsel is going to prepare for your deposition as an expert witness, it is equally critical that you prepare as well. Preparation for an expert deposition entails a number of activities:Do good work all the time.In some cases, experts are retained to prepare business valuation, economic damages, or financial forensic reports in the context of litigation. In those cases, it is critical to do good work, to support each opinion, to be sure that the math checks out, and to be certain that a report is internally consistent and consistent with an expert’s prior work, writings and speaking. However, your first deposition may not arise because you were retained as an expert. You may be deposed on a report that you prepared in the ordinary course of business. This could happen with a report prepared for tax purposes, for a buy-sell agreement, for an ESOP, or for some other purpose. In those cases, you don’t get a chance to “do the report over” for the litigation. You must live with the report you signed long ago. Remember to do good work all the time.Read your expert report. Experts write reports that summarize their opinions and provide the basis, support and rationale for their opinions. In business valuation and economic damages matters, expert reports can be of considerable length, perhaps 100, 200, 300 or more pages. In many cases, considerable time will have passed between the submission of an expert’s report and his or her deposition. This makes it essential to read the report carefully, and from cover to cover, including all boilerplate. An expert has to be familiar with what is in his report as well as what is not in the report.Review the entire file. An expert’s file will contain many documents, maybe hundreds or even many thousands of them. The expert must review the file to know what is there. In large litigations with literally thousands of documents, it may be necessary for another professional to review documents. If so, the expert then must review the key documents identified in that review. Not every document will have been relied upon, but you have to be familiar with the key documents supporting your opinion. When working on litigation matters, I routinely accumulate the major documents that will be referenced in a spiral-bound notebook. Depending on the circumstances, I may take my own notebook to deposition or trial because I am familiar with the book and the documents. In any event, I review those documents carefully, often multiple times.Prepare a list of key names, dates or other key information you do not want to forget. I typically prepare a list that includes the name(s) of our clients, all the attorneys we have worked with on our side, opposing counsel, opposing experts, and key dates or documents I may want for instant recall. There are no opinions on this list, just names and facts. You will only forget the name of your client one time – when the client is sitting in your deposition – before you initiate this habit.Respond fully to any subpoena for your file. Most expert depositions are noticed with subpoena duces tecum, which is a request for the expert’s presence at a deposition as well as for documentary evidence from his files. In our shop, subpoenas are provided to our in-house counsel, and she reviews the file in order to be sure that we comply. This means that experts shouldn’t put things into their files that they don’t want someone else to see. Opposing counsel will ask the expert whether he or she has complied with the subpoena.Meet with counsel to prepare for the deposition. This meeting (or meetings) provides a deadline for the expert in doing the preparations noted above. Counsel will usually have some idea of how opposing counsel will approach your deposition, and the themes he or she thinks you can expect to see. Counsel can give you information about the style of the opposing counsel who will be taking the deposition. It is a good idea to do an internet search and read biographical information about opposing counsel.Know your objective for the deposition. Some experts go into depositions loaded, as it were, for bear. They want to try to “win” the deposition by proving their opinions zealously.
An attorney told me long ago to avoid the temptation of trying to “win” a deposition. Counsel observed that the rules for depositions and trials as they relate to experts were written by attorneys and conducted by attorneys. Counsel then said something I’ve not forgotten: “Chris, your objective in this deposition is not to win it. Your objective is not to lose.”Discuss your approach to comments about opposing expert reports with counsel. In some cases, counsel will want you to be prepared to comment on the report of one or more other experts. If so, outline your comments in advance so that you are organized when asked for your opinions regarding the report(s). In other cases, counsel may have retained another expert to handle rebuttal, and you would not be expected to comment, even if asked by opposing counsel. It is okay not to have opinions about other experts.Talk with counsel about local rules applicable to depositions. In some jurisdictions, experts are not allowed to talk with counsel for their side during a deposition. I recall one arbitration in which I testified where this rule was in place. As we reached the end of the day during my testimony, opposing counsel opened a report that I had issued some years before and read a portion that appeared to impeach my testimony. The problem was, I couldn’t remember the details of that earlier report on the spot. Fortunately, the day ended at that point. The arbitration resumed three weeks later, and I was unable to talk with counsel about the testimony at all during that period. However, I did pull a copy of the report that opposing counsel had read from. Counsel had clearly taken his quote out of context. I brought a copy of the report when I returned to the stand and asked for time to respond to the final question from the previous session. With permission from my earlier client, I read the portion of the report that counsel had tried to trip me with, but I read that portion in appropriate context. In that light, there was no impeachment. Indeed, the earlier report supported my testimony in the arbitration. That’s a long story, but the point is, know the rules.Get a good night’s sleep the night before your deposition. Depositions can be long and grueling. In some jurisdictions, they are limited to seven hours of deposition time. Seven hours, though, can be a long time, so it is good to be rested. For multi-day depositions, getting good rest is critical. It takes a great deal of mental focus and physical energy to give a good deposition. So, take care of yourself as a key part of preparing.Wrapping UpThe central idea behind preparing for an expert deposition is to be sure that the expert is as ready as possible. Preparation is essential for experts to give good depositions.Mercer Capital brings analytical resources and over 35 years of experience to the field of dispute analysis and litigation support. We assist our clients through the entire dispute process by providing initial consultation and analysis, as well as testimony and trial support. Please contact us to discuss your needs in confidence.
Wisniewski v. Walsh and the Bad Behavior (Marketability) Discount in New Jersey
Peter Mahler reported on a recent New Jersey appellate level case focusing on the application of a 25% marketability discount in a statutory fair value determination in his New York Business Divorce blog. The New Jersey Appellate Division issued an unpublished decision in Wisniewski v. Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 [App. Div. Dec. 24, 2015]. The case is interesting in that it attempts to determine a marketability discount in relationship to the “bad behavior” of a selling shareholder.
The Wisniewski case has a long and tortuous history dating back to the mid-1990s. The case involves a successful family-owned trucking business founded by the father in 1952. Three siblings, Frank, Norbert, and Patricia owned the business equally following the father’s death. Frank assumed leadership of the business by 1973, and Norbert and Patricia’s husband also worked in the business. In 1992, Frank was sentenced to a prison term, leaving Norbert in charge of the business. Norbert stopped paying certain bills that had customarily been paid for Patricia and her husband, and diverted certain revenues from a business owned by Patricia to one in which she had no interest. In addition, even after Frank’s return, Norbert tried to exclude Patricia from a real estate deal that she ordinarily would have participated in.
The litigation began around 1995. Interestingly, the trial court held that Norbert was an oppressing shareholder, and none of the parties contested that finding or the court’s later decision that Norbert should be bought out. Hold that thought, because it becomes a key factor in the court’s determination of statutory fair value. I can only call the concluded marketability discount in the matter a “bad behavior” discount.The ValuationsThe court’s valuation was determined through two trials in 2007 and 2008. Roger Grabowski of Duff & Phelps was retained by Frank and Patricia (the company) and Gary Trugman of Trugman Valuation Associates was retained by Norbert. I have been unable to locate the trial court’s decision in that matter, and so I can only write about the valuation from the perspective of the appellate decision.The trial court issued opinions in October 2007 and July 2008, which explained how and why the trial judge concluded that the fair market value of Norbert’s interest was about $32.2 million. We learn in the appellate decision that the trial court applied a separate 15% “key man” discount “to account for Frank’s importance.” If the conclusion was $32.2 million for Norbert’s interest, then the value before the discount was about $37.9 million ($32.2 / (1 – 15%)). No marketability discount was applied by the trial court. This would place an implied value of the trucking business at about $114 million.We do not know the conclusions of either Grabowski or Trugman that were considered by the trial court. According to the appellate decision, the trial judge found Trugman’s discounted cash flow analysis more credible than Grabowski’s market approach. However, the trial judge used assumptions suggested by Grabowski for certain normalizing adjustments to operating expenses for Trugman’s discounted cash flow method.The Initial Appeals and Application of a Marketability DiscountThere was an appeal of the trial court’s decisions in 2007 and 2008. The appellate court, in a decision issued April 2, 2013, held in part that “the trial judge erred in not applying a marketability discount” and remanded “for the fixing and application of a marketability discount to the extent not already subsumed in the judge’s findings…”The 2015 appellate decision states regarding the remand to the trial court in 2013:On remand, Judge Hector R. Velazquez briefly contemplated that the record might need to be supplemented with expert testimony pertaining to the narrow issues presented, but ultimately decided against it; none of the parties quarrel with that approach now. Left to resolve the matter on the record developed after the first remand, Judge Velazquez heard oral argument and issued an opinion on October 16, 2013, concluding that a discount for marketability was not embedded in the prior valuation and that a discount of twenty-five percent should be applied. He entered a second amended final judgment to that effect on January 7, 2014.And of course the parties appealed and cross-appealed.The Final (?) AppealThe appellate decision was issued December 24, 2015. To cut to the chase, the appellate court found “no merit” in the appeal and affirmed Judge Velazquez’ 2014 opinion. The appellate decision recounts that Norbert was found to be an oppressing shareholder. This turns out to be an important point, because in New Jersey, the marketability discount is typically reserved for “extraordinary circumstances” involving inequitable or coercive conduct on the part of the seller, who is Norbert in this case.
The issue on appeal was whether the trial judge had erred in application of the 25% marketability discount because marketability may already have been considered in Trugman’s DCF analysis. The key facts relating to the marketability discount question, as best I can glean them from the 2015 appellate decision, include:Trugman’s Discount Rate Risk Factors. Trugman used a build-up method to develop his discount rate for his DCF analysis. The company-specific risk factors in the build-up included key man risk regarding Frank’s perceived management ability, customer relationships, customer concentrations, the closely-held nature of the trucking business, and undercapitalization. Trugman made two important additional points regarding the marketability of the business. He stated that the company is profitable, attractive, and marketable and that the company made substantial distributions on a regular basis that should offset any risks during a normal marketing period (of six to nine months). Trugman did not apply a marketability discount (or assumed it to be zero), noting that the discount rate was the “right place” to consider these risks. Recall also that the trial judge in the valuation trial had already applied a separate 15% key man discount after accepting Trugman’s DCF (as modified by Grabowski’s expense assumptions).Grabowski’s Marketability Factors. Grabowski had applied a marketability discount of 35% in his valuation. Judge Velaquez concluded that Grabowski and Trugman considered several of the same factors in reaching their discount rate and marketability discount, respectively. Grabowski’s marketability factors included heavy dependence on Frank as a key man, customer concentrations in the retail industry, the company’s size and closely held nature, its profitability, and the anticipated holding period. Grabowski per the court noted that his marketability discount was also “consistent with guidance from applicable [minority] studies and legal precedent.” Grabowski viewed the company as having a relative lack of marketability.
The appellate court notes the trial court’s decision:Judge Velazquez concluded, based on that record, that although Trugman and Grabowski had considered several of the same factors in formulating their discount rate and marketability discount, respectively, that Trugman had made no adjustment for marketability in building up his discount rate — in short, the judge concluded that no marketability discount was embedded in his evaluation. The judge rejected both expert opinions, moreover, in selecting an appropriate discount, and fixed the rate at twenty-five percent.It gets more interesting for valuation professionals. The appellate court reasoned that a marketability discount was necessary because of Norbert’s bad behavior towards his fellow shareholders (there was never a finding that his behavior harmed the company in any way).The second trial judge rejected application of a marketability discount following our first remand. He considered Frank’s criminal conviction, a factor Grabowski suggested would reduce the company’s value, but noted that while the company endured a lull during Frank’s absence, it resumed its growth on his return with no apparent hindrance attributable of his criminal history. Neither that nor any other circumstance, the trial judge at the time reasoned, justified application of the discount.
Although the reasoning was sound for the most part, we reversed because the judge at the time failed to consider that Norbert’s oppressive conduct had harmed his fellow shareholders and necessitated the forced buyout…[paraphrasing the New Jersey Supreme Court in Balsamides under similar circumstances]. …[A]bsent the application of a discount, the oppressing shareholder would receive a windfall, leaving the innocent party to shoulder the entire burden of the asset’s illiquidity in any future sale. Equity demanded application of the discount, or else the statute would create an incentive for oppressive behavior. (emphasis added)The appellate decision restated some of Judge Velazquez’ logic in making the following point:On remand, Judge Velazquez determined on the existing record that a marketability discount was not already embedded in the valuation. He recounted that the discount rate Trugman build up included a size premium and an adjustment for a series of company-specific factors including the company’s reliance on Frank, its customer concentration in the retail industry, and high debt. Although Grabowski had considered similar factors in formulating his marketability discount, the judge concluded that Trugman had certainly “utilized them in a different way” than to adjust for any lack of illiquidity. (emphasis added)As a business appraiser examining this case from business and valuation perspectives, the economic logic for applying a 25% marketability discount by the court is considerably strained. If a group of risk factors are considered in the DCF method that lower value in the context of that method, it is difficult to see how their further consideration for the application of an additional marketability discount is not double-counting. However, the appellate court addressed this issue as follows:Grabowski analyzed a handful of the same factors, among many others, in formulating his marketability discount, but, in contrast, focused on the inherent liquidity of closely-held companies and the anticipated holding period for a rational investor in this company. There was no clear indication in the record, then, that Trugman and Grabowski had accounted for the same risks relative to marketability, such that application of a separate marketability discount would cause double counting. (emphasis added)In the light of day, it would seem that there is double-counting to the extent that both appraisers considered the same factors that would reduce each of their values, even if they used those factors in different ways. And note that the original trial judge had already allowed for a key man discount of 15%, which occurred, obviously, after the experts had testified and provided their evidence. This discount, which certainly pertains to the “marketability” of a business, is substantial discount that had already been considered in the trial court’s conclusion. It just wasn’t labeled as a marketability discount.The Marketability (Bad Behavior) DiscountWhat it seems that we have in Wisniewski v. Walsh is a situation that is a business appraiser’s nightmare. At the original valuation trial, the court held that there should be no marketability discount. That was appealed. The appellate court then remanded back to the trial court for the application of a marketability discount to the extent that one was not already embedded in Trugman’s DCF analysis. The trial judge then, based on logic outlined above, concluded that no marketability discount was embedded in the DCF analysis and that the appropriate punitive marketability discount was 25%. This was appealed, and in this current appellate decision, the trial court’s marketability discount is affirmed.I have no problem if a court of equity wants to penalize a party for oppressive behavior to other shareholders. That is certainly one of the jobs that courts of equity are called upon to do in appropriate circumstances. And that discount can be zero, 10%, 20%, 25% or anything the court determines is appropriate in a specific case.I do have a problem with a court making an “equitable” decision and then trying to justify that decision based on parsing of valuation evidence.Assume an appraiser provided a valuation in another New Jersey statutory fair value matter involving the oppressive behavior of a selling shareholder named John. Let’s say that the value conclusion for the interest before the application of a “bad behavior discount” was $100 per share. The appraiser then concludes as follows:Based on my analysis of John’s bad behavior, I believe that a marketability (bad behavior) discount of 20% is appropriate.The appraiser might be thrown out of court. His opinion would certainly be given no weight. How then, is an appraiser to respond when the ultimate marketability, or bad behavior, discount will be determined by a judge who is responding to the equities of a matter? After all, valuation evidence pertaining to the marketability of a company or of an interest in a company has absolutely nothing to do with the behavior of any shareholder.Let’s look further at the appellate decision and we will see that the trial court’s conclusion has nothing to do with the economics of the trucking business in Wisniewski.The Court noted in Balsamides, supra, 160 N.J. at 377, 379, that marketability discounts for closely-held companies frequently ranged from thirty to forty percent, though the Court explained that selection of an appropriate rate, and the applicability of a rate in the first place, must always be responsive to the equities of a given matter.
Judge Velazquez properly rejected from the outset Norbert’s suggestion that the marketability discount be set at zero percent. Indeed, we had already decided that a marketability discount was required and Judge Velazquez was bound by our mandate.
After carefully canvassing the record, Judge Velazquez came to the conclusion that selecting a thirty to forty percent rate as described in Balsamides would excessively punish Norbert, the oppressing shareholder, beyond what the equities of this case required and, in light of the company’s past financial success and anticipated continued future growth, stood to “give the remaining shareholders a significant windfall.”
In choosing an appropriate marketability discount after rejecting portions of both expert opinions on the issue, Judge Velazquez acknowledged our Supreme Court’s advice in Balsamides that such discounts frequently ranged from thirty to forty percent, but noted that other studies supported a broader range, reaching as low as twenty percent. He alluded to authorities from other jurisdictions approving the application of a wide range of discounts, sensitive to the equities of each individual case, and to our decision in Cap City Products Co. v. Louriero, 332 N.J. Super. 499, 501, 505-07 (App. Div. 2000), allowing application of a twenty-five percent discount. (emphasis added)If trial courts determine marketability discounts as bad behavior discounts, there really is no way that business appraisers can provide meaningful information to a court. If the court’s concern is one of “the equities” in a matter rather than in determining the fair value or the fair market value of a business or interest in a business, then there is little that appraisers can do to help. In Wisniewski, the application of a marketability discount flowed, not from the lack of marketability of the trucking business, but from the bad behavior of Norbert. Neither Trugman nor Grabowski had a chance in that determination. All we can say is that the court’s ultimate conclusion for the bad behavior (marketability) discount fell within the range suggested by Trugman (0%) and Grabowski (35%) and had nothing to do with the relative marketability of the business at hand.Peter Mahler’s ConclusionMahler concluded similarly in his blog post:If you ask accredited business appraisers whether the determination of a marketability discount rate for the shares of a particular closely-held company should be based on case precedent involving other companies, I think the vast majority will answer “no.” I wrote a piece on that very subject last year, quoting from the IRS’s DLOM Job Aid and experts in the field. Yet cases such as Wisniewski point the other way, effectively encouraging advocates and judges to select a rate within a self-perpetuating, “established” range of case precedent based as much if not more on the “equities” of the case than the financial performance, prospects, and liquidity risks of the company being valued. It’s not for me to say whether appellate courts and legislatures should decide as a matter of policy to incorporate into fair value determinations equitable considerations based on the good or bad conduct and motives of the litigants toward one another. But I am saying that if that’s the way it’s going to be, there’s an associated cost in the form of greater indeterminacy in fair value adjudications which makes it harder for lawyers and valuation professionals to advise their clients and to reach buyout agreements before they ripen into litigation.Readers can see the bad news in this appellate decision in Wisniewski. The good news, I guess, it that most statutory fair value cases do not involve bad behavior on the part of a selling shareholder.
The Importance of Specialization in Investment Management
A Review of Philip Palaveev’s <em>The Ensemble Practice</em>
In an industry characterized by constant pressure to adapt to market conditions and offer highly specialized client service, many financial advisors still spend a significant portion of their time acquiring new clients rather than collaborating with other professionals. According to Philip Palaveev in his recent book The Ensemble Practice, the majority of financial advisory practices still function as "solos," or one individual against the entire market. This practice is inherently problematic in its lack of sustainability and the problems it poses for an owner who desires to leave a legacy post-retirement.Palaveev argues that, like prehistoric hunters and gathers, solo firms face constrained resources and limited growth due to the amount of time owners must spend on business development. Just as the discovery of agriculture allowed for specialization and the sharing of knowledge and resources, a team-based approach to asset management allows employees to focus on the cultivation of relationships with clients and other professionals. The result, again according to Palaveev, is a lasting organization with more predictable revenue streams.The book defines this organization as an "ensemble," or a team of financial advisory professionals that relies on the team rather than an individual to service and manage client relationships. The advice to shift away from reliance on the owner as a key man is very similar to the recommendations we heard in Success and Succession, but Palaveev offers insight into how and why to develop an ensemble practice even before succession planning becomes a priority.According to the book, an ensemble practice offers a number of tangible advantages. Ensembles are proven to grow faster, attract larger client relationships, achieve higher levels of profitability, and create more substantial long term value for their principals. However, they do require owners to relinquish some control, and not just in terms of influence on the business. A principal in an ensemble practice must ultimately accept a less flexible lifestyle due to his participation in an ambitious team of people. In addition, the process of actually achieving ensemble status is difficult, especially for firms with an ingrained individualistic sales culture. All considered, an ensemble practice offers a number of additional benefits that are promoted throughout the remainder of the book.Leverage and Growth. One of the first steps in the evolution towards ensemble status is the addition of less experienced professionals who can help increase profitability through leverage. According to Palaveev, hiring professionals with less experience and training them is the "most reliable path to building a valuable firm." Though a new hire will require a significant amount of investment, his inexperience will allow the senior advisor to continue to fashion the culture of the firm. This associate increases the income generating capacity of the senior advisor while incurring less expense for the firm per labor hour as compared to a more experienced individual. In addition, the associate can be mentored by the owner and allow for the future growth of the practice. A young, inexperienced professional helps incorporate enthusiasm and energy with the wisdom and relationship of the owner. However, Palaveev warns against a culture in which tenure leads to guaranteed promotion. He argues that 100% "home grown" firms are susceptible to inefficiencies and the possibility of missing out on new ideas and perspectives.Legacy. Eventually, the new associates hired will form the next generation of senior advisors and allow for the possibility of internal succession. In accordance with the advice offered in Success and Succession, Palaveev suggests that internal succession is more reliable and offers the owner more control over the terms of his exit. In contrast, external transactions involve years of hard transition work and the prospect of seeing a stranger take over the practice. Emphasis is again placed on starting the transition process early, because although in a growing firm staying invested will maximize the value to the majority owner, it will leave him with a highly valuable but highly illiquid “chunk of stock.”
In conclusion, this book provides valuable insight into how to successfully navigate the transition to an ensemble practice and highlights both the short term and long term benefits of this transition. It shares many themes with Success and Succession and helps solidify the importance of reducing key man risk early in the life of a practice. We would note that, in our experience, it requires a certain scale to implement the ensemble strategy, and it’s a bit of a chicken-and-egg issue as to whether you build a large enough practice first using a more traditional, individualistic sales culture and then try to redirect the culture toward specialization, or invest in specialization up front and hope the clients will come in to justify the overhead. One strategy has certain risks for the top-line, the other clearly affects the margin. In either event, Palaveev seems to capture the importance of specialization – which is significant in any profession – and provides a roadmap to implementation in a traditional investment management firm.
Bridging Valuation Gaps: Part 3
At Mercer Capital we recognize that the low price environment is forcing many E&P companies either to sell reserves to improve their cash balance, or to reorganize through Chapter 11 restructuring. This is the third and final post in a series aimed at helping E&P companies to navigate the sale of non-core assets and bankruptcy by examining how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. In past posts we discussed the difficulties of valuing PUDs and unproved reserves in low-price markets, and when option pricing can provide a more accurate valuation. In this third and final post we want to delve into the specifics of adapting option pricing from shares of stock to oil and gas, highlighting some of the challenges and key steps of the process.Pitfalls and Fine PrintOption pricing, most often used in valuing stock options, can incorporate factors overlooked by a traditional DCF and enable a company to show to potential buyers or stakeholders the value of PUDs and unproved reserves even in low-price environments. There are, however, key differences in PUD optionality and stock options that create limitations to the model and can make it challenging to implement. Below are some areas where keen, rigorous analysis can be critical:Observable Market. The DCF is typically the best estimate of reserve value, followed by the market approach. This relationship flips when crude prices fall. Market participants understand that prices will eventually recover while it is more difficult to show this expectation using a terminal value for the DCF because the precise date of market recovery is unknown. However, today the prices have fallen so far for so long that the market approach is no longer accurate either. The oil and gas market is operating like a department store having a going out of business sale. In these moments an option pricing method is particularly useful, as it can more fully account for the volatility of oil and gas prices—which have both year to year supply and demand changes and significant seasonal swings.Risk Quantification. We have found that oil and gas price volatility benchmarks (such as long term index volatilities) are not all-encompassing risk proxies when valuing specific oil and gas assets. If not analyzed carefully, the model can struggle to capture some critical production profile and geologic risks that could affect future cash flow streams considerably. Risks include production profile assumptions; acreage spacing; localized pricing versus a benchmark (such as Henry Hub or West Texas Intermediate Crude); and statistical “tail risk” in the assumed distribution of price movements.Sensitivity to Capital Expenditure Assumptions. Analysis of an asset or a project’s cash flows can be particularly sensitive to assumed capital expenditure costs. In assessing capital expenditure’s role as both a cash flow input and an option model input, estimations of future costs can be very challenging, but are an important assumption to measure properly as they drive much of the calculated value.Drilling Resource Availability and Service Costs. When oil and gas prices fall, the availability of drilling resources tends to rise while the costs of drilling and oilfield services often fall precipitousl These factors can create an oscillating delta in both cost and timing uncertainties as the marketplace responds by investing capital into underdeveloped reserves while the fuse burns on existing lease rights.Time to Expiration. This input can require granular analysis of field production life estimates coupled with expiring acreage rights, and then adjusted for the drilling plans of an operator. The resulting time-weighted estimate can present problems with assumption certainty. The time value of an option can increase significantly if the mineral rights are owned; unconventional resource play reserves are included; there are foreign reserves; or the reserves are held by production. In these instances, the PUD and unproved reserve option to drill can be deferred over many years, making the option more valuable by increasing the chance of market fluctuations that will make the reserves profitable.SummaryUtilization of modified option theory is not in the conventional vocabulary of many oil patch dealmakers, but the concept is considered among E&P executives as well during transactions in non-distressed markets. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), the time value of the out-of-the-money drilling opportunities can have significant worth in the marketplace.We caution, however, that there are limitations in the model’s effectiveness. Specific and careful applications of assumptions are needed, and even then Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace. Today’s marketplace is particularly murky, and an accurate appraisal is extremely valuable since establishing reasonable and supportable evidence for PUD, probable, and possible reserve values may assist in a reorganization process that determines the survival of a company. Given these conditions we feel that the benefits of using option pricing far outweigh its challenges.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
Bridging Valuation Gaps: Part 2
The current low price environment is affecting the finances of many E&P companies. At Mercer Capital we recognize that whether companies are looking to sell reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market.Option PricingOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As discussed in the first post of this installment, if one relied solely on the market approach many of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property’s future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either the PUDs potential for development can be altered by fluctuations in the current price outlook for a resource, or, as seen with the rise of hydraulic fracturing, drilling technology can change driving significant increases in the DCF value of the unproven reserves.This optionality premium or valuation increment is typically most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.Current Pricing Environment: Challenge = OpportunityAs oil prices have dropped—the high WTI price over the past six months was under $50 and the low under $30—PUD values may drop from 75 cents on the dollar to 20 cents on the dollar or less. After the last Recession, some PUDs faced a similar, yet more modest, decline in prices. The price level recovery for PUDs in 2011 was partly attributable to the recovery in the U.S. and global economies, and partly due to increases in the price of oil.
Valuation would be made easier if we could determine when oil prices would rise again. Let us look then to see what might change prices going forward. The consensus is that five main factors have significantly increased the world supply of oil and driven down prices:
The continued success of shale drillers in the U.S.OPEC’s choice to increase and hold production levels.The U.S.’s elimination of restrictions on crude oil exports.The recent lifting of Iran’s sanctions and the anticipation of additional supply from war-torn countries of Libya and IraOil consumption slowing down in countries like China.
While this sounds promising, we must remember the crash in oil prices in 1985 that remained below $20 until 2003. Every analyst has a best guess of what will happen, but there are simply too many variables involved in shifting oil prices to make accurate forecasts. Changes in any of the five drivers of low oil listed above could dramatically impact oil prices; and some of those drivers, such as the relationship between Iran and Saudi Arabia or China’s growth—contain thousands of variables that make them almost impossible to predict. In addition to all these considerations, the potential for technological changes creates another unpredictable component. A common solution in DCF models is to use the NYMEX WTI futures to project price. However, studies show that, even though buyers are estimating the value of this option into the prices they are willing to pay, this too is not a very accurate predictor of the future. When NYMEX forecasts $35 per barrel it could actually be $45 when that future date rolls around.
Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists which that many times vary widely from actual results. Note in the chart above how much the future forecasted prices changed in only one year. So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? In many cases they are following an options framework.
Real Options: Valuation FrameworkPUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in a similar oil price environment as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves.In practice, undeveloped acreage ownership functions as an option for reserve owners; they can hold the asset and wait until the market improves to start production. Therefore an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the natural gas commodity currently. This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. It is most accurate and useful when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, (i.e. five to 10 years). The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in table below.
When these inputs are used in an option pricing model the resulting value of the PUDs reflects the unpredictable nature of the oil and gas market. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. In a high oil price environment adding this consideration to a DCF will have little impact as development is scheduled for the near future and the chances for future fluctuations have little impact on the timing of cash flows. At low points, on the other hand, PUDs and unproved reserves may not generate positive returns and thus will not be exploited immediately. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), those reserves still have value based on the likelihood they will become positive investments when the market shifts at some point in the future. In the language of options, the time value of the out-of-the-money drilling opportunities can have significant worth. This worth is not strictly theoretical either, or only applicable to reorganization negotiations. Market transactions with little or no proven producing reserves have demonstrated significant value attributable to non-producing reserves, demonstrating the recognition by some buyers of this optionality upside.
All that said, there are some challenges and dangers in applying the options model to reserves. These issues will be covered in part three of this series. To learn more about option pricing, and whether it could help your company reach optimal results either in sales or bankruptcy negotiations, please contact Mercer Capital. Conversations are in confidence, and our experts combine decades of experience in both oil and gas and bankruptcy to help you succeed.
2016 Q1 Analyst Call Report
Our quarterly summary of analyst calls is as revealing as usual, as pacemakers in the asset management sector review this quarter’s performance and how it may shape the year ahead.Investor sentiment in the first half of last quarter indicated a growing fear of another U.S. recession, as commodity prices continued to drop while initial jobless claims increased and global growth stalled. By late March, however, commodity prices began to stabilize as central banks adopted easing plans to stimulate growth and the dollar eased against foreign currencies, on balance keeping equity prices relatively flat over the quarter despite interim volatility. Overall, the market continues to experience a shift from growth to value stocks that has increased prices, depressed earnings, and further engendered the flight to passive strategies within the RIA industry.Theme 1: A rocky start to the year has led to a modest pullback in the sector, despite a rebound in the second half of the quarter.“Weak and volatile markets for the first half of the quarter curtailed demand for return seeking assets. We felt this in particular in global high yield end equities” – Peter Kraus, AB“Despite a really difficult start to the year across most equity indices, despite a lot of volatility and a V-shaped recovery at the end of the quarter, we’re encouraged by the improvement in total company net flows, driven by ongoing strength across a number of different strategies.” - Richard Maccoy Weil, JNS“The first quarter of 2016 was defined by extreme volatility with large daily swings in asset prices and a sharp reversal in returns. S. equity markets begin the year on an extremely weak note with the S&P 500 posting its worst start in history. […] From this low, equities and commodities moved sharply higher over the remainder of the first quarter, resulting in most industries registering modestly positive returns for the period.” – Brian Casey, WHG“The unusual market volatility during the quarter created an environment that few active managers navigated successfully. Persistently slow growth, unusually accommodative global central banks, negative interest rates, and the uncertainty regarding the upcoming U.S. elections remain at the forefront of investor concerns.” – Philip James Sanders, WDRTheme 2: Much like the U.S., the global market started the quarter on a sour note, only to rebound later in the quarter due to central bank easing across the board (from the ECB to the Bank of Japan), as well as growth within emerging markets.“Exchange rates continue to be a challenge for us in Europe, but have improved recently. In Asia, many of our global trading clients have reduced risks. We’re only just beginning to see them come back into the emerging market asset class.” – Peter Kraus, AB“Turning to international business, we continue to see very strong growth. […] We’re winning business in Japan from both institutional and retail investors.” - Weil, JNS“Central bank policy makers were once again the major catalyst behind the market’s recovery. With the European Central Bank, Bank of Japan, and the People’s Bank of China providing additional stimulus, while the Federal Reserve did its part by once again delaying any additional rate hikes. As we’ve seen with previous central bank driven rallies, low quality, high-data names were the top performers over the second half of the quarter.” – Brian Casey, WHGTheme 3: The battle against active management is likely to continue, with firms trying to find ways to provide a balanced mix to customers while maintaining margins and differentiating from competitors.“I think that passive active battle is going to continue. I think investors have concluded so far that the way they experience active management in the last 20 years has been unproductive for them. […] We don’t think that’s rational, we don’t think it’s right, we understand why you are doing it, [and] we don’t think that’s right, but the answer the industry has to have and that we are promoting is to have managers who, one, are very capacity constrained; and, two, are investing in high conviction ideas and have, as I say, marginally different portfolios” – Peter Kraus, AB“This was a very difficult quarter for all active managers. So it was difficult for us to make the progress we might have hoped for against our performance fees. […] The challenges on the U.S. side are somewhat related to investment performance. I think they’re somewhat related to what’s going on in the marketplace for the main client base; the pressure that is created when many of those clients are looking at barbelling their portfolio and going for a large portion of passive and then very active for the remainder.” – Weil, JNS“In some ways, asset management companies are a little bit like ferryboats. You don’t want everybody running to the same rail at the same time because it causes the boat to rock a lot more than it otherwise would. And having this diversification in terms of products and having this diversification in terms of clients moving in different directions at different times is very helpful for maintaining the overall stability of the franchise.” – Weil, JNS“As we look forward, we see investors at a crossroads from an asset allocation perspective. Many have been disappointed by their allocation with the hedge funds. They are concerned over their fixed income valuations and are looking for where they can source returns to achieve their required rates of return.” - Brian Casey, WHGTheme 4: As a result of the growing demand for passive products, ETFs are gaining ground in popularity and demand, thereby making them even cheaper.“With clients increasingly using ETFs, with the majority of U.S. retail fund flows going to ETFs, it’s imperative that we’re able to develop, launch, and successfully raise ETF assets. […] I think to be successful in the ETF space, I don’t think you can just have one or two offerings. I think you need to offer a few more than that, and we will. It’s hard to predict with great confidence exactly which ETF will be more successful.” – Weil, JNS“I turn to ETFs, which is a very small business for us and it’s still in the early stages. But in terms of new products and in efforts going forward, I think there’s a lot of time and effort being spent there, [and] that’s becoming increasingly a much more important part of the retail investors diversified portfolio, [and] we want to assist with that, so I think there’s a great opportunity there.” – George Aylward, VRTS“Last week, we filed a registration statement with the Securities and Exchange Commission to register three exchange-traded managed funds, or ETMFs. We continue to believe ETMFs are unique and progressive investment product options that in time will be adopted broadly in the marketplace.” – Thomas W. Butch, WDRMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter at @RIA_Mercer.
Are Market Conditions Driving More FinTech Partnerships and M&A?
It has been an interesting few weeks for FinTech.Coming off recent years where both public and private FinTech markets were trending positively, the tail end of 2015 and the start to 2016 have been unique as performance has started to diverge.The performance of public FinTech companies has been relatively flat through the first quarter of 2016 (see Public Market Indicators on page 3 of the First Quarter 2016 FinTech newsletter), and signs of weakness have been observed in alternative/marketplace lending, as well as some of the more high profile FinTech companies that have gone public recently.The median return of the FinTech companies that IPO’d in 2015 was a decline of 16% since IPO (through 3/31/16). For perspective, Square, OnDeck, and Lending Club are each down significantly in 2016 (down 28%, 53%, and 64%, respectively from 1/1/2016 to 5/18/2016).Also, the broader technology IPO slowdown in late 2015 has continued into 2016 and no FinTech IPOs have occurred thus far in 2016.However, optimism for FinTech still abounds, and the private markets continue to reflect that with robust investor interest and funding levels.In 2016, 334 FinTech companies raised a total of $6.7 billion in funding in the first quarter (compared to 171 companies raising $3.2 billion in the first quarter of 2015), and Ant Financial (Alibaba’s finance affiliate) completed an eye-popping $4.5 billion capital raise in April.While the factors driving this divergence in performance between public and private markets are debatable, the divergence is unlikely to continue indefinitely.A less favorable public market and less attractive IPO market creates a more challenging exit environment for those “unicorns” and other private companies.Headwinds for the private markets could develop from more technology companies seeking IPOs and less cash flow from successful exits to fund the next round of private companies.Consequently, other strategic and exit options beyond an IPO should be considered such as partnering with, acquiring, or selling to traditional incumbents (banks, insurers, and money managers).The potential for M&A and partnerships is even more likely in FinTech, particularly here in the US, due to the unique dynamics of the financial services industry including the resiliency of traditional incumbents and the regulatory landscape.For example, consider a few of the inherent advantages that traditional banks have over non-bank FinTech lenders:Better Access to Funding. Prior to 2016, the interest rate/funding environment was very favorable and limited the funding advantage that financial institutions have historicallyhad relative to less regulated non-financial companies.However, the winds appear to be shifting somewhat as rates rose in late 2015, and funding availability for certain FinTech companies has tightened. For example, alternative lenders are dependent, to some extent, on institutional investors to provide funding and/or purchase loans generated on their platform, and a number have cited some decline in institutional investor interest.Banks Still Have Strong Customer Relationships. While certain niches of FinTech are enhanced by demand from consumers and businesses for new and innovative products and technology, presently, the traditional institutions still maintain the majority of customer relationships.As an example, the 2015 Small Business Credit Survey from the Federal Reserve noted that traditional banks are still the primary source for small business loans with only 20% of employer firms applying at an online lender.The satisfaction rate for online lenders was low (15% compared to 75% for small banks and 51% for large banks).The main reasons reported for dissatisfaction with online lenders was high interest rates and unfavorable repayment terms.Regulatory Scrutiny and Uncertainty related to FinTech.Both the Federal Reserve and the OCC have made recent announcements and comments about ways to regulate financial technology.In the online lending area specifically, regulatory scrutiny appears to be on the rise with the Treasury releasing a white paperdiscussing the potential oversight of marketplace lending and the CFPB signaling the potential to increase scrutiny in the area.The lack of a banking charter has also been cited as a potential weakness and has exposed certain alternative lenders to lawsuits in different states.At the same time that FinTech companies are increasingly considering, or being forced to consider, strategic options beyond an IPO, traditional incumbents are starting to realize that they must develop a strategic plan that considers how to evolve, survive, and thrive as technology and financial services increasingly intersect.For example, a number of banks are looking to engage in discussions with FinTech companies.A recent survey from BankDirector noted that boards are focusing more on technology with 75% of respondents wanting to understand how technology can make the bank more efficient and 72% wanting to know how technology can improve the customer experience.FinTech presents traditional financial institutions with a number of strategic options, but the most notable options include focusing on one or some combination of the following: building their own technology solutions, acquiring a FinTech company, or partnering with a FinTech company.One area where we have started to see more FinTech partnerships and M&A already start to play out is wealth management and the industry’s response to robo-advisory.Robo-advisers were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years).Consider the following announcements in this area over the last few years; on the acquisition front, BlackRock’s acquisition of FutureAdvisor in August 2015, Invesco’s acquisition of Jemstep, and Ally Financial’s acquisition of TradeKing in April 2016.On the partnering front, Motif and J.P. Morgan announced a partnership in October 2015, UBS announced a major partnership with SigFig in May 2016, and Betterment and Fidelity announced a partnership in October 2014. Community banks will also have an opportunity to enter the robo-advisory fray as Personal Capital announced a partnership with Alliance Partners that will allow over 200 community banks offer digital wealth advisory tools.While we do not yet know which strategy will be most successful, discussions of whether to build, partner, or buy will increasingly be on the agenda of boards and executives of both financial institutions and FinTech companies for the next few years.The right combination of technology and financial services through either partnerships or M&A has significant potential to create value for both FinTech companies and traditional financial institutions.Any partnership or merger should be examined thoroughly to ensure that the right metrics are utilized to examine value creation and returns on investment.Transactions and significant partnerships also have significant risks and potential issues will need to be discussed.For example, significant issues with M&A and potential partnerships can include: execution and cultural issues, shareholder dilution, whether the partnership is significant enough to create shareholder value and provide a return on investment, contingent liabilities, and regulatory pressures/issues.These issues must be balanced with the potential rewards, such as customer satisfaction/retention, shareholder value creation, and return on investment.If you are interested in considering strategic options and potential partnerships for your financial institution or FinTech company, contact Mercer Capital. Financial institutions represent our largest industry focus for over thirty years. We have a deep bench with experience with both FinTech companies and traditional financial institutions (banks, asset managers, and insurance companies).This uniquely suits us to assist both as they explore partnerships and potential transactions.
Whitepaper | A Layperson’s Guide to the Option Pricing Model
Bridging Valuation Gaps: Part 1
Due to a precipitous drop in oil prices since June 2014, oil exploration and production companies in the U.S. have struggled to pay their debts and in many cases have had to file for bankruptcy. This is the first post in a three part series examining how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. Whether companies are looking to sell these reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market.This first post looks at the traditional DCF valuation method and market approach method and how they underestimate value in down markets. The subsequent two sections will focus on one potential method to use in place of the DCF, the option pricing method, and will explore both its advantages in down markets and the dangers of adopting option pricing models for oil and gas.The Problem: Traditional Valuation in Distressed MarketsThe petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, such as in today’s low price environment, the DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 & P3) categories. The DCF’s use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project’s upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to reconsider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the forecasted future price deck, many, if not most, PUDs appear to have a negative DCF value.Some non-core asset transactions in today’s market seem to concur with this assessed zero value for all categories of unproven reserves and PUDs. An example of this is Samson Oil and Gas’s recent purchase of 41 net producing wells in the Williston Basin in North Dakota and Montana. The properties produce approximately 720 BOEPD, and contain estimated reserves of 9.5 million barrels of oil equivalent. Samson paid $16.5 million for the properties in early January 2016 and estimates that within five years they can fund the drilling of PUDs. Samson’s adjusted reserve report, using market commodity prices at the time of the transaction, indicated PDP reserves worth $15.5 million, PDNPs worth $1 million, and PUDs worth $35 million—a total of $52 million in reserves present valued at 10%. This breakdown indicates dollar for dollar value was given on the PDP and PDNP reserves, but zero cash value given on the PUDs.Significant decline and volatility in oil prices from (1) uncertain future demand and (2) current excess supplyDebt level pressures with (1) loan covenant requirements and (2) cash flow requirementsA low deal volume environment as market participants have been in a “wait and see” stance since oil prices began declining over twelve months ago.
Essentially there are few buyers in the current market place and many sellers desperate for cash. Since those sellers need cash quickly to sustain their business, they have to lower their asking prices to levels that will continuously attract bidders. The gap between an asset’s sale value and what it is worth to the new asset holder widens considerably.
What does this mean for the E&P companies looking to reorganize under a Chapter 11 Bankruptcy? There are five key concepts for management teams and their advisors to be familiar with to understand how reserve valuation impacts Chapter 11 reorganization.Liquidation vs. Reorganization. The proposed reorganization plan must establish a “reorganization value” that provides superior outcomes for shareholders relative to a Chapter 7 liquidation proceeding.Liquidation Value. This premise of value assumes the sale of all of the company’s assets within a short period of time. Different types of assets might be assigned different levels of discounts (or haircuts) based upon their ease of disposaReorganization Value. As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” Reorganization values are typically based on discounted cash flow (DCF) analyses.Cash-Flow Test. A cash-flow test examines the viability of a reorganization plan, and should be performed in order to determine the solvency of future operations. In practice, this test involves projecting future payments to creditors and other cash flow requirements including investments in working capital and capital expenditures.Fresh-Start Accounting. Upon emergence from bankruptcy, fresh-start accounting may be required to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradename, technology, or customer relationships. Fair value measurement of these assets typically requires use of the multi-period excess earnings method or other techniques often used in purchase price allocations following a business combination.
If recent market transactions are utilized to establish a liquidation value, then it stands to reason that very little, if any, value will be given to the PUD reserves. For a company trying to avoid liquidation in a distressed market where sale prices do not indicate true value, there may still be a way to show significant value if reserves are retained in reorganization. However, that reorganization value has typically been based on a DCF. It is possible that the DCF may capture significant value in PUD reserves, because in reorganization debt levels are adjusted. When debt levels are adjusted the cash flow PUD reserves need to generate to be viable is much lower. This will provide two significant benefits: more time and possibly more cash. More time may allow the global oil and gas prices to increase while the additional cash flow from lower interest payments may allow investment in future PUD wells.
Unfortunately, it is still the case that the present value calculation is strongly tied to current market conditions, and thus even for companies with reasonable leverage, many PUD and unproven reserves show negative cash flow. The presence of some sizable transactions made without significant PDPs shows that there are buyers who disagree with this assessment and see value in these reserves. The issue is demonstrating that value in either a sale or bankruptcy negotiation. An option pricing model is one solution that more accurately accounts for the value of the increased time provided by restructuring the debt. In the next two posts we will look at times when option pricing may be a better model, and examine its potential issues. For a more detailed explanation of bankruptcy, DCF methods, or option pricing, please contact one of our valuation experts.
Resolving Buy-Sell Disputes
On Being a Jointly Retained Appraiser
Detective shows are usually good for automotive product placement, and the 1980s television series, Magnum, P.I., was no exception. It didn't hurt that the show's main character, Thomas Magnum, solved crimes in tropical settings throughout Hawaii, necessitating a requisite number of bikini-clad women sipping Mai Tai's in every episode. But the show's most memorable character was probably Magnum's car, a Ferrari 308. The 308 wasn't the fastest Ferrari of all time; the 3.0 liter eight cylinder motor didn't muster much more than 200 horsepower. It was small enough to have great handling (the seat had to be modified to fit Tom Selleck's 6'4" frame), it had a targa top, and at full throttle it sounded like Barry White eating wasps. With a car like that, a do-gooder role mysteriously funded by an anonymous millionaire, and a very-casual-Friday-everyday dress code, one thing was certain: Tom Selleck had a good job.The closest we get to detective work at Mercer Capital is when we're jointly retained to resolve a shareholder disagreement over a buy-out. Whether we've been court-appointed or mutually chosen by the parties to do the project, we've done enough of these over the years to learn that the process matters as much as the outcome.As a consequence, we've developed some fairly strict procedures for engagements involving buy-sell fights. The backstories for most shareholder disputes in the investment management industry have common themes: long-time partner ends up at odds, usually for economic reasons, with the rest of the ownership and is more or less forced out. There are usually lots of negative emotions on both sides, mistrust, and even impaired careers. The necessity of the buyout is obvious: the ex-partner wants to be paid so he or she can move on, and the remaining partners don't want to share the spoils of ownership (distributions) with their ex any longer than necessary.As the jointly retained appraiser, we're often in the awkward position of serving as judge and jury on the valuation, without the usual protections afforded by a judge or jury (like unlimited indemnification or an armed bailiff). So, like a private detective, we're left on our own to design and conduct an investigation to reach a reasonable outcome. If the process is sufficiently robust and fair, the two parties may not like the result, but they'll have to accept it. Doing so involves focus on a few key issues.Working in a Glass HouseThere is no substitute for transparency. We generally require that all information requested by and shared with us be shared with both parties. We also copy all parties on our communications and request that they do the same. When we conduct interviews with the parties as part of our normal due diligence, we open those meetings to both parties. Typically, the parties agree to not attend each others' interviews so that they'll feel free to speak to us more openly, and inevitably this leads to accusations at some point of our being lied to "in closed door meetings." In reality, no one is blind to the motivations of the parties in a buy-sell dispute, and we usually hear some level of hyperbole from both sides.Separating Fact from OpinionLike any valuation engagement, we start with an information request to get the basic facts of the situation: financial statements, regulatory filings, organization charts, strategic plans, etc. Then we interview the parties, and (frequently) get very different interpretations of those facts. It is not unusual for both sides to have very earnest, if diametrically opposed, opinions of why the facts are the way they are. Squaring those interpretations against what we can discern to be the reality of the situation is part of our job.The Value of Client ReviewIn a normal valuation matter, we prepare a draft report for client review to make sure we understand key elements of the enterprise being valued. In the case of a shareholder dispute, this review process is more structured. We usually have both parties review our work product independently of each other and give a written review that is distributed to us and the opposing party. Then we allow the parties to comment (also in writing) on each other's review. Our expectation is that knowledge of this cross-review process will dissuade the parties from misconstruing issues in their initial comments on our draft. That doesn't always work, but at least we have the benefit of both perspectives before we issue a final report.Economic IndependenceA client in one of these matters told us that he had heard jointly retained appraisers tended to favor the firm over the ex-partner (he was an ex-partner). I haven't heard the same thing, but it's easy to be accused of bias. One of the ways we guard against this is by structuring the engagement such that it is clear our payment is not contingent on the outcome. We start the engagement with a retainer that is applied against the final billing and stipulate that bills be paid current before we release a draft report or a final report. This assures both parties that we're not in anyone's back pocket and that we have the economic freedom to express the opinion of value we think is appropriate.No Man Can Serve Two Masters…Suffice it to say, we've learned a lot of this the hard way. It's no fun to be the punching bag between former partners who no longer want to have anything to do with each other, and business divorces are among the most fractious engagements we find ourselves in. But it doesn't help matters for us to offer to make someone else's problem our problem. Our kind of detective work involves sticking to a disciplined process that is respectful of the facts and allows both parties to openly participate. Unfortunately, it doesn't involve much intrigue, car chases, or hair gel – which probably explains why so few television series are about finance.Tom Selleck on the job as Thomas Magnum | Photo Credit: Magnum Mania!
Ambiguity in Buy-Sell Agreements is Expensive
Usually, I like to start blogposts with the story of some legendary car remembered fondly for its contributions to the automotive community. The car photographed above, a 1990 Chrysler TC by Maserati, is not an example of that. The TC was the mutant offspring of a brief tryst between Lee Iacocca, who headed Chrysler, and Alejandro de Tomaso, who owned the Maserati brand at the time. Iacocca and de Tomaso signed an agreement to jointly produce a sport coupe, and this was the worst they could come up with: a convertible based on Chrysler’s K-car platform, powered mostly by weak Chrysler engines, but tarted up with hand-stitched leather upholstery and inexplicably manufactured in Italy. One might have expected the TC to have had Italian styling and American reliability – instead it was the other way around. None of it made sense any more than the peculiar porthole window in the hardtop. Somehow, over 7,000 were sold. May they rust in peace.Despite talented people, carefully developed business plans, and the best of intentions, not every partnership goes well, and some of those that don’t go well don’t end well either. When a partner leaves an investment management practice, the potential for a major dispute over the buy-out usually looms. Internally, at our firm, we sometimes refer to these situations as “business divorces”, even though the consequent acrimony often exceeds that of a marital dissolution.For the exiting partner who was either pushed out or who left in disgust, it’s usually their last shot at their adversaries. Getting paid in full, and maybe then some, becomes a way to even not only the economic score, but the emotional score as well. For the continuing partners, overpaying risks endangering the business, while a cheap buy-out might be seen as giving the ex-partner what he or she really deserve.Usually, no one sees a business divorce coming until it’s too late to prepare. Once the negative emotions are underway, it’s too late to get the partners to sign a shareholder agreement or modify one that’s inadequately drafted. We started writing about buy-sell agreements at Mercer Capital over ten years ago with the idea that we could help firms avoid costly disputes over ownership. We have succeeded in doing some work in that area, but we are often hired as a jointed retained appraiser to try to help clean up messes after a fight broke out.It is always dangerous to make blanket statements, but I think if we’ve learned one thing from working in the shareholder dispute arena, it’s that a poorly drafted buy-sell agreement may be worse than having none at all. The words on the page look pretty innocuous when everyone is getting along, and unclear verbiage and inadequate guidance can be dismissed (“We know what we mean…”). So, to that end, here are a few mistakes we’ve seen others make, in the hopes that you read this and don’t do the same.Be Clear about the Valuation DateIn one extreme case in which we were involved, there was a $250 thousand hearing just to get the court to determine what the appropriate valuation date was to buy out a joint venture partner. You probably won’t have that big an issue, but the valuation date can be extraordinarily significant. If you have a large RIA with a stable customer base and placid markets, the valuation date may not matter. But what if markets are particularly volatile? What if you’re buying out a partner who left because of FINRA sanctions and now your clients are asking lots of difficult questions? What if a very successful client service partner left for another firm and is now working diligently to move his clients? What if the death of a key partner risks the loss of large mandates? We have seen some buy-sell agreements specify that the entity be valued at the fiscal year end prior to the trigger event for the action, as doing so would value the entity without regard to the issue at hand. That’s one way to handle it, and doing so often benefits the departing shareholder. We have also seen buy-sell agreements specify that the entity be valued at a certain point after the triggering event, to let the dust settle. Obviously, this treatment can be beneficial to the firm if the partner leaving is contemporaneous with some kind of firm trauma. But, more often than not, the valuation date is not clearly specified in the buy-sell agreement. Don’t let that happen to you.Be Clear about How to Choose an AppraiserObviously, you want a valuation expert to handle your business divorce who is both trained and experienced in business valuation and who understands the investment management industry. Your buy-sell agreement should delineate the qualifications of the appraiser or appraisal firm to do the work. But how will he or she be chosen? We have seen agreements in which the appraiser is chosen by the company, and the obvious implication of this is that the departing or departed shareholder is suspicious of conflicts. We have also seen many situations where each party to the agreement chooses an expert who is supposed to agree on a jointly retained appraiser. This works better in theory than in practice, except in instances where the two sides propose the same third appraiser. Whatever you do, be specific about the process. We have been brought in many times after the court had to be asked to intervene on behalf of one side or the other.Be Clear about the Standard of ValueIf your buy-sell agreement doesn’t already specify fair market value as the standard and makes that clear by reference to a definition such as exists in the International Glossary of Business Valuation Terms, then that’s an easy fix. We worked on a lengthy and expensive litigation which was almost entirely related to ambiguity as to the standard of value. Absent clarity, a buy-sell agreement could be settled based on investment value to either the buyer or seller, some notion of intrinsic value, or statutory fair value – particularly since in many shareholder disputes the departing partner could argue for protection under some state fair value statute.Be Clear about Valuation Discounts and PremiumsUsually, the subject interest in a buy-sell dispute is a minority interest in a closely held business. This would suggest that it could be valued, absent guidance to the contrary, at a non-marketable, minority interest level of value (inclusive of discounts for lack of control and lack of marketability). I think it’s safe to say that most partners think of their interest in an RIA as their pro rata participation in the enterprise. If the firm is worth, say, $10 million, and they own 20%, they expect their interest to fetch $2 million per the buy-sell. The acquiring firm has ample economic motivation to argue for discounts, and indeed the continuing partners will benefit if the selling partner is bought out for less than pro rata enterprise value. On the other hand, a well-crafted shareholder agreement will also specify what is meant by enterprise value. Is it going concern on a stand-alone basis (what might be considered a financial control level of value) or is it the value that could be achieved in a synergistic change of control? There is no perfect answer, but think about your firm and how you and your partners would want to buy or be bought out.Best Practice is to PracticeEven with all of the above care given to your buy-sell agreement, it’s difficult to know what will happen once the trigger event has occurred unless you find out in advance. The best practice is to have an annual appraisal done pursuant to your buy-sell agreement. With an annual valuation, you and your partners will know who is doing the work, how the process will occur, and (within a range) what the result will be. It does mean some regular investment of time and money, but the typical dispute we’ve worked on would have paid for a couple of decades of annual appraisals, not to mention the immense frustration and distraction that a shareholder disagreement causes a firm. If you can’t imagine finding yourself or your firm in that situation, now is a good time to start preparing.
How Sweet It Was
In 2015 the United States consumed over 3.6 billion gallons of tea. There’s nothing like a cold glass of sweet tea on a hot day in Memphis, where the average humidity is over 80%. But too many glasses of sweet tea leads to a sugar crash that makes you feel worse than before.Until December, the amount of sweet light crude in the U.S. almost exceeded the amount sweet tea at any Southern picnic. The Shale revolution changed the domestic oil and gas industry. As the stockpiles of sweet light crude increased, and the price of WTI fell, refiners purchased cheap crude in the domestic market. Until December 2015, refiners could buy domestic crude in the U.S. at a price approximately 10% cheaper than the rest of the world, sell refined products in the global petroleum market where prices were dictated by world demand and supply, and realize juicy margins. While the oversupply of sweet crude was at first a blessing for refiners, their sugar crash may be a permanent one.Brent WTI SpreadThe shale revolution, in conjunction with the export ban, created an oversupply of light, sweet crude in the U.S., which put downward pressure on the price of domestic crude oil. This pressure can be seen by examining the WTI – Brent oil price spread. One year ago the European benchmark, Brent crude, sold for $6.33 more than its American counterpart, WTI. The lifting of the export ban has narrowed the Brent WTI spread to less than $1 per barrel today.Refiner Marker MarginThe refiner marker margin (RMM) is a general indicator, calculated quarterly by BP, which shows the estimated profit refiners earn from refining one barrel of crude. Refiners’ margins increased dramatically in the second and third quarters of 2015 as the price of crude fell and the price of refined petroleum products remained high. Refiners in the U.S. were on average making $25 per barrel of oil, while global profit margins barely reached $20 per barrel.Refiners anticipated crude oil exports would increase when the export ban was lifted which reduced excess supply in the U.S. and relieved the downward pressure on market prices. Once the price of crude increased in the U.S., refiners profit margins shrink. As you can see in the graph below, profits shrank as expected. But with falling crude prices worldwide, the compression of downstream margins cannot be explained by the story refiners expected.
If the export ban had been lifted in early 2014, before global crude prices started falling, the story would have played out as expected. However, when the export ban was lifted, the U.S. producers were then open to compete in a market which was swimming in crude oil. At year end, there were approximately three billion barrels of excess supply inventory across the globe. No one wanted our excess crude.
Exxon Mobil’s downstream earnings were down 67% from this time last year to $187 million for the three months ended March 31, 2016. The reduced downstream margin is driving much of that change, as the company attributes $470 million of their drop in revenue from Q4 2015 to Q1 2016 to this falling margin. On their most recent earnings call VP of Investor relations explained that in order to understand refiner’s current situation, you have to look at the macro level of supply and demand.
Thus decline in downstream profits was a result of excess global supply and the decreasing price of petroleum products around the globe. The export ban was lifted and U.S. raw crude oil exports initially declined relative to last year. U.S. Crude exports were down 26% in January and 13% February compared to the previous year. However, as the price of oil rebounded slightly, we have seen a 22% year over year increase in crude oil as of March 2016.
When the market readjusts and crude prices rise, E&P profits may increase back to what they were, however refiners may never see the same fat margins they used to as they are now operating in a global market place. Refiners may have to adjust to a new normal.
What Does This Mean for Valuation?While E&P companies have been struggling for over twelve months now in the current low price environment, refiners are just starting to feel the pressure. Although the valuation implications are not expected to be as extreme, we expect to see similar valuation issues in upcoming months as we have seen for E&P companies over the last year. As margins compress and cash flows decrease, valuation multiples are expected to fall.Mercer Capital has been valuing oil and gas companies for over 20 years. We understand the volatility of the oil and gas market and can help your company understand the value of your company beyond this year’s cash flows.
Why Should Your Firm’s Buy-Sell Agreement Require an Annual Valuation?
It’s all about Expectations Management
The 1970s weren’t too kind to the auto industry. Between the OPEC oil embargo, new environmental regulations and disco, automotive design mostly devolved into underpowered, uninspired boxes. One noteworthy exception to all this was the Pontiac Trans Am. Neither boxy nor underpowered, the Trans Am was a hot mess with a huge motor that overpowered the car’'s weak brakes and lousy handling. All in all, though, it worked. From the driver's seat, you could forget all about the "malaise" while you stared up at the sky through the T-tops or across the giant decal of a flaming bird on the hood. As GTs go, it was no Aston Martin, but it was good enough to help Burt Reynolds smuggle a semi full of Coors across the southeast in Smokey and the Bandit.What was a perfect statement about America in 1977 is not so applicable today. Almost 40 years later, Burt Reynolds is still around, but Pontiac isn't, and people are more likely to cross state lines to buy craft beer than Coors. It's a point worth remembering when thinking about how to value your RIA for purposes of a shareholder agreement: times change.A recurring problem we see with buy-sell agreements are pricing mechanisms that are out of date. Usually, this shows up in the form of some kind of rule of thumb valuation metric that is no longer market relevant. We've also seen buy-sell agreements that cite standards of value that don't exist in the modern valuation lexicon, and even some that specify appraisers from firms that no longer exist.Keeping the language in your agreement up to date is important, but the most reliable way to avoid some unintended consequence of your buy-sell agreement is to have a pricing mechanism that specifies a regular valuation of your RIA's stock. An annual valuation accomplishes a number of good things for an investment management firm, but the main one is managing expectations.If your ownership sees a set of consistently prepared appraisals over the course of several years, they know what to expect. By this I mean there is some level of agreement over who is to provide the valuation, what information will provide the basis of valuation, and how the valuation itself will be constructed. This doesn't guarantee that everyone will be satisfied with the conclusion of value, and our experience is that partners in investment management firms often have differing opinions of the value of an RIA. Some difference of opinion is to be expected, but the process of having a regular valuation prepared by an independent party can go a long way toward narrowing that difference of opinion. If there is little difference of opinion over the values at which ownership in a firm transacts, there will be little incentive to litigate when a sizable transaction comes along.Recommending an annual valuation may sound a little self-serving and, indeed, doing that sort of work is good business for us. We also handle dispute resolutions for shareholder disagreements, however, and the cost of that work is never less than several times the cost of an annual appraisal – not to mention substantial legal fees and the immeasurable cost of management distractions. All in all, we would rather dispense the ounce of prevention than the pound of cure.P.S.: There is an updated edition of the Trans Am available.
When Buy-Sell Agreements Blow Up
What Would Mom Do?
Nobody's perfect.You're a successful portfolio manager but you forgot Mother's Day this past weekend. What now? May I suggest you buy mom the ultimate grocery-getter: the Ferrari FF. I spotted the one photographed above outside my hotel last week in Grenoble, France, where I was for an all-too-quick business trip. The Ferrari FF has the credentials typical of Maranello: a 6.3 liter V-12 producing 651 horsepower and 504 foot pounds of torque that through the all-wheel drive system propels the FF to 60 miles per hour in less than four seconds on its way to a top speed of 208 mph.Unlike a new Bentley Bentayga – getting one of these for mom won't imply that you just want her to take over carpool for the grandchildren. Your mom may ask whether or not anyone really needs a two door station wagon that goes two hundred miles per hour and costs $300 thousand. Just tell her that the FF is a good example of the answer to a question that no one ever asked.The subtitle of Chris Mercer's original book on buy-sell agreements is "Ticking Time Bombs or Reasonable Resolutions?" Implicit in this title is that parties to buy-sell agreements too often discover the painful implications of the question never asked. I think about this every time we work on a dispute resolution project involving a buy-sell disagreement. In particular, I think about one of the first ones that I worked on, where maybe there was no disagreement, but should have been.Where There are Winners, There are LosersMany years ago we were hired to do valuation work for the estate of the founder of a successful RIA, who died unexpectedly. We were not asked to value the estate’s interest in the asset management firm as this was provided for by a mechanism in the buy-sell agreement. We were merely asked to check the math and make sure the estate wasn’t being short-changed. Long story short, it wasn't.There's no point in going into the particulars of the pricing mechanism in that RIA's shareholder agreement, (as that would be tangential to the story) but the value implied was rich. It might have been achievable in a change-of-control sale to a highly motivated buyer, with capacity, under the very best of circumstances. As it was, the company was required to redeem the interest with the help of some life insurance and, as I recall, some term financing. The decedent was the largest shareholder at the firm, and to the extent that anyone is a "winner" in these circumstances, the estate got the best of the pricing mechanism in the buy-sell agreement.Unfortunately, where pricing creates winners it symmetrically creates losers. The firm was on the hook for the redemption, which means that the remaining, or continuing, shareholders of this RIA were forced to overpay for the estate's interest, effectively diluting the economic value of their ownership for years to come. Compound this with the loss of the founder's contributions to the firm (he was an important client relationship manager), and the continuing partners had to essentially rebuild the value of their ownership. With favorable markets and good stock picking, they succeeded. We've seen other RIAs that, put in a similar circumstance, would not have fared so well.However, going to the other extreme (forcing buy-outs at a heavily discounted value) isn't necessarily better. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave's pro rata interest is worth $60 and Sam's pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave's 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors.Answering the Question Nobody AsksSo, when you look at your firm's shareholder agreement, think about the question – "Does my buy-sell create winners and losers?" If so, are you content with whom those winners and losers might be?Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What's not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for "paying too much" is to provide a windfall for former shareholders, which is even more difficult to defend operationally.What Would Mom Do?Ownership works best when it is structured to support the operations of the firm. Maybe this is easier said than done, but the lesson certainly applies to the mechanics of a buy-sell agreement. Your mom probably told you that "nobody ever said life was fair," but she wasn't giving license to promote unfairness. Balancing the fairness to both exiting and continuing shareholders in your buy-sell agreement will support the operations of your RIA, which will help build enduring value in the firm, ultimately benefiting everyone.
What Matters Most for RIA Buy-Sell Agreements?
In Our Experience…
In 1961, Jaguar stunned the automotive community by adapting its highly successful D-type race car, which had won the 24 hours of Le Mans three consecutive years in the late 1950s, to create the E-type road car. The E-type was instantly acclaimed. It had everything you could ask for in a sports car at the time: an inline six-cylinder motor that powered it to 60 mph in under seven seconds, monocoque construction, disc brakes, rack and pinion steering, independent front and rear suspension, and a top speed of over 150. Most importantly, it was gorgeous. Enzo Ferrari himself said it was "the most beautiful car ever made."No one ever said a particular buy-sell agreement was the "most beautiful" ever written (even in our office), but some are better than others. And, like a good sports car, you can break down the key elements of a buy-sell agreement that must be there for the agreement to be successful. The first hurdle to clear is for the buy-sell agreement to specify that the company is to be valued within reasonable parameters appropriate to the situation. We don't see many shareholders' agreements in the RIA community relying on "rule-of-thumb" like multiples of revenue or AUM – probably because, while simplicity is appealing, it's too easy for that kind of high level analysis to create unintended winners and losers in a buy-sell action.But that begs the question: if an asset manager's buy-sell is going to specify reasonable expectations for the value of the firm, what are they? We think there are at least four.1. A Buy-Sell Agreement Should Clearly Define the "Standard" of ValueThe standard of value is an important element of the context of a given valuation. We think of the standard of value as defining the perspective in which a valuation is taking place. Investment managers might evaluate a security from what they think it's worth (intrinsic value) as opposed to its trading price (market value) and make an investment decision based on that differential.Similarly, valuation professionals such as our squad look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The standard of value is so important, it's worth naming, quoting, and citing specifically which definition is applicable. The downsides of not doing so can be reasonably severe. Take, for example, the standard of "fair value." In dissenting shareholder matters, fair value is a statutory standard that can be very different depending on the legal jurisdiction. By contrast, fair value is also a standard of value under Generally Accepted Accounting Principles, as defined in ASC 820. GAAP fair value is similar to fair market value, but not entirely the same. In any event, it pays to be clear.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional writing on the implications of the standard, and thus makes application to a given buy-sell scenario more clear.2. Unless it is Clarified, There will be Costly Disagreement as to "Level of Value"Investment managers in publicly traded securities don't often have reason to think about the "level" of value for a given security. But closely-held securities, like common stock interests in RIAs, don't have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a lack of marketability.
Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement.
Fairness is a consideration here. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be "winners" and "losers" in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm's length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.
3. Don't Forget to Specify the "As Of" Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to avoid confusion), then the date might be the calendar year end. Consider whether you want the event precipitating the transaction to factor into the value? If not, maybe the as-of date should be the day before the event. Or maybe it matters that, say, a given shareholder died or otherwise left the organization, and it's worth considering the impact of the departure. If that's the case, then maybe the appropriate valuation date is the end of the fiscal year following the event giving rise to the transaction.This blogpost doesn't begin to name all of the reasons that specifying an "as-of" date matters to the appraisal, but you get the idea.4. Appraiser Qualifications: Who's Going to be Doing the Valuation?Obviously, you don't want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of "valuation experts" and "industry experts."Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated matters
Industry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industry
In all candor, there are pros and cons to each "type" of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor was absurd. The company had hired a reasonably well known valuation expert who wasn't particularly experienced in valuations in the RIA community. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value – much to the delight of his client. The departing shareholder, by contrast, hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company's appraiser. We were brought in to make sense of it all.
The buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to consider the ins and outs of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you shouldn't have to explain your business model in the process.Final ThoughtsI'll cover in a later blogpost how the appraisal process itself works, and the considerations above are by no means meant to be exhaustive. But when you consider just these four elements, you can see how ambiguity in a buy-sell agreement can be highly disruptive at an investment management firm. While we do occasionally advise clients on setting up shareholder agreements, more often we are called in when an "agreement" is in dispute. We'll cover one such story in next week's blogpost.
Mutual Fund Providers Down Sharply as ETFs Continue to Gain Ground
One streak that remains, albeit less reportedly, is passive funds’ dominance over their active counterparts over the last year. According to Morningstar, active funds endured $268 billion in net outflows over this period while their passive counterparts gained $382 billion in client assets. These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are trading in bear market territory while the market has flat lined over the last year.
Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies, but also sector-wide underperformance against their applicable benchmarks. Through the first two months of 2016, just 28% of large cap mutual fund managers are beating their benchmarks (27% for all of 2015) and only 1% posted positive returns, according to a Goldman Sachs study. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability.
Russel Kinnel of Morningstar elaborates on this trend in his recent article, “It’s Flowmegeddon! Outflows add to the challenges facing active stock fund managers.”
“The simple answer to this riddle is competition from exchange-traded funds. ETFs have gained the upper hand in the active/passive debate, even over open-end index funds, which generally offer comparable cost benefits. More advisors are switching to ETF-focused strategies, and, when they get a new client, they quickly sell the weakest performing active funds—possible all the actively managed funds—in the client’s current portfolio. Self-guided investors are moving to ETFs, too.”As Mr. Kinnel notes, these redemptions from active funds wouldn’t be so alarming in a bear market, but we’ve come a long way since the Financial Crisis. This current trend is about investor preferences not investor paranoia.On balance, passive funds appear primed to continue their dominance over active management, but we still question the sustainability of this trend over the long run. While fees are likely to continue their descent over time, it is hard to imagine that passive investing will completely replace active management. Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds. While we’re more bullish on the prospects of Golden State and Barca this season, we haven’t completely ruled out active managers in the ongoing quest for investor capital and advisory fees.
Asset Manager Valuations Mixed After a Rocky Q1
From a valuation perspective, it appears that alternative asset managers fared the best in Q1. The group’s median multiple rose 60% in the first three months of the year, besting all other classes of asset managers over the same period.
Closer inspection reveals a much bleaker quarter for the publicly traded hedge funds and private equity firms in our alternative asset manager index. Despite significant gains in the back half of the quarter, the group lost roughly 5% of its market cap during the first three months of the year. In other words, the E is falling faster than the P/E is rising for most of these businesses. With many names trading at a 40%+ discount to their 52 week high, the market seems to be questioning the long-term viability of many hedge funds and PE firms whose high fees and subpar performance have come under scrutiny in recent years.
On the other end of the spectrum, more traditional, long-only managers appear to have taken some market share from their alternative counterparts over the same period. Investors continue to grow wary of higher fees, especially when performance suffers, so this is no surprise to those who follow the sector. Still, hedge funds are typically better poised to profit from market volatility, which might explain the group’s advancement since its mid-February bottom.
Moving forward, this disparity is unlikely to persist if many of these publicly traded alt managers are to remain a going concern. The past few weeks have been promising, but the index as a whole lost roughly half of its market cap from July of last year to February of 2016. An opportunistic investor with a high risk tolerance might see this as a buying opportunity. Others will look skeptically at the sector’s prospects in the era of passive investing.
Mercer Capital’s Value Matters® 2016-04
Characteristics of a Good Buy-Sell Agreement
Business Divorces at RIA Firms
A fellow Mercer Capitalist recently purchased this beauty, a 1976 VEB Trabant or “Trabi,” at a car auction in Chicago. Ironically labeled as “the car that gave communism a bad name,” the Trabi was the most common vehicle in East Germany during the Soviet Bloc era and even made the Los AngelesTime’s prestigious “50 Worst Cars of All Time” list. If these rankings culminated in a March Madness style bracket pool, the Trabi would definitely deserve a #1 seed given its two-stroke pollution generator (that maxed out at 18 hp) and lack of basic amenities like turn signals and brake lights. The body was made of a fiberglass-like Duroplast (reinforced with recycled fibers of cotton and wood) and even had some parts manufactured from papier-mâché when the VEB production plant ran low on steel. As the Berlin Wall fell in 1989, thousands of East Germans drove their Trabis across the border as a sign of automotive liberation from the Communist Bloc.Like the Trabant, business divorces can be liberating, but are mostly just ugly and ill-conceived. This is especially true for RIA firms where the founding principals typically serve as Chief Investment Officers or portfolio managers for the larger accounts. As a result, these shareholders (and the RIA itself) have the most to lose when corporate disputes or partner buy-outs arise. Many times, these conflicts are unavoidable and are the natural bi-product of ownership transition and firm evolution. In these instances, a carefully crafted buy-sell agreement (“BSA”) can resolve these disputes in a fair and equitable manner (from a financial point of view) if the valuation process avoids these common pitfalls:Employing a fixed or formulaic valuation methodology. The most commonly used rule of thumb for valuing asset managers is price (or enterprise value) to AUM, which is fraught with all sorts of issues covered by a previous blog post. Even worse are formulas that call for a departing shareholder to be bought out at a pro rata percentage of book value or his/her capital contribution. Such metrics make little sense for RIAs, which often have minimal capital requirements and balance sheets, meaning one-side is likely to get bought out a price that is in no way indicative of fair market value for his or her equity interest. BSAs that call for fixed multiples of earnings or cash flow are less offensive to us, but don’t account for natural variations in cap rates and can be subject to margin manipulation by the managing partners.Delaying a valuation until a triggering event actually takes place. Business owners often have an inflated (and sometimes deflated) view of what their company is worth. Having the business appraised on a regular basis (annually or bi-annually) precludes the inevitable surprise that takes place when a trigger event occurs and allows both sides to gain familiarity with the appraisal process.Employing multiple appraisers and tie-breaker valuations when both sides’ experts inevitably disagree. Besides being costly and time-consuming, this technique can be especially problematic when there’s an outlier valuation or the parties can’t agree on a third appraiser. In any event, the process can be a huge distraction for an RIA’s management team and shareholder group.
The problem that we most often see with shareholder agreement disputes is the potential of a forced transaction creating winners and losers. If a departing shareholder is bought out at a premium to the value of the enterprise, that premium comes at the expense of the remaining shareholders. If the shares are bought at a discount, the remaining shareholders reap a windfall. Some buy-sell agreements are intentionally engineered to favor either the selling shareholder or the continuing shareholders, but if so everyone who is a party to the agreement should be aware of that long before the triggering event.
At Mercer Capital, we recommend a regular valuation process for buy-sell agreements at investment management firms for a number of reasons:The structure and process, in addition to being defined in the agreement, will be known by all parties to the agreement in advance.The appraiser’s valuation approaches and methodologies are seen firsthand by the parties before any triggering event occurs.The appraiser’s independence and objectivity will be evident in the consistency of methodology utilized over time.Because the appraisal process is exercised on a recurring basis, it should go smoothly when employed at triggering events and be less time-consuming (and expensive) than other alternatives.
Our colleague with the Trabi says that one benefit to ownership is that you never know what’s going to happen when you get into the car. Your buy-sell agreement should, on the other hand, be free of surprises. If it’s been a while since you looked under the hood of your shareholder agreement, we recommend you pull it out of the drawer, read it, and then call your legal counsel if you see the potential for any problems down the road. Then call us.
What is Normal Compensation at an Asset Management Firm?
Part 2
[caption id="attachment_10926" align="aligncenter" width="363"] The Lamborghini Miura was the first mid-engine V-12 road car, and established the company’s reputation for out-of-the-box design.[/caption]
[caption id="attachment_10919" align="aligncenter" width="363"] Ferrari’s competitor to the Miura, the Daytona, retained a traditional front engine layout, but its successor, the 365BB, adopted the same mid-engine format as the Miura.[/caption]
Legend has it that, sometime in the early 1960s, Italian tractor manufacturer Ferruccio Lamborghini burst into Enzo Ferrari’s office to complain about the Ferrari road car that Lamborghini had recently purchased. He didn’t like the design, thought the manufacture was crude, and was furious that the car was incredibly unreliable. Enzo Ferrari, who had always thought people who bought his overpriced road cars (which Ferrari sold only to fund the company’s racing ambitions) were dupes, told Lamborghini that if he could do better, he should. In 1963, Lamborghini founded a sports car manufacturing company, and Ferrari’s had a competitor ever since.
It took a few years for Lambo to gain a footing in the industry, but in 1966 the company introduced the Miura, a two seat sports coupe with a powerful V-12 engine mounted, in a revolutionary fashion for the time, between the passenger compartment and the rear wheels. It competed directly against Ferrari’s more conservative, twelve cylinder GT, the Daytona, and established Lamborghini’s personality as a manufacturer of innovative (and sometimes over the top) sports cars. The Daytona still outsold the Miura two to one, but today at auction a Miura will fetch three times what a similar vintage Daytona will. The more traditional design of the Ferrari appealed to buyers when the cars were new, but in retrospect, Lamborghini’s willingness to experiment is highly regarded.
One of the primary differences we observe in investment management firms is not engine placement, of course, but compensation programs. The Miura and Daytona were different approaches to the same product. Our experience is that there are multiple ways to handle staff compensation at investment management firms, and the manner in which compensation is handled often says a lot about the business model and culture of the firm.
The “Market” for Investment Management TalentOur experience tells us that the labor market for talent in the investment management community is not terribly efficient – at least not on a position to position, person to person basis. We have seen wide disparities in the compensation program for similar positions, which cannot be explained away by the cost of living in a given market, the size of the asset management firm, or the relative level of profitability.Mercer Capital’s Memphis office is housed in a 34 story high-rise. I’ve often wondered what I would learn by going floor to floor, office to office, in our building and asking what the receptionist in each office is paid. The data would be statistically significant at one level – there are probably 100 people employed as a “receptionist” in our building, all working for services firms and in the same zip code. If I were to do that, how large of a variation in compensation would you expect me to find? Is it possible that the highest paid receptionist in the building would make over twice that of the lowest paid receptionist? And what might account for those differences? Tenure? Size of firm? Profitability of firm? Actual nature of administrative responsibilities? Now imagine that you are, instead, trying to compare senior portfolio manager positions at long/short hedge funds in Kansas City and San Francisco: lining up salary, bonus compensation, performance-based compensation, equity compensation, etc.Our observation is that compensation at RIAs tends to be idiosyncratic, but by this we don’t mean to imply that it is idiotic. Simply put, compensation programs tend to evolve, purposefully, in asset management firms over time and over time take on a life of their own. Inevitably, compensation programs tend to be intertwined with business model and ownership. Internally, they make sense. Externally, they may be hard to compare with the “market.” When we are called in to provide a valuation, we have to make some rational sense of the compensation program to come up with a normalized margin that we can use to value the firm.Compensation Expert AnalysesAt Mercer Capital, we don’t hold ourselves out as compensation experts. But we do encounter a number of compensation experts and their work tends to follow a familiar pattern. Usually, the expert will evaluate the requirements and responsibilities of a given job at an investment management firm, and will use some form of statistical regression analysis to compare a market rate of compensation for that position with published pay data for similar positions at other firms.Not to debate the merits of statistical analysis, but this methodology has some obvious drawbacks. Comparability is hard to establish. No two person’s qualifications are the same, nor are any two positions’ requirements and responsibilities. Does the scale of the firm as measured by AUM matter more to the level of compensation for a CEO, for example, or is it more to be governed by the level of profitability? How are salary, bonus, and equity compensation to be compared – and are each worth the same on a dollar for dollar basis? Is participation in carried interest a factor? If so, finding suitably comparable market data is challenging.Public Company TrendsWhat we can know with some degree of precision is what publicly traded asset management firms spend on staff. This doesn’t answer the question of what a particular position with a particular firm in a particular market would and should pay, but it does give reasonable guidance as to what the compensation/margin tradeoff is for public companies, and in turn gives some idea of what it should be for private companies.Look, for example, at the interaction between compensation and margin at twenty large publicly traded investment management firms. From the trough of the credit crisis through the bull market in 2014, total annual revenues of these twenty firms almost doubled from $25.3 billion to $44.0 billion. If we break down expenses into compensation related costs and non-compensation related costs, we see that operating leverage is more pronounced with non-compensation related expense. Because some compensation related costs get buried in SG&A as distribution expenses or other outsourced services, it’s likely the case that compensation tracks revenue more closely than this high-level analysis suggests.
Nevertheless, the big story from this is operating margin. As revenues increase, margin does as well – even at the scale of these public companies. We see this to be the case, regularly, in the private company RIA space, but it’s interesting to see confirmation in the public space, where scale is such that one might expect margin expansion to be more muted.
SummaryInvestment management is a talent business, and that talent commands a substantial portion of firm revenue which often exceeds the allocation to equity holders. While there is no perfect answer as to what an individual or group of individuals should be compensated in an RIA, we can look to market data and compensation analysis, measured against the particular characteristics of a given investment management firm’s business model, to make reasonable assumptions about what compensation is appropriate and, by extension, what level of profitability can be expected.
RIA Compensation and Valuation: A Conundrum of Brobdingnagian Proportions
Part 1
Most of the history of race car development focused on creating larger and more complex motors that would generate greater amounts of horsepower. The tradeoff, frequently overlooked, was that a car has to be in scale with the motor, so more horsepower meant a larger and heavier car. A heavier car is more difficult to handle in corners and requires larger brakes. In racing it consumes more fuel (so more pit stops), and a more complex motor is necessarily less reliable.Colin Chapman was one of the first race car designers to recognize the tradeoff between power and weight, and his mantra, "add more lightness," inspired a whole generation of sports cars. Chapman's first road car, the Lotus Elite, had a small and simple, in-line four cylinder motor which only produced about 105 horsepower. What made the Elite competitive was that the car weighed only about 1,000 pounds (the current generation Chevy Tahoe can weigh six times that), so it handled like a dream and could travel at 130 mph. Consequently, the Elite won its class at Le Mans six years in a row.A similar tradeoff in an investment management firm's business model is that of compensation expense versus profit margin. Compensation is almost always the largest expense on an RIA's income statement and has a direct impact on net income.One of my earliest memories of working with clients in the RIA space was standing in the corridor of a $2 billion AUM equity manager one afternoon as the staff was packing up to go home. The managing partner took the opportunity to show me around the empty office and explain the business model to me: "Our assets get on the elevator and go home every night."Yet the most popular rule-of-thumb metric for valuing RIAs isn't price per employee, but price to AUM. The value of an RIA is not an accumulation of talent, but an accumulation of client assets that produce a healthy profit – after paying for things like talent. The contribution of client assets to profitability may be more consistent than the contribution of talent assets. "The meter's always running," my senior analyst at the time told me.The truth, of course, lies somewhere in-between. Managed assets produce a revenue stream which, after paying for rent and research and maybe a nice client dinner or two, must be divided between the staff (who service clients, manage the shop, and manage the portfolios) and the ownership of the firm (who may or may not be actively involved in operations). At Mercer Capital, our internal language to distinguish the two is return to labor and return to capital. Choosing how to allocate returns between labor and capital often says everything about an RIA's business model.A Tale of Two Managers…Take a look at the following pair of asset management firms: ACME and Smith. Both generate $10.0 million in revenue, and both spend $2.0 million on non-personnel related expenses. In both cases, that leaves $8.0 million to pay staff and provide a dividend stream or other return to shareholders. At this point the similarities end, and because of differences in compensation structure and the resulting differential in margins, Smith is five times as profitable as ACME.
Since we are a valuation firm, the question we are most likely to be asked at this point is, which firm is worth more: ACME or Smith? That's an interesting question which deserves more than a little thought. I can think of several occasions where we have been confronted with this very question both formally, when we were working out the share exchange on two similar RIAs with different expense and margin structures, and informally, when we coincidentally valued two very similar firms (for different projects) with approximately the same differential in their respective P&Ls as ACME and Smith.
On the basis of activity alone, maybe ACME and Smith are worth the same. If they have a similar fee schedule, then similar revenue implies similar AUM. But Smith is five times more profitable than ACME, so doesn't that mean Smith is worth, if not five times as much, at least considerably more? Absent conflicting information, the answer might be yes. Of course, there's usually conflicting information.
"Why" Matters More Than "What"Consider the possibility that ACME and Smith are both equity managers serving high net worth and institutional clients. Each employs the same number of staff, and each operates in markets with similar labor availability and costs of living. Now we know a lot of "what" there is to know about ACME and Smith, but we don't know enough of "why" they show the differential in margins.ACME operates in a state with a high corporate income tax rate, but no personal tax rate, so they pay out owner distributions in the form of bonuses that inflate compensation expense and deflate margins. Smith is neutral on the tax issue, but has a minority private equity owner that insists that partners are paid only modest salaries such that performance is rewarded for all owners, both inside and outside, via shareholder distributions.So Which Firm is Worth More?On the basis of the narrative above, ACME and Smith might be worth about the same. The market for talent being what it is, we might normalize the income statements of both companies and get to a similar margin structure (we will cover how to do that next week). Similar profits might yield similar valuations, but there is a business model difference which matters as well. ACME has more flexibility in its compensation structure and could bonus staff based on ownership and/or performance. This might be a recruiting advantage in the never ending war for talent, thus garnering better "assets" for ACME that will make it more successful than Smith. So is ACME worth more? As a shareholder in Smith, you might be concerned about the firm's ability to recruit talent, but you would not be concerned about sharing your distribution stream with that talent. So maybe the Smith shareholder has less upside, but that upside is better defined.The corollary to Collin Chapman's "add more lightness" here might be to give up on expensive talent and focus on margin, because profits are why businesses operate in the first place. Demonstrated profitability beats adjusted profitability any day. Alas, the early Lotus cars were not known for durability (Chapman also thought that a race car that wasn't falling apart at the finish line was overbuilt), and skimping on talent to the point that it impairs the longevity of an RIA does little to improve the value of the firm.Simple, huh?Next week we will finish the thought with Normalizing Compensation Expense.
Mercer Capital’s Value Matters® 2016-03
Characteristics of a Good Buy-Sell Agreement
Success and Succession Offers Targeted and Often Unexpected Insights on Internal Ownership Transition at RIAs
As the Baby Boomer generation continues to age toward retirement, many “founder-centric” asset management firms face the prospect of internal succession. The recent book “Success and Succession,” by David W. Bianchi, Eric Hehman, Jay Hummel, and Tim Kochis, is written from the perspective of three individuals who have experienced successful ownership transitions. The book provides some interesting insights into the logistical, financial, and emotional process that internal succession entails through colorful accounts of past triumphs and train wrecks.Some of the authors’ perspectives and insights are what one might expect. Operational realities cause many asset management firms to revolve around a key man, who may not prioritize a strategic succession or may lack a viable successor. He or she may have flawed beliefs that could doom the transition process, including the insistence that the firm remain the same following succession or the assumption of an unreasonably high valuation of the firm. While ownership transition should celebrate the achievements of the founder, it must also recognize the need for change in order to continue to serve the clients. Clearly, client communication during the transition is crucial, especially for a founder-centric firm in which the majority of client meetings and responsibilities have fallen on the exiting owner.Much of the above, while important, has been said by many others in many forums. The strength of “Success and Succession” is in more than a handful of unique insights into RIA ownership transition which get little if any attention from other industry commentators.Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner. The founder could feel the need to resume fulltime involvement in operations, fearing for his ongoing financial benefits from the firm. The authors advise both founders and successors to take a long term view and not focus on this short term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible, as his or her guidance is crucial when the successor faces major issues early on. But it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible. Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward. The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder took on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden. The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third party valuation. While it might seem easier to rely on valuation metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.”
All in all, the book is a practice-management must read for RIA owners contemplating succession – whether they are on the buy side or the sell side. Our experience advising clients on internal succession, in particular, is that successful transition requires a certain level of patience and humility on the part of both founder and successor, but above all long term commitment to a process rather than an expectation of a near term result. The book plugs the necessity of a third party valuation – and we would certainly second that – but we would add that a third party advisor with experience can often provide much needed perspective to keep a succession process realistic and give it the maximum opportunity to work for everyone.
Preferences and FinTech Valuations
2015 was a strong year for FinTech. For those still skeptical, consider the following:All three publicly traded FinTech niches that we track (Payments, Solutions, and Technology) beat the broader market, rising 11 to 14% compared to a 1% return for the S&P 500;FinTech M&A volume and pricing rose sharply over recent historical periods with 195 announced deals and a median deal value of $74 million in 2015 (Figure 1);A number of notable fundings for private FinTech companies occurred with roughly $9.0 billion raised among approximately 130 U.S. FinTech companies in larger funding rounds (only includes raises over $10 million).
One of the more notable FinTech events in 2015 was Square's IPO, which occurred in the fourth quarter. Square is a financial services and mobile payments company that is one of the more prominent FinTech companies with its high profile founder (Jack Dorsey, the Twitter co-founder and CEO) and early investors (Kleiner Perkins and Sequoia Capital). Its technology is recognizable with most of us having swiped a card through one of their readers attached to a phone after getting a haircut, sandwich, or cup of coffee. Not surprisingly, Square was among the first FinTech Unicorns, reaching that mark in June 2011. Its valuation based on private funding rounds sat at the top of U.S.-based FinTech companies in mid-2015.
So all eyes in the FinTech community were on Square as it went public in late 2015. Market conditions were challenging then (compared to even more challenging in early 2016 for an IPO), but Square had a well-deserved A-list designation among investors. Unfortunately, the results were mixed. Although the IPO was successful in that the shares priced, Square went public at a price of $9 per share, which was below the targeted range of $11 to $13 per share. Also, the IPO valuation of about $3 billion was sharply below the most recent fundraising round that valued the company in excess of $5 billion.
In the category its great pay if you can get it, most Series E investors in the last funding round had a ratchet provision that provided for a 20% return on their investment, even if the offering price fell below the $18.56 per share price required to produce that return. The ratchet locked in through the issuance of additional shares to the Series E investors. The resulting dilution was borne by other investors not protected by the ratchet.
On the flip side the IPO was not so bad for new investors. Square shares rose more than 45% over the course of the opening day of trading and then traded in the vicinity of $12 to $13 per share through year-end. With the decline in equity markets in early 2016, the shares traded near the $9 IPO price in mid-February.
IPO pricing is always tricky—especially in the tech space—given the competing demands between a company floating shares, the underwriter, and prospective shareholders. The challenge for the underwriter is to establish the right price to build a sizable order book that may produce a first day pop, but not one that is so large that existing investors are diluted. According to MarketWatch, less than 2% of 2,236 IPOs that priced below the low end of their filing range since 1980 saw a first day pop of more than 40%. By that measure, Square really is a unique company.
One notable takeaway from Square's experience is that the pricing of the IPO as much as any transaction may have marked the end of the era of astronomical private market valuations for Unicorn technology companies. The degree of astronomical depends on what is being measured, however. We have often noted that the headline valuation number in a private, fundraising round is often not the real value for the company. Rather, the price in the most recent private round reflects all of the rights and economic attributes of the share class, which usually are not the same for all shareholders, particularly investors in earlier fundraising rounds. As Travis Harms, my colleague at Mercer Capital noted: "It's like applying the pound price for filet mignon to the entire cow – you can't do that because the cow includes a lot of other stuff that is not in the filet."
While a full discussion of investor preferences and ratchets is beyond the scope of this article, they are fairly common in venture-backed companies. Recent studies by Fenwick & West of Unicorn fundraisings noted that the vast majority offered investors some kind of liquidation preference. The combination of investor preferences and a decline in pricing relative to prior funding rounds can result in asymmetrical price declines across the capital structure and result in a misalignment of incentives. John McFarlane, Sonos CEO, noted this when he stated: "If you're all aligned then no matter what happens, you're in the same boat… The really high valuation companies right now are giving out preferences – that's not alignment."
A real-world example of this misalignment was reported in a New York Times story in late 2015 regarding Good Technology, a Unicorn that ended up selling to BlackBerry for approximately $425 million in September 2015. While a $425 million exit might be considered a success for a number of founders and investors, the transaction price was less than half of Good's purported $1.1 billion valuation in a private round. The article noted that while a number of investors had preferences associated with their shares that softened the extent of the pricing decline, many employees did not. "For some employees, it meant that their shares were practically worthless. Even worse, they had paid taxes on the stock based on the higher value."
As the Good story illustrates, the valuation process can be challenging for venture-backed technology companies, particularly those with several different share classes and preferences across the capital structure, but these valuations can have very real consequence for stakeholders, particularly employees. Thus, it is important to have a valuation process with formalized procedures to demonstrate compliance with tax and financial reporting regulations when having valuations performed. Certainly, the prospects for scrutiny from auditors, SEC, and/or IRS are possible but very real tax issues can also result around equity compensation for employees.
Given the complexities in valuing venture-backed technology companies and the ability for market/investor sentiment to shift quickly, it is important to have a valuation professional that can assess the value of the company as well as the market trends prevalent in the industry. At Mercer Capital, we attempt to gain a thorough understanding of the economics of the most recent funding round to provide a market-based "anchor" for valuation at a subsequent date. Once the model is calibrated, we can then assess what changes have occurred (both in the market and at the subject company) since the last funding round to determine what impact if any that may have on valuation. Call us if you have any questions.
For those interested in additional FinTech trends, check out our latest FinTech industry newsletter and sign up for future issues here.
Related LinksFinTech Newsletter 4Q15 | Venture Capital Case Study: StripeIs a Bubble Forming in FinTechMercer Capital's Financial Reporting BlogMercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter at @MercerFairValue.
Value Driver Considerations in Appraising Sports Franchises
OverviewThe valuation of sports properties is often perceived as one of the most exciting areas of the appraisal profession. Sports business mandates constitute an amalgam of traditional valuation approaches applied to a specialized industry niche possessing its own distinct value drivers and considerations.Sports property valuations may be required in a variety of situations, including:mergers and acquisitions;fairness opinions;business reorganizations;shareholder disputes;structuring shareholder agreements;income tax;estate planning;insolvency;commercial litigation; andmarital disputes.
While the purchase and sale of professional sports franchises and arenas constitute the most visible event necessitating the participation of an experienced valuator, the foregoing situations also can give rise to valuation mandates. For example, in 1994, the Toronto Maple Leafs NHL franchise and the arena in which the team played, Maple Leaf Gardens, were owned by a public company, Maple Leaf Gardens, Limited, which was being taken private. Consequently, the fairness opinions that had been prepared in connection with this going-private transaction were called into question by The Public Guardian and Trustee of Ontario and the Attorney General for Ontario. A vigorous litigation ensued, in which the valuation professionals played a central role.
As is the case with many businesses, shareholder agreements can necessitate valuation mandates, as sports teams and arenas are often owned by numerous individuals and/or corporations. For example, at the date this was written, the Calgary Flames NHL franchise was held by over two dozen owners, and the Green Bay Packers NFL team was owned by several thousand individuals, most of whom were members of the local Wisconsin community.
Both friendly transactions and acrimonious disputes among shareholders occurring under such shareholder agreements will typically require the involvement of one or more valuation professionals to determine the value of the entity holding the sports-related assets (or interests therein).
Income tax and estate planning also constitute frequent sources of valuation work involving sports organizations. Those sports properties that have been owned by families will often, at some point, require valuations to be performed for intergenerational transfers of ownership among family members. Moreover, considering the significant appreciation in value experienced by professional sports franchises around the globe during the past few decades, owners of sports properties eventually may need to contend with capital gains-related issues. Valuation professionals often provide integral assistance in this process.
Insolvency or restructuring involving either a professional sports organization or one of the owners thereof is another event that will frequently necessitate the expertise of business valuators. For example, in the 1990s, there were several high-profile bankruptcies of English Premier League football (i.e., soccer) organizations that occurred after several previous rounds of financing had been obtained. At every step of the way, from the initial financing to the restructuring or asset liquidation process, business valuations are typically required to provide an indication of worth of the sports franchise and related properties.Price Versus Fair Market ValueThe valuation of professional sports properties provides an excellent illustration of the difference between price and fair market value in a "real world" setting. As valuation professionals are well aware, there are generally two distinct sets of circumstances where the value of a business is determined:Notional Market Valuation. Fair market value, fair value or some other legislated or defined value is often notionally determined in the absence of an open-market transaction. The value standard most frequently applied in notional market valuations is "fair market value." The generally accepted definition of this valuation term by North American courts is:The (highest)1 price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.Open-Market Transaction. Price is negotiated between a vendor and a purchaser acting at arm’s length. The term "price" is defined as "the consideration paid in a negotiated, open-market transaction involving the purchase and sale of an asset."
In a sports market context, sentimental value may occasionally represent a component of price. This concept is evidenced by a sports team owner who is an extremely wealthy individual and does not view the acquisition of a sports team from an economic perspective but rather as a "trophy." An investment involving sentimental value, in other words, may be ego-driven in nature and made by a purchaser who is willing and able to absorb significant losses.
Special interest purchasers are often present in the marketplace for professional sports properties. Special interest purchasers are generally defined as: "acquirers who believe they can enjoy post-acquisition economies of scale, synergies, or strategic advantages by combining the acquired business interest with their own." Examples of these types of purchasers are large companies possessing broadcasting, media and entertainment operations that can avail themselves of synergies presented by controlling assets relating to professional sports organizations. In recent years, a number of such companies have successfully acquired professional sports properties in order to benefit from the content provided to the purchaser’s media distribution network.
In the sports business world, both of the above sets of circumstances are frequently encountered. As is illustrated below, there may be significant differences between fair market value and price. For example, fair market value typically assumes the following conditions exist:equal knowledge and negotiating skills;no compulsion to transact;generally no special interest purchaser considerations;imprudent actions and emotions are not considered;vendor and purchaser are assumed to deal at arm’s length; andtransaction is assumed to be consummated for cash.
In contrast, the price determined in an open-market transaction may be influenced by the following considerations:unequal knowledge and negotiating skills;compulsion to transact may be present (e.g., a sale made in an insolvency setting even if the purchaser intends to continue the sports organization as a going concern);special interest purchasers may force the price upward;price may be struck as a result of imprudent decisions by the vendor, the purchaser or both;sentimental value considerations may force the price upward;outwardly, vendor and purchaser may appear to act at arm’s length, but may have common interests due to the elements of the transaction, such as vendor employment agreements, noncompetition agreements, etc.; and/orthe negotiated price may contain noncash elements, such as contingent "earn-out" or bonus payments, freely trading or restricted shares and/or debt instruments.Valuation ApproachesAs is the case with most businesses, a sports franchise’s value is derived from its future benefits, such as revenues, EBITDA and net cash flow. Among the factors influencing the perceived future benefits for a sports franchise include its management team, trademarks, brands and logos, customer "fan base" relations, customer contracts (e.g., season tickets, corporate boxes, personal seat licenses), player relations and contracts, broadcasting contracts, arena ownership or lease agreements, team-alliance synergies, local demographics (e.g., population size, wealth, popularity of sport), etc.Simply put, the fundamental goal for a sports team owner is to maximize the number of fans in the seats (or viewing the matches via broadcast media), and the goal for an arena/ stadium owner is to minimize the number of "dark nights" in which no event is occurring in the building.Admittedly, while future benefits often cannot be measured with absolute certainty, franchise values will change in a manner commensurate with perceived increases and decreases in such benefits. In the sports business world, while no single approach or formula can be used to determine the value of sports properties in every situation, different approaches and methods have been adopted for estimating future benefits and franchise/asset values.In sports business valuations, the Market Approach is often frequently utilized, considering the active market that exists for many professional sports properties. In the Market Approach, the subject sports property is compared to similar properties by performing a detailed analysis of prior transactions involving similar sports properties and/or in the ownership of the subject sports franchise or asset.Transactional IssuesIn analyzing transactions in sports properties, aside from reviewing the amount and structure of the transaction price, it is frequently necessary for the valuation professional to identify and quantify key organizational elements that generate value for the subject professional sports club, such as (but not limited to) management team and personnel, corporate operations, finance and technology.It is a sports business paradigm that the management team should, in maximizing franchise value, maintain and enhance the quality of the team brand. Such brand value enhancement may be performed in a variety of ways, including winning on-field victories and championships, attracting individual "marquee" players, fostering positive community relations and developing a robust tradition ultimately bestowing "iconic" status on the sports franchise.For example, the valuator should examine the quality of the management team, employees and players, focusing on the club’s ability to retain talent and expertise (on the field, among the coaching staff and in the front office). In order to enhance value, the sports organization should possess the potential to develop future leaders (for both players and management), avoid labor actions (e.g., strikes, lockouts), motivate commitment in its players and employees to the club’s culture and ethics, and strengthen relationships among management, players and employees.In assessing value of sports franchises in a transactional setting, the valuation professional should also examine the ability of the organization to maximize the potential of its corporate operations. For example, the franchise organization should constantly strive to improve capacity utilization wherever possible (e.g., selling out games, maximizing advertising and media revenue). Recent revenue maximization trends by franchise owners in this context have included selling advertising on fixed or rotating panels in close proximity to playing surfaces, inside arena corridors, on building exteriors and on game tickets. Sports team management should also be seeking to optimize other areas of business potential (e.g., creation of team-alliance synergies, increase in the number of official sponsors or partners with the club, etc.).Moreover, the sports organization should periodically assess what investments are required to expand or improve fixed-asset infrastructure (e.g., addition of seats, creation of premium or "club" seat categories, addition or expansion of facility restaurant, bar, concessions and parking facilities). Management should also be cognizant of ways to strengthen the franchise’s market position in the presence of other forms of entertainment competing for the same consumer, media and advertising spending sources.The valuation professional must examine the ability of the sports organization to maximize the value of its intangible assets. Aside from traditional items such as the franchise logo, influencing the popularity of merchandising and licensing revenues, in recent years, savvy sports-marketing experts have derived new sources for professional sports franchises to obtain revenues, notably the leasing of stadium/arena naming rights. Typically, building naming rights are leased for several million dollars annually for terms of 10 to 20 years; these stable revenues often flow directly to the bottom line of the club/building owner.Furthermore, in transactional contexts involving professional sports organizations, the valuation professional should assess the financial strength of the subject business. In particular, the valuator needs to place particular emphasis on the extent to which leverage has been (or may be) utilized to finance capital assets and franchise operations. Other financial issues should be reviewed, including the club’s ability to recognize and maximize all revenues (i.e., deferred revenues) from an accounting standpoint and to depreciate or amortize the franchise itself, player contracts, capital assets, etc. If the franchise is being positioned for sale, it may be desirable for the club to "clean up" the balance sheet, (e.g., eliminate redundant assets such as excess cash, marketable securities, non-operating real estate, inter-company or shareholder loans), adjust overvalued assets and other reserves in order to present the sports business’ true earning power, accelerate the collection of accounts receivable, etc.Finally, sports business valuation experts have increasingly focused on a franchise’s ability to enhance value through the creative use of technology. In recent years, technology has been utilized by sports team owners through innovations such as the use of web-based resources featuring fan club sites and live or archived game broadcasts. Many sports business experts predict a proliferation of fee-based broadcasts of matches and related content through television, Internet audio and video, as well as mobile phone media. Other uses of technology that may create franchise value relate to the extent to which technology can be implemented to improve communications (e.g., within the internal organization, with the fan base and among the league and its members).Value DriversBoth of the concepts of price and fair market value are often influenced by numerous value drivers that relate specifically to professional sports franchises. Among the frequently encountered examples of "external" value drivers (over which a franchise owner exerts little, if any influence) are included, but are by no means restricted to:degree of control of franchise operations by league;finite number of teams permitted in league (i.e., barriers to or ease of entry through expansion);franchise expansion fee (this often constitutes a "floor" to franchise value, as well as a windfall profit to franchise owners when received). For example, in the NHL, the most recent expansion fee paid for a new franchise, occurring 15 years prior to the publication of this paper, was U.S. $85 million. Media reports have stated that the next potential round of NHL expansion could command franchise fees as high as U.S. $400 million;extent and terms of revenue sharing;presence of salary cap;local market barriers to ownership entry/exit;availability of government grants or other forms of financial assistance;market demographics;market radius protection (in the NHL, each franchise is protected by a 50-mile radius, within which another franchise in the league cannot be operated without the existing owner’s permission);ability of the franchise to relocate; andextent to which league approval is required for franchise ownership transactions.
Moreover, included among the various salient "internal" value drivers over which a franchise owner typically possesses some ability to influence are:ticket revenue (e.g., season ticket base, ability to increase or vary ticket prices);broadcast revenue (e.g., from television, radio and Internet media);team-alliance synergies (i.e., synergies and benefits derived from common ownership of two or more sports teams);player-transfer fees (i.e., these represent highly lucrative sources of revenue in international soccer);advertising revenue;playoff revenue (revenues from post-season play often contribute significantly to profits);concessions revenue;merchandising and memorabilia revenue (including revenues from licensing team name and logo); andstadium/arena ownership revenues (derived from building sources such as luxury "club" seating, corporate boxes, naming rights and ancillary events such as concerts, unrelated sporting events, conventions, etc.).
Interestingly, two factors that do not always constitute significant value drivers for a sports franchise are the win-loss record of the club, as well as the individual players comprising the team. The impact of possessing (or lacking) either championship trophies or superstar players must be assessed by the valuation professional as to the incremental contribution of each to the value of a particular sports organization.
Among the important items on the expense side of the income statement that may materially impact the value of a professional sports franchise are included player salaries, which are, in turn, influenced by permitted contractual increases, free agency, union collective bargaining agreements, long-term injuries to or retirements of players, etc.
Franchise owners who do not own the stadium/arena facility will also be subject to leases for building rental, as well as possibly leases for concessions, merchandising and/or parking facilities. Moreover, some teams, such as Canadian NHL franchises, must contend with material foreign currency risk, as their revenues will be received in the local currency while some of their expenses (e.g., player salaries) may be denominated in a foreign currency. Finally, the ability of a sports club to claim amortization expense on its franchise cost, player contracts and capital assets will impact its fiscal situation, as well as its operating cash flows.ConclusionWhile the sports business field may be a source of some exciting mandates for the valuation practitioner, as the above narrative indicates, sports properties encompass a highly specialized segment of our profession that is subject to its own distinct challenges.This article originally appeared in Wolters Kluwer's Business Valuation Alert, January 2015.About the AuthorsDrew Dorweiler, MBA, CPA, ABV, CBV, ASA, CBA, CFE, CVA, FRICS, is Managing Partner at IJW Co.
Don Erickson, ASA, is Managing Director of Mercer Capital.
Endnote1 The word "highest" is added to the Fair Market Value definition in Canada.
2015: A Good Year for Banks
After weak broad market performance in the first quarter of the year and slow advances during the summer, U.S. stocks generally saw amplified returns in the fourth quarter of 2015. The largest banks (those with over $50 billion in assets) generally performed in line with broad market trends, but most banks outperformed the market with total returns on the order of 10% to 15% for the year (Figure 1).
Bank stock performance improved markedly in the fourth quarter as speculation following the FOMC’s September meeting suggested rate increases may begin in the fourth quarter. In mid-December, the FOMC met again and, after seven years of its zero interest rate policy, announced an increase in the target fed funds rate. The shift in monetary policy is expected to gradually improve strains on banks’ net interest margins and should be most apparent for banks with more asset-sensitive balance sheets, though community banks that may have made more loans with longer fixed terms or loan floors may experience some tightening in the short term.
Bank returns generally averaged around 0% to 30% in 2015, though 17% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realized negative total returns. These included banks continuing to deal with high levels of NPAs; banks that are located in oil-dependent areas such as Louisiana and Texas; and some banks that have been active acquirers that missed Street expectations. On the other end, a few high performers in 2015 include merger targets as well as banks that have seen more success from acquisition activity (Figure 2).
One of the primary factors contributing to stronger returns in 2015 was loan growth. Banks with loan growth over 10% exhibited above-average returns, while those with slower growth tended to exhibit lower returns, with the exception of banks that shrank their portfolios during the year, though for these banks the higher returns likely reflected prior years’ underperformance that was priced into the stocks (Figure 3).
Asset-sensitive banks also outperformed in 2015. While asset sensitivity is difficult to evaluate from publicly available data, we measured asset sensitivity by the proportion of loans maturing or repricing in less than three months from September 30, 2015, relative to total loans (both obtained from FR Y-9C filings). Limiting the analysis to publicly traded banks with assets between $1 billion to $5 billion reveals that the most asset sensitive banks returned about 16% in 2015, or 400 basis points more than less asset sensitive banks (Figure 4).
Though the smallest banks generally realized the highest returns in 2015, pricing multiples were strongest for banks with assets between $1 and $10 billion, which generally saw better profitability than the smaller banks. Year-over-year, pricing multiples generally remained flat from 2014 (Figure 5).
Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.
The Oil and Gas Shift is Impacting the Industry in a Few Key Areas
Anybody who has been to a gas pump in the last several months can tell you that the energy industry is currently in the throes of change. Prices are falling to lows that they haven’t seen in almost a decade and the industry itself is being impacted in a large number of different ways. The changing face of economics and the marketplace has presented an entirely new set of challenges that businesses will have to adapt to in order to thrive well into the future.The Changing Face of Economics and the MarketplaceAnother significant change that will impact the oil and gas industries in 2015 and beyond has to do with current market fluctuations that will affect profitability. It’s no secret that oil prices started plummeting in 2014 and show no signs of slowing down. Bernstein Research, for example, estimates that a full 1/3 of all shale projects in the United States become unprofitable once prices fall below $80.This is a case-by-case basis, however, and is not blanket fact. The Bakken formation in North Dakota, for example, will still be profitable so long as prices do not fall below $42 per barrel – according to the IEA. ScotiaBank’s own research indicates that prices have to stay between $60 to $80 per barrel for the Bakken formation to remain profitable.Changes in Production and DemandA large part of the reason why oil prices are continuing to fall has to do with two other significant changes that are impacting the industry: namely, changes to the total amount of oil that the United States and Canada are producing, as well as changes to the demand for oil in areas of the world like Europe and Asia.According to the International Energy Agency (also commonly referred to as the IEA), shale production in the United States is expected to shift dramatically in the coming years. In scenarios both where oil prices remain roughly where they are and where they continue to fall even farther, the IEA predicts that shale production will still continue to grow, just at a much slower rate than it has been in the last several years. To put that into perspective, production is still expected to increase an additional 950,000+ barrels per day throughout the entirety of 2015.Another important factor to consider has to do with infrastructure with regards to existing investments. There are a large number of energy companies that have already paid a great deal of money purchasing land, obtaining necessary permits and performing other tasks necessary to drilling. Even if oil prices continue to fall, these companies can’t necessarily curb back on their production or they fear losing an even greater investment than initially feared. In these types of situations, the true “break even” price in production varies depending on the operator and their tolerance versus the amount of debt that they’ve taken on. Even still, it may be too early to tell in many cases how firm those tolerances really are.The boom in increased oil production in the United States and Canada has created something of a tricky situation for the industry as a whole. After sinking a huge amount of money into infrastructure over the last several years, businesses now have to contend with falling prices that show no signs of slowing down. In order to adapt they will have to look for ways to embrace new technology and streamline production in order to stay profitable well into the future and to break through into a bold new era for the industry as a whole.This article was originally published in Valuation Viewpoint, January 2015.
Does the Clippers $2 Billion Deal Make Sense?
In recent court testimony, Bank of America – Merrill Lynch (“BoA”) revealed its bid book (“Project Claret”) prepared for potential buyers of a NBA franchise, the Los Angeles Clippers (“Clippers”). We are going to analyze elements within the Project Claret document with a particular focus on the revenue estimate of the local media contract renewal in 2014.Let’s look at BoA’s estimate of local media revenues primarily related to television content. BoA forecasted television rights payment in June 2014 year-end at $25.8 million from the current contract projecting it to $125 million for a new local media contract. Michael Ozanian of Forbes recently estimated the 2014 new contract amount to most likely be closer to $75 million. I agree with Mr. Ozanian for the following reasons:If the Los Angeles Lakers (“Lakers”), back in 2011, signed a local media television rights contract for $5 billion over 25 years, then the average is approximately $200 million a year. Typically these contracts have annual escalation clauses and if the total payout is $5 billion, then the amount in 2012 is close to $100 million for the Lakers. You need to escalate that to about $110 million in 2014.The television ratings of the Lakers are multiples of the Clippers and cable subscribers ultimately pay for the right’s fees. So if you are a sophisticated buyer of sports content, like Fox Broadcasting Company or Time Warner Cable, are you going to pay the same dollar amount for the Clippers as you did for the Lakers? The Clippers have ½ the television ratings of the Lakers (1.28 vs 2.72) in the current year. To quote a recent Variety article, “This is believed to be the closest the Clippers have come to the Lakers in television ratings since the 1999-2000 season.” Additionally, the Lakers experienced a very poor win/loss record in the 2013-2014 season. If one analyzed their historical results, the Clippers have less than 1/3 of the viewership as the Lakers (121,000 vs 390,000) last year.
Therefore, how much will the Clippers realistically get in 2014 with the new contract? $75 million is approximately 68% of our estimated Lakers deal amount and seems generous based on the raw ratings numbers. However, if we utilize the Forbes estimate of $75 million in 2014 and the other BoA revenue estimates for game admissions ($62.3 million) and other team revenue ($136.8 million), the total revenue estimate for the Clippers would be $274.1 million in 2014 versus the $324.1 million utilized in BoA Project Claret.
If one assumes a multiple of 5x revenues, which is the high end of multiples paid for an NBA team to date, the indicated enterprise value estimate is $1.370 billion, a far cry from $2 billion. Additionally, many times when dealing with estimates of future results (in this case an estimate of future revenue) the valuation multiple applied should be lower than actual transaction multiples. These multiples are calculated based on historical revenues, which are usually lower than future estimates.
It seems clear to us that based on the data available the $2 billion price from Steve Ballmer is a good deal for the Sterling Trust.
This article was originally published inValuation Viewpoint, August 2014.
Exploring the Major League Baseball Value Explosion
From 2000 to 2005, Major League Baseball teams were selling for much less than National Football League teams, i.e., typically under $200 million. Most of the MLB teams were showing losses at the time, and there was limited interest in buying the teams that did come up for sale. But the buying and selling environment changed dramatically in 2012, with the Los Angeles Dodgers selling for over $2.15 billion in a spirited auction with sixteen initial bidders.1What has caused this explosion in MLB prices and do these high prices make sense?In this article, I attempt to answer this question as I discuss MLB franchise price/value changes in the last fifteen years and whether these dramatic jumps in prices/values make economic/market sense.First, I illustrate actual transaction prices for MLB teams in the early 2000s. I then show the significant increases—starting in 2008—leading to the blockbuster $2.15 billion Dodgers deal in 2012.I then demonstrate the value changes published by Forbes Magazine and discuss key economic changes in the industry (i.e. MLB) that have contributed to these price jumps of twice—and sometimes three times—the 2005 prices for MLB franchises.Finally, I explore the actual financials for the Texas Rangers and a history of the prices paid for the Rangers over the years.For definition purposes, when we discuss values, we are always discussing enterprise (equity + debt), not equity values, and when we discuss revenue multiples, we are discussing total revenues from team/franchise and stadium interests, but excluding regional sports network (RSN) interests.Deal Prices and MLB Values Estimated by Forbes MagazineAs Chart 1 shows, enterprise prices for MLB teams from 2000 to 2005 were less than $200 million, except for the 2004 Dodgers deal, which came in at $430 million. In 2006, two transactions increased to the low $400 million range. In 2008, a San Francisco Giants deal indicated $700 million, and the Chicago Cubs in 2009 were sold for over $800 million. In 2009 during the “Great Recession,” a smaller market team, the San Diego Padres, transacted at $500 million. Also in 2009, the Texas Rangers sold at $595 million during a bankruptcy bidding war. Finally, the chart shows the big jump with the bankruptcy auction prices of the L.A. Dodgers and their stadium and land at $2.15 billion in 2012.Changes in Revenue MultiplesUnlike entities in other industries, major league sports teams are usually valued using a market approach rather than an income approach. Most of their enterprise values are referenced as a multiple of team and stadium revenues.The multiples in revenues paid for actual transactions in the early 2000s were in the 2.0 times to 2.5 times range, but recent deals have been over 4.0 times revenues. The recent 4.0 times multiple reflects anticipated growth in revenues since sophisticated and well-heeled buyers are anticipating significant future revenue growth.In Table 1, Forbes estimates are developed by Forbes editors utilizing public sources, their proprietary methods of estimating team revenues and expenses, and their judgment as to the valuation multiple to be applied to their revenue estimates.3
By 2014 (see Table 2), Forbes average MLB value estimate had jumped to $811 million and had a 3.3 times multiple. The values ranged from $2.5 billion for the Yankees to $485 million for the Tampa Bay Rays.
The average revenue estimates for the league have only increased from $183 million to $237 million or thirty percent. Yet the average valuation multiple increased from 2.6 times to 3.3 times causing the average team value to increase sixty-four percent. What caused this significant increase? The answer: potential for increased local revenues due to an explosion in media rights fees.
Meteoric Media Rights Fee IncreasesAs mentioned earlier, recent media rights fees for local broadcasts of MLB teams have increased three to five times that of older contracts. These older contracts may have been ten years in length, but the new ones can be in force as long as twenty-five years.Unlike the total revenues for NFL teams and, to a lesser extent, those of the NBA, local media rights fees make up the majority of revenues for MLB teams. In many markets, the content providers (cable and satellite companies) are vying for a unique live product that can differentiate them in the marketplace. This competition has caused bidding wars for TV and other media rights to MLB teams.The largest current local MLB media contract was negotiated by the L.A. Dodgers and was recently approved by MLB. In this contract, the L.A. Dodgers will reportedly receive $6 billion after a revenue-sharing split with MLB. This equates to an average of $240 million a year over twenty-five years. The old Dodgers contract was approximately $50 million dollars in its last year.The next highest are the Texas Rangers and the Houston Astros at $80 million a year on average. In addition, the national TV MLB has jumped also—see Table 3.
It should be noted that part of the massive increase in payments to the L.A. Dodgers by Time Warner Cable is covered by Time Warner’s plan to pass the costs on to other pay TV providers, including Direct TV, Dish Network, Charter Communications, and Cox Communications.
Currently, Time Warner Cable and their providers are deadlocked on the price increases they will pay for airing the L.A. Dodger games. The providers contend that Time Warner’s cable price for their L.A. Dodger sports channel is too high. How this negotiation is settled will affect prices other providers pay nationwide. For example, the Houston Astros RSN has not been picked up by many of the local providers and the RSN has been forced to file for bankruptcy.
Table 4 shows the changes in the MLB National media contracts with the various networks. We note that the ESPN contracts increased from $296 million a year to $700 million a year. The Fox contract increased from $257 million a year to $525 million a year, etc. In short, the new national contracts increased by 120 percent from the other contract.
At the height of the recession, the San Diego Padres sold for $500 million in 2009. It resold in 2012 for $800 million due primarily to a major jump in a local media contract.
Are the teams making so much money that they warranted such a much higher price based on profits? The answer, surprisingly, is “no, not really.”
Case Study: Texas RangersThe Texas Rangers sale in 2009 to the highest bidder out of bankruptcy court7 is a good example (Table 5).
Note that these numbers were prior to any regional media contract increases now scheduled to begin with the 2015 season.
Also note that annual amounts shown in the both the local and national contracts are averages and the initial year of the contract is usually much less than the average price shown.
All teams are subject to a player salary cap, which come with significant penalties if violated. So conceptually, if your revenues go up $50 million in a particular year, that amount could fall to the bottom line. How much is $50 million of profit worth to buyers whose primary value driver is not cash flow? It could be $500 million. It could be $1 billion. Which then causes people to wonder how much profit do these teams actually make?
The answer is that many lose money—some significant amounts. Many people ask why anyone would pay these amounts to buy teams if they do not make a reasonable profit.
There are two main answers to that:
Every buyer has a different motivation.Few of us can look at “investments” through the lens of a multi-billionaire to whom a $10 to $50 million annual loss is not significant to their financial well-being.Texas Rangers Price HistoryThe Texas Rangers also provide a good example of transaction price changes in the MLB. Table 6 shows the transactions in the team since 1974.
Please note that in the $595 million 2010 transaction, the team was making very little money and with signing bonuses deducted, was not cash flow positive. What is the value of this team, considering such facts?
ConclusionThe intensity of local revenues for MLB has created a perfect storm for MLB teams as the media engages in a buying frenzy for live local sports entertainment.Multiples of 4.0 times revenues are now becoming the new normal versus 2.0 times prior to 2006 driven by local revenue growth with media leading the way. Media contracts are increasing three to five times the annual amounts negotiated in the early to mid-2000s. The outlook for increased local media contracts will create new and higher MLB club transactions for years to come.But what about value creation? In the case of the Dodgers, if their media revenue increases up hypothetically $200 million a year from the previous contract, how much increase in value will that create? Could it be an extra billion dollars or more? At the end of the day, these local media contract increases, coupled with the new increased national media contracts, generally tend to support the new much higher level of MLB prices.Obviously, the smaller markets do not enjoy the same increases as the major markets like Los Angeles and New York, etc., but their new contracts will increase in multiples of older contracts i.e., from $15 to $20 million a year to $50 million plus as media providers compete for the exclusive content that live sports provides.This article was originally published inThe Value Examiner, September/October 2014.EndnotesBrian Solomon, “$2 Billion Dodgers Sale Tops List of Most Expensive Sports Team Purchases Ever,” Forbes Magazine, March 29, 2012, http://www.forbes. com/sites/briansolomon/2012/03/29/2-billion-dodgers-sale-tops-list-ofmost-expensive-sports-team-purchases-ever/.Michael K. Ozanian and Kurt Badenhausen, “The Business of Baseball,” Forbes Magazine, April 16, 2008, http: http://www.forbes.com/2008/04/16/baseballteam-values-biz-sports-baseball08-cx_mo_kb_0416baseballintro.html. Note the remaining nineteen teams are shown on the NACVA website at http://www.nacva.com/examiner/14-SO-Charts.asp.Until recently, Forbes was the only public source of estimates for major league sports teams. They have been developing revenue, profit, and value estimates for over seventeen years. Numbers are as of Dec. 31, 2013.Mike Ozanian, “Baseball Team Values 2014 Led by New York Yankees at $2.5 Billion,” Forbes Magazine, March 26, 2014, http://www.forbes.com/sites/mikeozanian/2014/03/26/baseball-team-values-2014-led-by-newyork-yankees-at-2-5-billion/.Sources: Proprietary team sources.6 Christina Settimi, “Baseball Scores 12 Billion in Baseball Deals,” Forbes Magazine, October 2, 2012, www.forbes.com.Bankruptcy Court For The Northern District Of Texas Fort Worth Division, Texas Rangers Baseball Partners, Chapter 11, Case No. 10-43400-DML.Source: ProprietarySource: Proprietary
Are There Really 2 NHLs?
When it comes to the four major league sports (NFL, MLB, NBA, NHL), the NBA and MLB have had less success in Canada vs. the USA, primarily due to demographics. With the exception of Toronto, most of the cities tend to be smaller and have fewer corporate headquarters relative to U.S. cities. Currently there is only one NBA and one MLB team in Canada, both in Toronto.There is one major league sport, however, that is thriving in Canada, the National Hockey League (“NHL”). The NHL teams in Vancouver, Calgary, Edmonton, Winnipeg, Ottawa, Toronto and Montreal are doing very well. In fact, they’re doing much better on average than their U.S. counterpart cities that have much larger populations (i.e. Dallas and Atlanta which is now a former NHL city). So much so that one may say there are really two NHLs, the Canadian NHL and the U.S. NHL.How can that be?Let’s look at the estimated 2013 franchise values of the teams as published by Forbes magazine. Three of the seven Canadien teams are in the top four of league franchise values. The Toronto Maple Leafs are first at $1.2 billion, the Montreal Canadiens third at $775 million and the Vancouver Canucks fourth at $700 million. The NHL league average is $413 million. The remaining Canadian teams are valued as follows:(#11) Calgary Flames $420 million(#14) Edmonton Oilers $400 million(#15) Ottawa Senators $380 million(#16) Winnipeg Jets $340 million
Our home team, the Dallas Stars, comes in at $333 million and the Columbus Blue Jackets rank last at $175 million.
Now some interesting numbers: the seven Canadian teams feature values averaging $595 million, while the 23 American NHL teams average $358 million. That’s a little over half of the Canadian teams.
How can the New York Islanders, with a metropolitan statistical area (“MSA”) population of 19.9 million, be worth $195 million, while the Winnipeg Jets, with an MSA population of 0.7 million, are valued at $340 million? Additionally how can Vancouver, with a MSA population of 2.3 million, be valued at $700 million? The franchise value relationship with MSA population does not directly correlate. How can this be?
The answer is the popularity of hockey in Canada has no comparison to most U.S. cities. Hockey is the national sport of Canada. Kids grow up playing it, watching it and living it. That culture creates much greater revenue and profits for their teams. This can be demonstrated by analyzing the national television revenues and the local revenues of NHL teams.NHL: National Television RevenuesThe U.S. has a population of 319 million people vs. 35 million for Canada, yet the national TV rights for the NHL in Canada was recently won by Rogers Communications for $5.2 billion over 12 years, or an average of $433 million a year. This compares to the $2 billion, 10-year NBC U.S. deal which averages $200 million per year. In addition, 65% of the Canadian national TV rights will be shared with the 23 U.S. teams. It is interesting that a country with one-tenth the population gets about 2.2 times the national TV revenues compared to the U.S. and then has to share with the U.S. teams.NHL: Local RevenuesLocal TV rights are retained by the teams, as are other local revenues from suites, sponsorship and ticket revenues. Here again, the Canadian teams far outshine the U.S. teams. Forbes estimates the average NHL ticket prices in Canada for six out of the seven teams was $70 for non-premium tickets. Forbes estimated that small markets, Edmonton and Calgary, each had $1.6 million in annual ticket revenues. Compare that figure with the New York Rangers ticket revenue of $1.8 million, and that comparison is shocking (if that is not shocking to you, please compare populations of the three cities). Additionally, local television viewing shows the same type of comparisons as national TV viewing. Therefore, smaller Canadian markets like Vancouver will have multiples of local TV revenue when compared to a larger U.S. market, like Dallas.ConclusionIn conclusion, after considering the numbers, it is hard to make a case for franchise value comparison between Canadian and U.S. NHL teams. Clearly, the economics indicate there are two different NHLs.This article was originally published inValuation Viewpoint, October 2014.
NBA Team Values: Three Ways Cuban and his Owner Bretheren are Cashing In
In a recent article Mark Cuban commented how media revenues will push National Basketball Association (“NBA”) valuations far higher than they are currently. “If we do this right, it’s not inconceivable that every NBA franchise will be worth more than $1 billion within ten years,” he was quoted as saying. While that observation could be on the money, it’s not the only engine that drives NBA team values. NBA franchises are unique properties that are often among the most attractive and reported upon assets in the US (and globally for that matter thanks to Mr. Prokhorov). The undergirding economics of these teams are complex and nuanced. When value drivers align, good things happen and value is unlocked. Like a flywheel with momentum, certain dynamics can push values upward quickly. However, the same dynamics can push the flywheel off its hinges, bringing values crashing down. It’s an exciting property that doesn’t always follow the path of conventional valuation theory, which might be a reason why a Maverick like Mark Cuban loves it so much.NBA franchise values have recently gone in an upward direction as evidenced by the Sacramento Kings’ $534 million sale in January 2013. That’s quite a figure for the 27th ranked metropolitan statistical area (“MSA”) in the country. This transaction is especially fascinating in light of the Philadelphia 76ers (5th largest MSA) selling for only $280 million just 18 months earlier. What fuels such a vast difference? We explore three issues that contribute considerably to these variances – media rights, arena lease structure, and the NBA’s collective bargaining agreement (“CBA”). Some of these factors are more within an owner’s control than others, but all of them contribute to situational changes that valuations hinge upon. We’ll also explore the tale of two transactions: the 76ers and Kings, to see why and how these factors influence the purchase price.Media Rights: The Quest for Live ContentIt is important to note the majority of NBA team revenues come from local sources, (i.e. game day revenues and local media contracts). The most dynamic (and thus value changing) of these sources in the past few years has been local media rights. National media revenues in NBA are significant but are a much lower percentage of total revenues than the biggest league in North America, the NFL. According to Forbes, the 30 NBA teams collectively generated $628 million from local media last season (about $21 million average per team). In addition, national revenues from ESPN, ABC & TNT total $930 million per year and these deals expire in 2015-2016. It’s a relatively balanced mix compared to the other major leagues. NHL & MLB’s media revenues are more locally focused, while the NFL is nationally dominated.Basketball’s popularity has grown in recent years. This, coupled with intense media competition for quality live content, has fueled increased media contracts in many markets at unprecedented levels (300% to 500%) over prior contracts.Live sports programming has a relatively fixed supply and is experiencing increased demand from networks looking for content those viewers will watch live. This commands higher advertising dollars compared to content that is consumed over DVRs and online forms (Netflix, Hulu Plus, Amazon Prime, etc.). Content providers also covet the low production costs and favorable demographics of younger fans. These factors, among other variables, have helped fuel the rapid price increases for sports media rights.Recently, new media rights contracts across all sports programming have soared to record high annual payout levels. The NHL signed two new TV deals in April 2011 which more than doubled the league’s previous annual payouts with an upfront payment of $142 million. Even the media rights for Wimbledon have seen an increase in the amount of suitors. The NBA’s current national deal expires in a couple of years (2016). Many people expect that the next deal’s value will at least double the current agreement. [Side note: In negotiations that date back to the 70’s ABA/NBA merger, two brothers – Ozzie and Daniel Silna, received a direct portion of the NBA’s national TV revenues – in perpetuity. That’s right…perpetuity. In January 2014 they agreed to a $500 million upfront payment from the NBA and a pathway to eventually buy them out completely. The old transaction has withstood litigation and it has been termed as ‘the greatest sports business deal of all time’] At the local level, in 2011 the Los Angeles Lakers signed the richest television deal in the NBA which dwarfs other teams. The contract reportedly averages $200 million per year for 20 years. The upper tier NBA franchises historically have received $25 to $35 million annually. Some big market teams have expiring contracts in the next few years, such as the Mavericks. While bidding has not yet begun, it’s reasonable to expect Mr. Cuban and his Mavericks to anticipate a healthy bump in rights fees in the future assuming good counsel and creative structuring.How did these factors translate to the Kings and 76ers? Even with substantial MSA differences, they were at opposite ends of the media spectrum. The Kings’ deal with CSN California expires after this season, which put ownership in strong position to negotiate a new deal at the time of the transaction. The 76ers signed a 20 year contract in 2009 with Comcast Sports Net, which was reported by Forbes to be “undervalued” from the 76ers perspective, reportedly paying the team less than $12 million the season prior to purchase. That’s quite a difference and it almost surely played a pertinent role the Kings’ and 76ers’ valuations.Arena Lease and Structure: Slicing Up the Game Day PieIn the NBA, game day and arena revenue typically make up the lion’s share of a franchise’s income. These revenue streams filter up from a multitude of sources. Aside from regular ticket sales there are club seats, suites, naming rights, parking, concessions, merchandise, and sponsorship revenue. In addition there are non-game revenues such as concerts, events and meetings. On the expense side there’s rent (fixed or variable), revenue sharing (or a hybrid arrangement), capital expenditures, maintenance, overhead allocation and more. All of these aspects are negotiable among the business, municipal, and legal teams involved.Arena deal structures vary across the board. For example, the Detroit Pistons own The Palace at Auburn Hills while the Golden State Warriors are tenants at Oracle Arena (probably until 2017/2018 anyway). Most arena structures involve some form of public/private partnership. One common theme is public ownership, usually financed via local bonds, with the sports franchise as a tenant paying rent of some form. The chief aspect to consider for legal teams is how to structure agreements for the various revenue streams, expense and capital items.Historically, some of the most negotiated aspects to the arena lease are how proceeds from certain items as defined by the CBA are allocated. For example, while players as a group receive a flat percentage of basketball related income (“BRI”), they receive reduced percentages of others, such as luxury suites and arena naming rights. This nuance represents an opportunity for team ownership to retain a larger portion of these revenues and legal teams to employ shrewd negotiating tactics. In addition, as the arenas age and significant maintenance costs are required, cost sharing between the public/private partnerships can become an issue. Lease structure also can make outright ownership of a stadium appear less attractive without a partner to share or bear costs.Again as we examine the Kings and 76ers a contrasting picture emerges. Prior Kings’ ownership (the Maloofs) and the city could not reach an agreement on a new stadium lease after nearly a decade of negotiations. Initially there was a buying group that planned to move the team to Seattle, but then, new local ownership purchased the team (with substantial input from the NBA). This agreement included an agreement for a new $447 million stadium (the majority funded publicly) and a guarantee to keep the team in Sacramento. This new deal was reported to be more favorable to ownership and gives the franchise an opportunity to attract more fans and create refreshed revenue channels. The 76ers on the other hand had already been locked into a long term lease at less favorable terms that were more geared towards revenue sharing with Comcast. Again, the Kings’ new opportunity appears more attractive than the 76ers existing arrangement.Collective Bargaining Agreement: Leveling the Playing FieldOn December 8, 2011, after a 161 day lockout, the NBA and its player union reached a new collective bargaining agreement. This agreement brought about meaningful changes to the salary structures, luxury tax, BRI, and free agency (among other things). Although the CBA is not under direct control of a franchise owner, its impact on competiveness, team operational strategy and expense management is significant.The changes were important for owners, who had reportedly lost over $300 million annually as a group in the three prior years to the negotiations. From a valuation perspective three items deserve focus: (i) length, (ii) BRI, and (iii) luxury tax provisions. Prior to the agreement, there was a great deal of uncertainty as to how negotiations would play out. Uncertainty infers risk and where there’s more risk, values usually fall. The 10 year agreement (with a 2017 opt-out) brings stability to both players and owners as to what operating structure they can plan for the near to intermediate term future. In addition, BRI revenue splits to the players were lowered from 57% of BRI to around 50% for most of the contract. This split brings cash flow relief (but not competitive relief) to owners across the league. Lastly, the luxury tax structure became much more punitive for big-spending owners, like Cuban. In fact, it economically functions similarly to a hard salary cap that the NFL and NHL employ. In light of this change, NBA franchises have committed an enormous amount of time and resources to understand and execute an appropriate competitive strategy. The luxury tax provisions even the competitive playing field for smaller market teams such as Sacramento and the Memphis Grizzlies (who sold for a reported $377 million in October 2012) and constrains the spending of larger market teams such as the Mavericks, Lakers or Knicks.How did this facet play out with the Kings and 76ers? All one needs to know is that the 76ers were sold before the new CBA was agreed (Summer 2011) to and the Kings were sold after the CBA was in effect (January 2013). Timing, coupled with the Kings small market status, has an increasingly positive effect on them compared to the 76ers. Advantage: Kings.Takeaway: NBA Boats Don’t Necessarily Need the Tide to Rise (or Fall)NBA franchise values are on the rise. There is a buzz around the league that if there were teams on the market the price would be robust right now. The values are driven by a number of different factors (TV, arena rights, CBA), some that cannot be controlled by owners and their advisory teams, but others that can be. Don’t be fooled by market size. A value creation scenario can occur in almost any market. In one of the smallest markets in the country, Tom Benson paid more for the Hornets than Josh Harris’ group did for the 76ers. However, owner involvement, savvy counsel and careful negotiations are a must; because as some transactions have shown, there are no guarantees.This article was originally published in The Texas Lawbook in March 2014.
2015 Bank M&A Recap
Statistics can be deceptive. The bank M&A market in 2015 could be described as steady, bereft of any blockbuster deals. According to SNL Financial 287 depositories (253 commercial banks and 34 thrifts) agreed to be acquired in 2015 compared to 304 in 2014 and 246 in 2013. Since 1990, the peak in M&A transactions occurred in 1994 (566) followed by 1998 (504). For those who do not remember, 1998 was the blockbuster year when NationsBank/Bank of America, Norwest/Wells Fargo, Bank One/First Chicago NBD and SunTrust Banks/Crestar Financial among others agreed to merge (Figure 1).
There has been a cumulative impact of M&A activity over the years. As of September 30, 2015, there were 6,270 insured depositories compared to about 18,000 institutions in 1985 when interstate banking laws were liberalized. M&A activity when measured by the number of transactions obviously has declined; however, that is not true on a relative basis. Since 1990, the number of institutions that agreed to be acquired in non-assisted deals ranged between 1.4% (1990) and 4.6% (1998) with an overall median of 3.2%. Last year was an active year by this measure, with 4.4% of the industry absorbed, as was 2013 (4.5%).
What accounts for the activity? The most important factors we see are (a) good asset quality; (b) currency strength for many publicly traded buyers; (c) very low borrowing costs; (d) excess capital among buyers; and (e) ongoing earnings pressure due to heightened regulatory costs and very low interest rates. Two of these factors were important during the 1990s. Asset quality dramatically improved following the 1990 recession while valuations of publicly traded banks trended higher through mid-1998 as M&A fever came to dominate investor psychology.
Today the majority of M&A activity involves sellers with $100 million to $1 billion of assets. According to the FDIC non-current loans and ORE for this group declined to 1.20% of assets as of September 30 from 1.58% in 2014. The most active subset of publicly traded banks that constitute acquirers is “small cap” banks. The SNL Small Cap U.S. Bank Index rose 9.2% during 2015 and finished the year trading for 17x trailing 12 month earnings. By way of comparison, SNL’s Large Cap U.S. Bank Index declined 1.3% and traded for 12x earnings. Strong acquisition currencies and few(er) problem assets of would-be sellers are a potent combination for deal making.
Earnings pressure due to both the low level of rates (vs. the shape of the yield curve) and post-crisis regulatory burdens are industry-wide issues. Small banks do not have any viable means to offset the pressure absent becoming an acquirer to gain efficiencies or elect to sell. Many chose the latter. The Fed may have nudged a few more boards to make the decision to sell by delaying the decision to raise short rates until December rather than June or September when the market expected it to do so. “Lift-off” and the attendant lift in NIMs may prove to be a non-starter if the Fed is on a path to a one-done rate hike cycle.
As shown in Figure 2, pricing in terms of the average price/tangible book multiple increased nominally to 142% in 2015 from 139% in 2014. The more notable improvement occurred in 2014 when compared to 2013 and 2012, which is not surprising given the sharp drop in NPAs during 2011-2013. The median P/E multiple was 24x, down from 28x in 2014 and comparable to 23x in 2013. The lower P/E multiple reflected the somewhat better earnings of sellers in which pricing was reported with a median ROA of 0.65% compared to 0.55% in 2014. Although the data is somewhat murky, we believe acquirers typically pay on the order of 10-13x core earnings plus fully-phased-in, after-tax expense savings.
Figure 3 provides perspective on pricing based upon size and profitability as measured by LTM ROE. Not surprisingly, larger and more profitable companies obtained better pricing in terms of the P/TBV ratio; however, as profitability increases the P/E multiple tends to decline. That is not surprising because a higher earning bank should have fewer issues that depress current earnings.The other notable development in 2015 was the return of non-SIFI large banks to the M&A market after largely being absent since the financial crisis as management and regulators sorted through the changes that the Dodd-Frank Act mandated. BB&T Corporation, which is among the very best acquirers, followed-up its 2014 acquisitions for Bank of Kentucky Financial Corp. and Susquehanna Bancshares with an agreement to acquire Pennsylvania-based National Penn Bancshares. The three transactions added about $30 billion of assets to an existing base of about $180 billion. Other notable deals included KeyCorp agreeing to acquire First Niagara ($39 billion) and Royal Bank of Canada agreeing to acquire City National Corporation ($32 billion). Also, M&T Bancorp was granted approval by the Federal Reserve to acquire Hudson City Bancorp ($44 billion) three years after announcing the transaction.To get a sense as to how the world has changed, consider that the ten largest transactions in 2015 accounted for $17 billion of the $26 billion of transaction value compared to $9 billion of $19 billion in 2014. The amounts are miniscule compared to 1998 when the ten largest transactions accounted for $254 billion of $289 billion of announced deals that year.Law firm Wachtell, Lipton, Rosen & Katz (“Wachtell”) noted that with the approval of several large deals this year there is more certainty to the regulatory approval process and there is no policy to impede bank mergers x-the SIFI banks. A key threshold for would-be sellers and would-be buyers from a decision process has been $10 billion of assets (and $50 billion) given enhanced regulatory oversight and debit card interchange fee limitation that applies for institutions over $10 billion. Wachtell cited the threshold as an important consideration for National Penn’s board in its decision to sell to BB&T.There were a couple of other nuances to note. While not always true, publicly-traded buyers did not receive the same degree of “pop” in their share prices when a transaction was announced as was the case in 2012 and 2013. The pops were unusual because buyers’ share prices typically are flat to lower on the news of an announcement. Several years ago the market view was that buyers were acquiring “growth” in a no-growth environment and were likely acquiring banks whose asset quality problems would soon fade.Also, the rebound in real estate values and resumption of pronounced migration in the U.S. to warmer climates facilitated a pick-up in M&A activity in states such as Georgia (11 deals) and the perennial land of opportunity and periodic busts—Florida (21). The recovery in the banking sector in once troubled Illinois was reflected in 25 transactions followed by 20 in California.As 2016 gets underway, pronounced weakness in equity and corporate bond markets if sustained will cause deal activity to slow. Exchange ratios are hard to set when share prices are volatile, and boards of sellers have a hard time accepting a lower nominal price when the buyer’s shares have fallen. Debt financing that has been readily available may be tougher to obtain this year if the market remains unsettled.Whether selling or merging, we note for the surviving entity a key goal should be something akin to Figure 4 in which there is shared upside for both the acquirer’s and seller’s shareholders (assuming a merger structured as a share exchange). A well-structured and well-executed transaction can improve the pro forma bank’s profitability and growth prospects. If so, all shareholders may benefit not only from EPS accretion, but also multiple expansion.
We at Mercer Capital have over 30 years of experience of working with banks to assess transactions, ranging from valuation to issuing fairness opinions in addition to helping assess the strategic position (e.g., sell now vs. sell later). Please call if we can help your institution evaluate a significant corporate transaction.
August Market Performance & Augustus Caesar
In contemplating August’s market activity, our thoughts drifted to Roman times. In 45 B.C., the Roman Senate honored Julius Caesar by placing his name on the month then known, somewhat drably, as Quintilis. Later, the Senate determined that Augustus Caesar deserved similar recognition, placing his name on the month after July. But this created an immediate issue in the pecking order of Roman rulers – up until then, months alternated between having 30 and 31 days. With July having 31 days, poor Augustus’ stature was diminished by placing his name on a month having only 30 days. To rectify this injustice, the Senate decreed that August also have 31 days, accomplished by borrowing a day from February and shifting other months such that September only had 30 days (to avoid having three consecutive 31-day months).We provide this historical interlude to illustrate that, while July and August now are equivalent in terms of the number of days, the market environment in these two months during 2015 bore few similarities. In August, volatility returned, commodity prices sank, and expectations of Federal Reserve interest rate action in September diminished.Most broad stock market indices declined between 6% and 7% in August, taking the indices generally to negative territory year-to-date in 2015. As indicated in Figure 1, except for the largest banks, publicly-traded banks generally outperformed the broader market, both year-to-date in 2015 and in August specifically.
For the year, banks benefited from several factors. First, investors appear to expect that rising interest rates will, if not enhance banks’ earnings, at least prove to be a neutral factor. Other sectors of the market, though, may be less fortunate, as companies face higher interest payments or other adverse effects of higher interest rates. Second, banks generally reported steady growth in earnings per share, as assisted by a benign credit environment.
Within any index, though, the performance of individual companies may vary greatly. Seeking to isolate factors influencing the August market performance, we focused on publicly-traded banks with assets between $500 million and $5 billion. Given the market backdrop, these 212 banks performed relatively well in August, with a median share price depreciation of only 1.1% (see Figure 2). For the year, the median bank reported a 2.9% increase in its stock price.
While linking company-specific factors to market performance during a volatile period is difficult, we identified three groups of banks that underperformed in August:
After losing investor favor in the second half of 2014, banks in the oil patch states of Louisiana, Oklahoma, and Texas performed well in 2015, advancing by 9% between December 31, 2014 and July 31, 2015. However, oil prices falling below $40/barrel dealt these banks a setback in August, as the median share prices of banks in these states fell by 5%.All the banks that completed IPOs during 2015 fell during August, with a median depreciation of 6%. Nevertheless, post-IPO performance remains favorable, as all the banks reported share prices at August 31, 2015 that exceeded their IPO prices by 10% to 20%. Investors in these banks may have wished to realize profits during a volatile period.Banks identified with Asian American communities also suffered, owing to their perceived greater exposure to slowing economies in China and throughout the Asian region. Even after the August decline, though, these banks have reported solid performance in 2015.
Several risks that influenced August’s volatility have not dissipated, including uncertainty surrounding China’s opaque (and potentially over-leveraged) economy and the effect of any Fed policy tightening. Analyst estimates for 2016 EPS often suggest favorable growth over 2015, and such estimates bear watching to the extent that the recent market volatility spills over into the real economy.
What’s Stopping Banks from Getting into Wealth Management and How to Overcome It
Final Thoughts on AOBA
In the mid-1960s, the Department of Transportation was considering banning the sale of convertibles in the U.S. because of safety concerns for occupants in the event of roll-overs. What we now know as the “sun-roof” became a popular response to this regulatory threat, but Porsche went one step further and developed a version of its popular 911 series that had a removable roof and a removable (plastic) rear window known as the “Targa”. Essentially, the Targa was a convertible with a cosmetically-integrated roll-bar, or a cross between a coupe and a convertible that provided the open-air experience of one with the (relative) safety of the other.The DOT never actually banned the sale of convertibles in America, but Porsche pressed on and the potential for regulation spawned a response that, over time, became recognized as an iconic design. Other automakers quickly followed suit, and a trend was born. Porsche still offers the 911 in a Targa configuration, although the mechanism for removing the roof has become considerably more elaborate.Do Regulations Suggest a New Model for Banking?As discussed in last week’s blog, economic circumstances and technological change, to say nothing of Dodd-Frank, are forcing banks to reconsider their business models. For many, the opportunity in this lies in another piece of legislation: the repeal of Glass-Steagall. Much like Porsche discovered fifty years ago, many banks are responding to regulatory changes by opting for a hybrid model that pairs trust and wealth management operations with traditional banking. The advantages of banks developing their investment management operations are pretty easy to see: it produces a more stable and diverse revenue stream, it provides more touch points for customer relationships, and it can substantially improve a bank’s return on equity.Some see this opportunity very clearly. Last year, I attended a reception at a successful trust bank and overheard a conversation between the CFO’s mother and a new employee at the bank, whom she told “we just used the lending function to pay bills until we could ramp up the wealth management practice.” I decided that evening that when a corporate executive’s relatives can express the strategic plan perfectly in twenty five words or less, it’s a good plan.Of course, opportunity is a two way street, and banks looking to venture into investment management, especially by acquisition, typically encounter a couple of major obstacles: balance sheet dilution and culture clash. Both of these challenges arise from the main difference between traditional banking and asset management. Whereas banking is asset heavy and personnel light, asset management requires not much of a balance sheet, but plenty of expensive staffing. It’s a significant difference that can only be managed head on.ROE > TBVFrom the perspective of a typical money manager, banker obsession with tangible book value can seem without merit, particularly in an era where net interest margins are evaporating and pursuing return on assets can seem Quixotic. But at some level, banking is what it is, and without TBV to leverage, there’s no bank. For a bank with excess equity, even today it can look much more attractive to buy another bank instead of an RIA.Despite our current era of low and declining NIMs, TBV dilution for an acquiring bank paying 50% more than tangible book can be earned back in three or four years, thanks to the opportunities for expense saves in the right merger. RIAs often transact for lower pre-tax multiples than banks, but the price to book multiples can be nearly incalculable. A wealth manager might sell for eight or nine times pre-tax net income (the real range is larger), but 90% of that transaction is ultimately allocable to intangible assets. There is little in the way of expense saves in combining, say, an existing wealth management firm with a bank’s trust operations. The earn-back period on tangible book dilution for an investment management acquisition can stretch to a decade, absent favorable markets or other growth catalysts, which is more than a lot of banks are willing to bear.There’s plenty of reason to absorb the TBV dilution, though, and for banks to do RIA acquisitions anyway. Most banks are starved for ROE these days, and there’s no quicker path to improving ROE than trading some book value for the recurring earnings that only an asset management shop can provide. Bank mergers may be easier to digest financially on the front end, but after the dust settles, it’s just more bank, which doesn’t solve the problem of how to make money when the environment for banks is as negative as it is currently.While the dilution to TBV can’t be avoided, some of the dilution can be mitigated (or at least justified), by paying for a substantial portion of the acquisition with a performance-based earn-out. It isn’t uncommon to pay one-third or more of the purchase price of an asset management firm acquisition using contingent considerations. While there’s still a down payment, or initial consideration, to be paid in an investment management firm acquisition, an earn-out consideration can at least allow the bank to experience part of the TBV diminution at the same time that earnings are being produced to justify the balance sheet impact.This model works even better when the contingent consideration is paid as compensation (bonuses), so book value dilution is avoided altogether, and the acquirer gets the real time tax benefit of salary expense. Few selling investment managers are willing to agree to this because of the tax impact to them, but it’s a negotiating point worth remembering.Managing (Accepting) Culture ClashIt’s not an exaggeration to say that investment management firms brag about how much they pay their people, and banks brag about how little they pay their people. The regulatory item that requires banks to disclose their average compensation – where lower is considered better – has never existed in the investment management community (where the material trappings of success were the ultimate performance ratio).Banks acquiring asset management firms have to accept the fact that they can’t put a bunch of investment managers on a bank’s compensation plan without enduring value-killing turnover and customer attrition. An RIA’s business model is inescapably different than a bank, and the rigid work environment and salary structure that is endemic to banking simply won’t work in the investment management community.This can make integrating an RIA acquisition into an existing trust operation especially challenging, and at some level there has to be acceptance on the front end that the wealth managers will probably make more than the lenders, but that their impact on the bank’s P&L will justify it. It isn’t unusual to see personnel costs in a well-run, mature RIA sum to half of revenue. The revenue and profit per employee of an RIA is simply much greater than the same metrics applied to a bank, and compensation is higher.So while the mixture of Mazdas and Maseratis in the employee parking lot may be awkward at first, in the long run, a bank with a successful trust or wealth management franchise will provide growth opportunities and earnings stability that benefit all of a bank’s stakeholders.Eyes Wide OpenIt remains to be seen whether the either/or business model of banks with wealth management practices (or wealth management practices with banking operations – depending on your perspective) will endure like the Targa design of the 1960s. But the banking environment today demands something of a response, and developing a revenue stream from investment management offers banks a path to remain relevant and independent in spite of a lousy lending and regulatory environment. We just recommend bankers accept the challenges that come with RIA acquisitions and face them head on. In some regards, the issues of tangible book value dilution and culture clash stem from the very reason banks should be getting into investment management – a high margin, capital light financial service that is difficult to commoditize. In the end, the challenges of acquisition/integration are actually the sources of upside – so long as you’re willing to accept a little wind in your hair.
Strategic Planning for Community Banks on the Mend
Despite much commentary about the significant economic and regulatory headwinds impacting community banks, profitability is on the mend. Community bank earnings improved in the trailing twelve months ended June 30, 2015 with net income up 14% to $17.6 billion compared to $15.5 billion in the twelve months ended June 30, 2014.1 Nearly 60% of community banks reported higher profitability based upon annualized first half 2015 net income compared to 2014 levels. The number of unprofitable banks also declined to 41 in the second quarter of 2015, compared to 109 in 2014 and 167 in 2013. The median return on assets (ROA) for community banks was up to 0.96% (annualized based upon the first half of 2015), which was the highest level since 2008.As detailed in Figure 1, key contributors to improving earnings were higher net interest income and lower loan loss provisions. Loan growth drove the improvement in net interest income as 84% of community banks reported loan growth in the trailing twelve month period, with the median community bank’s loan growth rate reported at 7.2%. Loan growth offset net interest margin (“NIM”) compression as NIMs were at their lowest level over the 10-year historical period. As the Federal Reserve’s zero-interest rate policy (“ZIRP”) grinds on, asset yields continue to compress while funding costs have essentially reached a floor. One interesting item to gauge in future quarters is how much interest rate and credit risk is being taken by community banks to grow loans and earnings.
Another sign of improving community bank health is that deal activity is up from recent prior periods as shown in Figure 2. Price/earnings multiples have also improved in recent periods (Figure 3) and appear to be relatively in line with long-term trends at approximately 20x. Price/tangible book multiples are still below longer-term trends, largely reflecting that although improved from the Great Recession returns on assets and equity remain below pre-financial crisis levels.
While it is difficult to tell whether community bank earnings have peaked and how long this cycle may last, improving profitability expands the strategic options available to community banks. A recent article by SNL Financial noted that a number of community banks are looking to sell as earnings may have plateaued. While selling is one option available to community banks in this environment, the range of strategic options available is much broader than that. A well-rounded strategic planning session should include an assessment of the bank’s unique strengths, weaknesses, and opportunities as well as a review of the bank’s performance and outlook relative to both its history and peers. Then, a broader discussion of a range of options that can deliver growth and enhance shareholder value should be discussed. Those other options could include organic and/or acquisitive growth and other ways to provide liquidity and enhance returns to shareholders such as special dividends, share repurchases, management buy-outs, and employee stock ownership plans.
Founded in 1982, in the midst of and in response to a previous crisis affecting the financial services industry, Mercer Capital has witnessed the industry’s cycles. Despite industry cycles, Mercer Capital’s approach has remained the same – understanding key factors driving the industry, identifying the impact of industry trends on our clients, and delivering a reasoned and supported analysis in light of industry and client specific trends.
Mercer Capital has experience facilitating strategic planning sessions for community banks and providing a broad range of specialized advisory services to the sector. Contact us to discuss scheduling a strategic planning session or your institution’s specific needs in confidence.
Small Bank Holding Companies: Regulatory Update & Key Considerations
During 1980 the Federal Reserve issued the Small Bank Holding Company Policy Statement (“Policy Statement”), which recognized from a regulatory perspective that small bank holding companies have less access to the capital markets and equity financing than large bank holding companies. Although the Fed has sought to limit holding company debt so that the parent can serve as a “source of strength” to its subsidiaries, especially the deposit-taking bank subsidiaries, the Policy Statement allowed small bank holding companies to utilize more debt to finance acquisitions and other ownership transfer-related transactions than would be permitted by large bank holding companies. The Policy Statement initially applied to bank holding companies with assets less than $150 million; it was amended in 2006 to include bank holding companies with assets up to $500 million. Effective May 15, 2015, the threshold increased to consolidated assets of less than $1 billion for both bank holding companies and savings and loan holding companies, provided that the company complies with the Qualitative Requirements and does not:engage in significant nonbanking activities either directly or through a nonbank subsidiaryconduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or indirectly through a nonbank subsidiaryhave a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the SEC
Holding companies that meet the above requirements may use debt to finance up to 75% of the purchase price of an acquisition, but are subject to the following ongoing requirements:parent company debt must be retired within 25 years of being incurredparent company debt-to-equity must be reduced to 0.30:1 or less within 12 years of the debt being incurredthe holding company must ensure that each of its subsidiary insured depository institutions is well capitalizedthe company is expected to refrain from paying dividends until it reduces its debt-to-equity ratio to 1:1 or less
The primary benefit of small bank holding company status is that it creates a larger universe of bank and now savings and loan holding companies that are not subject to the Federal Reserve’s risk-based capital and leverage rules, including the Basel III rules. As of year-end 2014, 454 bank holding companies with assets between $500 million and $1 billion filed a Y-9C according to SNL Financial LC. From a functional standpoint, small bank (and S&L) holding companies do not file a quarterly Y-9C or Y-9LP; instead these companies only file a Y-9SP semi-annually. Regulatory capital rules for these companies continue to apply to their bank subsidiaries, which represents no change from past practice.ImplicationsExpansion of Policy Statement eligibility is likely to affect strategic and capital planning for small BHCs.Companies that now fall under the Policy Statement oversight can use traditional debt at the holding company level and potentially generate higher returns on equity with a lower cost of capital. Senior debt may be used to replace existing capital such as SBLF preferred stock or fund stock repurchases or dividend distributions.Higher capital requirements for larger bank holding companies, coupled with relaxed capital regulations for small bank holding companies, may provide smaller companies an advantage when bidding on acquisition targets inasmuch as the ability to fund acquisitions with a greater proportion of debt results in a lower cost of capital.S corporation bank holding companies should remain particularly cognizant of the 1:1 debt/equity ratio constraint that should be maintained in order to declare dividends. For S corporations, the inability to declare dividends may result in shareholders being responsible for their pro rata share of the BHC’s taxable earnings with no offsetting distributions from the BHC. Since the debt/ equity ratio is calculated using equity determined under Generally Accepted Accounting Principles, significant volatility in securities carried as available-for- sale may impair the BHC’s ability to declare dividends.If the subsidiary bank holds assets with more onerous risk weightings under the Basel III regime (such as mortgage servicing rights), the holding company may wish to evaluate whether holding such assets at the holding company, rather than the bank, may be more capital efficient.
For more information or to discuss a valuation or transaction advisory issue in confidence, please do not hesitate to contact us.
Can Getting into Wealth Management Save Community Banking?
An AOBA Conference Followup
Last week, Brooks Hamner and I spoke at Bank Director’s Acquire or Be Acquired Conference in Scottsdale about how banks can build value through their trust and wealth management businesses. Our session got a great response, probably because we were some of the only speakers offering the banking community some hope. Most of the sessions at AOBA this year were, on balance, fairly gloomy. Between a yield curve that is entirely inhospitable to net interest margins and technology that threatens to denude the value of expensive branch networks, session after session seemed targeted at one message to bankers: sell.Just before AOBA began, RM Sotheby’s held one of its annual collector car auctions at the same resort, and conference attendees could wander outside between sessions and watch the Sotheby’s auction “winners” load their precious iron onto car carriers to ship them home. I was reflecting on one of the more pessimistic conference sessions while watching a late 60s Aston Martin being loaded onto a truck, and it reminded me of a project I worked on early in my career.James Bond and the Future History of BankingAbout fifteen years ago, I was sitting in the boardroom at David Brown Group in Huddersfield, England, while the management team eulogized what was once one of the greatest industrial companies in the U.K. The boardroom still felt like the British seat of power it had once been, with a massive Scottish oak conference table and oil paintings of successive generations of David Browns (some of them knighted) looming from the walls. Next door was a vast factory that had, at its peak around World War II, employed 40,000 workers building tractors and heavy industrial equipment. The company was so successful that Sir David Brown was able to indulge one of his hobbies, buying Aston Martin in 1947 and investing in it heavily to return England to competitiveness in auto racing. It’s because of David Brown that many Aston Martins still carry the “DB” series badges (one current model is a DB9) even though David Brown sold Aston Martin in 1972. The automaker was never profitable, but Brown had accomplished his goal anyway: Aston Martin was a prominent name in racing in the 1950s and 60s, and even James Bond favored the marque (much to the chagrin of Bentley and Jaguar).The David Brown Group I consulted with wasn’t even a shadow of its former self: technological change and a global recession got the best of the company in the 1960s, and after a series of damaging restructurings and neglectful owners, all that was left was a niche manufacturer with about 200 employees, operating as a mostly-forgotten unit of an American conglomerate.Fifty years from now, we may look back on the threat to banking today as being as severe as what David Brown faced in the 1960s. Banks won’t fix this by getting into sports car racing, but one opportunity is wealth management. It’s no secret that many banks treat their trust departments like an afterthought. We estimate that maybe a third of bank trust franchises are profitable, and the excuses for hanging onto an underperforming trust department are pretty similar bank to bank:Trust complements other lines of business by maintaining major relationships.There’s no easy solution as to whom to sell trust to or how to unwind it.Trust is staffed by loyal and long term employees of the bank whom management wants to support.
But trust, if ignored, can become an earnings-dilutive cauldron of liability. Legacy relationships maintained by trust can become abusive of the time and attention of trust staff. And long term employees, while loyal in one sense, can become more focused on self-preservation than supporting their institution. Those are just the problems trust departments can face in good times.Are Trust Franchises an Asset or a Liability?If net interest margins were headed up and returns on equity were solid, unprofitable and possibly risky trust operations would be easier to ignore. The reality today, of course, is very different. Banking is in a race to rationalize operations, and from talking with community bankers from across the country at the AOBA conference, it sounds like a lot of bankers are looking for ways to either get out of trust or to refocus on the business to make it a viable (if not vital) part of their business. It won’t surprise you to hear that we suggest the latter approach.A seemingly obvious solution is to acquire existing wealth management companies to bulk-up and supplement trust. Greater scale brings better expertise to customers, and margins to the bank. For over-capitalized banks trying to boost ROE, acquiring a wealth management firm is an opportunity to invest some equity for a high returning asset (swapping some “E” for more “R”). AUM-based fees are largely uncorrelated from the credit cycle, and wealth management customers have different decision cycles than, say, commercial loan clients. Trust and wealth management (we look at these interchangeably because both are revenue streams supported by client assets) don’t require large ongoing capital commitments, and the costs of these operations are largely embedded in staffing. On the surface, it seems like a perfect way for many community banks to diversify their financials and grow despite a tough environment for banking.As for the seller’s perspective, the RIA industry is facing a physical cliff, with more practicing series-7 registered reps over the age of 70 than under the age of 30. Many, if not most, of the 11,000 RIAs in the U.S. have inadequate ownership/leadership transition plans and will ultimately have to sell to a more established institution with experience in growing talent for senior roles. Many RIAs are not suitable acquisition candidates for banks, but many are.So why aren’t banks rushing to buy RIAs? It’s risky to make sweeping generalizations, but based on our experience there are two obstacles banks must overcome to acquire an RIA: culture clash and balance sheet dilution. Both are inevitable, but both are also manageable. More on that next week.
Bridging Valuation Gaps for Undeveloped and Unproven Reserves
The petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, however, such as in today's low price environment, the DCF can break down in light of marketplace realities and "gaps" in perceived values can appear.While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 &P3) categories. The DCF's use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project's upside associated with the PUDs and unproven reserves.At times, market conditions can require buyers and sellers to reconsider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the forecasted future price deck, many—if not most—PUDs appear to have a negative DCF value.Distressed MarketsIn the past, we have analyzed actual market transactions to show that buyers still pay for PUDs and unproven reserves despite a DCF that results in little or no value. In today’s market, however, asset transactions of “non-core assets” indicate zero value for all categories of unproven reserves. A highlighted example of this is Samson Oil and Gas’s recent purchase of 41 net producing wells in the Williston Basin in North Dakota and Montana. The properties produce approximately 720 BOEPD and contain estimated reserves of 9.5 million barrels of oil equivalent. Samson paid $16.5 million for the properties in early January 2016 and estimates that within five years they can fund the drilling of PUDs. Samson’s adjusted reserve report, using the most current market commodity prices, indicated PDP reserves worth $15.5 million, PDNPs worth $1 million and PUDs worth $35 million—a total of $52 million in reserves present valued at 10%. This breakdown indicates dollar for dollar value was given on the PDP and PDNP reserves, but zero cash value given on the PUDs.Is this transaction the best indication of fair market value or fair value?We believe there is a convincing argument to be made that the Samson transaction and a handful of other asset deals in the previous six months are not the best indication of asset value. In short, these sales could be categorized as distressed or “fire sale” transactions for the following reasons:Significant decline and volatility in oil prices from (1) uncertain future demand and (2) current excess supply.Debt level pressures with (1) loan covenant requirements and (2) cash flow requirements.The low deal volume environment as market participants have been in a “wait and see” stance since oil prices began declining over twelve months ago.
In this low price environment, buyers don’t have to blink first. These factors indicate that some companies may feel pressure to lower their asking prices to levels that continuously attract bidders. The market looks distressed.
What does this mean for the fair market value/fair value of oil and gas assets? The definitions of fair market value and fair value require buyers and sellers to operate in a “distress-free” environment. When the marketplace is not distress-free, perhaps non-market methods should be utilized to estimate the real value of PUDs and unproven reserves. In these scenarios, one useful method to price these assets is the use of option theory.Option PricingIf one solely relied on the market approach, it appears much of these unproven reserves would be deemed worthless. Why then, and under what circumstances, might the unproven reserves have significant value?The answer lies within the optionality of a property's future DCF values. In particular, if the acquirer has a long time to drill, one of two forces come into play: either (1) the current price outlook can change radically for a resource, and subsequently alter the PUDs or (2) drilling technology can change, such as the onslaught of hydraulic fracturing, and the unproven reserves accrue significant DCF value.This optionality premium or valuation increment is typically most pronounced in unconventional resource play reserves, such as coal bed methane gas, heavy oil, or foreign reserves. This is additionally pronounced when the PUDs and unproven reserves are held by production. These types of reserves do not require investment within a fixed short timeframe.Current pricing environment: challenge = opportunityOne of the primary challenges for industry participants when valuing and pricing oil and gas reserves is addressing PUDs and unproven reserves. As oil prices have dropped over 50% in the last six months, reaching 12 year lows, it should be anticipated that PUD values may drop from 75 cents on the dollar to 20 cents on the dollar or less. After the Great Recession, some PUDs faced a similar, yet more modest, decline in price. The price level recovery for PUDs in 2011 was partly attributable to the recovery in the U.S. and global economies, and partly due to increases in the price of oil.
Five main factors have significantly increased the world supply of oil and driven down prices:
The continued success of shale drillers in the U.S.OPEC’s choice to continue to increase production.The U.S.’s elimination of restrictions on crude oil exports.The recent lifting of Iran’s sanctions.Oil consumption slowing down in countries like China.
In August of 2015, it was estimated that Iran’s return to the global oil market would add approximately one million barrels of oil a day to the market and decrease the price of oil by $10 per barrel. Iran is currently ready to increase exports by half a million barrels of oil per day, and the fear of further over-supply pushed the price of oil below $30 on Friday, January 15. Now, the question is when will oil prices recover? The Chief of the IEA estimated that oil prices will recover in 2017. Prices are predicted to remain low in 2016 as expected demand for oil is growing at lower rates than in the past thanks to economic slowdowns in China, India, and Europe. However, the growth in oil supply is predicted to slow in 2017 as the current cuts in research and development catch up with many exploration and production companies. We must also remind ourselves of the crash in oil prices in 1985 that remained below $20 until 2003.
As previously mentioned, PUDs are typically valued using the same DCF model as proven producing reserves after adding in an estimate for the capital costs (capital expenditures) to drill. Then the pricing level is adjusted for the incremental risk and the uncertainty of drilling “success,” i.e., commercial volumes, life and risk of excessive water volumes, etc. This incremental risk could be accounted for with either a higher discount rate in the DCF, a RAF or a haircut. Historically, in a similar oil price environment as we face today, a raw DCF would suggest little or no value for the PUDs or unproven reserves. Interestingly, market transactions with similar reserves (i.e., with little or no proven producing reserves) have demonstrated significant amounts attributable to non-producing reserves, thus demonstrating the marketplace's recognition of this optionality upside.
Studies have shown that NYMEX futures are not a very accurate predictor of the future, and yet buyers are estimating the value of this option into the prices they are willing to pay. When NYMEX forecasts $35 per barrel, it could actually be $45 when that future date rolls around.
So what actions do acquirers take when values are out of the money in terms of drilling economic wells? Why do acquirers still pay for the non-producing and seemingly unprofitable acreage? Experienced dealmakers realize that the NYMEX future projections amount to informed speculation by analysts and economists which many times vary widely from actual results. Note in the chart above how much the future forecasted prices changed in only one year.
Real Options: Valuation FrameworkIn practice, undeveloped acreage ownership functions as an option for reserve owners; therefore, an option pricing model can be a realistic way to guide a prospective acquirer or valuation expert to the appropriate segment of market pricing for undeveloped acreage. This is especially true at the bottom of the historic pricing range occurring for the NG commodity currently.This technique is not a new concept as several papers have been written on this premise. Articles on this subject were written as far back as 1988 or perhaps further, and some have been presented at international seminars.The PUD and unproved valuation model is typically seen as an adaptation of the Black Scholes option model. An applicability signal for this method is when the owners of the PUDs have the opportunity, but not the requirement, to drill the PUD and unproven wells and the time periods are long, i.e. five to 10 years. The value of the PUDs thus includes both a DCF value, if applicable, plus the optionality of the upside driven by potentially higher future commodity prices and other factors. The comparative inputs, viewed as a real option, are shown in table below.Pitfalls and fine printThere are, of course, key differences in PUD optionality and stock options as well as limitations to the model. Amid its usefulness, the model can be challenging to implement. Below are some areas in particular where keen rigorous analysis can be critical:Observable market – Unlike a common stock, there is no direct observable market price for PUDs. The inherent value of a PUD is the present value of a series of cash flows or market pricing for proven reserves, if available. All commodity prices are volatile, but oil and gas prices are more volatile than most since they have both year-to-year supply and demand changes in addition to significant seasonal swings.Risk quantification – We have found that oil and gas price volatility benchmarks (such as long term index volatilities) are not all-encompassing risk proxies when valuing specific oil and gas assets. If not analyzed carefully, the model can sometimes have trouble capturing some critical production profile and geologic risks that could affect future cash flow streams considerably. Risks can include items such as (1) production profile assumptions; (2) acreage spacing; (3) localized pricing versus a benchmark (such as Henry Hub or West Texas Intermediate Crude); and (4) statistical “tail risk” in the assumed distribution of price movements.Sensitivity to capital expenditure assumptions – Underlying analysis of an asset or a project’s economics can present particular sensitivity to assumed capital expenditure costs. In assessing capital expenditure’s role as both (1) a cash flow input and (2) an option model input, estimations of future costs can be very acute, yet challenging, assumptions to properly measure.Time to expiration – This input can require granular analysis of field production life estimates coupled with expiring acreage, then filtered within the drilling plans of an operator. The resulting weighted time estimate can present problems with assumption certainty.
The availability of drilling resources tends to decline while the costs of drilling and oilfield services tend to rise, often precipitously, when oil and gas prices rise. These factors can present an oscillating delta in both cost and timing uncertainties as the marketplace responds by investing capital into underdeveloped reserves while the fuse burns on existing lease rights. The time value of an option can increase significantly if (1) the mineral rights are owned; (2) unconventional resource play reserves are included; (3) there are foreign reserves; or (4) the reserves are held by production. In these instances, the PUD and unproved reserve option to drill can be deferred over many years, thereby extending the option.SummaryUtilization of modified option theory is not in the conventional vocabulary among many oil patch dealmakers, but the concept is clearly implicitly considered (as evidenced in many market transactions). This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. Here, the DCF will often yield little or no value even though transactions are being made for substantial values, thereby validating our belief that option theory is being utilized in the marketplace either directly or indirectly. If the right to drill can be postponed an extended period of time, i.e. five to ten years, the time value of those out of money drilling opportunities can have significant worth in the marketplace.We caution, however, that there are limitations in the model’s effectiveness. Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Specific and careful applications of assumptions are musts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.
How to Combat the Margin Blues?
Following the Great Recession, significant attention has been focused on bank earnings and earning power. While community bank returns on equity (ROE) have improved since the depths of the recession, they are still below pre-recession levels. One factor squeezing revenue is falling net interest margins (i.e., the difference between rates earned on loans and securities, and rates paid to depositors). Community banks are more margin dependent than their larger brethren and have been impacted to a greater extent from this declining NIM trend. As detailed in Figure 1 below, NIMs for community banks (defined to be those with assets between $100 million and $5 billion) have steadily declined and were at their lowest point in the last ten years in early 2015.
While there are a number of factors that impact NIMs, the primary culprit for the declining trend is the interest rate environment. As the Federal Reserve's zero-interest rate policy ("ZIRP") grinds on, earning asset yields continue to reprice lower while deposit costs reached a floor several quarters ago. Loan growth has also been challenging for many banks for a variety of reasons, which has stoked competitive pressures and negatively impacted lending margins. While competitive pressures can come in many forms, several data-points indicate intense loan competition giving way to easing terms. For example, the April 2015 Senior Loan Officer Opinion Survey on Bank Lending Practices noted continued easing on terms in a number of loan segments. This appears to be supported further by reported community bank loan yields, which have slid close to 200 basis points (in all loan segments analyzed) since 2008 as shown in Figure 2.
Aside from paying tribute to the late B.B. King and playing "Everyday, everyday I have the blues," what can community bankers do in order to combat the margin blues? While not all-encompassing, below we have listed a few strategic options to consider:
Increase Leverage. One strategic consideration to maintain ROE in light of declining NIMs may be to increase leverage subject to regulatory limits. Some potential ways to deploy available capital include growing loans organically, M&A, stock buybacks, and/or shareholder dividends. For those below $1 billion in assets, recent legislation has relaxed holding company capital requirements by exempting them from the consolidated regulatory capital ratios. For those that are capable, small bank holding companies may choose to upstream excess capital to the holding company from bank dividends or lever the holding company to fund special dividends and/or buybacks. This higher leverage strategy may be viewed as too aggressive by some shareholders and investors though.Consider M&A. An investor at a recent community bank conference noted that he would rather see banks sell than head down lending's slippery slope. This is not surprising to hear because competitive lending pressures usually seed tomorrow's problem assets. M&A represents a classic solution to revenue headwinds in a mature industry whereby less profitable smaller companies sell to the larger ones creating economies of scale and enhanced profitability. Some signs of this can be seen in recent periods as deal activity has picked up. Beyond expense synergies, acquirers may see temporary NIM relief resulting from accretion income on the acquired assets, which are marked to fair value at acquisition. For those community banks below $1 billion in assets, the combination of the relaxed capital requirements for their holding companies and more options for holding company debt may attract some to consider M&A as a strategic option.Acquire/Partner with Non-Financials. Another strategic option may be to expand into non-traditional bank business lines that are less capital intensive and offer prospects for non-interest income growth such as acquisitions or partnerships with insurance, wealth management, specialty finance, and/or financial technology companies. We have spoken on acquiring non-financials in different venues and there is some evidence of increased activity in the sector. For example, a recent article noted a growing trend in acquisitions of insurance brokers or agencies by banks and thrifts, with deal volume on pace to significantly exceed 2014. Another interesting example of this strategy being deployed includes the recent partnership announced between Lending Club and BancAlliance that allows over 200 community banks to access the peer-to-peer lending space.Improve Efficiency by Leveraging Financial Technology. While compliance and regulatory costs continue to rise as NIMs decline, the industry faces intense pressure to improve efficiency. Technology is an opportunity to do so as both commercial and consumer customers become more comfortable with mobile and online banking. Thus, many banks may view the margin blues as a catalyst to consolidate and/or modernize their branch network and/or invest in improved technology offerings to reduce longer-term operating costs and still meet or exceed customer expectations.Maintain Status Quo. Experience may lead bankers to wait on the Fed to act and usher a return to "normal" yields and "normal" NIMs. Banks with a healthy amount of variable rate loans and non-interest bearing deposits will see an immediate bump in revenue if short-term rates rise, while most traditional banks eventually will see a reversal in NIM trends. But as has been enumerated in past Bank Watch articles, rates have been expected to rise for a "considerable time," and yet continue to remain at historic lows.Further, the potential negative impact of rising rates on credit quality is difficult to foretell. Yet, even this status quo strategy may present some opportunities for those bankers to employ certain of the other strategies mentioned previously in small doses.
Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank's unique situation in confidence and ways that your bank may consider addressing the margin blues, feel free to give us a call or email.
Using Employee Stock Ownership Plans: Helping Community Banks with Strategic Issues
In our view, Employee Stock Ownership Plans (ESOPs) are an important omission in the current financial environment as a number of companies and banks lack a broader, strategic understanding of the possible roles of ESOPs as a tool to manage a variety of strategic issues facing community banks. Given the strategic challenges facing community banks, we strive to help our clients, as well as the broader industry, fill this gap, and discuss some common questions related to ESOPs in the following article.We will be glad to discuss your bank’s current situation as well as the role an ESOP can play in detail. If you are interested in learning more about ESOPs, read our book,The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence (you can find it in the Products section of our website). In addition, if you would like to speak to a Mercer Capital professional, contact Jay Wilson at 901.685.2120 or wilsonj@mercercapital.com.For those less familiar with ESOPs, we answer a few basic questions related to ESOPs. For those more familiar with ESOPs, skip to the question entitled “How can an ESOP help the bank deal with strategic issues?”.What Is an ESOP and How Does It Work?ESOPs are a written, defined contribution retirement plan, designed to qualify for some tax-favored treatments under IRC Section 401(a). While similar to a more typical profit-sharing plan, the fundamental difference is that the ESOP must be primarily invested in the stock of the sponsoring company (only S or C corporations). ESOPs can acquire shares through employer contributions (either in cash or existing/newly issued shares) or by borrowing money to purchase stock (existing or newly issued) of the sponsoring company. Once holding shares, the ESOP obtains cash via sponsor contributions, borrowing money, or dividends/distributions on shares held by the ESOP. When an employee exits the plan, the sponsoring company must facilitate the repurchase of the shares, and the ESOP may use cash to purchase shares from the participant. Following repurchase, those shares are then reallocated among the remaining participants.What Are Some Tax Benefits Related to ESOPs?Similar to other profit-sharing plans, contributions (subject to certain limitations) to the ESOP are tax-deductible to the sponsoring company. The ESOP is treated as a single tax-exempt shareholder. This can be of particular benefit to S corporations, as the earnings attributable to the ESOP’s interest in the sponsoring company are untaxed. The tax liability related to ESOP planholder’s accounts is at the participant level and generally deferred similar to a 401(k) until employees take distributions from the plan.Who Can Sponsor an ESOP?Both publicly traded and private banks/holding companies (C or S-Corps.) can sponsor ESOPs, but the benefits are often more profound for private institutions that are not as actively traded, as the ESOP can promote a more active market and enhance liquidity more for the privately-held shares.How Can an ESOP Help The Bank Deal With Strategic Issues?While not suitable in all circumstances, an Employee Stock Ownership Plan may provide assistance in resolving a number of strategic issues facing community banks and can offer benefits to plan participants, existing shareholders, and the sponsor company, including:Augmenting capital, particularly for profitable institutions facing limited access to external capital. Though an ESOP strategy generally builds capital more slowly than a private placement alternative or a public offering, it provides certain tax advantages and may result in less dilution to existing shareholders. For additional perspective, consider the following example. Let us assume that the holding company has $5 million of debt or preferred stock (this example could also include TARP or SBLF funding) with a five year term and an interest rate of 5%. Assuming that the subsidiary bank is the holding company’s primary source of cash (which is often the case for most community banks), the typical option to service this holding company obligation would be dividends from the bank to the holding company. However, an ESOP is another option that might be worth considering as ESOP contributions are tax-deductible expenses and this allows the bank’s capital position to benefit. In the ESOP strategy, cash contributions received by the ESOP are used to purchase newly issued shares of the sponsor’s common stock (in this case, the holding company), providing liquidity that the bank holding company then uses to service holding company’s debt. As detailed in the table below, the ESOP strategy provides the necessary cash flow to the holding company for its obligations but results in approximately $2 million of added bank capital (approximately 35% of the cash needed to service the holding company obligation) at the end of the five-year period. This higher capital could be used in a variety of ways by the underlying bank, either to fund future earning asset growth organically or through acquisitions, pay additional distributions to the holding company for shareholder dividends, or as a cushion against adverse events such as credit losses. However, there is a trade-off to augmenting the bank’s capital using the ESOP strategy, as the holding company’s shares outstanding will increase thereby causing dilution to existing shareholders.Facilitating stock purchases and providing liquidity absent a sale of the bank to outsiders by creating an "internal" stock market whose transaction activity can promote confidence in stock pricing. The ESOP offers the further advantage of providing a vehicle to own shares that is “friendly” to the existing board of directors. For example, the ESOP can offer an alternative exit strategy beyond selling the bank to outside investors through an IPO or acquisition by providing a liquidity avenue that allows for ownership transition while maintaining independence. For C-corporations, the shareholder may even have the ability to sell his or her shares in a tax-free manner subject to certain limitations related to a Section 1042 rollover, including the ESOP owning 30% or more of each class of outstanding stock after the transaction and the seller reinvesting the proceeds into qualified replacement property from 3 to 12 months after the sale; and,Providing employee benefits and increasing long-term shareholder value. ESOPs provide a beneficial tool in rewarding employees at no direct cost to themselves by providing common stock and tying their reward to the long-term stock performance of the bank/company, which can serve to increase employee morale and shareholder value over time. For example, a recent study by Ernst & Young1 found that the total return for S Corporation ESOPs from 2002 to 2012 was a compound annual growth rate of 11.5% compared to the total return of the S&P 500 over the same period of 7.1%. The measure of S ESOP returns considers cumulative distributions as well as growth in value of net assets, net of those distributions (i.e., growth in underlying value per share).What Is the First Step for Those Considering an ESOP?For those considering implementing ESOPs, the first step is generally a feasibility study of what the ESOP would actually look like once implemented at your bank. Parts of the study would include determining the value of the company’s shares, the pro-forma implications from the potential transaction/installation, as well as what after-tax proceeds the seller might expect. This will help determine whether the bank should proceed, wait a few years to implement, or move to another strategic option. There are typically a number of parties involved in implementations including among others an appraiser/valuation provider, trustee, attorney or plan designer, and administrative committee.What Are Some Potential Drawbacks to ESOPs?ESOPs are subject to both tax and benefit law provisions (such as the ERISA act of 1974). Certain negatives associated with them can include:The costs of setting up and maintaining the plansThe repurchase obligation for the sponsoring company as employees retire or exit the planRegulatory issues with the Deportment of Labor serving as primary regulator and the IRS being able to review plan activitiesFiduciary roles associated with ESOP trusteesPotential complexities related to shareholder dilution from issuing new sharesAre There Any New Developments for ESOP Trustees to Consider?For existing ESOPs, two recent legal and regulatory developments have brought up important issues for trustees to consider as well.DudenhoefferIn 2014, the Supreme Court ruled on the case of Fifth Third Bancorp v. Dudenhoeffer, which involved a public company that matched employee contributions to a 401(k) plan by contributing employer stock to an ESOP that was part of the plan. The ruling states that the standard of prudence applicable to all ERISA fiduciaries also applies to ESOPs, though ESOP fiduciaries are not required to diversify the ESOP’s holdings. The Court ruling was focused on public company ESOPs, but its implications for private company ESOPs are unclear. However, trustees should consider ensuring an investment policy statement is in place for the ESOP, stating that the policy is to invest primarily in employer stock in accordance with the purpose of the Plan; and, if applicable, the policy statement could potentially clarify that employees have diversification options through other benefit plans such as a 401(k) plan.GreatBanc TrustScrutiny related to ESOPs, particularly as it relates to certain valuation issues, has increased in recent years, with the DOL bringing a number of cases against trustees and other parties. In the case of Perez, Secretary of the DOL v. GreatBanc Trust Company, there is a process agreement that we encourage ESOP companies and their trustees to review. While the process requirements are only specific to GreatBanc, the case has received a lot of attention in the ESOP community.In October 2012, The U.S. Department of Labor filed a lawsuit against GreatBanc Trust Co. and Sierra Aluminum Co. in the U.S. District Court for the Central District of California. Among other issues identified in the suit, the DOL alleged that GreatBanc violated the Employee Retirement Income Security Act by breaching its fiduciary duties to the Sierra Aluminum Employee Stock Ownership Plan when it allowed the plan to pay more than fair market value for employer stock in June 2006. The suit also named the ESOP’s sponsor, Sierra Aluminum, as a defendant. The sponsor’s indemnification agreement with GreatBanc allegedly violated ERISA regulations. The suit focuses on the quality of the appraisal on which the trustee relied, particularly on the supportability of the assumptions used in the cash flow projection.As part of the settlement negotiations, the DOL and GreatBanc have agreed upon a specific set of policies and procedures as trustee of an ESOP. While specific to GreatBanc, the transaction procedures are presumed to be applicable to all Trustees and related appraiser relationships. The process requirements cover the following areas:Selection and Use of Valuation AdvisorOversight of Valuation AdvisorFinancial StatementsFiduciary Review ProcessPreservation of DocumentsFair Market ValueConsideration of Claw-BackOther ProfessionalsIn general, the process agreement makes clear that trustees must ensure that ESOP valuations are well documented with thoroughly supported assumptions.How Can Mercer Capital Help?Mercer Capital has been providing ESOP appraisal services for over 25 years and has extensive ESOP experience through providing annual valuations, installation advisory, feasibility studies, financial expert services related to legal disputes, and fairness opinions. Our appraisals are prepared in accordance with the Employee Retirement Income Security Act (“ERISA”), the Department of Labor, and the Internal Revenue Service guidelines, as well as Uniform Standards of Professional Appraisal Practice (“USPAP”). We are active members of The ESOP Association and the National Center for Employee Ownership (NCEO). Our professionals have been frequent speakers on topics related to ESOP valuation throughout our 32-year history. Mercer Capital professionals also co-authored the publication, The ESOP Handbook for Banks (2011), which provides insight into key ESOP-related issues affecting banking organizations.For additional ESOP resources, view our whitepapers Insights on ESOPs and Choosing a New ESOP Appraiser.Endnote1 Contribution of S ESOPs to participants’ retirement security: Prepared for Employee-Owned S Corporations of America March 2015) Report can be accessed at: http://www.efesonline.org/LIBRARY/2015/EY_ESCA_S_ESOP_retirement_ security_analysis_2015.pdf.
How Banks Build Value via Trust and Wealth Management Franchises
In the late 1960s, Enzo Ferrari committed to building an "entry-level" sports car that would appeal to a more mass-affluent buyer than his eponymous marque. His design team engineered a mid-engine two seater with a 2.4 liter, six cylinder motor called the Dino, named after his late son who was to be heir to the Ferrari dynasty. Although Ferrari manufactured the car and eventually badged a later version of it, the original design was never a “Ferrari Dino,” just a Dino. Buyers of the car did well on their entry-level investment – well preserved Dinos now routinely sell at auction for close to half a million dollars.There are a few Dinos for sale right now in Scottsdale, where Brooks Hamner and I are attending Bank Director’s Acquire or Be Acquired conference. We spoke today on how banks can build value through trust and wealth management franchises. It just so happens that there are a number of annual collector car auctions going on here at the same time, and I could draw more than a few parallels between the events.Much like Enzo Ferrari’s strategy fifty years ago, banks are looking to reach a mass-affluent investor community by offering sophisticated asset management services and personal attention once reserved for high net worth and institutional clients. Time will tell if this acquisition binge is as transformational for the banking community as the Dino was for Ferrari (today more than half the cars they sell follow the same mid-engine format). I’m sure acquiring bankers hope that investing in their trust and wealth management businesses will pay off as well as the purchase of a Dino did in the late 1960s – even if ownership may not be quite as much fun.Here’s the slide-deck from our presentation. Even with the present market instability, banks have an interesting opportunity to expand their financial services while diversifying their revenue streams with asset management. We sense some growing demand for sophisticated trust services, and a lot of RIAs in the wealth management space see banks with existing trust departments as a complementary environment to sell into. Give us a call if you’d like to know more. I’ll be back with some conference hearsay next week.
Mercer Capital’s Value Matters® 2016-02
Unicorns, Delaware, and Private Company Financial Disclosure
Five Things to Improve the Value of Your Investment Management Practice
Which Have Nothing to Do with the Stock Market
Cold enough for ya?Back in early December when the temperature was unusually high and the VIX was unusually low, many of our clients were calmly contemplating 2016 while they developed their budgets for the year ahead. Six weeks later, the debate over whether or not weakness in high yield would spread has been settled — and most of the eastern U.S. is covered in snow.Boxer Mike Tyson once said, “Everybody has a plan – ‘til they get hit in the face.” With equity markets and most debt markets draining AUM from client portfolios lately, many asset managers and wealth managers are reeling. Between watching firm revenues tail off with all the red on the screen, plus fielding phone calls from anxious and sometimes angry clients, it’s easy to feel out of control, if not helpless. But out of control and helplessness are two different things.I once read an interview with a veteran airline pilot who said that, when confronted with a crisis, the first thing to do was order coffee. In other words, step away from the crisis, get control of your own thinking, and consider your options from there. In that spirit, take a moment to step away from Bloomberg, grab some coffee, and think about the business of your investment management firm.Here are some brief thoughts about five topics, posed as questions, that can make or break the value of RIAs. These topics have longer term and more strategic implications than the day-to-day fluctuations in capital markets, and while equity research may be more fun, these are more reliably lucrative.1. Do the Right People Own the Right Amount of Your Firm?Ownership is a sticky wicket, and indeed can be the most distracting issue for an otherwise successful shop — all the more reason to focus on ownership now, rather than kicking the can down the road another quarter. Any ownership program has benefits and tradeoffs. Usually that tradeoff involves rewards to the builders and producers of the firm versus the sustainers and future leadership.We have some clients with dynamic ownership programs that get tweaked every year. This willingness to be flexible can allow RIAs to ensure that the ownership is supporting the long term strategy of the firm. But doing that means giving up some of the “permanence” that is usually associated with ownership, and can make equity participation walk and talk a lot more like a compensation plan.Others have a hard time getting shares moved from generation to generation, usually because the spread between the bid and the ask is just too wide. A frequent internal quip at Mercer Capital is that RIAs are worth so much that no one can afford to own them. Some try to solve this with interesting terms or creative financing, but we usually discourage clients from trying to cure price with terms.2. Are Your Corporate Documents Updated and in Order?Specifically, think about your buy-sell agreement and whether or not it supports the long term continuity of leadership at your firm. What is the pricing mechanism in your ownership agreement? What happens if someone dies? What if the partner group has a member who is no longer productive to work with – can you fire them and buy them out?It won’t surprise anyone to learn that we recommend calling for an independent appraisal to establish pricing at the time of a transaction. Not that we know more about what your firm is worth than you do, but our experience is that, when a valuation dispute arises (often when an owner is kicked out), the bid/ask spread can be huge. With an independent valuation opinion resulting from a structured process, the matter can be resolved by someone with no skin in the game other than their professional reputation.Of course, the best way to avoid confrontations over valuation is to get a regular valuation analysis prepared by an outsider. It sets the stage for ownership transitions, and while there is still usually some spread between expectations and reality, at least the spread is much more narrow.3. Do Your Client Demographics Support your Business Model?Just like ownership, the client base of every RIA evolves. The question is: are you managing that evolution for the long term strategic benefit of your firm?We did expert testimony work a few years ago for a partner in a firm managing $6 billion for 14 institutional clients. Needless to say, that’s an efficient and highly profitable way to run an RIA – until you post too many periods of negative alpha.Most client concentrations aren’t that extreme, but it’s always worth thinking about whether you have the optimal client composition. If you run an independent trust company or wealth management firm, you probably have mostly high net worth clients. What do they have in common? Did they make their money from the same industry? Are they geographically concentrated? How old are they? How are their kids involved in the family wealth? Is that money being managed for this generation or the next?We sat down recently with an asset manager who has, over time, managed their client base very deliberately. They are a straightforward long-only manager, but they have investors via mutual funds, wrap programs with wire-house firms, direct relationships with high net worth clients, direct institutional relationships, and institutional relationships they handle through consultants. They explained that, because their investment style goes in and out of favor with trends in the market, they wanted clients with a diversity of pressure points and decision timelines. If their performance dips because of market conditions, not everyone heads for the exit at once. If they outperform, they don’t immediately slam up against their capacity with a lot of hot money that will leave just as quickly.4. Is Your Firm Growing Because of Markets, or Because of Marketing?As a follow-on to the commentary about customer demographics, it’s important to think about what you’re selling. Investment performance waxes and wanes, so just selling alpha in good times can really burn a shop when the market turns. Having a message that resonates about what you do that is unique can attract clients when you are outperforming and when you are underperforming, and it is a more reliable way to accumulate AUM than the steady upward drift of the capital markets.Also, don’t forget to market to (educate) your existing clients. If they are educated about why you do what you do, they’re less likely to leave when the market doesn’t favor your style. A dollar of AUM retained is worth just as much as a dollar of AUM gained – maybe more.5. Do You Have a Series of Products Available to Grow Beyond the Capacity of Your Current Offerings?In scarcely a generation, the investment management profession has gone from offering relatively straightforward buy-low-sell-high services to ETFs to ESG. Clients still want their investment managers to buy low and sell high (or least buy high and sell higher), but the “buckets” have changed some and will continue to change.It’s an obvious statement that you have to be offering products that clients want to buy. But if you were starting your RIA fresh today, what would your product offering be? From where you are today, is there a logical progression of product offerings to capitalize on your firm’s strengths and grow your client base and AUM base for decades to come?It’s difficult to know what kinds of products clients will want in the future, but it’s certain that clients will want investment management products in the future, and will probably be willing to pay about 100 basis points for products that are sufficiently differentiated such that clients can see the value.Improving the Value of Your Practice Regardless of Market DynamicsHappiness is expectations netted against reality. Unless you came into this year massively overweight cash, or with a big short position on energy, you’re not too happy and neither are your clients. However, it’s a good time to keep your eye on the practice management ball, because it will give you a competitive advantage in a year where most RIA managers can’t get their minds off the ticker.If you can improve the fundamentals of your practice in 2016, the markets will eventually take care of themselves, and you’ll be in a better position to profit when the bears go back into hibernation. It has been our consistent experience that good practice management builds value in an RIA, and in turn building value in an investment management practice reinforces the better aspects of the business model.In that vein, Brooks Hamner and I will be at the Arizona Biltmore in Scottsdale next week to speak to Bank Director’s Acquire or Be Acquired conference about how banks can build the value of their trust and wealth management franchises. This happens to coincide with several important collector car auctions, not to mention 75 degrees and sunshine. Yes, I can hardly contain my excitement. We’ll post the slide deck, and hopefully photos of some premium iron, next week.
Are You GIPS-Compliant?
The Global Investment Performance Standards (GIPS®) were adopted by the CFA Institute in 1999 and are widely accepted among the international investment management industry. GIPS are a set of ethical principles based on a standardized, industry-wide approach that apply to investment management firms and are intended to serve prospective and existing clients of investment firms. While compliance by investment firms is voluntary, many investors consider GIPS compliance to be a requirement for doing business with an investment manager. Alternative managers have lagged behind the industry in claiming compliance with GIPS, but changes in the industry suggest GIPS compliance is becomingly increasingly important.On the CFA Institute Market Integrity Insights blog, Beth Kaiser identifies two reasons GIPS compliance is becoming increasingly important, specifically for alternative investment managers. One driver is that alternative strategies are becoming increasingly mainstream and investors and consultants are engaging in more comprehensive due diligence. Compliance with GIPS can help managers to stand out amongst their peers. Furthermore, the issuance of the GIPS Guidance Statement on Alternative Investment Strategies in 2012 makes it easier for alternative investment managers to comply.The GIPS Guidance Statement on Alternative Strategies and Structures specifically addresses compliance for hedge funds and other alternative investment strategies. GIPS standards state that portfolios must be valued in accordance with the definition of fair value and that all investments, regardless of liquidity, must have valuations that adhere to the definition of fair value. In addition, firms are to disclose if pricing has been performed internally and not by an external third party.At the 2015 GIPS Annual Conference, it was revealed that the California Public Employees’ Retirement System (CalPERS) inquires of all investment managers, including alternative investment managers, seeking to do business with them whether they are GIPS-compliant. The position of CalPERS in the industry suggests that managers will take the steps necessary to win its business and that GIPS-compliance is quickly becoming the norm for investment managers.Related LinksPortfolio Valuation - Private Equity Marks & TrendsUpdated: Valuation Best Practices for Venture Capital and Private Equity FundsRules for the Modern Investment ManagerMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Asset Manager and Mutual Fund Valuations Continue their Decline through Year-end
A quick look at year-end pricing of publicly traded asset managers reveals a continued skid in multiples for traditional RIAs and mutual funds with modest advancement for the alternative managers and trust banks.
Earnings multiples are essentially a function of risk and growth, so a decline in cap factors for the traditional managers and mutual funds means one of two things must be happening: either the cost of capital is increasing or the growth outlook for asset managers is stalling. Despite the Fed’s recent actions, WACC’s are generally declining in most industries. There is no reason to assume the cost of capital is now higher in asset management than a year or two ago, so the trend in multiples suggests that the growth outlook for RIA earnings continues to be revised downward.
Given that traditional asset managers and mutual funds are so highly levered to market conditions, some consider RIA valuations as a de facto futures contract on the broader indices. If that’s the case, a continued contraction in multiples could portend a pullback or lack of upside for the stock market in general. The market activity on the first trading day of this year tends to confirm this suspicion.
Since most of the group is currently trading at a 30% discount to their 52 week high, the market is clearly bearish on the prospects for many of these businesses moving into the new year. Meanwhile, more optimistic investors will view this as a buying opportunity for companies that have gotten a lot cheaper in recent months.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Mercer Capital’s Value Matters® 2016-01
Wisniewski v. Walsh: Bad Behavior (Marketability) Discount in New Jersey
TSC buys $2.5B manager for Six Times (!)?
As usual, it’s not that easy
Over the Christmas holiday weekend I had the coveted experience of riding in a friend’s recently restored 1970 DeTomaso Mangusta. I didn’t take him up on the offer to drive the car as the roads were a little damp and Mangustas are notorious for being a little tail-happy, especially in the wet. The last thing I wanted was to be responsible for putting so much as a scratch on a specimen car that is as rare as hen’s teeth. DeTomaso built 401 of them before switching production to the much more common Pantera in 1972. There are maybe 200 Mangustas surviving today. This particular car was bought by my friend’s dad at an auction in Florida over twenty years ago. It had been owned by a member of Pablo Escobar’s drug cartel and still had a bullet hole in the fender. After restoration, it’s probably better today than new – so despite the sordid provenance I wasn’t too keen on sliding it into a bridge abutment.What’s even more rare than the Mangusta was the announcement earlier this month that Tri-State Capital Holdings, Inc. (traded on the Nasdaq as TSC) bought The Killen Group, a $2.5 billion manager of the Berwyn mutual funds, for about six times EBITDA. More specifically, TSC paid Killen $15 million cash up front (based on trailing EBITDA of $3.0 million), plus an earn-out paying 7x incremental EBITDA (which could add another $20 million to the transaction price). So, best case scenario for Killen is for them to deliver about $6 million in EBITDA and get paid $35 million (!).On the surface, the deal looks awfully cheap. Reading between the lines, Killen has a (very sustainable) effective average fee of 56 basis points, a normalized EBITDA margin of 35%, and a five-star rating form Morningstar on its largest mutual fund product, the Berwyn Income Fund (BERIX). All good. So why didn’t Killen make a killing (extract a double-digit EBITDA multiple from TSC)? No one expects that kind of an asset manager to sell low. At first glance, it’s the bookend to the Edelman transaction back in October, which appeared to be priced astronomically high. In the end, though, the two deals have more in common than not. In both cases the headline price gives one impression of the deal, while the underlying narrative says something very different.Much of the valuation work we do in the RIA space is, for one reason or other, performed pursuant to a standard of value known as fair market value. The standard of value is essentially a framework for the perspective of a given appraisal. Fair market value is defined by the American Society of Appraisers as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.When we look at transactions data in preparing fair market value appraisals, one thing we keep in mind is that transactions do not occur at fair market value – or if so only by coincidence. Transactions involve real buyers and sellers, not hypothetical ones. They might act at arm’s length in an open and unrestricted market, but usually they have a compelling reason to transact. It seems like that was the case in the TSC/Killen transaction.The press release and slide deck that went with the announcement didn’t go into detail, but TSC management alluded to Killen reporting $3.0 million in trailing twelve month EBITDA, which was really about $5.0 million net of a trading error. A $2.0 million trading error is substantial, but we don’t know much else about it. What we do know from looking at Killen’s ADV is that they also reported some FINRA compliance issues which appear to be connected with their president and chief compliance officer.Admittedly, the disclosure is thin and what is disclosed doesn’t sound terribly ominous. But some consider any “yes” answer to regulatory issues to be a big red flag, especially in connection with a $2.0 million trading error. Charlie Munger once said that, in the securities industry “integrity is like oxygen, no one thinks about it until it’s gone – then it’s the only thing they think about.” If the regulatory issue threatened Berwyn’s five-star rating, it could have a huge impact on client behavior. Put all of this in the context of a small firm (13 employees) with an aging founder who still holds a control position in the stock, and you’ve got what appears to be a motivated seller.We won’t speculate on what the multiple “could have been” in absence of the factors mentioned above, or what specific role they played in generating the terms of the Killen sale to TSC. But it appears to be an outlier transaction for outlier reasons, and like the Edelman deal shouldn’t be misinterpreted as signaling anything unusual about valuations in the asset management industry.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Updated: Valuation Best Practices for Venture Capital and Private Equity Funds
The International Private Equity and Venture Capital Valuation (IPEV) Guidelines were developed in 2005 to set out recommendations on best practices in the valuation of private equity investments. The IPEV Board is made up of leading industry associations from around the world, including the National Venture Capital Association (NVCA) and the Private Equity Growth Capital Council (PEGCC) in the United States. In October 2015, the IPEV Board published draft amendments to the existing guidelines that, if approved, will go into effect at the beginning of 2016.The IPEV Valuation Guidelines are intended to be applicable across a range of private equity funds, defined in a broad fashion to encompass seed and start-up venture capital, buyouts, growth/development capital, mezzanine debt, and other types of private investment vehicles. While US GAAP and IFRS financial reporting guidelines do not require that the IPEV Guidelines be followed, the IPEV Guidelines were created with the compliance requirements and implications of these standards in mind.The stated objective of the IPEV Valuation Guidelines is to set out best practices where private equity investments are reported at “Fair Value” to help investors make better economic decisions. The guidelines are concerned with valuation from a conceptual, practical, and investor reporting standpoint and do not seek to address best practice as it relates to internal processes, controls/procedures, governance, committee oversight, or the experience/capabilities required of the valuation professional.The proposed amendments to the IPEV Guidelines include edits to improve readability and clarity of understanding, as well as technical edits. The technical edits include the following:Update on IASB Unit of Account Progress to conform with international standards.Additional guidance emphasizing that fair value estimates (1) should be developed independently for each reporting entity (or fund) and (2) should be estimated using consistent valuation techniques.Modification of guidelines for the valuation of debt for purposes of determining the value of equity, including the treatment of prepayment penalties in the calculation of the fair value of debt.New guidelines to describe back-testing, including assessing what information was known as of the Measurement Date and whether known information was included in the Fair Value assessment.New guidelines aimed at clarifying certain valuation techniques, including the use of Market Approaches (Price of Recent Investment, Multiples, Industry Valuation Benchmarks, or Available Market Prices), Income Approaches (Discounted Cash Flows), and Replacement Cost Approach (Net Asset Value).Discussion of certain special considerations, including non-control minority positions, guidance on mathematical models, and guidance on the sum-of-the-parts method.
With increasing activity and interest from investors, valuation guidance for private equity and venture capital investments continues to become more clearly defined. Mercer Capital will continue to present periodic updates on the evolving fair value landscape here at the Financial Reporting Blog and other forums.
For more information on the guidelines, please refer to the International Private Equity and Venture Capital Valuation Guidelines, Edition December 2015 DRAFT. If you have questions regarding fair value or fair value measurements, please contact a Mercer Capital professional to discuss your situation in confidence.
Normalizing Adjustments to the Income Statement
Normalizing adjustments adjust the income statement of a private company to show the prospective purchaser the return from normal operations of the business and reveal a “public equivalent” income stream.
A Few Thoughts on Valuing Investments in Startups
Concurrent with Madeleine Harrigan’s post last week about IPOs being the new private equity downround, the financial reporting group at Mercer Capital published an interview with the head of the group, Travis Harms, on the difficulties mutual funds face in valuing level 3 assets (think Square). The following is an excerpt from that interview.With respect to portfolio valuation, who are your clients and what services do you provide?
In our portfolio valuation practice, clients cover the spectrum from debt-focused funds, to hedge funds, traditional private equity funds, venture funds, and sector-focused credit and equity funds. Despite the diversity of strategies, what they all have in common is the need to develop reliable, defensible fair value marks for hard-to-value assets in a real-time reporting cycle.
That reporting cycle varies by client – we mark some assets on a monthly basis, while we look at others annually. The frequency with which we mark assets is generally a function of the fund manager’s ability to develop interim marks on their own – do they have the requisite expertise and staffing to develop and document reasonable interim marks?
Now, of course, the fund manager has the expertise to value assets. However, the fund manager’s valuation objective is to determine “intrinsic” or “investment” value, which may well differ from the prevailing market consensus. That is not the objective of fair value reporting, though. Fair value is not the fund manager’s price target based on his investment thesis. It is a particularly defined standard: fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Developing and documenting the corresponding market participant inputs can be time-consuming and requires a different perspective than the fund manager is accustomed to using.
Sometimes we are developing our own independent estimates of fair value from scratch; other times we are examining the fund manager’s own estimates for the purpose of providing positive assurance that the marks are reasonable. Regardless of the scope of our work, documenting, presenting, and defending our conclusions to auditors and, potentially, regulators is always part of our job.
Looking to the VC markets a bit, you have commented on the Unicorn phenomenon and suggested that from a valuation perspective, “What’s obvious isn’t real, what’s real isn’t obvious.” What do you mean?
What we mean by that is that – while the headline valuation ascribed to a company following a fundraising round is obvious (price x fully-diluted shares outstanding), that is not the real value of the company. What is less obvious, but considerably more real, is that the price per share in the most recent round reflects all of the rights and economic attributes of that share class. Those rights and attributes are not the same for all of the other shares included in the fully diluted share count. It’s like applying the per-pound price for filet mignon to the entire cow – you can’t do that because the cow includes a lot of other stuff that is not filet. In the same way, the “obvious” pxq calculation overstates the value of an early-stage company. Now, no doubt the values of many “unicorns” are substantial, even when calculated correctly – but the real values are not nearly as obvious as the often breathless headlines would suggest.
Last week, a Wall Street Journal article elaborated on some of the difficulties that mutual funds face in valuing their investments in startups. Based on your experience with providing periodic fair value marks for VC funds, what are some of the elements that go into valuing such investments? What are some of the pain points?
Valuing startup investments, including “unicorns” such as those mentioned in the Wall Street Journal article, requires developing a thorough understanding of the economics of the most recent funding round, which provides a market-based “anchor” for valuation at subsequent measurement dates. What we find most effective is to build our valuation model so that it corroborates the “anchor” value as of the date of the most recent external funding round. Once our model is appropriately calibrated, we can then develop appropriate market participant model inputs for the measurement date that take into account changes in markets, company performance, and prospects for future exit with regard to timing, amount, and form.
Valuing these investments is particularly challenging given the illiquidity of the securities. When observable transactions occur only sporadically or at long intervals, it can be difficult to assess how changes in the market and company prospects will influence value. The longer the holding period – in other words, as you move from days to months to years – the greater the uncertainty regarding reasonable inputs and the wider the range of potential outcomes. Things become even more difficult when you layer in the unique features of many of these securities, such as liquidation preference, conversion, participation, and other rights and features.
Finally, the WSJ article discusses the fact that there is variation, sometimes substantial, in the valuation marks provided by different investors in the same company. Is that troublesome?
Is it troubling that different reasonably informed investment professionals come to different good faith estimates of the fair value of the securities we’ve been discussing? No. As we mentioned previously, illiquidity necessarily increases uncertainty. This is a phenomenon that you can observe even in securities that trade in markets – the less liquid and shallower the market, the wider the bid-ask spread will be. Even if you follow a rigorous calibration process like we outlined earlier, there is uncertainty about inputs. For example, you may know – on the basis of an observed market transaction – that a company’s value was $40 at a particular date, but what you still cannot directly observe is whether that was 8 times 5 or 10 times 4. Those unobservable inputs will necessarily breed good faith differences of opinion as the $40 value becomes stale with the passage of time. That is not to say that anything goes – there is a range of reasonable conclusions. But no, different estimates of fair value for these securities are not in themselves troubling.
A different question, whether it is troubling – given this valuation uncertainty – that an open-end mutual fund owns such securities is for the regulators to decide. It may be that the fair value estimates are reasonable, and reasonably different, but those differences are simply not tolerable from a regulatory standpoint. That, however, is ultimately not a valuation question.Related LinksUnicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t ObviousHow to Value Venture Capital Portfolio InvestmentsValuation Best Practices for Venture Capital FundsMutual Funds Flail at Valuing Hot Startups Like Uber (subscription required)Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Are IPOs the New Down Round?
There's something about nature that abhors a vacuum. Right now that vacuum seems to be the imbalance between the public and private markets, with the latter attracting maybe too much interest since the credit crisis, at the expense of the former. Blame fair value accounting or Sarbanes-Oxley or the plaintiff's bar, but it has been some time since being public was actually considered a good thing. With interest running high in the "alternative asset space" and cheap debt for LBOs, the costs of being public have not been particularly worthwhile. This situation is not sustainable, and was never meant to be. Family businesses can stay private forever, but institutional investors eventually need the kind of liquidity that can only come from the breadth of ownership afforded by established public markets. Valuations are never really proven until exposed to bids and asks.
So the circumstance in which private capital markets are considered more desirable than public markets is to express an illiquidity preference which is at odds with basic investment logic and the requirements of portfolio management. This cannot last, and the end – which appears to now be unfolding - will ripple throughout the asset management industry.
Continuing a trend set into motion in the first half of 2015, third quarter IPO activity fell 34% year over year in 2015, while the median capital raised in private fundraising rounds hit a staggering $92 million. The tech industry in particular has suffered from a glut of capital in late-stage funding rounds, leading to a general hesitation to leave the safe (because it is comfortably theoretical) harbor of the private market. Only 11% of IPOs completed in 2015 so far involved tech companies, with a majority of them generating returns of less than 3% from their IPO prices, and producing a negative 15% from their debut closing prices. Within the tech industry, the sheer amount of capital inflow from the private market has distorted the usual hubbub around the IPO. Private valuations have quietly (and in some cases, publicly) reached levels unsustainable in the public market, and companies now face a reality in which going public may in fact devalue the company – at least from late financing rounds.
It seems only fitting that a company whose entire platform is built on the concept of impermanence should fall prey to the largest tech devaluation in the private market in 2015. Snapchat, a photo, text and video messaging app in which messages "self-destruct" in ten seconds or less, took a hit this past week when it was revealed that Fidelity Investments cut the value of its stake in the company by a whopping 25%. Earlier this year, BlackRock reduced its valuation of the cloud-storage software DropBox by 24%. However, as mutual funds, both Fidelity and BlackRock are obligated to mark their portfolios to market on a regular basis and disclose their valuations. In the third quarter, plummeting gas prices, unstable Asian markets, and whatever new catastrophe was going on with the Eurozone were in full effect. As a result, Twitter saw its stock price fall by 29%, while Facebook also had less than stellar returns. In all likelihood, Snapchat and DropBox were victims of market pressure rather than fundamental performance.
It's a buyer's market in the IPO world, as 16% of IPOs downsized their debuts during the third quarter. Investors burned by lower than expected returns in the public market are putting pressure on startups to offer protections or lower their share price. Square, Inc., a mobile payment company founded in the heart of Silicon Valley, recently announced plans to sell 27 million shares in an IPO offering ranging from $11 to $13 per share, a significant discount from the company's October 2014 funding round that valued shares at $15.46. Granted, late stage Square investors are operating under a "ratchet" agreement (not the adjective kind). Square agreed to provide extra shares to certain investors if the company went public at a share price lower than the funding valuation the investor bought in at. If Square goes public at a share price below $15, the IPO will trigger the ratchet and diminish the outstanding shares. But terms don't fix price, as the "protection" afforded some Square investors will come from other Square investors. Ultimately, price is a zero sum game.
Although startups do not often publicize whether investor protections are in place, it is an additional factor that has led several startups to postpone a planned IPO. LoanDepot is the latest company to get cold feet before their big day, as the company's prospective share price plummeted from a high of $18 per share to below $12. Instead of floating the lower valuation, LoanDepot walked, citing "market conditions" as the primary culprit behind the lower valuation. The IPO market has become a waiting game, as more and more startups have punted going public in favor of private capital. Whether the current market squeeze filters its way down to affect private valuations is only a matter of time. It's hard to imagine that a buildup of companies waiting to go public will somehow improve IPO pricing.
And it is hard to imagine this ending well. ZIRP and arguably over-regulated public markets have created a robust private market, but it is a market of "Level 3" assets without validation. If private markets seize, will they also become more regulated? If rates ever rise significantly, can financing get rolled over to sustain leveraged ownership? Can pension plans and endowments satisfy their funding liabilities without liquidity for alternative assets? At some point, liquidity preference is going to have to restore some reason for public ownership. Ultimately, though, the question is whether that comes from improvement in the public markets or deterioration in the private market.
Asset Manager Valuation and Rules of Thumb
One of the most glorious places on earth to eat is La Colombe d’Or in Saint-Paul de Vence, France – just above Nice. Known as much for its art collection as for its food, just inside the garden entrance at the restaurant is a giant marble thumb, carved by the artist Cesar, to greet you as you enter. The placement appears inspired to give guests the "thumbs-up" on their arrival or departure from the restaurant, setting up the right mood for a tremendous calorie fest (and corresponding tab). It’s impressive, at least until you notice the collection of Legers, Picassos, Calders, and Miros that "Cesar’s Thumb" has to compete with.The shorthand method of valuation in many industries has long been some kind of "rule of thumb", usually a multiple of some measure of gross scale or activity.Twenty years ago, money managers were often thought of as being worth something on the order of 2% of assets under management. Even today, transactions in RIAs often disclose only the transaction value, which when compared to the latest AUM measure in the firm's ADV filling, yields something of a transaction value as a percentage of AUM. Because this is often the only valuation metric available from an RIA transaction, it still receives a lot of press – more than it deserves.A not very close look at the transactions data belies the use of price-to-AUM as a standalone indication of value. While some recent RIAs have transacted at a value that was at or near 2% of AUM, others are very different. And publicly traded asset managers might command 4% of AUM or more.So, obviously, there's more to the story than a measure of central tendency with regard to AUM. The 11,000 plus RIAs in the U.S. come in all shapes and sizes, and the value of any business is typically some conversion from a measure of expected future cash flow, not simply activity.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days when RIAs typically garnered on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.The reality, today, can vary widely. If that same RIA is a fixed income manager, the fee schedule on managing debt instruments might only yield 30 basis points, or $3.0 million on $1.0 billion in AUM. Running a fixed income shop of that size might require fewer people than an equity manager, and the cost per employee might be lower. Still, if the EBITDA margin were lower, say 20%, then distributable cash flow might be more on the order of $600 thousand for the fixed income manager, or less than a quarter of that in the first example. Again, if the prevailing multiple of EBITDA is 8x, then the implied valuation, or $4.8 million, is less than half of one percent of AUM, and a quarter of the value implied by the rule of thumb.So what do rules of thumb tell us? To the extent that businesses transact with certain measures of value in mind, they become self-fulfilling prophecy and are instructive as to value. Asset managers are usually pretty savvy with regard to ROI, though, so profitability matters. Fee schedules (realized, not just published) influence the return off a given dollar amount of AUM, as do cost structures. And this is before we talk about concentration risks, growth trends, and overall sustainability of the business model. And it's before we talk about how sought after asset management is today as a sustainable source of profitable returns. Fee schedules may be down. Margins may be all over the place. Risks vary wildly. And multiples may be higher.So the next time someone suggests a rule of thumb to value your RIA, don't hesitate to ask: whose thumb?
Asset Manager M&A Continues Ascent Despite Sell-Off
Despite the recent setback in the markets, RIA transaction activity posted solid gains for Q3 and into the month of October. We caution against reading too much into this since transaction value is often not reported, though it is promising that the number of deals has increased fairly consistently over the last year. The fourth quarter looks to continue this trend with Hellman & Friedman’s recent purchase of Edelman Financial (covered in a previous post).
The quarter-end multiples for the public RIAs reveals that pricing remains firm but not egregious, a conducive environment for continued transaction activity in the sector. Prospective buyers will also be intrigued by many of these businesses now trading at a 30% discount to their 52 week high.
[caption id="attachment_9618" align="aligncenter" width="650"] Source: SNL Financial[/caption]
Placing the recent uptick in its larger historical context reveals a lull in deal making after the active 2006 to 2009 period that culminated in BlackRock’s purchase of Barclay’s asset manager business.
The sector’s ability to shrug off the most recent correction is a testament to its resiliency in the face of declining management fees and impending regulatory changes. Despite the recent uptick, we believe the backlog for deal making remains fairly robust given the four year pause in transactions from 2009 to 2013 and the aging demographics of many investment management firms. The real threat to deal making would be a longer, more pronounced downturn in the equity markets that would crater AUM levels and investor confidence. We note the decline in transaction activity following the financial crisis of 2008 and 2009 as indicative of what another bear market could do to M&A trends.
The outlook for deal making is therefore more nuanced and dependent on market conditions. The market’s stabilization since the last correction has clearly boded well for sector M&A, and the future appears bright – as long as security pricing holds up. Another significant setback would likely curtail the recent momentum and valuation levels.
What are you afraid of this Halloween? FinCEN
If you haven’t already figured out your costume, let this serve as a reminder that Halloween is coming this Saturday night. If you’re an investment manager, you already have a lot to be scared of this season, but at least that opens up some possibilities for Halloween attire. You could come dressed as earnings season (Eeyore). You could come dressed as the end of capital gains treatment for carried interests (Robin Hood). You could come as the Headless Horseman (robo-advisors). You could come dressed as Frankenstein (multi-strategy ETFs). You could come dressed as Donald Trump (Donald Trump). You could come dressed as the Fed (any hockey mask will do). Or you could always dress up like the living dead, and tell your friends that the zombie that haunts your dreams has a name, FinCEN, the US Treasury Department’s Financial Crimes Enforcement Network.In the midst of a bumpy third quarter, the FinCEN released a proposal to establish anti-money laundering requirements for advisers registered with the Securities and Exchange Commission (SEC). If you think you’ve seen this horror movie before, you have. FinCEN made the same proposal back in 2003 – but then withdrew it as the financial world came crashing down in 2008, citing the “passage of time” as the primary reason. Apparently the passage of more time led regulators back to the same place in the corn maze. On August 25, FinCEN dusted off the proposal and is trying once more to bring investment advisors under the anti-money laundering (AML) obligations.On the second go-around, FinCEN’s proposed rules have more (and sharper) teeth than the 2002 and 2003 proposals. Not only will registered investment advisors (RIAs) have to establish and maintain AML program requirements, advisors will be subject to additional suspicious activity reporting, information sharing, and record keeping. Investment advisers would be defined as “financial institutions” and would be required to file Currency Transaction Reports (CTRs), keep records on the transmittal of funds, and allow FinCEN to require advisers to search their records and voluntarily share information between financial institutions. Advisers would be responsible for filing suspicious activity reports (SARs) to FinCEN on any investor suspected of nefarious behavior. SARs reports are generally filed for transactions in excess of $5,000, though the adviser has discretion on reporting activity below the minimum threshold. Thankfully, all SARs reports are protected under a safe harbor provision to protect advisers from potential litigation for disclosing investor activity.The greatest challenge under the proposal, however, will be in implementing the AML program itself. The AML program requirements are built on four main pillars, with varying degrees of difficulty in application. The pillars include 1) implementing and overseeing policies, procedures, and controls; 2) hiring or appointing an AML Compliance Officer; 3) ongoing employee training; and, 4) independent testing or auditing of the program. Although the proposal only applies to the larger, non-exempt investment advisers (advisers with less than $100 million in AUM are not required to register with the SEC), the burden of implementation will fall heavily on smaller RIAs without risk management processes already in place. The proposed rules will require additional staff, in-depth training, ongoing monitoring and oversight, and external expertise. RIAs are able to adapt existing rules and contractually delegate some parts of the compliance process, with the caveat that the RIA will remain fully responsible for the efficacy of the program. With the SEC capable of enforcing the AML requirements, all advisers will be spending a lot more time – and money – ensuring compliance.Those in favor of the AML compliance believe the RIA industry got off easy, as it is still undecided on whether or not small and mid-sized RIAs, exempt reporting advisers, and foreign private investment advisers will be subject to the proposed rules. Misery loves company. FinCEN also expects to further address the controversial topics of customer identification procedures and information sharing requirements through future regulations. Although the proposal does not include a customer identification program requirement as stringent as those found within banks and broker-dealers, RIAs may have a hard time checking accounts and transaction records against names provided by FinCEN without stronger due diligence into customer identities.Comments on the Proposed Rules are open until November 2, although it is expected that the AML proposal will be passed mostly intact.Sometimes the fear of a thing is worse than the thing itself, and being haunted by proposed regulations may indeed turn out to be worse than compliance. But this horror show may turn into a series with multiple episodes, so clutch your popcorn and stay tuned.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Monday Morning Quarterback: Edelman sells for $800 million (!)
Last week brought the news that PE firm Hellman & Friedman had acquired Lee Equity Partners's controlling interest in mega wealth manager Edelman Financial. Edelman is headed by radio-show personality Ric Edelman, and manages about $15 billion for over 28,000 clients. While terms of the deal were not officially disclosed, the Wall Street Journalreported the transaction valued Edelman at a number north of $800 million, a nice pickup from Edelman's going private deal in 2012, which transacted the company at $263 million. The financial press was practically hyperventilating over the price last week, but a little analysis on the number reveals pricing that is more normal than most would imagine.Breathe normallyThe headline optics of the deal are eye-popping. An $800+ million price is more than triple the transaction value only three years ago, and further implies a price to AUM multiple of over 5% (!). The financial press that immediately followed the announcement ballyhooed the deal as proof that RIAs were hot properties fetching premium pricing and that we could expect more of the same. Count us as being a little more measured in our perception of the deal. While we're not going to describe the Edelman deal as a "meh" transaction, the firm's underlying fundamentals are likely far more responsible for the price than an overheated market. Indeed, our analysis suggests Edelman's pricing was fairly normal. Here are a few reasons to be happy, but not ecstatic, about the Edelman sale:Edelman is a growth machineWhen Edelman went private three years ago, the company reported assets under management of about $8 billion. It's almost twice that today. While a 30% CAGR in AUM has no doubt been assisted by bull market tailwinds, most of Edelman's growth has been from growing its investment advisor base and, correspondingly, the number of clients.Past growth explains the change in valuation from the 2012 going private transaction to the current deal, but Edelman is showing signs of continued growth as well, increasing the number of investment advisors by about 20% this year. RIAs can't always count on the market to grow the top line, but if a marketing platform is there to add clients, value will accrue.Edelman fetches premium feesThe real reason Edelman commanded such a high multiple of AUM is the firm's superior ability to extract fees per dollar of AUM.Investment management fee schedules are all over the map, with robo-advisors clocking in at around 25-40 basis points, and wealth managers often sticking between 100 and 125 basis points. Historical disclosures suggest that Edelman commands big fees for what they do. In their last public filing (Q2 2012), Edelman boasted investment management fees of over $32 million. Using that quarter as a proxy for an annual run rate of almost $130 million, Edelman was earning realized fees of 160 basis points on AUM of $8 billion. Even assuming that has been dialed back some by market forces puts Edelman's investment management fee base today at something on the order of $225 million.Add this to the Company's other revenue streams (which probably haven't scaled up to the same extent in the past three years), and we would estimate Edelman's revenue today to be on the order of $300 million. That's no threat to Schwab, but in the independent RIA space it suggests that Edelman has defied certain laws of gravity for wealth managers that have plagued other shops at much lower levels of performance. No doubt the scale of Edelman, the pricing power of their services in the market place, and the potential to grow further attracted a strong multiple.As a caveat to this, higher than market fee schedules are at risk of being "normalized" and doubtless this influenced the valuation of Edelman. That said, it is likely they have been successful at maintaining their value to customers in the marketplace so far.Edelman has revenue sustainabilityRic Edelman built his firm as a radio personality dispensing advice and gathering assets. His advisor network was excellent at client conversion and retention, and that formula has held up. The cult of personality firm, which we have written about in other posts, has drawbacks. Some still suggest that the firm's dependence on Edelman at the helm is a risk. We do not entirely disagree, but note that with 28,000 clients investing on average $536 thousand with Edelman, the firm has a solid lock on the mass-affluent investor market.Client demographics are a big factor in the value of investment managers, and while it's easier to service a few huge clients, if they leave they take firm value with them. The great thing about larger wealth managers like Edelman is that there is client diversification and product diversification, such that revenue is highly sustainable going forward.For a PE manager looking for investment return opportunities in what seems to increasingly be a low return environment, Edelman offers a higher quality coupon than most. We know that better coupons pay lower yields, which in Edelman's case suggests a multiple at the high end of the range.Edelman probably has a solid marginSince Edelman has been private for three years, we don't have a lot of margin visibility, but we can look back to 2012 and see what we can normalize to get there, especially if it's consistent with industry norms. Our analysis of Edelman's run rate at the time of the going private transaction suggests an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin on the order of 30% to 35%. That's strong, but not out of range with similar firms in the wealth management space. Edelman may have achieved some margin leverage with the growth it has experienced over the past three years, but probably not much. Thus Edelman's margin provided an optimal circumstance for the valuation multiple, with solid profit performance that does not need "repair" from a new owner, but also not so high as to risk being unsustainable.Edelman likely got a good, but not extraordinary, multiplePut it all together and the Edelman transaction looks fairly normal. Assuming an EBITDA margin at or just about 30%, consistent with the level of profitability the company reported before the 2012 going private transaction, HF paid a high single digit multiple of EBITDA.
The deal multiple was likely upward biased by the growth pattern and trajectory of the company, and the risk mitigation afforded by a diverse client base and large scale. Weighing down the multiple was likely some lingering concern over the dependence on Ric Edelman as the spiritual guru of the organization, concern over the sustainability of the firm's fee schedule, and some angst in general over the direction of capital markets. As solid as this pricing was, we wonder if Edelman couldn't have fetched closer to $1 billion a year ago when folks believed the market had more room to run.
But that's neither here nor there. Kudos to Edelman and Lee Equity Partners for a solid return on their three year investment in the company, and to Hellman & Freidman for acquiring a great franchise at a reasonable price such that their investors can also profit. All in all, an increasingly rare event in the PE universe.
Fairness Opinions and Down Markets
August has become the new October for markets in terms of increased volatility and downward pressure on equities and high yield credit. This year has seen similar volatility as was the case in some memorable years such as 1998 (Russian default; LTCM implosion), 2007 (tremors in credit markets), 2008 (earthquakes in credit and equity markets) and 2011 (European debt crisis; S&P’s downgrade of the U.S.). Declining commodity markets, exchange rate volatility and a pronounced widening of credit spreads finally began to reverberate in global equity markets this year.So far the downdraft in equities and widening high yield credit spreads has not slowed M&A activity. Preliminary data from Thomson Reuters for the third quarter indicates global M&A exceeded $1 trillion, which represents the third highest quarter on record and an increase of 11% over the year ago quarter. Activity is less broad-based though as 8,989 deals were announced compared to 10,614 a year ago.Immediately prior to intensified pressure on risk-assets, Thomson Reuters estimated that as of August 13 global M&A was on pace for a record year with $2.9 trillion of announced transactions globally (+40% vs. LYTD) and $1.4 trillion in the U.S. (+62%). Within the U.S., strategic buyer activity rose 53% to $1.1 trillion while PE M&A rose 101% to $326 billion.LBO multiples have been trending higher since 2009. The median LBO EBITDA multiple for broadly syndicated large deals was 10.1x through September, while middle market multiples expanded to 10.3x. Debt to EBITDA multiples for LBOs were 6.0x for large deals YTD and 5.5x for middle market transactions.No one knows what the future holds for markets. Deal activity could slow somewhat; however, a weak environment for organic revenue growth will keep many strategic buyers engaged, while lower prices for sellers if sustained will make more targets affordable for private equity provided debt financing costs do not rise too much. As of October 14, the option-adjusted-spread (OAS) on Bank of America Merrill Lynch’s High Yield Index was 6.31%, up from 5.04% at year-end and 4.83% a year ago.The role of the financial advisor becomes tougher too when markets are declining sharply. Obviously, sellers who do not have to sell may prefer to wait to see how market turmoil will play out while buyers may push to strike at a lower valuation. Questions of value and even fair dealing may be subjected to more scrutiny.Fairness opinions seek to answer the question whether a proposed transaction is fair to a company’s shareholders from a financial point of view. Process and especially value are at the core of the opinion. A fairness opinion does not predict where a security—e.g. an acquirer’s shares—may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view. Nevertheless, declining markets in the context of negotiating and opining on a transaction will raise the question: How do current market conditions impact fairness?There is no short answer; however, the advisor’s role of reviewing the process, valuation, facts and circumstances of the transaction in a declining market should provide the board with confidence about its decision and the merits of the opinion. Some of the issues that may weigh on the decision process and the rendering of a fairness opinion in a falling market include the following:Process vs. Timing. Process can always be tricky in a transaction. A review of fair dealing procedures when markets have fallen sharply should be sensitive to actions that may favor a particular shareholder or other party. A management-led LBO after the market has fallen or a board that agrees to buyback a significant shareholder’s interest when prices were higher are examples. Even an auction of a company may be subject to second guessing if the auction occurred in a weak environment.Corporate Forecasts. Like the market, no one knows how the economy will perform over the next several years; however, consideration should be given to whether declining equity markets and widening credit spreads point to a coming economic slowdown. A baseline forecast that projects rising sales and earnings or even stable trends may be suspect if the target’s sales and earnings typically fall when the economy enters recession. A board should consider the implications of any sustained economic slowdown on the subject’s expected financial performance with follow-through implications for valuation.Valuation. Unless markets experience a sharp drop from a valuation level that reflects a widely held view that multiples were excessive, a sharp pullback in the market will cause uncertainty about what’s “fair” in terms of value. DCF valuations and guideline M&A transaction data may derive indications that are above what is obtainable in the current market. Transactions that were negotiated in mid-2007 and closed during 2008 may have felt wildly generous to the seller as conditions deteriorated. Likewise, deals negotiated in mid-2012 that closed in 2013 when markets were appreciating may have felt like sellers left money on the table. There is no right or wrong, only the perspective provided from the market’s “bloodless verdict” of obtaining a robust market check if a company or significant asset is being sold. It is up to the board to decide what course of action to take, which is something a fairness opinion does not address.Exchange Ratios. Acquisitions structured as share exchanges can be especially challenging when markets are falling. Sellers will tend to focus on a fixed price, while buyers will want to limit the number of shares to be issued. The exchange ratio can be (a) fixed when the agreement is signed; (b) fixed immediately prior to closing (usually based upon a 10 day volume-weighted average price of the buyer); or (c) a hybrid such as when the ratio floats based upon an agreed upon value for the seller provided the buyer’s shares remain within a specified band. Floating exchange ratios can be seen as straightjackets for buyers and lifejackets for sellers in falling markets; rising markets entail opposite viewpoints.Buyer’s Shares. An evaluation of the buyer’s shares in transactions that are structured as a share exchange is an important part of the fairness analysis. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles. The historical perspective can then be compared with the current down market to make inferences about relative performance and valuation that is or is not consistent with comparable periods from the past.Financing. If consummation of a transaction is dependent upon the buyer raising cash via selling shares or issuing debt, a sharp drop in the market may limit financing availability. If so, the board and the financial advisor will want to make sure the buyer has back-up financing lined-up from a bank. The absence of back-stop financing, no matter how remote, is an out-of-no-where potential that a board and an advisor should think through. Down markets make the highly unlikely possible if capital market conditions deteriorate unabated. While markets periodically become unhinged, a board entering into an agreement without a backstop plan may open itself to ill-informed deal making if events go awry.
A market saw states that bull markets take the escalator up and bear markets take the elevator down. Maybe the August sell-off will be the pause that refreshes, leading to new highs, tighter credit spreads, and more M&A. Maybe the October rebound in equities (but not credit, so far) will fade and the downtrend will resume. It is unknowable.
What is known is that boards that rely upon fairness opinions as one element of a decision process to evaluate a significant transaction are taking a step to create a safe harbor. Under U.S. case law, the concept of the "business judgment rule" presumes directors will make informed decisions that reflect good faith, care and loyalty to shareholders. The evaluation process is trickier when markets have or are falling sharply, but it is not unmanageable. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies engaged in transactions during bull, bear and sideways markets garnered from over three decades of business.
Many Alternative Asset Managers in Bear Market Territory
A particularly rocky quarter for the equity markets precipitated huge market cap losses for most of the publicly traded hedge funds and PE firms. The lone bright spot and only sector component to generate a positive return over the last year is Blackstone, which benefited from strong performance fees on its portfolio company investments earlier this year. Still, the stock is down over 20% since its peak in May, which shows just how volatile the industry can be, particularly during times of market distress (our recent post discusses the impact of the recent downturn on asset manager shares).
With over $300 billion in AUM, Blackstone’s size is both a blessing and a curse. On the one hand, a large AUM base affords it the opportunity to invest in a multitude of asset classes and industries to enhance its risk/return profile with a diverse product offering. But, size can be a drag on performance and cut into carried interest fees if the underlying fund’s stature trumps viable investment opportunities. Still, some of this risk is mitigated by the added stability of higher management fees from a larger asset base. And the market doesn’t seem to mind this trade-off as AUM fees represent a relatively stable source of income to complement unpredictable and often inconsistent returns from carried interest.
Stocks of publicly traded PE firms have typically displayed more volatility than traditional money managers, and building larger funds with longer investment horizons may be one way to temper this disparity. Diversifying fund offerings beyond LBOs and into other asset classes such as hedge funds and real estate also helps. Sector analyst Marc Irizarry at Goldman Sachs notes, "All of these firms…have done a lot to diversify their businesses or to position themselves to grow assets on a more sustainable basis." Indeed alt manager shares have outperformed the RIA index as a whole over the last year, albeit by a fairly small margin.
Much of the divergence in financial and investment performance within the alternative asset manager sector can be explained by timing. A Bloomberg News piece in Financial Advisor expounds, "buyout firms' earnings rarely follow a linear path because they are driven by the lumpy timing of exits as well as the "mark-to-market" valuations of fund holdings, which are vulnerable to market swings and required each quarter under accounting rules." The economic cycles and gyrations in the stock market since the financial crisis have compounded this volatility as many of the deals that were struck at the last buyout peak of 2005 to 2007 have taken longer to exit at profitable levels, so their shareholders have yet to witness a full fund cycle while these businesses have been publicly traded.
Irizarry elaborates, "[alternative asset managers] are still 'show-me' stories in the eyes of the market. There's some reluctance on the part of investors to ascribe higher valuations on these managers until they see how sustainable these businesses really are."
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Rough Quarter for the RIA Industry
Q3 was an especially bad quarter for asset managers, with the group losing over $40 billion in market capitalization during a six week skid. Given the sector’s run since the last financial crisis, many suggest this was overdue and only pulls RIA valuation levels closer to their historic norms. The multiple contraction reflects lower AUM balances and the anticipation of reduced fees on a more modest asset base.
The most recent sell-off brings the industry to the brink of a bear market despite the S&P being down only 10% or so over the last few months. Such underperformance is not surprising for a business tethered to market conditions and investor sentiment. The market is acknowledging that revenue for equity managers is directly tied to index movements and earnings often vary more than management fees due to the presence of fixed costs (as demonstrated in the example below). Combining these dynamics with some multiple contraction reveals the market’s rationale for discounting these businesses in recent weeks.
The impact on sector M&A is more nuanced. On the one hand, the lower price tag might entice prospective buyers fearful of overpaying. Yet for others the market’s recent variability could spook potential investors, and sellers may be less inclined to part with their businesses at a lower valuation. Though the third quarter figures aren’t out yet, the recent slide could curtail the deal making momentum we’ve witnessed over the last year-and-a-half.
The outlook also remains uncertain and will ultimately be determined by market movements and asset flows. We’re neither smart enough nor dumb enough to predict future market movements and will defer that to the experts. As for asset flows, fee-richer active funds are losing ground to indexes and alternative products despite typically outperforming more passive strategies during market downturns. Overall, asset flows to riskier products (active or passive) are unlikely to improve until the recent volatility declines to more normal levels.
[caption id="attachment_9360" align="aligncenter" width="500"] Source: Morningstar[/caption]
Look out below! As capital market valuations apex, so too will RIA margins
Investment returns and the steady upward drift of equity markets are usually kind to investment management firm profits and valuations.This does not seem to be a “usual” period, however, and it serves as a reminder that profit margins are not simply an allocation of returns to equity holders; they also serve as a margin of safety in bear markets.Few industries are as susceptible to market conditions as the typical RIA.With revenues directly tied to stock indexes (in the case of equity managers) and a relatively high percentage of fixed costs, industry margins tend to sway with market variations.While the concept of operating leverage is not new to anyone in the asset management industry, it is easy to forget how easy it is for margins to collapse in a market downturn.It is, of course, striking to notice how RIA margins have recovered to the previous peak of 2007, a potentially ominous warning for equity markets now.Even more striking is how deep profits can fall in a market meltdown.The Qs reflecting the P&L impact from the most recent correction aren’t out yet, but we suspect that profits will be adversely affected for at least the next couple of quarters, depending on the extent of the downturn.Indeed, the market appears to be already anticipating this for most publicly traded asset managers, as they have lost several billion dollars in aggregate market cap over the last six weeks.On the private end of the spectrum, smaller, closely held RIAs tend to be more susceptible to market conditions than their publicly traded counterparts.Private RIAs don’t typically have the AUM and corresponding profit margins to serve as a cushion against a bear market.Anecdotally, we saw many asset managers with under $1 billion in AUM report negative earnings in 2008 and 2009 (at least for a few quarters) while most of the public RIAs stayed in the black.A healthy, larger RIA with 30% to 40% margins in good times can absorb a bear market event without reporting a loss, but many closely held asset managers with half that margin aren’t so resilient.The upward drift in the market from 2009 to 2014 buoyed AUM levels to new highs without the corresponding increase in expenses for many asset managers whose only variable costs tend to be compensation related.As a result, our group of publicly traded asset managers was able to recoup their entire 11% drop in average profit margins in just one year after the financial crisis. Only a few years after 2009, asset manager margins swelled to unprecedented levels; but operating leverage works both ways, and many public RIAs are trading in bear market territory following last month’s correction.The recent downturn should serve as a wake-up call to an industry that hasn’t had much interference in its upward trajectory over the last several years.As valuations drop and revenues contract, more attention must be devoted to expense controls if margins are to be maintained in the short run.Moving forward, this may be a challenge for many industry participants facing higher regulatory costs, a growing complexity of financial products, and personnel expenses that have moved almost in lockstep with revenue since the credit crisis.All of these costs tend to be fairly sticky on the downside.
Against a backdrop of increasing fee pressure and robo-advisory competition, this correction may have been long overdue for an industry that’s nearly doubled in size since the Great Recession. Though future market performance remains uncertain, it’s hard to imagine that RIA margin expansion will continue its ascent from the prior six years without another bull market tailwind.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
Valuing RIAs
Understanding the value of an investment management business requires some appreciation for what is simple and what is complex. On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the particular risks and opportunities of a given investment management firm is fundamental to developing a valuation.
Valuing RIAs
Understanding the value of an investment management business requires some appreciation for what is simple and what is complex. On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the particular risks and opportunities of a given investment management firm is fundamental to developing a valuation.
Unicorn Valuations
What’s Obvious Isn’t Real, and What’s Real Isn’t Obvious
In the two short years since Aileen Lee introduced the term "unicorn" into the VC parlance, the number of such companies has steadily increased from the 39 identified by Lee’s team at Cowboy Ventures to nearly 150 (and growing weekly) by most current estimates. Pundits and analysts have offered a variety of explanations for the phenomenon, with some identifying unicorns as the sign that the tech bubble of the late 1990s has returned under a different guise, others attributing the existence of such companies to structural changes in how innovation is funded in the economy, and the most intrepid of the group suggesting that the previously undreamt valuations are fully supported by the underlying fundamentals given the maturity and ubiquity of the internet, smart phones, tablets, and related technologies.We suspect there is merit to each of these perspectives. As valuation analysts, however, what sets our hearts atwitter is the very definition of "unicorn", which is predicated on valuation. Since companies are christened unicorns upon closing a financing round, one would assume valuation to be self-evident. Alas, that is generally far from the case. Because of the common features of VC investments, the "headline" valuation numbers are not reliable measures of the market value of the underlying enterprises. As a result, the frequent breathless comparisons of the value of startup X to publicly traded stalwart Y are often overblown and potentially misleading.Consider the following example. The capitalization of a hypothetical freshly-minted unicorn, BlueCo, is summarized in the following table:
With 200 million fully-diluted shares post issuance, the $5.00 per share Series E offering results in a headline valuation of $1.0 billion (on a pre-money basis, BlueCo’s headline valuation is $825 million). But is BlueCo really worth $1 billion? In other words, what does the Series E investment imply about the value of the stakes in BlueCo held by other investors?
The value of the whole is equal to the sum of the individual parts. So, for BlueCo to truly be worth $1 billion, all 200 million fully-diluted shares must be worth $5.00 each. But the various share classes are not created equal. At each subsequent funding stage, investors in startup companies negotiate terms to provide downside protection to their investment while preserving the upside potential if the subject company turns out to be a home run. Such provisions commonly include some or all of the following:
Liquidation preferences that put the latest investors at the front of the line for exit proceeds. This is especially advantageous in the event the Company fails to meet expectations (basically LIFO treatment: the last one in is the first one out).Cumulative dividend rights that cause the liquidation preference to increase over time. When such rights are present, the preferred investors not only stand at the front of the line, but are entitled to a return on their investment if there are sufficient proceeds.Anti-dilution or ratchet provisions that allow preferred investors to hit the reset button on many of their economic rights in the event the company is forced to raise money in the future at a lower price.Participation rights that allow the preferred investors to simultaneously benefit from the payoff to common shares while also recovering their initial investment via liquidation preference.A recent New York Times article highlighted additional, more exotic rights and privileges being attached to recent financings.
For the sake of illustration, we will assume that the terms of BlueCo’s Series E preferred shares are generally favorable to the other investors: pro rata liquidation preference to other preferred investors, non-cumulative dividends, and no participation rights. Despite these relatively benign terms, owning Class E shares is clearly preferable to owning more junior classes. Consider the waterfall of proceeds under various strategic sale exit scenarios:
Even under the relatively disappointing $400 million exit scenario, the Scenario E shareholders are entitled to return of their investment, or $5.00 per share, while the proceeds to more subordinate classes range from $1.14 per share to $3.00 per share. The following chart depicts the superiority of the proceeds for Series E preferred shares to Series A shares over enterprise exit values less than $1.0 billion:
The area between the payoff lines for Class E and Class A preferred shares represents the incremental value available to the more senior Class E shares. Borrowing from the fair value measurement lexicon, if the recent Series E issuance price of $5.00 per share is consonant with market participant expectations, then that same group of market participants would rationally assign a lower value to the Class A shares. Valuation analysts use two primary techniques for estimating the magnitude of the difference in share value across the various classes. Examining the relative merits of the two techniques (the probability-weighted expected return method, or PWERM, and the option pricing method, or OPM) is beyond the scope of this blog post. Both models are reasonably intuitive but require numerous assumptions for which irrefutable support can prove elusive.
We use the OPM to illustrate the impact of the rights and preferences of the most senior preferred shareholders on the economic value of a nominal unicorn. The two most subjective assumptions in the OPM are the time remaining until exit and the return volatility of the underlying business. The sensitivity table below depicts the implied total enterprise value of BlueCo (that would reconcile to the $5.00 per Series E preferred share transaction price) using the OPM under a range of assumptions for exit timing, given assumed volatility of 100%:
Over the range of exit timing assumptions noted above, the implied total enterprise value ranges from less than $600 million to just over $800 million, meaningful discounts to the $1 billion headline number. The reliability of the OPM and the assumed inputs can be debated; however the point remains that, since the subordinate classes are necessarily worth less than Series E, the total enterprise value is less than $1 billion.
So what?
Is the preceding analysis just so much valuation pedantry? Perhaps, but we suggest that these observations reflect one practical peril of high valuations for late stage investors and management teams. The implied enterprise value based on rights and preferences of senior investors is relevant precisely because buyers in the exit markets for start-up companies – strategic sales and IPOs – assess the value of the entire enterprise, not individual interests. The exit markets assign a value for the entire company, exhibiting a serene indifference to how that value is allocated to various investors. This can result in unflattering headlines and unpleasant outcomes for late stage investors.
Let’s return to the BlueCo example to illustrate. Assume that the appropriate assumptions for BlueCo from the sensitivity table above are three years to exit, implying an enterprise value of $748 million. In the year following the Series E investment, BlueCo management executes its strategy successfully, causing the enterprise value to increase 30% to $975 million. If BlueCo exits via a strategic sale at that point, none of the incremental enterprise value will accrue to the Series E investors; despite identifying an attractive company, and the strong execution of management, the Series E investors will receive their capital back with no return.
If the exit occurs instead by IPO, things get even more awkward. In contrast to a strategic sale, an IPO is a pro rata exit, meaning that the realized return for the Series E preferred investors will actually be negative, despite the 30% increase in enterprise value. Further, the Company and its management team will likely be subject to some unfavorable press for executing a "downround" IPO, although in reality, it generated a handsome return for the investor group as a whole.
So when is a unicorn really a unicorn? We hesitate to draw a bright line; circumstances and assumptions vary. Regardless of size, the lesson for investors and management teams at early-stage companies is to beware the headline valuation number. Appearances can be deceiving.
An Introduction to Dividends and Dividend Policy for Private Companies
Excerpted from Z. Christopher Mercer, FASA, CFA, ABAR,'s newest book, Unlocking Private Company Wealth. It is reprinted here with permission.
The issue of dividends and dividend policy is of great significance to owners of closely held and family businesses and deserves considered attention.
Fortunately, I had an early introduction to dividend policy beginning with a call from a client back in the 1980s.
I had been valuing a family business, Plumley Rubber Company, founded by Mr. Harold Plumley, for a number of years. One day in the latter 1980s, Mr. Plumley called me and asked me to help him establish a formal dividend policy for his company, which was owned by himself and his four sons, all of whom worked in the business.
Normally I do not divulge the names of clients, but my association with the Plumley family and Plumley Companies (its later name) was made public in 1996 when Michael Plumley, oldest son of the founder and then President of the company, spoke at the 1996 International Business Valuation Conference of the American Society of Appraisers held in Memphis, Tennessee. He told the story of Plumley Companies and was kind enough to share a portion of my involvement with them over nearly 20 years at that point.
Let’s put dividends into perspective, beginning with a discussion of (net) earnings and (net) cash flow. These are two very important concepts for any discussion about dividends and dividend policy for closely held and family businesses. To simplify, I’ll often drop the (net) when discussion earnings and cash flow, but you will see that this little word is important.(Net) Earnings of a BusinessThe earnings of a business can be expressed by the simple equation:Earnings = Total Revenue – Total CostCosts include all the operating costs of a business, including taxes. C Corporations. If your corporation is a C corporation, it will pay taxes on its earnings and earnings will be net of taxes. The line on the income statement is that of net income, or the income remaining after all expenses, including taxes, both state and federal, have been paid. By the way, if your company is a C corporation, feel free to give me a call to start a conversation about this decision.S Corporations and LLCs. If your corporation is an S corporation or an LLC (limited liability company), the company will make a distribution so that its owners can pay their pass-through taxes on the income. To get to the equivalent point of net income on a C corporation’s income statement, it is necessary to go to the line called net income (but it is not) and to subtract the total amount of distributions paid to owners for them to pay the state and federal income taxes they owe on the company’s (i.e., their pass through) earnings. This amount would come from the cash flow statement or the statement of changes in retained earnings.
Ignoring any differences in tax rates, the net income, after taxes (corporate or personal) should be about the same for C corporations and pass-through entities.(Net) Cash FlowCompanies have non-cash charges like depreciation and amortization related to fixed assets and intangible assets. They also have cash charges for things that don’t flow through the income statement. Capital expenditures for plant and equipment, buildings, computers and other fixed assets are netted against depreciation and amortization, and the result is either positive or negative in a given year. Capital expenditures tend to be "lumpy" while the related depreciation expenses are amortized over a period of years, often causing swings in the net of the two.There are other "expenses" and "income" of businesses that do not flow through the income statement. These investments, either positive or negative, relate to the working capital of a business. Working capital assets include inventories and accounts receivable, and working capital liabilities include accounts payable and other short-term obligations. Changes in working capital can lead to a range of outcomes for a business. Consider these two extremes that could occur regarding cash in a given year: Make lots of money but have no cash. Rapidly growing companies may find that while they have positive earnings, they have no cash left at the end of the month or year. They have to finance their rapid growth by leaving all or more than all of earnings in the business in the form of working capital to finance investments in accounts receivable and/or inventories and in the purchase of fixed assets to support that growth. Make little money, even have losses, and generate cash. Companies that experience sales declines may earn little, or even lose money on the income statement, and still generate lots of cash because they collect prior receivables or convert previously accumulated inventories into cash during the slowdown.
Working capital on the balance sheet is the difference between current assets and current liabilities. Many companies have short-term lines of credit with which they finance working capital investments. The concept of working capital, then, may include changes in short-term debt.
In addition, companies generate cash by borrowing funds on a longer-term basis, for example, to finance lumpy capital expenditures. In the course of a year, a company may be a net borrower of long-term debt or be in a position of paying down its long-term debt. So we’ll need to consider the net change in long-term debt if we want to understand what happens to cash in a business during a given year.
We are developing a concept of (net) cash flow, which can be defined as follows in Figure 11.Most financial analysts and bankers will agree that this is a pretty good definition of Net Cash Flow.Net Cash Flow is the Source of Good ThingsWe focus on cash flow because it is the source of all good things that come from a business. The current year’s cash flow for a business is, for example, the source of:Long-term debt repayment. Paying debt is good. Bankers are extremely focused on cash flow, because they only want to lend long-term funds to businesses that have the expectation of sufficient cash flow to repay the debt, including principal and interest on the scheduled basis. Interest expense has already been paid when we look at net cash flow. Companies borrow on a long-term basis to finance a number of things like land, buildings and equipment, software and hardware, and many other productive assets that may be difficult to finance currently. They may also borrow on a long term basis to finance stock repurchases or special dividends.Reinvestment for future growth. Investment in a business is good if adequate returns are available. If a company generates positive cash flow in a given year, it is available to reinvest in the business to finance its future growth. Reinvested earnings are a critical source of investment capital for closely held and private companies Reinvesting with the expectation of future growth (in dividends and capital gains) is an important source of shareholder returns, but the return is deferred, at least in the form of cash, until a future date.Dividends or distributions. Corporate dividends are also good, particularly if you are a recipient. Cash flow is also the normal source for dividends (for C corporation owners) or what we call “economic distributions,” or distributions net of shareholder pass-through taxes (for S corporation and LLC owners).What is a Dividend?At its simplest, a dividend (or economic distribution) reflects the portion of earnings not reinvested in a business in a given year, but paid out to owners in the form of current returns.For some or many closely held and family businesses, effective dividends can include another component, and that is the amount of any discretionary expenses that likely would be “normalized” if they were to be sold. Discretionary expenses include: Above-market compensation for owner-managers. Owners of some private businesses who compensate themselves and/or family members at above-market rates should realize that the above-market portion of such compensation is an effective dividend.Mystery employees on the payroll. Some companies place non-working spouses, children or other relatives on the payroll when no work is required of them.Expenses associated with non-operating assets used for owners’ personal benefit. Non-operating assets can include company-owned vacation homes, aircraft not necessary for the operation of the business, vehicles operated by non-working family members, and others.
It is essential to analyze above-market compensation and other discretionary expenses from owners’ viewpoints to ascertain the real rate of return that is obtained from investments in private businesses. In an earlier chapter, we touched on the concept of the rate of return on investment for a closely held business. Assuming that there were no realized capital gains from a business during a given year, the annual return (AR) is measured as follows:Now, we add to this any discretionary expenses that are above market or not normal operating expenses of the business that are taken out by owners:We now know what dividends are, and they include discretionary benefits that will likely be ceased and normalized into earnings in the event of a sale.We won’t focus on discretionary benefits in the continuing discussion of dividends and dividend policy. However, it is important for business owners to understand that, to the extent discretionary benefits exist, they reflect portions of their returns on investments in their businesses.In summary, dividends are current returns to the owners of a business. Dividends are normally residual payments to owners after all other necessary debt obligations have been paid and all desirable reinvestments in the business have been made.Dividends and Dividend Policy for Private CompaniesWith the above introduction to dividends for private companies, we can now talk about dividend policy. The remainder of this chapter focuses on seven critical things for consideration as you think about your company’s dividend policy.Every company has a dividend policy.Dividend policy influences return on business investment.Dividend policy is a starting point for portfolio diversification.Special dividends enhance personal liquidity and diversification.Dividend policy does matter for private companies.Dividend policy focuses management attention on financial performance.Boards of directors need to establish thoughtful dividend policies.
We now focus on each of these seven factors you need to know about your company’s dividend policy.Every Company Has a Dividend PolicyLet’s begin with the obvious observation that your company has a dividend policy. It may not be a formal policy, but you have one. Every year, every company earns money (or not) and generates cash flow (or not). Assume for the moment that a company generates positive earnings as we defined the term above. If you think about it, there are only three things that can be done with the earnings of a business:Reinvest the earnings in the business, either in the form of working capital, plant and equipment, software and computers, and the like, or even excess or surplus assets.Pay down debt.Pay dividends to owners (or economic distributions – after pass-through taxes – for S corporations and LLCs) or repurchase stock (another form of returns to shareholders).
That’s it. Those are all the choices. Every business will do one or more of these things with its earnings each year. If a business generates excess cash and reinvests in CDs, or accumulates other non-operating assets, it is reinvesting in the business, although likely not at an optimal rate of return on the reinvestment. Even if your business does not pay a dividend to you and your fellow owners, you have a dividend policy and your dividend payout ratio is 0% of earnings.
On the other hand, if your business generates substantial cash flow and does not require significant reinvestment to grow, it may be possible to have a dividend policy of paying out 90% or even up to 100% of earnings in most years. This is often the case in non capital intensive service businesses.
Recall that if a business pays discretionary benefits to its owners that are above market rates of compensation, or if it pays significant expenses that are personal to the owners, it is the economic equivalent of paying a dividend to owners. So when talking to business owners where such expenses are significant, we remind them that they are, indeed, paying dividends and should be aware of that fact.
Some may think that discretionary expenses are the provenance of only small businesses; however, they exist in many businesses of substantial size, even into the hundreds of millions in value.
Discretionary expenses are not necessarily bad, but they can create issues. In companies with more than one shareholder, discretionary expenses create the potential for (un)fairness issues. However, discretionary expenses are paid for the benefit of one shareholder or group of shareholders and not for others, they are still a return to some shareholders.
Every company, including yours, has a dividend policy. Is it the right policy for your company and its owners?Dividend Policy Influences Return on Business InvestmentTo see the relationship between dividend policy and return on investment we can examine a couple of equations. This brief discussion is based on a lengthier discussion in my book, Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2007). There is a basic valuation equation, referred to as the Gordon Model. This model states that the price (P0) of a security is its expected dividend (D1) capitalized at its discount rate (R) minus its expected long term growth rate in the dividend (Gd). This model is expressed as follows:D1 is equal to Earnings times the portion of earnings paid out, or the dividend payout ratio (DPO), so we can rewrite the basic equation as follows:What this equation says is that the more that a company pays out in dividends, the less rapidly it will be able to grow, because Gd, or the growth rate in the dividend, is actually the expected growth rate of earnings based on the relevant dividend policy.We can look at this simplistically in word equations as follows:Dividend Income + Capital Gains = Total ReturnDividend Yield + Growth (Appreciation) = Cost of Equity (or the discount rate, R)These equations reflect basic corporate finance principles that pertain, not only to public companies, but to private businesses as well. There is an important assumption in all of the above equations – cash flow not paid out in dividends is reinvested in the business at its discount rate, R.There are many examples of successful private companies that do not pay dividends, even in the face of unfavorable reinvestment opportunities. To the extent that dividends are not paid and earnings are reinvested in low-yielding assets, the accumulation of excess assets will tend to dampen the return on equity and investment returns for all shareholders.Further, the accumulation of excess assets dampens the relative valuation of companies, because return on equity (ROE) is an important driver of value. For example, consider the following relationship without proof:ROE x Price/Earnings Multiple = Price/Book ValueAt a given multiple of (net) earnings available in the marketplace, a company’s ROE will determine its price/book value multiple. The price/book value multiple tells how valuable a company is in relationship to its book value, or the depreciated cost value of its shareholders’ investments in the business.Let’s consider a simple example. Assume that a company generates an ROE of 10% and that the relevant market price/earnings multiple (P/E) is 10x. Using the formula above:In this example, the company would be valued at its book value and the shareholders would not benefit from any “goodwill,” or value in excess of book value. Consider, however, that a similar company earns an ROE of 15%.Assuming the same P/E of 10x, it would be valued at 150% of its book value.Suppose the second company, because of its superior returns, received a P/E of 11x. In that case the price/book multiple would be 165%.
To the extent that a company’s dividend policy influences its ongoing ROE, it influences its relative value in the marketplace and the ongoing returns its shareholders receive.
In short, your dividend policy influences your return on investment in your business, as well as your current returns from that investment.Dividend Policy is a Starting Point for Portfolio DiversificationRecall the story of my being asked to help develop a dividend policy for a private company. The company had grown rapidly for a number of years and its growth and diversification opportunities in the auto parts supply business were not as attractive as they had been. The CEO, who was the majority shareholder, realized this and also that his sons (his fellow shareholders) could benefit from a current return on their investments in the company, which, collectively, were significant.We reviewed the dividend policies of all of the public companies that we believed to be reasonably comparable to the company. I don’t recall the exact numbers now, but I believe that the average dividend yield for the public companies was in the range of 3%. As I analyzed the private company, it was clear that it was still growing somewhat faster than the publics, so the ultimate recommendation for a dividend was about 1.5% of value.The value that the 1.5% dividend yield was compared to was the independent appraisal that we prepared each year. Based on the value at the time, I recall that the annual dividend began at something on the order of $300,000 per year. But, for the father and the sons, it was a beginning point for diversification of their portfolios away from total concentration in their successful private business.Your dividend policy can be the starting point for wealth diversification, or it can enhance the diversification process if it is already underway.Special Dividends Enhance Personal Liquidity and DiversificationA number of years ago, I was an adviser to a publicly traded bank holding company. Because of past anemic dividends, this bank had accumulated several million dollars of excess capital. The stock was very thinly traded and the market price was quite low, reflecting a very low ROE (remember the discussion above).Because of the very thin market for shares, a stock repurchase program was not considered workable. After some analysis, I recommended that the board of directors approve a large, one-time special dividend. At the same time I suggested they approve a small increase in the ongoing quarterly dividend. Both of these recommendations provided shareholders with liquidity and the opportunity to diversify their holdings.Since the board of directors collectively held a large portion of the stock, the discussion of liquidity and diversification opportunities while maintaining their relative ownership position in the bank was attractive.At the final board meeting before the transaction, one of the directors did a little bit of math. He noted that if they paid out a large special dividend, the bank would lose earnings on those millions and earnings would decline. I agreed with his math, but pointed out (calculations already in the board package) that the assets being liquidated were very low in yield and that earnings (and earnings per share) would not decline much. With equity being reduced by a larger percentage, the bank’s ROE should increase. So that increase in ROE, given a steady P/E multiple in the marketplace, should increase the bank’s Price/Book Value multiple.The director put me on the spot. He asked point blank: "What will happen to the stock price?" I told him that I didn’t know for sure (does one ever?) but that it should increase somewhat and, if the markets believed that they would operate similarly in the future, it could increase a good bit. The stock price increased more than 20% following the special dividend.Special dividends, to the extent that your company has excess assets, can enhance personal liquidity and diversification. They can also help increase ongoing shareholder returns. I have always been against retaining significant excess assets on company balance sheets because of their negative effect on shareholder returns and their adverse psychological impact. It is too easy for management to get "comfortable" with a bloated balance sheet. If your business has excess assets, consider paying a special dividend. Your shareholders will appreciate it.Dividend Policy Does Matter for Private CompaniesSomeone once said that earnings are a matter of opinion, but dividends are a matter of fact. What we know is that when dividends are paid, the owners of companies enjoy their benefit, pay their taxes, and make individual choices regarding their reinvestment or consumption.The total return from an investment in a business equals its dividend yield plus appreciation (assuming no capital gains), relative to beginning value. However, unlike unrealized appreciation, returns from dividends are current and bankable. They reduce the uncertainty of achieving returns. Further, if a company’s growth has slowed because of relatively few good reinvestment opportunities, a healthy dividend policy can help assure continuing favorable returns overall.Based on many years of working with closely held businesses, we have observed that companies that do not pay dividends and, instead, accumulate excess assets, tend to have lower returns over time. There is, however, a more insidious issue. The management of companies that maintain lots of excess assets may tend to get lazy-minded. Worse, however, is the opposite tendency. With lots of cash on hand, it is too easy to feel pressure to make a large and perhaps unwise investment, e.g., an acquisition, that will not only consume the excess cash but detract from returns in the remainder of the business.Dividend policy is the throttle by which well-run companies gauge their speed of reinvestment. If investment opportunities abound, then a no- or low-dividend payout may be appropriate. However, if reinvestment opportunities are slim, then a heavy dividend payout may be entirely appropriate.Any way you cut it, dividend policy does matter for private companies.Dividend Policy Focuses Management Attention on Financial PerformanceBoards of directors are generally cautious with dividends and once regular dividends are being paid, are reluctant to cut them. The need, based on declared policy, to pay out, say, 35% of earnings in the form of shareholder dividends (example only) will focus management’s attention on generating sufficient earnings and cash flow each year to pay the dividend and to make necessary reinvestments in the business to keep it growing. No management (even if it is you) wants to have to tell a board of directors (even if you are on it) or shareholder group that the dividend may need to be reduced or eliminated because of poor financial performance.Boards of Directors Need to Establish Thoughtful Dividend PoliciesIf dividend policy is the throttle with which to manage cash flow not needed for reinvestment in a business, it makes sense to handle that throttle carefully and thoughtfully. Returns to shareholders can come in the form of dividends or in the form of share repurchases.While a share repurchase is not a cash dividend, it does provide cash to selling shareholders and offsetting benefits to remaining shareholders. Chapter 10 of the book (Leveraged Share Repurchase: An Illustrative Example) provides an example of a substantial leveraged share repurchase from a controlling shareholder to provide liquidity and diversification.From a theoretical and practical standpoint, the primary reason to withhold available dividends today is to reinvest to be able to provide larger future dividends – and larger in present value terms today. It is not a good dividend policy to withhold dividends for reasons like the following:A patriarch withholds dividends to prevent the second (or third or more) generations from being able to have access to funds.A control group chooses to defer dividends to avoid making distributions to certain minority shareholders.Dividends are not paid because management (and the board) want to build a large nest egg against possible future
adversities.Dividends are not paid to accumulate excess or non-operating assets on the balance sheet for personal or vanity
reasons.Dividend policy is important and your board of directors needs to establish a thoughtful dividend policy for your business.ConclusionDividends and dividend policies are important for the owners of closely held and family businesses. Dividends can provide a source of liquidity and diversification for owners of private companies. Dividend policy can also have an impact on the way that management focuses on financial performance.To discuss corporate valuation or transaction advisory issues in confidence, please contact us.
Rules for the Modern Investment Manager
This guest post first appeared on Mercer Capital's Financial Reporting Blog on July 17, 2015.
On May 20, 2015, the Securities and Exchange Commission proposed new rules and amendments to modernize and enhance information reported by investment companies and investment advisers. The proposed rules would be applicable to most investment companies registered under the Investment Company Act of 1940 and all investment advisers registered under the Investment Advisers Act of 1940.
The SEC is the primary regulator of the asset management industry, and over the years, assets under management have grown, new product structures have been developed, and technology has evolved. The SEC staff estimated that there were approximately 16,619 funds registered with the SEC as of December 2014 as well as 11,500 investment advisers and 2,845 exempt reporting advisers as of January 2015. Assets of registered investment companies exceeded $18 trillion at year-end 2014, having grown from $4.7 trillion at year-end 1997.
Per SEC 33-9776, the proposed rules aim to:Increase the transparency of fund portfolios and investment practices both to the Commission and to investors,Take advantage of technological advances both in terms of the manner in which information is reported to the Commission and how it is provided to investors and other potential users, andWhere appropriate, reduce duplicative and otherwise unnecessary reporting burdens in the industry.
The proposed rules include two new forms (N-PORT and N-CEN), new rule 30e-3, and amendments to Regulation S-X that would rescind current Forms N-Q and N-SAR.
Management investment companies currently are required to report their complete portfolio holdings to the SEC on a quarterly basis (on Form N-Q for 1Q and 3Q and Form N-CSR for 2Q and 4Q). The proposed Form N-PORT would replace Form N-Q, would require registered funds other than money market funds to provide portfolio-wide and position-level holdings data to be filed monthly with the SEC, and would be available to the public every third month, sixty days after the end of the month. Form N-PORT requires a structured format that will make it easier to analyze and requires additional data not currently provided on Forms N-Q or N-CSR such as information relating to derivative investments and certain risk metric calculations that measure a fund's exposure and sensitivity to market conditions.
Rule 30e-3 provides funds the option to meet shareholder report transmission requirements by posting reports online, if certain conditions are met.
The proposed amendments to the existing Regulation S-X require standardized enhanced derivatives disclosures in fund financial statements. Currently, Regulation S-X does not include standardized requirements as to the terms of derivatives that must be reported for most types of derivatives including swaps, futures, and forwards. The proposed amendments should allow for greater comparability between funds and help all investors better assess a fund's use of derivatives.
Form N-CEN would replace the existing Form N-SAR, which was adopted thirty years ago, and continue to report census-type information similar to Form N-SAR. The new form will replace some of the outdated elements of Form N-SAR with ones that are more relevant today. In addition, Form N-CEN will be filed in XML format, which will reduce filing burdens and make it more user friendly for the SEC and other users. Finally, Form N-CEN would be filed annually, rather than semi-annually as is currently required by Form N-SAR
The investment adviser proposals include amendments to the investment adviser registration and reporting form (Form ADV) and amendments to Investment Advisers Act Rule 204-2. The proposed amendments to Form ADV would require aggregate information about separately managed accounts, incorporate certain "umbrella registration" filing arrangements that are currently outlined in staff guidance, and provide additional business information about the adviser's offices, the number of employees, and the use of social media.
The amendments to the Investment Advisers Act Rule 204-2 would require advisers to maintain records of the calculation of performance information distributed to any person, which is more stringent than the existing rule that applies to information distributed to ten or more persons. Furthermore, the amendments would require advisers to maintain communications related to performance or rate of return of accounts as well as securities recommendations.
Mercer Capital provides investment managers, RIAs, trust companies, private equity firms, and other financial sponsors with corporate valuation, financial reporting valuation, transaction advisory, portfolio valuation, and related services. Contact a Mercer Capital professional to discuss your needs in confidence.Related LinksPortfolio Valuation: Private Equity Marks & Trends | Second Quarter 2015Portfolio Marks: 2Q15 OutlookAsset Management Industry NewsletterMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.
New York’s Largest Corporate Dissolution Case: AriZona Iced Tea
After several years of litigation involving a number of hearings and trials on various issues, a trial to conclude the collective fair value of a group of related companies known as the AriZona Entities (also referred to as "AriZona" or "the Company"), occurred. The trial was held in the Supreme Court, State of New York, Nassau County, New York, the Hon. Timothy Driscoll, presiding. The trial lasted from May 22, 2014 until July 2, 2014.1The Court's decision in what I will refer to as "the AriZona matter" (or "the matter") was filed on October 14, 2014. I have not previously written about the AriZona matter because I was a business valuation expert witness on behalf of one side.2 I was asked not to publish anything while the matter was still pending. The parties recently closed a private settlement of the matter, so there will be no appeal.There are numerous quotes from the Court's decision in Ferolitov.Vultaggio throughout this article. However, in an informal article of this type, I will not cite specific pages for simplicity and ease of reading.Background about the CaseThe overall litigation had numerous complexities; however, the valuation and related issues were ultimately fairly straightforward. The Court had to determine the fair value, under New York law, of a combined 50% interest in the AriZona Entities as of two valuation dates. The first date, October 5, 2010, pertained to a portion of the 50% block, and the remainder of the block was to be valued as of January 31, 2010.The Court's decision focused on the first valuation date, or October 5, 2010, and we will do the same in this analysis of the case.The case citation in the footnote below provides the names for all plaintiffs and defendants in the matter. For purposes of this discussion, we simplify the naming of the "sides" in the litigation, following the Court's convention.The group of plaintiffs, led by John Ferolito, is referred to as "Ferolito" herein. I worked on behalf of Ferolito. Similarly, the group of defendants, led by Dominick Vultaggio, is referred to as "Vultaggio."
Expert witnesses for Ferolito included Z. Christopher Mercer (Mercer Capital), Basil Imburgia (FTI Consulting), Dr. David Tabak (NERA Economic Consulting), Christopher Stradling (Lincoln International), and Michael Bellas (Beverage Marketing Corporation). Mercer was the primary business valuation expert. Imburgia testified on developing adjusted earnings for AriZona. Stradling, an investment banker, also testified regarding the value of AriZona. Finally, Bellas testified regarding the revenue forecast he developed for AriZona and that was employed by Mercer in the discounted cash flow method.
Expert witnesses for Vultaggio included Professor Richard S. Ruback (Harvard Business School and Charles River Associates), who was the primary valuation expert, and Dr. Shannon P. Pratt (Shannon Pratt Valuations). Pratt testified on the topic of the discount for lack of marketability but did not offer an independent valuation opinion. Other experts worked on behalf of Vultaggio, but their opinions received little treatment in the Court's decision.Background about the AriZona EntitiesThe AriZona Entities market beverages (principally ready-to-drink iced teas, lemonade-tea blends, and assorted fruit juices) under the AriZona Iced Tea and other brand names. At the valuation dates, the Company sold product through multiple channels, including convenience stores, grocery stores, and other retailers, primarily in the United States. International sales comprised about 9% of total sales.The Company was founded in 1992 by Vultaggio and Ferolito, who each owned 50% of the stock at that time. It grew rapidly to the range of $200 million in sales and significant profitability and remained at that level until 2002, at which time sales began to rise rapidly and consistently, reaching about $1 billion in 2010.Normalized EBITDA (earnings before interest, taxes, depreciation and amortization), as determined by Basil Imburgia on behalf of Ferolito, was $181 million for the trailing twelve months ending September 2010, which the Court accepted. While the text of the decision states that Imburgio's EBITDA for that time period was $173 million and a table shows it as $169 million, Imburgio's concluded EBITDA was, indeed, $181 million, which the Court accepted and Mercer accepted, as well.Ruback's estimate of EBITDA for calendar 2010 was $168 million. There was no disagreement over the recent strong earnings of AriZona.AriZona was, at the valuation dates, an attractive, profitable and growing company that was gaining market share in the ready-to-drink (RTD) tea industry. It was the only private company in the $1 billion sales range in the non-alcoholic beverage industry in the United States. In the years and months leading to the valuation date, several very large companies, including Coca-Cola, Tata Tea, and Nestle Waters, held discussions with either Vultaggio and the Company, Ferolito, or both, regarding the potential acquisition of either the Company or the 50% Ferolito interest.The Level of Value for Fair ValueCounsel for Ferolito interpreted fair value in New York as being at the strategic control level based on the following case law guidance:"[I]n fixing fair value, courts should determine the minority shareholder's proportionate interest in the going concern value of the corporation as a whole, that is, 'what a willing purchaser, in an arm's length transaction, would offer for the corporation as an operating business.'" 3Mercer provided a conclusion of fair value at the strategic control level of $3.2 billion, which included the consideration of the sharing of certain expected operating synergies with hypothetical buyers. Stradling offered a conclusion of strategic control value in the range of $3.0 billion to $3.6 billion.The Court did not consider that strategic value was appropriate for its determination of fair value. After citing several cases, including Friedman v. Beway Realty Corp. ("Beway"), the Court concluded:4These principles make clear that the Court may not consider AriZona's "strategic" or "synergistic" value to a hypothetical third-party purchaser, as Ferolito urges. A valuation that incorporates such a "strategic" or "synergistic" element would not rely on actual facts that relate to AriZona as an operating business, but rather would force the Court to speculate about the future.Interestingly, the Court did not quote the language from Beway noted just above. What would a willing purchaser like Tata Tea, Coca-Cola, or Nestle Waters pay for AriZona? Whatever price these "willing purchaser[s], in an arm's length transaction" would offer would certainly include consideration of potential synergies. I do not say this to argue with the Court's conclusion, but to point out that the conclusion is not reconciled with the plain language of Beway.The Court concluded that it would value the Company using the "financial control" measurement (as described by Mercer in the Mercer Report and in testimony at trial). However, that decision did force the Court to "speculate about the future" because the Court's conclusion, which was based on Mercer's discounted cash flow (DCF) method, employed a ten year forecast of revenues and expenses.In anticipation of the Court's decision regarding strategic control value, Mercer also provided conclusions of fair value at the financial control level. These values were $2.4 billion as of October 5, 2010 and $2.3 billion as of January 31, 2011.The Ruback Report offered a standard of value that can be described as "business as usual." 5It is my understanding that, under New York law, the fair value of shares of Arizona Iced Tea values the company as a going concern operated by its current management with its usual business practices and policies.No case law guidance was offered by Ruback for this "business as usual" standard, which included management's inability or unwillingness ever to raise product prices.The Ruback Report's conclusion of fair value for 100% of AriZona's equity was $426 million. The concluded enterprise value is well below 3x EBITDA.In its decision, the Court concluded that consideration of expected synergies was speculative and did not consider Mercer's conclusions at the strategic control level of value. The Court focused instead on Mercer's financial control valuations. The Court rejected the "business as usual" standard offered in the Ruback Report.The Court Focuses on Discounted Cash FlowThe Ruback Report took the position that the discounted cash flow method was the appropriate method for the determination of the fair value of AriZona.Mercer applied a weighting of 80% to the DCF method. But Mercer and Stradling considered the use of guideline public companies and guideline transactions, as well. Mercer accorded the guideline public company indications with the remaining weight of 20%. Because of the substantial weight placed on the DCF method by Mercer, the difference in position was relatively minor.The issue for the Court was one of comparability. Obviously, I thought the use of guideline public companies was relevant, and that the selected group of public companies was sufficiently comparable to provide solid valuation evidence at the financial control level. Nevertheless, the Court disagreed and focused solely on the discounted cash flow valuation.The Court's Determination of Fair ValueHaving determined that the focus would be on the discounted cash flow method, the Court looked at the key components of the DCF methods employed by Mercer and Ruback. As noted, the Court's starting point was the discounted cash flow analysis from the October 5, 2010 DCF method from the Mercer Report.After concluding that Mercer's DCF method was the starting point for analysis, the Court developed a very logical examination of the key components of the DCF analysis, providing sections reaching conclusions on the following assumptions:RevenueCostsTerminal ValueTax Amortization BenefitTax Rate"Key Man" DiscountDiscount RateOutstanding Cash, Non-Operating Assets, and DebtDiscount for Lack of Marketability
In the following sections, we address each of these assumptions, although I have reordered them to facilitate the discussion.
The starting point is the DCF conclusion already includes one assumption made by the Court. In disregarding Mercer's guideline public company method and its somewhat lower indicated value, the starting point for the Court's analysis was increased by $79.2 million, or from $2.36 billion to $2.44 billion.1. Anticipated RevenueThe Bellas Report provided a ten year forecast of expected future revenues for AriZona. He forecasted domestic revenues and provided a separate forecast for expected future international sales assuming a conscious effort on the part of the Company to focus on international sales, which comprised some 9% of revenues at the valuation date. The Court wrote:6Based on the depth and breadth of Bellas' experience, the significant research regarding the trends in the RTD industry and AriZona in particular, and his demeanor throughout this testimony, the Court credits Bellas' testimony in its entirety regarding AriZona's future revenues.The Court provided a review of the Bellas Report's analysis and my adoption of the analysis, concluding as follows:7Upon relying on Bellas' projections for AriZona's domestic and international prospects, Mercer projected AriZona's revenue to grow a compounded annual growth ("CAGR") rate of 10.2%, which is consistent (and may well be conservative when compared to) AriZona's CAGR from 2006-10 of 13.9%. The Court thus adopts Mercer's revenue projections. In so doing, the Court notes Mercer's impressive expertise in the field of business valuation, including (a) completing some 400 business valuation per year [that's 400 for Mercer Capital, not Mercer], including a significant number of valuations exceeding $1 billion, (b) extensive business appraisal credentials, and (c) publication of over 80 articles regarding different valuation issues. By contrast, Ruback's experience in business valuation is almost entirely academic in nature.In the final analysis, the Court adopted the revenue projection of the Bellas Report which, in turn, was reviewed, analyzed and accepted for the Mercer Report.8 Revenues were forecasted to increase about 7.7%, rising from the last twelve months in September 2010 of $958 million to $2.0 billion in 2020.Although the Bellas revenue forecast adopted by Mercer was deemed aggressive by the Vultaggio side, AriZona's revenues were forecasted to reach $2.2 billion by 2020 in the Ruback Report.2. Operating CostsThe Court observed that in the past, AriZona had been able to manage costs. The Court was presented information regarding historical cost of goods sold, operating expenses, and resulting EBITDA, both in dollar terms and in terms of the resulting historical EBITDA margins.The Court noted that Mercer used past costs as a basis to forecast future costs. The Ruback Report assumed that future costs would rise faster than revenue, with resulting pressure on profit margins.To make the point about the unreasonableness of the Ruback Report's cost assumptions, the Court quoted a portion of my trial testimony:9[Ruback] utilizes a business plan that I don't believe has any bearing in history or any bearing in any evidence I have seen. He conducts – he assumes a business plan that basically assumes that Mr. Vultaggio and the management at AriZona are incompetent and [in]capable of adapting to evolving business conditions.The Ruback Report made two critical assumptions that resulted in an unrealistic and unreasonable forecast of costs and the resulting impact on forecasted EBITDA and EBITDA margins. First, costs were projected to increase with expected inflation. Second, all prices were held constant over the entire projection period. The result was a precipitous drop in the forecasted EBITDA margin. A picture is helpful.The chart below provides historical EBITDA margins and the forecasted margins employed in the Mercer Report (green) and the Ruback Report (red).
In the final analysis, the Court credited Mercer's testimony regarding AriZona's anticipated costs. In so doing, having already adopted its revenue forecast, the Court adopted the Mercer Report’s forecasted income for the ten year forecast period employed in that report.
3. Tax Rate AssumptionThe Court did not, however, entirely adopt the forecasted net income and net cash flow of the Mercer Report. For some reason, the Court selected tax rates from the Ruback Report, which were the sum of the marginal personal rate and the marginal state rates, presumably because of AriZona's S corporation status.The Ruback Report assumed a personal marginal tax rate of 35%, an average state income tax rate of 4.5%, and a corporate tax rate of 4% for AriZona itself. These were added together, not accounting for the deductibility of state taxes for federal income tax purposes, and a tax rate of 43.5% was posited for the forecast.The Court correctly noted that there was no explanation of the use of the blended federal/tax rate in the Mercer Report. I can only say that the usual table that illustrates the calculation of the blended federal and state tax rate was missing from the relevant valuation exhibits. Nevertheless, the investment bankers who provided testimony also provided blended federal/state rates similar to the 38% used in the Mercer Report. I did not have an opportunity to address this issue, either on direct or cross-examination during trial testimony.It is fairly standard to begin the valuation of an S corporation on as "as if" C corporation basis. Then, if there are benefits that are additive to value for the S corporation, they can be considered separately. I valued AriZona on an "as if" C corporation basis and then separately considered the tax amortization benefit as being accretive to value for the Company.Pratt, who testified for Vultaggio, agrees with this, as was pointed out in Part I of the Gilbert Matthews article series cited in endnote 2.It is important to recognize that both C corps and S corps pay taxes on corporate income. Whether that tax is actually paid by the corporation or the individual is absolutely irrelevant. What is relevant is the difference between the value of a company valued as a C corporation…and [as] an S corporation. It is for this reason that most S corporation models begin by valuing the company "as if" a C corporation… and then go on to recognize the benefits of the Sub-chapter S election.10All parties, including Stradling and the other investment bankers who provided opinions or whose work was introduced into evidence (except Professor Ruback) valued AriZona, which was an S corporation, as if it were a C corporation, because the likely buyers of the Company were publicly traded C corporations.There has been an ongoing debate in the valuation profession regarding whether there should be a valuation premium accorded to an S corporation like AriZona relative to a similar C corporation. I have written and testified that an S corporation is worth no more than an otherwise identical C corporation. However, it is hard to find otherwise identical corporations for comparison.What I have written is that there is no inherent increase (or decrease) in the value of enterprise cash flows whether their corporate wrapper is an S corporation or a C corporation. There are lots of things that can change the proceeds of a sale to a seller between the two types of corporations, including:An S corporation that retains earnings enables its owners to build basis in their shares, thus sheltering future capital gains taxes. The basis of ownership in C corporations remains at cost until the shares are sold.An S corporation's assets can be sold, enabling the buyers to write up assets for future depreciation or amortization. This write-up and subsequent amortization provides a tax amortization benefit that can enable buyers to pay more for an S corporation. See the next section. In the alternative, the parties can elect a Section 338(h)(10) Election, which provides substantially the same effect as a purchase of assets.A C corporation may have embedded capital gains on assets that would be realized upon a sale of assets.
By raising the tax rate above the expected tax rates of likely buyers, the Court effectively lowered the DCF value in the Mercer Report by $196 million, or about 8%. This is simply an incorrect treatment, in my opinion from economic or financial viewpoints.
It is my understanding that the Court later requested additional information on the issue of appropriate tax rates for the valuation of an S corporation like AriZona. No one knows if a change might have been made because the matter has settled.4. Tax Amortization BenefitThe Court did not agree with the consideration of a tax amortization benefit in the Mercer Report. The tax amortization benefit was calculated on the assumption that, in a hypothetical sale of AriZona as an S corporation (assumed to be structured as an asset sale), the write-up of intangible assets over the minimal tangible assets on the balance sheet would give rise to a tax amortization benefit to the buyer. The present value of this benefit was calculated over the 15 year amortization period allowed under then current tax law.On cross-examination, I noted that I had not used such a benefit before in valuing an S corporation. However, I did note that this benefit had been a point of negotiation between the AriZona parties and Nestle Waters, and was included in valuation calculations leading to a $2.9 billion offer (that was not finalized) in the months leading up to the valuation date.I also noted that while this synergy had been provided to the seller in the financial control valuation, all other potential synergies, including those from operating expenses or enhanced revenues or lower cost of capital, were specifically allocated to hypothetical buyers.The Court did not allow this benefit, noting that I have written that S corporations should not be worth more than C corporations. What I have long said is that S corporations should not be worth more than otherwise identical C corporations. The Court's decisions regarding the tax rate above assured that AriZona was valued at less than an otherwise identical C corporation. The decision regarding the tax amortization benefit denied the value impact of a benefit that was clearly already on the table in negotiations ongoing only a few months before the valuation date.The effect of not including the tax amortization benefit lowered the Court's conclusion of fair value by about 14% (about $336 million) relative to the $2.364 billion conclusion of financial control value in the Mercer Report.5. The Terminal Value EstimationThe final cash flow in the DCF method is the estimation of the terminal value, which represents the present value of then-remaining future cash flows at the end of the finite projection period.The Court rejected the terminal value estimation in the Ruback Report, which called for a liquidation of the business at the end of the ten year forecast period. The Court believed that AriZona was a company poised for long-term growth.The long-term growth rate assumption used in the terminal value estimation in the Mercer Report was 4.5%, which was the sum of long-term real growth and inflation, as discussed in the Mercer Report. The weighted average cost of capital was 10.8%, so the terminal multiple of net cash flow was [1 / (10.8% - 4.5%)], or an implied multiple of terminal year EBITDA of just under 9x.The Court accepted the terminal value estimation from the Mercer Report, noting that it might be too conservative.6. The Discount Rate (Weighted Average Cost of Capital)There was little development of the discount rate in the Ruback Report, which concluded with a weighted average cost of capital ("WACC") of 11.0%.The WACC was developed in the Mercer Report using a "build-up method" to reach an equity discount rate. The equity discount rate included consideration for company-specific risk associated with the centrality of Mr. Vultaggio to the Company's operations as well as risks associated with the sustainability of new product innovation.The cost of debt was estimated and a capital structure was assumed based on the (non-comparable per the Court) guideline public companies in the Mercer Report.The resulting WACC was 10.8% for the October 5, 2010 valuation date, which was accepted by the Court.7. "Key Man" DiscountAs noted above, the Mercer Report included consideration of Mr. Vultaggio's importance to the Company in the development of the discount rate. Pratt testified on behalf of Vultaggio regarding a key man discount, but none was employed in the Ruback Report.Given the testimony at trial about the importance of Vultaggio to the operations of AriZona, the Court believed that it was important for this to be considered in the valuation process. Pratt also testified that consideration for a key person discount could be included as an adjustment to the discount rate in a discounted cash flow method.The Court considered that the Mercer Report had made appropriate consideration of key man issues in the discount rate development, which was accepted as noted above.8. Outstanding Cash, Non-Operating Assets and DebtThe Court accepted the analysis of non-operating assets and the consideration of debt as presented in the Mercer Report. There was significant cash on hand at both valuation dates as well as other non-operating assets that were readily collectible. There was also some debt owed primarily to Vultaggio.The Ruback Report subtracted debt at the valuation date, but did not include cash or other non-operating assets in its conclusion. Rather, those assets were held for the ten years of the forecast period and then discounted for ten years to the present in the Ruback Report, which argued that the cash was needed for operations. Given the 11.0% WACC in the report, this effectively discounted the non-operating assets by 65%, or about $100 million.A specious argument was made in the Ruback Report that the cash was needed to pay for the valuation judgment. The Court saw clearly that the cash was a part of value at the valuation date and that payment of the valuation judgment was a separate issue.The Court observed that the net non-operating assets were $137.6 million at October 5, 2011 and $161.4 million at January 31, 2011. Both totals were derived from the Mercer Report.The Court's Financial Control ValueThe Court did not provide a separate section to develop its financial control value, so we will do so now for clarity. Figure 1 summarizes the discussion to this point.
The economics of the Court's analysis can now be summarized in relationship with the original DCF valuation in the Mercer Report. As the preceding discussion shows, the Court accepted the Mercer Report's Financial Control conclusion with three exceptions:
No weight was placed on the guideline public company method. This had the effect of increasing value by about 3%. So the beginning point of the Court's analysis was $2.443 billion, as shown in Figure 1.The Court changed the blended federal/state tax rate of 38% in the Mercer Report to the personal rate of 43.5% from the Ruback Report. This had the effect of decreasing the Court's conclusion by about 8%, or by $196 million.Finally, the Court did not allow the tax amortization benefit employed in the Mercer DCF analysis. This lowered the Court's conclusion by $336 million, or about 14%.
Overall, my interpretation of the Court's financial control value was $1.911 billion. Relative to the $2.364 billion conclusion of financial control value in the Mercer Report, the Court's conclusion was lower by $453 million, or about 19%.
The Court's financial control value of $1.991 billion is 4.7 times greater than the analogous conclusion in the Ruback Report of $426 million. I make the comparison at the financial control level because that's the level at which such comparisons should be made in a fair value matter in New York. I say that because courts, and this Court, often show an ability to understand the economics of valuations. Justice Driscoll certainly did that.
But when it comes to the next assumption, the discount for lack of marketability, or DLOM, or marketability discount, the courts in New York make the rules. The only problem is that they don't tell appraisers or anyone what the rules are.9. The Marketability Discount (DLOM)The Court's treatment of the marketability discount does not make sense from my perspective as a business valuer and a businessman. The discussion of the marketability discount, which is a $478 million adjustment in the Court's analysis, consists of just over three pages.Because this marketability discount is such a large and important adjustment, I will spend a significant amount of space discussing it.The Pratt and Ruback ReportsThe Court's determination of fair value was clearly conducted at the financial control level of value. The beginning point for the Court's determination was the financial control values provided in the Mercer Report as of October 5, 2010. The methodology of the Ruback Report also yielded a conclusion at the financial control level of value.The Ruback Report cited two studies in developing the DLOM, the Longstaff Model and the Silber Study.11 The Ruback Report stated that the Longstaff Model provided an "upper bound" for marketability discounts, and it was ignored in the final conclusion regarding the marketability discount.The Silber study reported an average restricted stock discount of 34%, and this was used as the basis for the Ruback Report's conclusion of a 35% marketability discount.As pointed out in the Reply Report, this use of the average from the Silber Study was inappropriate and misleading.12The Silber Study broke its sample into two distinct populations, those with discounts greater than 35% and those with discounts less than 35%.The group with discounts greater than 35% had a mean discount of 54%, median prior year revenues of $13.9 million and median prior year loss of $1.4 million. This group had an average market capitalization of $34 million.The group with discounts less than 35% looked entirely different. The mean discount was a much lower 14%, average revenues were $65 million, with median prior year earnings of $3.2 million, and an average market capitalization of $75 million.Compared with the second group of the Silber Study, AriZona had revenues of approximately $1.0 billion and pro forma after-tax net income of approximately $100 million. Even using the Ruback Report's flawed equity valuation of $426 million (before discounts), AriZona would be among the most attractive companies in the second group, if not the most attractive. If detailed transactional information were available from the Silber Study, relevant comparisons might suggest that a premium (i.e., a negative discount) should be applied. The range of "discounts" in the Silber Study was from a minus 13% (a premium of 13%) to a discount of 84%. Given AriZona's attractiveness relative to the sample of companies studied, the Silber Study supports a marketability discount of zero percent.
Pratt also testified that the appropriate marketability discount should have been 35%. The Pratt Report cited numerous minority interest studies and analyzed a number of factors, most of which applied to illiquid minority interests of companies, although he also testified that any DLOM should be based only on corporate or enterprise factors and not on shareholder level factors.
Unfortunately, I did not get time during direct testimony to address Ruback's 35% DLOM. Counsel for AriZona certainly did not want to question me about it during their cross-examination of me.The Mercer ReportThe Mercer Report cited a number of New York cases in support of a recommended marketability discount of 0%. I will discuss those in the context of the analysis of the Court’s treatment below.The bottom line is that AriZona is a large, highly successful company in a niche in the beverage industry that many players, both in the beverage industry and outside it, would like to own. Graphically, this positioning was shown in the Mercer Report as follows:
AriZona (and Ferolito) had had significant discussions with Coca-Cola, Nestle Waters, and Tata Tea in the months and years prior to the valuation date. These discussions yielded informal offers ranging from $2.9 billion to more than $4 billion for 100% of the AriZona Entities.
The record was clear that Vultaggio did not want to sell his shares or the Company in total. He exhibited reluctance to complete any transaction leading to the valuation dates and did not cooperate to facilitate the sale of the Ferolito shares. Ultimately, there were no transactions leading to the valuation date.
The Mercer Report referred to discussions like those noted above as indicative of the interest of capable buyers. This was one factor considered in concluding that the appropriate marketability discount was 0%.
The Court's AnalysisThe Court began its analysis by stating:13At the outset, nearly all courts in New York that have considered the question of whether to apply a DLOM have answered in the affirmative.I knew trouble was coming when I read that sentence. The Court then went on:14The instant case is readily distinguishable from each of the three cases upon which Ferolito relies in support of his claim that there should not be any DLOM at all. [emphasis added]I’m not a lawyer, but it seems to beg the question to begin an analysis by saying that nearly all courts have said positive marketability discounts were appropriate as a basis for applying one in the case of AriZona. Every case is fact-dependent. The fact is, there are a growing number of New York fair value decisions where 0% or very small marketability discounts have been concluded. This should make it important to reference at least some of them to see how AriZona compares.I testified in Giaimo, which involved two real estate holding companies. In that case, a special master concluded that the appropriate marketability discount was 0%.15 The 0% discount was affirmed by the New York Supreme Court, although using only a portion of the logic that I testified about. On appeal, the marketability discount was concluded to be 16%.16I also testified in the case Man Choi Chiuand42-52 Northern Boulevard, LLC v. Winston Chiu, involving another real estate holding company.17 In that case, the New York Supreme Court held that a 0% marketability discount was appropriate. That decision was left untouched in the appeal of the matter.As we will see, there are other 0% marketability discount cases, some of which are more relevant to AriZona than real estate holding companies.The Court said that Ferolito (Mercer) relied on three cases in support of no marketability discount. There were actually six cases analyzed in the Mercer Report from business and valuation perspectives.Friedman v. Beway18Beway was cited in the Mercer Report in support of the selection of the control level of value. Beway was cited in the early "General Principles of Valuation" section of the Court’s decision, but it was not cited in the Court's short discussion of the marketability discount.
However, Beway itself is instructive regarding the applicability of a marketability discount, at least from a logical standpoint. Key citations were included in the discussion. Beway is quoted in the Mercer Report to illustrate important guidance in fair value determinations:"[I]n fixing fair value, courts should determine the minority shareholder's proportionate interest in the going concern value of the corporation as a whole, that is, ‘what a willing purchaser, in an arm's length transaction, would offer for the corporation as an operating business.'"This is the same quotation found at the beginning of this analysis regarding the appropriate level of value. Beway addresses the applicability of a minority discount:"[a] minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern,"This is important because such a discount:"would result in minority shares being valued below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts."Beway also argues against the unjust enrichment that would occur if a minority discount were allowed in a New York fair value determination."to fail to accord to a minority shareholder the full proportionate value of his [or her] shares imposes a penalty for lack of control, and unfairly enriches the majority stockholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder."Again, I'm not a lawyer, but the economic effect of applying a marketability discount is to lower the price below that which "a willing purchaser, in an arm's length transaction, would offer" for a business as a going concern.Further, the application of marketability discount results in "minority shares being valued below that of majority shares" and therefore violates the principle that "all shares of the same class" be treated equally.Finally regarding these quotes, the application of a marketability discount provides a windfall to control shareholders by imposing "a penalty for lack of control," because no controlling shareholder would ever sell his or her shares based on a discount for lack of marketability. We will see the effect of this penalty below.Beway, unfortunately, is inconsistent on its face in arguing strongly against the application of a minority discount while calling for consideration of a marketability discount, which, if applied, undermines the very principles that the case espouses. Obviously, that is my opinion from business and valuation perspectives. I have no legal opinions.Matter of Walt's Submarine Sandwiches, Inc.19The Court attempted to distinguish Walt's Submarine Sandwiches, which provided for a 0% marketability discount, from AriZona. In Walt's Submarine Sandwiches, "a DLOM was not appropriate where there was testimony of increased profits, expansion and 120 responses to a 'for sale' advertisement in the Wall Street Journal."First, there was adequate testimony of "increased profits and expansion" for AriZona leading to the valuation dates (covered above). The Court seemed to think that because there were a "geometrically smaller number of expressions of interest for AriZona", this is not a valid comparison from a business perspective. However, companies like AriZona are not sold through advertisements in the Wall Street Journal or anywhere. Large companies are carefully marketed by qualified professionals to limited universes of carefully selected financial and strategic buyers. There was substantial testimony from investment bankers regarding the attractiveness and marketability of AriZona.The Mercer Report stated about Walt's Submarine Sandwiches specifically, following significant discussion regarding the attractiveness and marketability of AriZona:20In Matter of Walt's Submarine Sandwiches, the Court rejected application of a marketability discount, finding that: "The record, including testimony of increased profits, expansion and 120 responses to a 'for sale' advertisement in The Wall Street Journal, amply supports a finding of respondent's marketability." If offered for sale, multiple potential acquirers would be interested in acquiring the AriZona Entities.The AriZona Court's analysis of Walt's Submarine Sandwiches, in my opinion from a business perspective, fails to demonstrate that the relevant facts are "readily distinguishable" from AriZona.Ruggiero v. Ruggiero21The AriZona Court noted that in Ruggiero, "there was 'insufficient explanation' to support a DLOM, which is far from the case here." That's the entire distinction made. If we look at the decision in Ruggiero, we see something different:22The sole issue the Court had with Mr. Glazer's explanation was his 20% discount for lack of marketability for which he did not provide sufficient explanation. In this sense the Court agreed with Plaintiff's expert that Zan's does constitute a somewhat unique niche business. Thus, the Court removed…the deduction for lack of marketability.One expert did not provide sufficient explanation for a 20% marketability discount. The other described the company as a "somewhat unique niche business," and apparently suggested a 0% marketability discount. The Ruggiero Court agreed with that characterization, and removed the marketability discount.The AriZona Court also noted that Ruggiero was not a BCL § 1118 case. This would appear to be a distinction without a difference because Beway instructs that the same valuation principles hold for BCL § 623 cases.In the Mercer Report, it was noted:23In Ruggiero v. Ruggiero, the Court concluded that no marketability discount was appropriate since the subject business constituted "a somewhat unique niche business." Among the unique attributes of the AriZona Entities is the fact that it is one of only four (and the only private) available U.S. non-alcoholic beverage systems with scale available to potential acquirers.The AriZona Court's analysis of Ruggiero, in my opinion from a business perspective, fails to demonstrate that the relevant facts are "readily distinguishable" from AriZona.O'Brien v. Academe Paving, Inc.24The AriZona Court's entire dismissal of O'Brien v. Academe Paving is in a single sentence: "Finally, in O'Brien v. Academe Paving, Inc. (citations omitted) the trial court appears to have applied an impermissible minority discount, rather than a DLOM." 25The O'Brien Court did refuse to allow an impermissible minority discount, citing the same passage from Beway noted above. Unfortunately, the characterization of the discussion regarding the DLOM would appear to be incorrect.The Court in O'Brien quoted Beway about the appropriateness of consideration of marketability discounts and then noted:The Court continued, in that same decision [Beway], and repeats here, that marketability discounts for close corporations (such as these here) are entirely proper if it is a factor used in valuing the corporation as a whole, not just a minority interest. 26At several points, the O'Brien Court stated that Academe/JOB was a very desirable and marketable commodity within the paving industry. The purpose of valuations conducted near the valuation date was to assist with a potential sale of the business. The business was marketable, attractive and was for sale.The O'Brien Court concluded regarding the marketability discount:As Mr. Griswold saw no need to factor an illiquidity discount into his analysis of the "enterprise value" of Academe/JOB for either April or November of 1999, so the Court sees no need to do so now.It should be clear that the application of a 0% marketability discount in O'Brien v. Academe Paving was an intentional decision by that Court based on the facts and circumstances of the case.The analysis in the Mercer Report stated the following about O'Brien:In O'Brien v. Academe Paving, Inc. the Court noted that marketability discounts are appropriate in fair value determinations in cases for which "the reduction of value of close corporations is thought to be necessary to reflect the (theoretical) circumstance that no 'market' buyer would want to buy into such a corporation, even if shareholders were willing to sell their interests (which, under most circumstances, they are not)." Noting that, in a sale of the subject business, petitioners' shares would not be subject to discount, the Court concluded that, since the subject company was "a very desirable/marketable commodity" within its industry, the appropriate marketability discount was 0%. The attractiveness and desirability of the AriZona Entities to potential acquirers has been discussed throughout this report.27The AriZona Court's analysis of O'Brien v. Academe Paving, in my opinion from a business perspective, fails to demonstrate that the relevant facts are "readily distinguishable" from AriZona.The Mercer Report discussed two other cases.In Quill v. Cathedral Corp., the Court noted that the receipt of offers for the subject business (and a subsequent sale at the asking price within a reasonable period of time) indicated that "the actual sales price received reflected any marketability discount and that no further deduction should be made from the value of petitioners' shares."28 The Supreme Court's reasoning was upheld on appeal.29 We should note that there was a second, apparently less marketable company involved in this litigation. For that company, the Supreme Court applied a 15% marketability discount, which was also upheld on appeal. With respect to the AriZona Entities, the conclusion of fair value is consistent with the offers from potential acquirers discussed previously in this report.30and,In Adelstein v. Finest Food Distributing Co.,31 the Court determined that a 5% marketability discount was appropriate for the subject business by reference to assumed transaction costs involved in a sale. As a percentage of the sales price, transaction costs are generally inversely related to the amount of the proceeds. In the event of the sale of a multi-billion company like AriZona, one would anticipate transaction costs to be much less than 5% of the purchase price.32Another case was mentioned by the AriZona Court, that of Zelouf International Corp. v. Zelouf, which was published shortly before the decision in AriZona.33 In that case, Justice Kornreich did not apply a marketability discount. The AriZona Court noted that "as readily demonstrated by the stalled Nestle negotiations, the very reasons for a DLOM here have resulted in – or are at least strongly correlated with – the failure of Ferolito to sell his shares prior to the proceeding."Zelouf actually stands for another principle (as I read it from business and valuation perspectives), that the lack of desire on the part of controlling shareholders to sell, potentially ever, should not be the cause for imposing an illiquidity discount on the dissenters (or, by inference, on Ferolito in the AriZona matter). Peter Mahler, writer of the well-known New York Business Divorce Blog, wrote the following:Justice Kornreich found the risk of illiquidity associated with the company "more theoretical than real," explaining there was little or no likelihood the controlling shareholders would sell the company, i.e, themselves would incur illiquidity risk upon sale. Imposing DLOM in valuing the dissenting shareholder's stake, therefore, would be tantamount to levying a prohibited discount for lack of control a/k/a minority discount.34The AriZona Court distinguished this matter from Zelouf based on stalled Nestle negotiations involving Ferolito. In Zelouf, Justice Kornreich accepted a 0% marketability discount because the controlling shareholders did not want to sell, potentially ever. The logic was that if the controlling shareholders would never suffer from illiquidity, then the dissenting shareholder should not be charged with a marketability discount. Vultaggio did not want to sell at all and was very clear about that in both word and actions.A further development in Zelouf was published December 22, 2014.35 In this supplemental decision, Justice Kornreich made the following statements:[N]o New York appellate court has ever held that a DLOM must be applied to a fair value appraisal of a closely held company. On the contrary, the Court of Appeals has held that "there is no single formula for mechanical application." Matter of Seagroatt Floral Co., Inc., 78 NY2d 439, 445 (1991). Indeed, the Court of Appeals recognizes that "[v]aluing a closely held corporation is not an exact science" because such corporations “by their nature contradict the concept of a market' value." Id. at 446. As set forth in the Decision, since Danny is not likely to give up control of the Company, Nahal should not recover less due to possible illiquidity costs in the event of a sale that is not likely to occur. [emphasis added]And further:[I]n this case, under the unique set of facts set forth in the Decision, applying a DLOM is unfair. This court's understanding of the applicable precedent is that, while many corporate valuation principles ought to guide this court's analysis, this court's role is not to blithely apply formalistic and buzzwordy principles so the resulting valuation is cloaked with an air of financial professionalism. To be sure, sound valuation principles ought to be and indeed were utilized in computing the Company's value (i.e., the court's adoption of most of Vannucci's valuation). Nonetheless, the gravamen of the court's valuation is fairness, a notion that is undefined, making it a classic question of fact for the court. Fairness, in this court's view, necessarily requires contextualizing the applicable valuation principles to the actual company being valued, as opposed to merely deciding a priori, and in a vacuum, that certain adjustments must be part of the court's calculus. From this perspective, the court reached its conclusion that an application of a DLOM here would be tantamount to the imposition of a minority discount. Consequently, the court finds it fairer to avoid applying a minority discount at all costs rather than ensuring that all hypothetical liquidity risks are accounted for. [Citation omitted.] [emphasis added]Justice Kornreich went on to say that if forced to impose a marketability discount, it would be 10%, citing another recent New York fair value case, Cortes v. 3A N. Park Ave Rest Corp.36 Suffice it to say, Zelouf is not "readily distinguishable" from the AriZona matter, at least in my opinion from business and valuation perspectives. Rather, the logic of Zelouf supports a 0% marketability discount, since it was the actions of the controlling shareholder, Vultaggio, that caused Ferolito's sale negotiations to break down.The AriZona Court went on to agree with Vultaggio that their claims justified "some semblance of a discount." Those bases included the following:the fact that AriZona did not have audited financial statements for many years prior to the valuation datethe extensive litigation between the shareholders,the uncertainty about the company's S Corporation status,the transfer restrictions in the Owner's Agreement.
These issues do not, in my opinion, justify a marketability discount of 25% for AriZona, as will be seen through the Court's own analysis.Testimony showed that absent shareholder fighting, AriZona's financial statements could readily be audited. The reasons for the lack of a completed audit stemmed from the litigation at hand. The Court stated:
"First, as Gelling's testimony established, AriZona's financial statements can be readily audited, particularly when the shareholders are no longer battling with each other." (emphasis added)Importantly, the litigation between the two shareholders would be terminated by the very case at hand. The Court stated:
"Second, as credibly explained by Ferolito's investment banker Rita Keskinyan, the litigation between the two shareholders would necessarily cease when one shareholder's interests are acquired." (emphasis added)And the litigation would surely cease if 100% of the Company were sold as a "going concern" in the hypothetical transaction contemplated by Beway.The so-called "uncertainty about the company's S-Corporations status" was likely immaterial. The Court stated:
"Third, the uncertainty about the company's S-Corporation status is, at most, a scenario about which reasonable minds have differed." (emphasis added)Further, no buyer of AriZona would be concerned about the S corporation status. The buyer would only purchase assets if there were any concern at all. Any remaining issues re S corporation status would be a problem for the remaining owners of shell S Corporation (i.e., after assets are sold), and not a problem for the purchaser, who bought assets.Transfer restrictions on interests in a company's equity in an Owner's Agreement should logically have no impact on the value of 100% of the equity of a business sold as a going concern, which is the standard from Beway, which states that such restrictions should be "literally inapplicable."
The AriZona Court undermined its own logic for a substantial marketability discount in its own analysis, at least as I read the decision from business and valuation perspectives.
I think that this discussion shows that a 25% DLOM for an attractive, saleable company like AriZona, is excessive and unreasonable, or, to use Justice Kornreich's term, perhaps unfair.DLOM and Prejudgment InterestThe combined impact of the three changes to assumptions in the Mercer Report's financial control analysis lowered the Court's adjusted financial control value to $1.911 billion (from $2.364 billion), which was derived in Figure 1 above. Figure 2 picks up at that point.
The Court imposed a 25% marketability discount. What does that mean? Well, it lowered value by some $478 million. That is a tremendous price for so-called lack of marketability or illiquidity, particularly given the obvious and demonstrable desire of capable buyers to acquire AriZona. I seldom use words like that in writing, but it is unavoidable. The conclusion of financial control value was lowered from $1.911 billion to $1.433 billion, which was the Court's conclusion of fair value in AriZona.
For context, a marketability discount of 5% was allowed in the Adelstein v. Finest Food Distributing Co. based on assumed transaction costs on a sale of the business. As noted above and in the Mercer Report, with a company the size of AriZona, such transaction costs would be substantially lower than 5%. A 5% marketability discount would provide for almost $100 million of transaction costs in an actual sale of Arizona at the Court's financial control value of $1.911 billion. That would, in my opinion, be quite excessive in itself.
At this point, we see that the Court found that prejudgment interest was due Ferolito because of the wait between the October 2010 valuation date and the October 2014 decision date. The prejudgment interest, which was set at 9%, continued based on the decision until the matter was resolved.
Prejudgment interest at a simple interest rate of 9% per year amounts to $129 million on a base fair value of $1.433 billion. In the four years between the valuation and decision dates, the accrual of interest raised the Court's conclusion to $1.949 billion, as estimated in Figure 2.
The value of the combined Ferolito 50% interest in AriZona based on the conclusion of fair value plus prejudgment interest was therefore $975 billion, which was to accrue prejudgment interest at the rate of 9% (simple), or $64.5 million per year (or half of $129 million on 100% of the concluded fair value). These are big numbers, but AriZona is a big and valuable private company.
An Impermissible Minority Discount?The Court performed its analysis and developed a conclusion of fair value at the financial control level of value of $1.911 billion. It then took a 25% marketability discount. We examined prejudgment interest in Figure 2. However, prejudgment interest is not part of value. It is interest, or payment for waiting from October 2010 (valuation date) to October 2014 (decision date) to receive the judicial determination of fair value.We return to examining only the conclusion of fair value before the imposition of prejudgment interest in Figure 3.
Assume with me that the conclusion of strategic value in the Mercer Report of $3.204 billion is reasonable. In a real transaction, corporate tax rates would be used by real market participants and the tax amortization benefit would be considered in the negotiations leading to a transaction.
I am not arguing with the Court about the decision to disregard strategic control value in favor of financial control value, but it is important to see the impact of decisions and examine them in that light. As seen above, there is a $1.293 billion discount from the strategic control value to the Court's financial control value. In the absence of litigation, Ferolito and Vultaggio each owns half of the option value of selling the company and receiving their respective shares of strategic control value.
The decision to move to financial control reduces the Ferolito share by $647 million, which is a direct addition to the Vultaggio option value. We will use this result below.
The Court imposed a 25% marketability discount to its concluded financial control value of $1.911 billion, yielding a resulting conclusion of fair value of $1.433 billion. However, the focus of the analysis is on the marketability discount of 25%, or $478 million dollars. Figure 4 focuses only on financial control value.
Figure 4 begins with the Court's concluded financial control value of $1.911 billion.
Remember, value is value and interest is interest, so to understand the value transfers involved in the Court's analysis, we have to focus on financial control value.
Ferolito and Vultaggio share in financial control value at 50% each. Their pro rata shares are therefore $956 million each, or half of $1.911 billion each. The Court imposed a 25% marketability discount, so the Ferolito share is reduced by $239 million, yielding an indication of fair value of $717 million, or 50% of the Court's after DLOM value conclusion of $1.433 billion (Figure 3).
The results get interesting here. While Ferolito's value is reduced by the marketability discount, Vultaggio's value is increased by exactly the same amount. Vultaggio's share of the Court's financial control value is $1.194 billion, or 62.5% of financial control value of $1.911 billion. Vultaggio's $717 million share represents only 37.5% of that value.
The result of the imposition of a 25% marketability discount is to transfer $478 million of value to the Vultaggio column, resulting in a 66.7% premium in value for Vultaggio. In other words, the imposition of the marketability discount at the enterprise level ($478 million) resulted in a shift in value of that entire amount to Vultaggio's 50% interest.
The imposition of a marketability discount of 25% results in a dollar-for-dollar penalty in value for the seller in a fair value case where the ownership is 50%-50%. What this boils down to deserves highlighting:
Mathematically and practically, the imposition of a minority discount would do exactly the same thing as the imposition of a marketability discount. However, transferring value by imposing a minority interest discount is forbidden by Beway. If transferring value from the minority (or non-controlling) owners to the controlling owners is forbidden on the one hand (i.e., a minority discount), it would seem that the other hand (i.e., the marketability discount) would be forbidden as well. From the viewpoint of the non-controlling shareholder, there is no distinction – value transferred to the controlling owner(s) is value transferred by whatever name it is given.I'm reminded of the father who told his son not to hit his sister after he was caught in the act. He stopped, but a few minutes later, he kicked her. When his father asked why he had done that, he said because you didn't tell me not to kick her. Well, the New York courts say emphatically that you can't hit your sister (i.e., by imposing a minority discount). But then the father (New York appellate courts) say you can kick her (by imposing a marketability discount). No wonder the kids (judges, lawyers, and business appraisers) are confused.This is an issue that desperately needs clear appellate court guidance in New York.In Figure 5, we see that there is countervailing logic against the marketability discount, because given that the Court in the AriZona matter selected the financial control level of value rather than the strategic level, potential value is definitely transferred to Vultaggio in this case and controlling owners in general when marketability discounts are applied.
Figure 5 examines both the potential shift in value in moving from strategic to financial control as well as the actual shift in value by imposing a 25% marketability discount in the AriZona matter.
In Figure 5, we again begin with the strategic control value from the Mercer Report of $3.204 billion.
Line 1. Ferolito and Vultaggio each share, while they are 50%-50% owners, this potential value (or option), or $1.602 billion each in value. We calculated the discount in potential value from the strategic level down to Court's financial control to be $1.293 billion (i.e., from $3.204 billion down to $1.911 billion) in Figure 3.Line 2. This results in a loss of potential value of $647 million (half of the discount from Strategic Control to Financial Control) for Ferolito, which is accretive to value to Vultaggio by exactly the same amount. What that means is that, at least theoretically, the day after the settlement, Vultaggio could sell the Company for $3.204 billion and reap a substantial windfall. That potential windfall is the $647 million discount for Ferolito that is added to the Vultaggio column.Line 3. The financial control value for Ferolito is $956 million. In practical terms, Vultaggio would receive $3.204 billion in the hypothetical sale and then pay Ferolito at the $956 million financial control value (or repay the lender), leaving him with $2.249 billion. This amount is 2.4 times greater than the financial control value accorded to Ferolito.Line 4. At this point, we apply the Court's 25% marketability discount in the Ferolito column. The way things work, this is a direct shift of an equivalent amount to Vultaggio.Line 5. The concluded fair value for the 50% Ferolito share of AriZona is $717 million. This compares to the concluded potential value for Vultaggio of $2.488 billion, or 3.5 times greater.I am not arguing for the use of strategic control value in New York fair value cases. That is a matter for New York appellate courts to decide. However, I am suggesting that for the potential benefit of strategic value that applies in operating business cases for remaining owners, equity (dare I use that word) could call for the elimination of the marketability discount in New York fair value cases.Without providing detailed evidence at this point, I can safely say that the great majority of jurisdictions in the United States have reached this conclusion.Concluding ThoughtsThis has been a lengthy analysis. Let's conclude with a few highlights:In my opinion, at least, the logic supporting a marketability discount of 0% for attractive, marketable companies, and relevant comparisons to AriZona, should have supported the 0% conclusion for the marketability discount in the Mercer Report in New York fair value cases.The case law logic supporting a minority discount of 0% in selected New York cases would also, if applied consistently, support a 0% marketability discount for an attractive, saleable company like AriZona.In this matter, any valuation discount, whether a minority discount or a marketability discount, has the effect of transferring value directly from the non-controlling owner(s) to the controlling owner(s).As shown in this analysis, the selection of financial control as the appropriate level of value for an operating company like AriZona already provides a potential “windfall” for controlling shareholders. I'm not suggesting that any court should order a sale of a company to achieve this value or select strategic value as the appropriate level of value for fair value. However, I do suggest that it is an equitable issue that could or should be considered in fair value determinations in New York.Lastly for this summary, prejudgment interest is not value as of a valuation date. We cannot reasonably look at the Court's conclusion, including interest, as the conclusion of fair value. That conclusion represents fair value plus prejudgment interest, and interest is interest, not value. The enormous transfer of value and potential value that occurred with this decision is masked by thinking that the final conclusion, including interest, represents fair value. Fair value was – and had to be – determined at the valuation date of October 5, 2010.
In the final analysis, the Court substantially agreed with the DCF method as employed in the Mercer Report, differing only on three assumptions. The Court then applied a marketability discount of 25%, which, in my opinion and based on the analysis above, was not differentiated to AriZona and was not justified. In fact, it was undermined by the Court's own analysis.
The good news is that the matter has been settled between the parties. A long and contentious period of litigation has ended. The settlement has not been made public, and that likely will not occur.
The bad news is that the Court of Appeals in New York will miss an excellent opportunity to reexamine the marketability discount issue.
ENDNOTESJohn M. Ferolito and JMF Investments Holdings, Inc., Plaintiffs, against AriZona Beverages USA LLC, AZ National Distributors LLC, AriZona Beverage Company LLC, Defendants, In the Matter of the Application of John M. Ferolito, the Holder of More Than 20 Percent of All Outstanding Shares of Beverage Marketing, USA, Inc., Petitioner, For the Dissolution of Beverage Marketing, USA, Inc., John M. Ferolito and the John Ferolito, Jr. Grantor Trust (John M. Ferolito and Carolyn Ferolito as Co-Trustees), both individually and derivatively on behalf of Beverage Marketing USA, Inc., Plaintiffs, against Domenick J. Vultaggio and David Menashi, Defendants. New York Supreme Court, Nassau County, No. 004058-12. ("Ferolito v. Vultaggio")Others have written about the AriZona Matter, including:Peter Mahler, New York Corporate Divorce Blog, "Court Rejects Potential Acquirers' Expressions of Interest, Relies Solely on DCF Method to Determine Fair Value of 50% Interest in AriZona Iced Tea," October 27, 2014Gilbert E Matthews (Parts I and II) and Michelle Patterson (Part II):, Financial Valuation and Litigation Expert, "How the Court Undervalued the Plaintiffs' Equity in Ferolito v. AriZona Beverages:""Part I: Tax-Affecting S Corporation Earnings" (April/May 2015)"Part II: Ferolito and the Application of DLOM in New York Fair Value Cases" (June/July 2015).Friedman v. Beway Realty Corp., 87 N.Y.2d 161, 168 (1995) (emphasis in original) (quoting Matter of Pace Photographers, Ltd., 71 N.Y.2d 737, 748 (1988)).Ferolito v. Vultaggio.Expert Report of Richard S. Ruback, dated February 17, 2014, with valuation conclusions as of December 31, 2010 ("the Ruback Report"), page 4.Ferolito v. Vultaggio.Ferolito v. Vultaggio.The forecasted growth in the Mercer Report for financial control was actually at a CAGR of 7.7%. The Court's reference to a 10.2% CAGR actually applied to Mercer's strategic control value, which considered the ability of a strategic partner to enhance growth. Both forecasts were provided in the Bellas Report previously mentioned.Ferolito v. Vultaggio.Pratt, Shannon P., Valuing a Business Fifth Edition (McGraw Hill, 2008), pp. 618-619.Francis A. Longstaff. "How Much Can Marketability Affect Security Values?" The Journal of Finance, December 1995, Vol. 50, No. 5, pages 1767-1774, and William L. Silber. "Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices." Financial Analysts Journal, July August 1991, pages 60-64.Citing an analysis prepared by Mercer in a book published in 1997. Mercer, Z. Christopher, Quantifying Marketability Discounts (Peabody Publishing, 1994), pages 63-66.Ferolito v. Vultaggio.Ferolito v. Vultaggio.Matter of Giaimo v. Vitale, 2011 NY Slip Op 50714(U) (Sup. Ct. NY County).Matter of Giaimo v. Vitale, 2012 NY Slip Op 08778 [101AD3d 523].Man Choi Chiu and 42-52 Northern Boulevard, LLC v Winston Chiu Index Nos. 21905/07, 25275/07.Beway v. Friedman.Matter of Walt's Submarine Sandwiches, 173 A.D.2d 980, 981 (3d Dep't 1991).The Mercer Report, Master Page 105.Ruggiero v. Ruggiero, Index No. 36299-2012 (2013).The Mercer Report, Master Page 104.The Mercer Report, Master Page 104.O'Brien v. Academe Paving, Inc., Index No. 99-2594 RJI No. 99-1794-M, at 13-14 (Sup. Ct. Broom Cnty. 2000).Ferolito v. Vultaggio.O'Brien v. Academe Paving, Inc., Index No. 99-2594 RJI No. 99-1794-M, at 13-14 (Sup. Ct. Broom Cnty. 2000).The Mercer Report, Master Page 104.Quill v. Cathedral Corp., RJI 10-90-2887, at 8 (Sup. Ct. Columbia Cnty, June 8, 1993).Quill v. Cathedral Corp. 215 A.D.2d 960 (3d Dep't 1995).The Mercer Report, Master Page 104.Adelstein v. Finest Food Distributing Co., 2011 WL 6738941 (N.Y.Sup.), 2011 N.Y. Slip Op. 33256(U) (Sup. Ct. Queens Cnty. Nov. 3, 2011).Mercer Report, Master Page 105.Zelouf International Corp. v Zelouf, 2014 NY Slip Op 51462(U) [Sup Ct, NY County Oct. 6, 2014].Peter Mahler, New York Business Divorce Blog, "Court's Rejection of Marketability Discount in Zelouf Case Guided by Fairness, Not 'Formalistic and Buzzwordy Principles'," January 5, 2015.Zelouf International Corp. v. Zelouf, Index 653652/2013 (Dec. 22, 2014).Cortes v 3A N. Park Ave Rest Corp., 2014 WL 5486477 (Sup Ct, Kings County Oct. 29, 2014).
The Valuation of Asset Management Firms
To many people, asset management is the business model dreams are made of. A few skilled people in one office can make millions providing a sophisticated and straightforward service. Billing simply requires deducting fees from client accounts, and the upward drift of the markets propels revenue growth. Looked at from the inside-out, however, it is a fiercely competitive industry in which one is judged unforgivingly by the numbers, and depending entirely on relationships between owners, employees, and clients. Profit margins can be huge, but can evaporate in two quarters of a bear market.On one level, all RIAs (registered investment advisors) are alike, as there are significant similarities between development of fee income and the composition of the expense base to support the revenue that generates and sustains profitability. Nonetheless, recognizing the distinct characteristics of a given investment management firm is necessary to understanding its value in the marketplace.All Businesses SellLike all private companies, ownership interests in RIAs eventually transact. Whether voluntary or involuntary, these transactions tend to be among the most important of the owner’s business life.The table below depicts events ranging from voluntary transfers such as gifts to family members or an outright sale to a third party to involuntary transfers such as those precipitated by death or divorce. An understanding of the context of valuing your business is an important component in preparing for any of these eventualities.Industry Conditions & IssuesThe idea of independent investment advisors gathered steam as high net worth clients migrated from the transactional sales mentality of brokerage firms. The financial advisory business model transformed from large wire house shops, and cold calling staffs paid by transaction-based commissions, to credentialed professionals paid on the basis of assets under management, or AUM. The popularity of RIAs centered on the fiduciary responsibility associated with such practices, as well as the greater degree of accessibility and high touch nature of their business operations. Additionally, the smaller size of independent advisors allowed for greater innovation and more specialized services. The number of total investment advisors registered with the SEC has increased four-fold from approximately 6,000 in 1999 to over 30,000 today (excluding all investment advisors only required to register with their respective states). Parallel to the proliferation of RIAs is the rise of state-regulated independent trust banks in the wake of mega-bank mergers and bailouts following the financial crisis of 2008. While there has been some consolidation of firms, the rate of acquisition in the industry has been far outpaced by startup formation.In spite of all the changes taking place in recent years, there remains some debate regarding whether the asset management industry is mature or evolving. If anything, it is continuing to niche into more discrete asset classes, investment styles, and client focus.Rules of ThumbThere are both formal and informal approaches to value, and while we at Mercer Capital are obviously more attuned to the former, we don’t ignore the latter. Industry participants often consider the value of asset managers using broad-brush metrics referred to as “rules-of-thumb.” Such measures admittedly exist for a reason, but cannot begin to address the issues specific to a given enterprise.Understanding why such rules-of-thumb exist is a good way to avoid being blindly dependent on them. During periods of consolidation, buyers often believe that the customer base (or AUM in the case of an asset manager) of an acquisition candidate can be integrated with the acquiring firm’s existing client assets to generate additional profits. So if most asset managers are priced at, say, 10x earnings and profit margins are 40%, the resulting valuation multiple of revenue is 4.0x. If revenue is generated by average fees of 50 basis points of assets under management, then the implied valuation is about 2% of AUM. Note, however, all the “ifs” required to make the 2% of AUM rule of thumb work.As with other businesses, the revenue of asset management firms is a function of price and quantity. In this case, price represents the rate charged for assets under management, and quantity reflects the asset base or AUM for RIAs. Value, however, is related to profits, which can only be derived after realizing the costs associated with delivering asset management services. High priced services are typically more costly to deliver, so margins may fall within an expected range regardless of the nature of the particular firm. Still, larger asset managers generally realize better margins, so size tends to have a compounding effect on value.Activity ratios (valuation multiples of AUM, AUA, revenue, etc.) are ultimately the result of some conversion of that activity into profitability at some level of risk. If a particular asset manager doesn’t enjoy industry margins (whether because of pricing issues or costs of operations), value may be lower than the typical multiple of revenue or AUM. On a change of control basis, a buyer might expect to improve the acquired company’s margins to industry norms, and may or may not be willing to pay the seller for that opportunity.In the alternative case, some companies achieve sustainably higher than normal margins, which justify correspondingly higher valuations. However, the higher levels of profitability must be evaluated relative to the risk that these margins may not be sustainable. Whatever the particulars, our experience indicates that valuation is primarily a function of expected profitability and is only indirectly related to level of business activity. Rules- of-thumb, if used at all, should be employed with an appropriate level of discretion.As an example of this, industry participants might consider RIAs as being worth some percentage of assets under management. At one time, asset manager valuations were thought to gravitate toward about 2% of AUM. The example below demonstrates the problematic nature of this particular rule of thumb for two RIAs of similar size, but widely divergent fee structures and profit margins.
Firm A charges a higher average fee and is significantly more profitable than Firm B despite having identical AUM balances. Because of these discrepancies, Firm A is able to generate over six times the profitability of its counterpart. Application of the 2% rule yields a $20 million valuation for both businesses, an effective EBITDA multiple of 8x for Firm A and 50x for Firm B. While 2% of AUM, or 8x EBITDA, may be a reasonable valuation for Firm A, it is in no way representative of a rational (or non-synergistic) market participant’s realistic appraisal of its counterpart; it would imply an effective EBITDA multiple of 50x. It is our experience that money managers with higher asset balances, fee structures, and profit margins typically attract higher AUM multiples in the marketplace. In the case of RIAs with performance fee components to their revenue stream, the math gets a bit more interesting.
Background Concepts of "Value"The industry issues discussed above can and should impact the valuation of asset managers, but a professional valuation practitioner considers other issues as well.Many business owners are surprised to learn that there is not a single value for their business or a portion of their business. Numerous legal factors play important roles in defining value based upon the circumstances related to the transfer of equity ownership. While there are significant nuances to each of the following topics, our main goal is to help you combine the economics of valuation with the legal framework of a transfer (whether voluntary or involuntary).Valuation DateEvery valuation has an "as of date" which, simply put, is the date at which the analysis is focused. The date may be set by legal requirements related to a certain event, such as death or divorce, or may be implicit, such as the closing date of a transaction.PurposeThe purpose of the valuation is significant to how the valuation is performed. A valuation prepared for one purpose is not necessarily transferable to another. The purpose of the valuation is likely to determine the “standard of value.”Standard of ValueThe standard of value is a legal concept that influences the selection of valuation methods and the level of value. There are many standards of value, the most common being fair market value, which is typically used in tax matters. Other typical standards include investment value (purchase and sale transactions), statutory fair value (corporate reorganizations), and intrinsic value (public securities analysis). Using the proper standard of value is part of obtaining an accurate determination of value.Level of ValueWhen business owners think about the value of their business, the value considered commonly relates to the business in its entirety. From this perspective, the value of a single share is the value of the whole divided by the number of outstanding shares. In the world of valuation, however, this approach may not be appropriate if the aggregate block of stock does not have control of the enterprise; in some cases, the value of a single share will be less than the whole divided by the number of shares.
The determination of whether the valuation should be on a controlling interest or minority interest basis can be a complex process, and it is also essential. A minority interest value often includes discounts for a lack of control and marketability; therefore, it is quite possible for a share of stock valued as a minority interest to be worth far less than a share valued as part of a control block. Grasping the basic knowledge related to these issues can help you understand the context from which the value of a business interest is developed.
Typical Approaches to ValuationWithin the common valuation lexicon, there are three approaches to valuing a business: the asset approach, the income approach, and the market approach.The Asset ApproachThe various methodologies that fall under the umbrella of the asset approach involve some market valuation of a subject company’s assets net of its liabilities. In the case of an RIA, the primary “assets” of the business get on the elevator and go home every night. In some contexts, it may be useful to evaluate the worth of a company’s trade name, assembled workforce, customer list, or other intangible assets. The balance sheet can be significant regarding the presence of non-operating assets and liabilities or excessive levels of working capital, but the value of any professional services firm, including asset managers, is usually better expressed via the income and market approaches.The Income ApproachThe income approach usually follows one of two methodologies, a discounted cash flow method or a single period capitalization method. The discounted cash flow methodology (or DCF) requires projecting the expected profitability of a company over some term and then “pricing” that profitability using an expected rate of return, or discount rate. Single period capitalization models generally involve estimating an ongoing level of profitability which is then capitalized using an appropriate multiple based on the subject company’s risk profile and growth prospects. In either case, the income approach requires a thorough analysis of the risks and opportunities attendant. In the case of valuing asset managers, the income approach can be a useful arena to delineate issues unique to the industry and the particular company.Within the spectrum of asset managers, entities styled as family office operations may exhibit lower growth (which, all else equal, would suggest lower valuations), but also more stable client bases (with higher probability of recurring revenue, which tends to raise valuations). On the other end of the spectrum, valuing a hedge fund manager might require balancing the potential for supernormal earnings growth with supernormal earnings volatility.A wealth manager or independent trust company might fall somewhere in between these two extremes. These RIAs tend to enjoy a loyal (sticky) customer base, but often at the price of lower margins expected in a multi-discipline, high-touch business where client expectations for technical expertise and customer service compound staffing costs. There are similar opportunities for earnings leverage as with any asset manager, but these can be tempered by the nature of services that these asset managers provide.The Market ApproachOf the three approaches to value, the market approach may be the most compelling due to the high availability of pricing data. The market approach can be accomplished in a number of ways: by looking at the valuation multiples implied by outright sales of similar businesses, or by observing the trading activity in shares of publicly held companies.While the market approach may be the most useful way to value assets managers, it is often the most misused. It is possible to find transactions involving investment management companies or publicly traded trust banks and RIAs that are similar to a given RIA, but it is also important to understand and isolate what is different about the subject company that can affect value.Market data also has its drawbacks. Transactions data may offer limited information about multiples paid for various measures of profitability, and there may be no real way to isolate potential synergies reflected in the transaction pricing that might have been unique to the buyer and seller. Publicly traded investment management firms offer more thorough and consistent data, but they tend to be much larger and more diversified than closely-held RIAs.The potential differences in margin and product line have already been discussed in this article, but smaller asset management firms may have other limitations that are a product of scale. These issues include greater dependence on certain managers or clients, the loss of which could be difficult to replace without a detrimental impact on the financial returns of the business. Narrow product offerings or problems in the economic area served by the RIA could also constrain growth opportunities. Of course, it’s also possible that a subject enterprise might have a better than market opportunity because of a particular customer base served or a particular product offering.In any event, the valuation multiples implied by transaction activity or public asset managers may and often do require some adjustment for various factors before application to the subject RIA.Putting It All TogetherValuation analysis is not complete if it is left untested. In the valuation of RIAs, whatever methodologies are employed should ultimately reconcile to a conclusion of value that is reasonable given expectations for the company relative to industry pricing. This might ultimately fit within some kind of rule of thumb, but only by coincidence. Experience has taught us that in the asset management industry, as elsewhere, maximizing opportunity and minimizing risk usually enhances value.
Put In An Order for More AAPL – But First, Let Me Take a Selfie!
Recently, Russia took on the awesome task of trying to deter rampant narcissism by opening a 24/7 helpline to support anyone thinking they might be addicted to photographing themselves – a selfie hotline – if you will. Russia’s Interior Ministry went to social media to educate its citizens on the dangers of taking selfies, which include falling down stairs, being attacked by wild animals, and being hit by trains. Selfie addiction, according to the Politburo, is very real and very dangerous.
Asset managers should take heed, and consider dialing in. Of all the concentration risks that an RIA faces, dependence on key staff ranks at or near the top. Unless you’ve taken the CFA Institute’s indoctrination (advice) and you just run an index fund (in which case, why are you competing with Vanguard?), your business is tied, sometimes to an extreme degree, to the persons who work with you, and maybe you yourself.
Talent is everywhere, yes, but clients who choose to invest with a given firm frequently do so, directly or indirectly, based on their confidence in the individual(s) who will be servicing their account and making their investments. The primary assets of an RIA “get on the elevator and go home at night,” and in our country (not sure about Russia), a firm can’t have title to individuals. Even with a non-compete.
That said, sometimes good people can be too good.
A sector asset manager investing in small cap equities for large institutional clients might be able to run $5 billion with twelve or fifteen people, of whom maybe five are actually involved in the investment research and portfolio management process. A comparable wealth management firm would require 100 employees or more to manage as much wealth. The fee schedules of the two shops might be similar, generating similar revenue streams. But margins are likely to be very different. A sector asset manager as we’ve described could generate twice the EBITDA margin off of the same revenue as the wealth management firm. High margins aren’t everything, though; which one would you rather own?
One paradox of value in an RIA is that the driver of growth in a firm, usually an individual, can also be its undoing (e.g. everyone’s favorite selfie-manager, Bill Gross). The small cap manager described above is at risk every time one of its portfolio managers crosses the street in traffic. High margins don’t always portend high valuations, because high margins can be hard to sustain. And, although it takes a strong personality to build an investment firm, that doesn’t mean it has to become an all-expenses-paid ego trip.
Consider the asset outflows around the time of Bill Gross’s departure from PIMCO.
[caption id="attachment_9013" align="aligncenter" width="500"] Source: Business Insider[/caption]
Looking at the chart above, you would think PIMCO was insane to let Gross leave. Janus was clearly trying to reverse asset flow trends when it agreed to take in Gross despite his controversial personality.
[caption id="attachment_9014" align="aligncenter" width="500"] Monthly Asset Flows at Janus Capital Since 2009[/caption]
And, of course, asset flows do have impact on value. PIMCO’s parent, Allianz, has pretty well underperformed Janus since Gross left.
[caption id="attachment_9015" align="aligncenter" width="500"] Source: SNL Financial[/caption]
It isn’t so much that Allianz has performed poorly, as that Gross woke things up a bit at Janus. That trend has shown remarkable endurance so far, but the message is clear that key staff and value are interactive in RIAs.
This simple fact has so many implications for asset managers that they’re hard to list, but here are a few.
Compensation per capita at RIAs can be astronomical. The cure to this is typically to grow AUM faster than staff compensation. Indeed, the more successful a team is, the more assets they attract. This should (and often does) lead to operating leverage, but successful team members can command more compensation. Margins don’t grow forever.RIA transactions are frequently structured with as much as 25% to 50% of total consideration being paid in the form of an earn-out. This may cover some of the risk of client and product transition, but mostly it means that buyers and sellers share in that risk.Many capital providers who invest in RIAs don’t even try to cash out key employees, taking partial positions in the firms so that managers remain invested and economically tied to the firm.The profession is facing something of a physical cliff, as RIAs that began within a decade or so of the start of ERISA (1974) struggle to transition ownership from aging founders to the next generation. This is complicated by many things, most notably high valuations. It’s easy to quip that RIAs are worth so much no one can afford to buy them, but that’s a topic for another day.
Ideally, an RIA grows beyond the reputation and attributes of an individual or group of individuals and becomes a brand, such that clients come as much or more for the institution than the people. Easier said than done. But sustainability of the revenue stream over time has a big influence on value.
Of course, maybe the investing world will be taken over by index funds and robo-advisors. Until then, though, FINRA should consider installing a selfie hotline.
Death Week (for Active Management?)
Mercer Capital's asset management valuation practice is run from our main office in Memphis, Tennessee, and this time of year here means one thing: Death Week. Every year since his death on August 16, 1977, the city of Memphis spends a week memorializing Elvis Presley, the King of Rock and Roll. If you have never been, Death Week is basically seven to ten days of activities in which the Presley faithful arrive from every continent to pay their respects and enjoy what has to be some of the hottest, most humid weather anywhere on the globe.From all the press lately, you would expect that a similar wake was being held for active management, and with it, much of the RIA community. Elvis is dead, and so too must be active management. We live in the age of auto-tune and robo-advisors, a time when big vocal chords and beating the market have become anachronisms – or are they?Academics have been testifying as to the shortcomings of active management for decades, and by the time I was studying for the CFA exams (back in the '90s, as a colleague is quick to remind me), what was then known as AIMR (a midlife identity crisis between its founding as ICFA and what is now known as CFAI) had joined in to "educate" us on the relative virtue of passive investing. Today, ETFs and indexing are common, and in the wealth management community, have done much to streamline asset allocation. For asset management, though, the rise of indexing is the number one threat to the lifeblood of the RIA community: fees.The RIA business model is, after all, pretty simple; AUM times fee schedule equals revenue, revenue minus labor costs and other more mundane expenses equals margin, and sustainability of margin drives value. If active management fees are threatened, it will ultimately threaten to disinflate valuations in the asset management community.There is cause for concern. A study performed by the Investment Company Institute (or "ICI") and Lipper showed average mutual fund expenses and fees declining 30% (!) over the past fifteen years, from about 99bps to 70bps in equity funds (read the study at www.icifactbook.org). Bond funds fared only slightly better, dropping 25% from an average 76bps to 57bps over the same period. The trend-line is basically unbroken with not inconsequential declines over the past three to five years.
The decline in fees has been stealthy, as active managers haven't been cutting fees so much as missing out on new assets to manage. During this same timeframe, AUM in equity index funds has increased almost six fold, from $384 billion in 2000 to $2.1 trillion last year. Actively managed funds have reduced fees somewhat: with expense ratios dropping from 106 basis points in 2000 to 86 last year. Some of this can be attributed to the growth in size (and the corresponding efficiencies) created by larger actively managed equity funds, but the competitive threat from equity index funds (with average fees of 11 basis points), has to have kept more than one young manager contemplating a buy-in to his or her RIA up at night.
Anecdotally, our valuation practice at Mercer Capital seems to serve an RIA community that is unaffected by all of this. We routinely ask clients if they are facing fee pressure and/or are contemplating revising fee schedules downward, and we are routinely told "no."
Institutional clients are reasonably savvy about negotiating fees, but they always have been. High net worth clients just "want to win", and are willing to pay for the opportunity to do so. Who's to say they're wrong? Many commentators have written that active management is more challenging today than ever precisely because of the professionalization of the investment management industry (when everyone is skilled and educated, no one has an advantage). But passive investing could ultimately generate its own demise, as the rise of robo-group-think in the market constrains liquidity in many securities, and creates the kinds of price inefficiencies that favor active management. Passive investing may eventually just be a "style" that falls out of favor.
As the old saying goes in economics, in the long run we'll all be dead (or at least retired), so this is no time to be sanguine about fee schedules. Investors of all stripes have more options to put their money to work, investment costs are becoming more transparent than ever, and switching is becoming easier. As clients become more sophisticated, the RIA community will become more so as well, defending fees with unique strategies and service offerings, and defending margins with better use of technology and managed staffing costs. But that's a topic or two for another post.
Does Size Matter for RIAs?
Smaller asset managers outperformed their larger brethren over the last year. Still, it’s important to remember that our smallest sector of asset managers (AUM under $10 billion) is the least diversified and therefore most susceptible to company-specific events.
Its strength is more attributable to DHIL’s (~80% of the market-weighted index) outsized gain in market value rather than any indication of investor preference towards smaller RIAs.
For closely held RIAs, size appears to be more prevalent at least at a certain asset level. Managers with less than $100 million in AUM typically lack the profitability of a billion dollar plus RIA though exact breakeven points tend to vary with location and fee structure. The inherent operating leverage of the asset management business allows margins to expand with AUM as the incremental expenses associated with rising fees can be relatively minimal. Higher AUM balances can also serve as a cushion against future losses from client attrition and may lead to higher valuations though pricing also comes down to growth prospects, which can be more of a challenge for the larger managers.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry
Portfolio Valuation: How to Value Venture Capital Portfolio Investments
The following outlines our process when providing periodic fair value marks for venture capital fund investments in pre-public companies.Examine the most recent financing round economicsThe transaction underlying the initiation of an investment position can provide three critical pieces of information from a valuation perspective:Size of the aggregate investment and per share price.Rights and protections accorded to the newest round of securities.Usually, but not always, an indication of the underlying enterprise value from the investor’s perspective.
Deal terms commonly reported in the press (example) focus on the size of the aggregate investment and per share price. The term "valuation" is usually a headline-shorthand for implied post-money value that assumes all equity securities in the company’s capital structure have identical rights and protections. While elegant, this approach glosses over the fact that for pre-public companies, securities with differing rights and protections should and do command different prices.
The option pricing method (OPM) is an alternative that explicitly models the rights of each equity class and makes generalized assumptions about the future trajectory of the company to deduce values for the various securities. Valuation specialists can also use the probability-weighted expected return method (PWERM) to evaluate potential proceeds from, and the likelihood of, several exit scenarios for a company. Total proceeds from each scenario would then be allocated to the various classes of equity based on their relative rights. The use of PWERM is particularly viable if there is sufficient visibility into the future exit prospects for the company.
The economics of the most recent financing round helps calibrate inputs used in both the OPM and PWERM.Under the OPM, a backsolve procedure provides indications of total equity and enterprise value based on the pricing and terms the most recent financing round. The indicated enterprise value and a set of future cash flow projections, taken together, imply a rate of return (discount rate) that may be reasonable for the company. Multiples implied by the indicated enterprise value, juxtaposed with information from publicly traded companies or related transactions, can yield valuation-useful inferences.Under the PWERM, in addition to informing discount rates and providing comparisons with market multiples, the most recent financing round can inform the relative likelihood of the various exit scenarios.
When available, indications of enterprise value from the investor’s perspectives can further inform the inputs used in the various valuation methods.
In addition to the quantitative inputs enumerated above, discussions and documentation around the recent financing round can provide critical qualitative information, as well.Adjust valuation inputs to measurement dateBetween a funding round and subsequent measurement dates, the performance of the company and changes in market conditions can provide context for any adjustments that may be warranted for the valuation inputs. Deterioration in actual financial projections may warrant revisiting the set of projected cash flows, while improvements in market multiples for similar companies may suggest better pricing may be available for the company at exit. Interest from potential acquirers (or withdrawal of prior interest) and general IPO trends can inform inputs related to the relative likelihood of the various exit scenarios.Measure fair valueMeasuring fair value of the subject security entails using the OPM and PWERM, as appropriate and viable, in conjunction with valuation inputs that are relevant at the measurement date. ASC 820 defines fair value as, "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."Reconciliation and tests of reasonablenessA sanity check to scrutinize fair value outputs is an important element of the measurement process. Specifically as it relates to venture capital investments in pre-public companies, such a check would reconcile a fair value indication at the current measurement date with a mark from the prior period in light of both changes in the subject company, and changes in market conditions.Mercer Capital assists a range of alternative investment funds, including venture capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors. Call us – we would like to work with you to define appropriate fund valuation policies and procedures, and provide independent opinions of value.
Why Banks Are Interested in RIAs
As noted in Mercer Capital’s presentation to the 2014 Acquire or Be Acquired conference sponsored by Bank Director entitled Acquisitions of Non-Depositories by Banks, the relatively high margins associated with asset management is one of the many reasons that banks and other finance companies have been so interested in RIAs over the last few years.[caption id="attachment_8888" align="aligncenter" width="500"] Source: SNL Financial[/caption]
Other often-cited rationales for bank acquisitions of asset managers include:
Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow AUMHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesPotential for cross-selling opportunities with bank’s existing trust customers
Although deal terms are rarely disclosed, the table below depicts some recent examples of this trend with pricing metrics where available.
While multiples for activity metrics (AUM and revenue) can be erratic and tend to vary with profitability, EBITDA multiples are often observed in the 10x-15x range for public RIAs with their private counterparts typically priced at a modest discount depending on risk considerations, such as customer concentrations and personnel dependencies. Powered by a fairly steady market tailwind over the last few years, many asset managers and trust companies have more than doubled in value since the financial crisis and may finally be posturing towards some kind of exit opportunity to take advantage of this growth.
Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry
Statutory Fair Value
Statutory “fair value” is the standard of value for valuation in the dissenters’ rights and shareholder oppression statutes of the majority of states. Disagreements over the applicability (or not) of certain valuation premiums or discounts provide the source of significant differences of opinion between counsel for dissenting shareholders and, unfortunately, between business appraisers. However, in this whitepaper on statutory fair value, we hope to outline sufficient valuation and finance theory so we can begin to examine cases, i.e., judicial interpretations of what fair value means. With the proper background, we will be able to understand and to interpret what the courts have said in the context of valuation theory.This e-book consists of a series of posts originally published on the blog Valuation Speak between February 2011 and January 2012.
Mercer Capital’s Value Matters® 2015-04
Fairness Opinions in Down Markets
Mercer Capital’s Value Matters® 2015-03
New York’s Largest Corporate Dissolution Case | AriZona Iced Tea Tea’d Up for Appellate Review, But It Won’t Happen Owners
Mercer Capital’s Value Matters® 2015-02
25 Questions for Business Owners
Mercer Capital’s Value-Matters® 2015-01
Managing Private Company Wealth is a Big Deal
Mercer Capital’s Value Matters® 2014-03
Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective
Mercer Capital’s Value Matters® 2014-02
Richmond v. Commissioner
Mercer Capital’s Value Matters® 2014-01
Koons v. Commissioner
Community Bank Stress Testing
For a hypothetical example to accompany this article, please see "Community Bank Stress Testing: A Hypothetical Example."While community banks may be insulated from certain more onerous stress testing and capital expectations placed upon larger financial institutions, recent regulatory guidance suggests that community banks should be developing and implementing some form of stress testing and/or scenario analyses. The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.”1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.”3The hallmark of community banking has historically been the diversity across institutions and the guidance from the OCC suggests that community banks should keep this in mind when adopting appropriate stress testing methods by taking into account each bank’s attributes, including the unique business strategy, size, products, sophistication, and overall risk profile. While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the Bank’s complexity and portfolio risk. However, the guidance does note that stress testing can be applied at various levels of the organization including:Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.”4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.Further, stress tests can be applied in “reverse” whereby a specific adverse outcome is assumed that is sufficient to breach the bank’s capital ratios (often referred to as a “break the bank” scenario). Management then considers what types of events could lead to such outcomes. Once identified, management can then consider how likely those conditions are and what contingency plans or additional steps should be made to mitigate this risk.Regardless of the stress testing method, determining the appropriate stress event to consider is an important element of the process. Little guidance was provided although the OCC’s guidance did note that the scenarios should include a base case and a more adverse scenario based on macro and local economic data. Examples of adverse economic scenarios that might be considered include a severe recession, downturn in the local economy, loss of a major client, or economic weakness across a particular industry for which the bank has a concentration issue.The simplest method described in the OCC guidance as a starting point for stress testing was the “top-down” portfolio level stress test. The “Hypothetical Stress Testing Example” that follows provides an illustrative example of a portfolio level stress test based largely on the guidance and the example provided from the OCC.What Should We Do with the Stress Test Results?The answer to this question will likely depend on the bank’s specific situation. For example, let’s assume that your bank is relatively strong in terms of capital, asset quality, and recent earnings performance and has taken a proactive approach to stress testing. A well-reasoned and documented stress test could serve to provide regulators, directors, and management with the knowledge to consider the bank’s capital levels more than adequate and develop and approve the deployment of that excess capital through a shareholder buyback plan, elevated dividend, capital raise, merger, or strategic acquisition. Alternatively, let’s consider the situation of a distressed bank, which is in a relatively weaker position and facing heightened regulatory scrutiny in the form of elevated capital requirements. In this case, the stress test may be more reactive as regulators and directors are requesting a more robust stress test be performed. In this case, the results may provide key insight that leads to developing an action plan around filling the capital shortfall (if one is determined) or demonstrating to regulators and directors that the distressed bank’s existing capital is adequate. The results of the stress test should enhance the bank’s decision-making process and be incorporated into other areas of the bank’s management of risk, asset/liability strategies, capital and strategic planning.How Mercer Capital Can HelpHaving successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience to solve complex financial issues impacting community banks. Mercer Capital can help scale and improve your bank’s stress testing by assisting your bank in a variety of ways, ranging from providing advice and support for assumptions within your Bank’s pre-existing stress test to developing a unique, custom stress test that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank. Regardless of the approach, the desired outcome is a stress test that can be utilized by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. Feel free to call Mercer Capital to discuss your bank’s unique situation in confidence.Endnotes1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html. 2Ibid. 3“Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011. 4OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
Mercer Capital’s Value Matters® 2013-06
The Defining Elements of a Valuation Engagement: They Are More Important Than You Think
Mercer Capital’s Value Matters® 2013-05
8 More Mistakes to Avoid in Valuations According to Tax Court Decisions
Mercer Capital’s Value Matters® 2013-04
16 Mistakes to Avoid in Valuations According to Tax Court Decisions
Mercer Capital’s Value Matters® 2013-03
Your Business Will Change Hands: Important Valuation Concepts to Understand
The Ins and Outs of Business Development Companies
With more than 35 public registrants reporting nearly $40 billion of assets under management, business development companies, or BDCs, are increasingly important financial intermediaries, matching a wide variety of businesses needing capital with yield-hungry investors eager to provide it.Compared to private equity funds, BDCs have historically garnered less media and investor awareness, although the persistent low yield environment has helped to raise the profile of BDCs. Like private equity funds, BDCs invest in a portfolio of generally illiquid securities of privately held companies. Unlike private equity funds, which are structured as finite-lived investment partnerships, BDCs are publicly traded vehicles accessible to retail investors, providing permanent capital for investment. As long as certain distribution requirements are met, BDCs are not subject to income tax. Like any other publicly traded company, a BDC must file quarterly and annual reports with the SEC. These reports provide a window into the trends and economic factors influencing the broader universe of investors providing debt and equity capital to middle market companies.The purpose of this whitepaper is to review the principal financial statement components of BDCs with a view to clarifying the factors that are most likely to influence financial performance.
Mercer Capital’s Value Matters® 2013-02
The Management Interview: Why It’s an Important Piece of the Valuation Process and What You Should Expect
Mercer Capital’s Value Matters® 2013-01
The Level of Value: Why Estate Planners Need to Understand This Critical Valuation Element of a Buy-Sell Agreement
Understand the Value of a Start-Up Company
Valuation for start-up enterprises can be a tricky proposition. Regardless of industry, start-ups generally share a common set of operational characteristics and valuation needs that are distinct from mature firms. Because both the subject enterprise and valuation purpose are misfits within the context of typical valuation work, typical valuation practices are generally not applicable for start-up companies.In recent years, valuation issues have become increasingly important due to changing IRS and accounting rules, as well as increasing regulatory and shareholder scrutiny, which together compound potential troubles for start-up companies.In the past, industry specific start-up “rules of thumb” may have been sufficient to serve as reasonable basis for any valuation concern. While the simplicity of such rules can be appealing, the scrutiny of the IRS, SEC, and your auditors in combination with the potential liability associated with misreporting make it critical that value be determined and articulated in a credible fashion. In this article, we will discuss common circumstances that give rise to the need for a valuation, basic valuation concepts, and specific valuation considerations relevant to a start-up company.
Fair Market Value vs. The Real World
The world of fair market value is not the real world. It is a special world in which the participants are expected (defined) to act in specific and predictable ways.
Fairness Opinions
A fairness opinion provides an independent objective analysis of the financial aspects of a proposed transaction from the point of view of one or more of the parties to the transaction.They are often used to protect the interests of company directors, stockholders, investors and involved parties with any kind of fiduciary responsibility. While fairness opinions can not only help avoid disagreements among the individual stakeholders or between stakeholders and the Board, a fairness opinion is often necessary for a Board to have fulfilled their fiduciary duties.Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate a critical transaction, providing timely, accurate and reliable results. We have significant experience advising boards of directors, management, trustees, and other fiduciaries of middle-market public and private companies in a wide range of industries. Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction, and we are well-versed in the new industry standards regarding fairness opinions issued by FINRA in late 2007.A variety of factors in transactions involving both public and private companies can trigger the necessity for a fairness opinion, including:Merger or sale of the companySale of subsidiary businesses, or distinct lines of businessRecapitalizationsStock repurchase programsSqueeze-out transactionsSpinoffs, spinouts, or split-upsCertain ESOP-related transactionsOther significant corporate events
When performing a fairness opinion, it is also important to take into account any number of alternatives that may exist to the proposed transaction. As a valuation services firm, Mercer Capital is particularly well-equipped to provide the analysis for a deal in which a consideration other than cash if offered – namely, when the consideration is an interest in a closely held company.
Mercer Capital's comprehensive valuation and transaction experience with public and private capital companies empowers us to efficiently provide unbiased fairness opinions that can rely on to assure stakeholders that the decisions being made are fair and reasonable.
Contact a Mercer Capital professional to discuss your needs in confidence.
Out of the File Cabinet: The Ideal Time to Review Your Buy-Sell Agreement
Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.The Ideal Time to Review Your Buy-Sell AgreementThe time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.Things to Look for When Reviewing Your Buy-Sell AgreementAs you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.Fixed Price Agreements Are Typically Never UpdatedFixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.Formula Agreements Often Outgrow Their FormulaFormula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?Valuation Process Agreements Are Often the Most WorkableBuy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.We suggest a Single Appraiser - Select Now, Value Now process. For more information on this valuation process, see this article.Six Things That Should Be Clear in Any Valuation Process AgreementRegardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.Standard of value. The standard of value is the identification of the type of value to be used in a specific valuation engagement. The proper identification of the standard of value is the cornerstone of every valuation. Will value be based on “fair market value” or “fair value” or some other standard? The parties to the agreement should select that standard of value. If they do not, the appraisers will have to select it and the parties may not like their choices.Level of value. Will the value be based on a pro rata share of the value of the business or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process and to the shareholders of any business who are parties to its buy-sell agreement. If knowledgeable choices are not made by the parties to the agreement, someone else, i.e., the appraiser(s), will make it for them. The problem is that many agreements are written such that they are subject to differing interpretations regarding the appropriate level of value.The “as of” date. Every appraisal is grounded at a point in time. That time, referred to as the “as of date” or “valuation date”, provides the perspective, whether current or historical, from which appraisals are prepared. Unfortunately, some buy-sell agreements are not clear about the valuation date which should be used by appraisers. Because value changes over time, it is essential that the “as of” date be specified.Qualifications of the appraiser(s). If the parties do not decide on the kind of appraiser(s) they want to help for their buy-sell agreements, then, unfortunately, almost anyone can be named by either party to the agreement. Do you want a college professor who has never done an appraisal as the appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? How about a shareholder’s brother who has an MBA but has never valued a business before? The picture is clear. Buy-sell agreements must specify the qualifications of appraisers who may be called when trigger events happen.Appraisal standards to be followed. It is in the interest of all parties to ensure that selected appraiser(s) follow accepted business valuation standards. Some buy-sell agreements do this by naming the specific business appraisal standards that must be followed by the selected appraiser(s). Business appraisal standards provide minimum standards (criteria) to be followed by business appraisers in conducting and reporting their appraisals.Funding mechanisms. The funding mechanism is thought of separately from valuation yet is an important aspect of any buy-sell agreement. Why? Because life insurance is often purchased on the lives of one or more owners of companies having buy-sell agreements. Does the agreement tell the appraisers how the parties want the proceeds to be treated in their valuations? Appraisers will develop potentially widely divergent valuation conclusions depending on whether the life insurance is a funding vehicle (and not considered in reaching a value conclusion) or a corporate asset (and added to value prior to determining price for the agreement).A Tool to Help in Reviewing Your Buy-Sell AgreementBuy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.
Mercer Capital’s Value Matters® 2010-04
The Time to Gift is Now
Mercer Capital’s Value Matters® 2010-05
Managing Complicated Multi-Tiered Entity Valuation Engagements
Mercer Capital’s Value Matters® 2010-03
The 1042 Rollover: Resurrected Interest in Tax Benefits for Selling Shareholders in ESOP Transactions
Mercer Capital’s Value Matters® 2010-02
Legislation Update: Grantor Retained Annuity Trusts
Mercer Capital’s Value Matters® 2010-01
Opportunities Amid Uncertainty?
Mercer Capital’s Value Matters® 2009-10
Judicial Opinions Regarding Fractional Interests in Real Estate
Mercer Capital’s Value Matters® 2009-09
The Six Defining Elements of a Process Buy-Sell Agreement
Mercer Capital’s Value Matters® 2009-08
What is the Fair Market Value of Your Promissory Note?
Mercer Capital’s Value Matters® 2009-07
Interest Rate Swaps and Fair Value
Mercer Capital’s Value Matters® 2009-06
Business Value During & After the Recession
Mercer Capital’s Value Matters® 2009-05
For Banks in 2008, a Recession Gloomed
Mercer Capital’s Value Matters® 2009-04
Selecting a Business Appraiser
Mercer Capital’s Value Matters® 2009-03
How ESOPs Work
Mercer Capital’s Value Matters® 2009-02
S Corporation Banks Beware
Mercer Capital’s Value Matters® 2009-01
Recession, Market Meltdown Put Focus on Goodwill Impairment
Mercer Capital’s Value Matters® 2008-12
Consider the Alternate Valuation Date
Mercer Capital’s Value Matters® 2008-11
Grantor Retained Annuity Trusts: A Perfect Storm
Mercer Capital’s Value Matters® 2008-10
IRS Provides New Tax Incentives for Banks in Change of Control Transactions
Mercer Capital’s Value Matters® 2008-09
Fairness Opinions: Q&A from an ESOP Perspective
Mercer Capital’s Value Matters® 2008-08
Sub-Chapter S Conversions for Banks
Mercer Capital’s Value Matters® 2008-07
Valuation Best Practices: Hedge Fund Investment Portfolios
Mercer Capital’s Value Matters® 2008-06
Court Demands NAV Reduced by 100% of BIG Tax Liability
Mercer Capital’s Value Matters® 2008-05
Treatment of Life Insurance Proceeds in Buy-Sell Agreement Valuation
Mercer Capital’s Value Matters® 2008-04
Customary and Not-So-Customary Services in the Litigation Arena
Mercer Capital’s Value Matters® 2008-03
FINRA Rule 2290 Aims to Increase Transparency of Fairness Opinions
Mercer Capital’s Value Matters® 2008-02
An Overview of SFAS 141R
Mercer Capital’s Value Matters® 2008-01
2007: A Year to Forget for Banks
Mercer Capital’s Value Matters® 2007-12
Good Things Come to Those Who Don’t Wait
Mercer Capital’s Value Matters® 2007-11
Reasonable Valuation of Illiquid Mortgage-Backed Securities
Mercer Capital’s Value Matters® 2007-10
A Guide to Reviewing Purchase Price Allocations
Mercer Capital’s Value Matters 2007-09
Valuing Trust Companies Requires Special Attention
Mercer Capital’s Value Matters® 2007-08
Empirical Evidence Confirming the Importance of a Transaction Advisor
Mercer Capital’s Value Matters® 2007-07
Recent Cases Highlight Problem Areas in Buy-Sell Agreements
Mercer Capital’s Value Matters® 2007-06
Palm, Inc. – Leveraged Recapitalizations and Business Value
Mercer Capital’s Value Matters® 2007-05
Often Overlooked Yet Important Items in Process Buy-Sell Agreements
Mercer Capital’s Value Matters® 2007-04
A Review of Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?
Mercer Capital’s Value Matters® 2007-03
The Clock is Ticking for Section 409a Compliance
Mercer Capital’s Value Matters® 2007-02
ESOARS to Offer Market Pricing of Employee Stock Options?
Mercer Capital’s Value Matters® 2007-01
Buy-Sell Agreements: Two and a Tie-Breaker
Mercer Capital’s Value Matters® 2006-12
Multiple Appraiser Process Buy-Sell Agreements
Mercer Capital’s Value Matters® 2006-11
Life Insurance Proceeds in Valuation for Buy-Sell Agreements
Mercer Capital’s Value Matters® 2006-10
A New Approach to Fair Value: Welcome to FAS 157
Mercer Capital’s Value Matters® 2006-09
Not All Classes of Equity Were Created Equal
Mercer Capital’s Value Matters® 2006-08
IRS Code Section 409A and Valuation
Mercer Capital’s Value Matters® 2006-07
The Estate of Charlotte Dean Temple
Mercer Capital’s Value Matters® 2006-06
8 Things You Need to Know About Section 409A
Mercer Capital’s Value Matters® 2006-05
USPAP Sanctions Use of QMDM?
Mercer Capital’s Value Matters® 2006-04
Mercer Capital is Now an ESOP Company
Mercer Capital’s Value Matters® 2006-03
Rate & Flow: An Overview of an Alternative Approach to Determining Active/Passive Appreciation in Marital Dissolutions
Mercer Capital’s Value Matters® 2006-02
Watch Out For IRC Section 409A
Mercer Capital’s Value Matters® 2006-01
Private Initial Offerings
Mercer Capital’s Value Matters® 2005-12
Second Fairness Opinions
Mercer Capital’s Value Matters® 2005-11
An Overview of Personal Goodwill
Mercer Capital’s Value Matters® 2005-10
Valuing Employee Stock Options: A Guide for Choosing Either Lattice or Black Scholes
Mercer Capital’s Value Matters® 2005-09
Sprint Nextel and Nextel Partners: What is Fair Market Value?
Mercer Capital’s Value Matters® 2005-08
Your Corporate Buy-Sell Agreement: Ticking Time Bomb or Reasonable Resolution?
Mercer Capital’s Value Matters® 2005-07
Embedded Capital Gains, One More Time: Estate of Jelke v. Commissioner
Mercer Capital’s Value Matters® 2005-06
Corporate Value Engineering: Is Your Business Ready for Sale?™
Mercer Capital’s Value Matters® 2005-05
What We DO Is More Important Than What We SAY
Mercer Capital’s Value Matters® 2005-04
Announcing a New Blog – ‘Mercer on Value
Mercer Capital’s Value Matters® 2005-03
What’s Fair is Fair?
Mercer Capital’s Value Matters® 2005-02
When is Fair Market Value Determined? Estate of Helen M. Noble v. Commissioner
Mercer Capital’s Value Matters® 2005-01
Proposed USPAP Revisions Highlight the Factors of the Quantitative Marketability Discount Model
A Layperson’s Guide to the Option Pricing Model
The option pricing model is often used to value ownership interests in early-stage companies.